Cost 1

© The Institute of Chartered Accountants of India
ii
This Study Material has been prepared by the faculty of the Board of Studies
(Academic). The objective of the Study Material is to provide teaching material to the
students to enable them to obtain
4. knowledge in the subject. In case students need
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Basic draft of this publication was prepared by CA. Vandana D Nagpal
Edition : April, 2023
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BEFORE WE BEGIN….
In contemporary business environment, existence of an entity depends on the

way it faces the challenges posed by the competitive market conditions and deals
with the same. Cost leadership being one of the competitive strategies, gives an
added advantage to the entity. Cost being an important aspect for survival and
growth in business, requires a mandatory awareness about the cost control and
cost reduction methods. Fourth industrial revolution, also known as Industry 4.0,
lays more emphasis on the digitization of information for effective decision-
making, which enables an entity in keeping ahead in competition. Cost and
Management accounting, a discipline of accounting, enables an entity in taking
timely decisions by provisions of cost, profitability and other relevant information.
Chartered Accountants, as a global business solution provider, play an important
role in business, have an onus by helping an entity to achieve its long-term
objectives. In this direction, Cost and Management Accounting helps Chartered
Accountants in taking timely and informed business decisions. In view of nobility
of the objective to provide quality academic inputs to the students of CA course,
the Board of Studies (BoS) of ICAI has decided to bring forth Study Material of
Cost and Management Accounting. This Study Material contains all relevant and
contemporary topics like Digital Costing, Government e-Marketplace (GeM)
Process of tender and quotation, Direct Expenses, Various Short-term decisions,
Budgets and motivation, Feedback and Feedforward controlling in budgeting as
detailed out in the syllabus.
Under the Revised Scheme of Education and Training, at the Intermediate Level,
students are expected not only to acquire professional knowledge but also to
develop the ability to apply the knowledge in real life business situations. The
process of learning should also help the students in imbibing professional skills,
i.e., the intellectual skills and communication skills, necessary for achieving the
desired professional competence.
The entire syllabus has been divided into fifteen chapters. The chapters have been
grouped into two modules:
Module-1 Consisting of seven chapters namely:
Chapter-1: Introduction to Cost and Management Accounting
Chapter-2: Material Cost

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Chapter-3: Employee Cost and Direct Expenses

Chapter-4: Overheads-Absorption Costing Method
4.
Chapter-5: Activity Based Costing
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Chapter-6: Cost Sheet
Chapter-7: Cost Accounting Systems
Module-2 Consisting of eight chapters namely:
Chapter-8: Unit & Batch Costing

Chapter-9: Job Costing
Chapter-10: Process & Operation Costing
Chapter-11: Joint Products & By Products
Chapter-12: Service Costing
Chapter-13: Standard Costing
Chapter-14: Marginal Costing
Chapter-15: Budget and Budgetary Control
The content for each chapter at the Intermediate level has been structured in the
following manner –
1. Comprehensive Learning Outcomes: Learning outcomes which you need to
demonstrate after learning each topic have been detailed in the first page of each
chapter. Demonstration of these learning outcomes would help you to achieve
the desired level of technical competence.
2. Chapter Overview: As the name suggests, this chart/table would give a
broad framework of the contents covered in the chapter.
3. Introduction: A brief introduction is given at the beginning of each chapter,
which would help you get a feel of the topic.
4. Content: In each chapter, the topics have been covered following ‘step by
step’ approach. The concepts are explained in student-friendly manner with the
aid of Examples/illustrations/diagrams/flow charts/Pictorials as per requirement.
These value additions would help you develop conceptual clarity and to get a
good and quick grasp of the topic. Diagrams, Pictorials and Flow charts would
help you understand the concepts in a better manner. Illustrations would help
you understand the application of concepts/ provisions. More illustrations/

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Practical questions in Test Your Knowledge section have been added to enable a
thorough practice of variety of questions. The flow of content in chapter have
been reviewed and changed to make it more student friendly.
5. Illustration with Answers: Illustrations and examples has been included in
the Study Material systematically, after discussion on each topic, so that
application of the concept can be understood very clearly. This would also enable
you to learn and sharpen your application skills and test your understanding.
6. Multiple Choice Questions (MCQ): In the New Scheme of education and
training, assessment for 30 marks in each paper at the intermediate and final level
would be by way of case scenario based MCQs. Questions in this segment would
comprise of a case scenario followed by a few MCQs based on the case scenario.
All case scenario based MCQs would be application oriented. There would be 4
options in each MCQ, out of which the student has to choose the correct
option. In the subject of Cost and Management Accounting, a student has to
apply the Cost and Management Accounting concepts learnt in solving the MCQs
based on the case scenario. In order to hone the application and analytical skills
of students, independent MCQs have been included in every chapter of this Study
Material. Solving these MCQs will enhance your conceptual clarity and sharpen
your analytical skills.
7. Summary: A summary of the chapter is given at the end to help you revise
what you have learnt. It would especially help you to revise the chapter(s) quickly
the day before the examination.
8. Test Your Knowledge: This comprises of Multiple-Choice Questions (MCQs),
Theoretical Questions and Practical Problems with solutions which test the
breadth and depth of your understanding of the topic.
9. Skill Specification Assessment: An indicative skill specification Assessment
Grid has been incorporated in the study material for better understanding of the
students. An effort has been made to arrange the questions/illustrations/exercise
accordingly.
In this Study Material, formats of Financial Statements (i.e. Balance Sheet, Income
Statements etc) and financial terms used are for illustrative purpose only. For
appropriate format and applicability of various Standards, students are advised to
refer the study material of appropriate subject (s).

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Further the solutions/answers contained in the study material are based on

certain assumptions and other logical alternative assumption/ approach/
presentation may be possible. 4.
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We have made every effort to make the Study Material student-friendly and to
enable the students to have conceptual clarity on various topics of this subject.
Every effort has been made to remove typing errors (if any)/ clerical errors (if
any)/ missing content (if any)/ formatting errors (if any), or any other error, so as
to make Study Material error free, however if inadvertently any error is present
and found by readers, they may send it to us immediately, so that it can be
rectified at our end.
In case you need any further clarification/ guidance, you may send your queries
through ICAI BoS App.

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SKILL SPECIFICATION ASSESSMENT GRID

Skill Level Manner of Assessment Illustrative verbs used
of Skills to construct learning
outcomes
Level-I: Understanding or List – Preparing a list of

grasping ability (Defining,
Knowledge and State – Mentioning clearly
stating, enlisting,
Comprehension or fully the details of.
identifying, and
explaining concepts / Define – Explaining the
provisions / theories / exact meaning of.
principles relating to the
Describe – Giving detailed
relevant subject area.)
narration of something or
key features.
Distinguish – Mentioning or
highlighting the difference
between.
Explain – Making the

meaning of.
Identify – Recognizing
something.
Illustrate – Explaining
something with the help of
an example.
and similar verbs
Combination of verbs:
Comprehend and Explain;
Identify and explain and
similar verbs.

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Level-II: Applying and analyzing Application:

the concepts learned
Application and 4. Apply – Putting theoretical
during the grasping level.
Analysis viii knowledge for practical
(Application: Applying purpose.
concepts / provisions /
Calculate – Arriving at some
theories / principles in value by following
problem solving in non- numerical/ analytical
complex scenarios.) procedures.
Compute - Arriving at some

value by following
numerical/ analytical
procedures.
Determine- Ascertain or
establish exactly by
calculation or workings.
Find/ Find out- Ascertain or

establish exactly by
calculation or workings.
Demonstrate – Proving
something with certainty
using practical means.
Prepare – Making
something ready for any
use.
Reconcile – Making or
proving consistency/
compatibility.
Solve – Find an answer or

solution to something
Tabulate – Exhibiting the

required information in a
tabular form.

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Compare and contrast and
similar verbs.
(Analysis: Applying, Analysis:

comparing and analysing
Analyze - Examining
concepts / provisions /
something in detail.
theories / principles in
problem solving in Categorize - Arranging
moderately complex something in a predefined
scenarios.) group or class or division.
Compare - Examining the

differences or similarities
between.
Construct - Building or
compiling.
Discuss - Writing about or

examining in detail.
Interpret - Translating in
intelligible or familiar or
understandable terms.
Analyse and apply and

similar verbs.

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SYLLABUS
4.
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PAPER – 4: COST AND MANAGEMENT ACCOUNTING

(One Paper- Three hours- 100 Marks)
Objectives:
(a) To develop an understanding of the basic concepts and applications to
establish the cost associated with the production of products and provision
of services and apply the same to determine prices.
(b) To develop an understanding of cost accounting statements.
(c) To acquire the ability to apply information for cost ascertainment, planning,
control and decision making.
(d) To apply costing methods to determine the costs for different purposes.
(e) To apply appropriate techniques to support short term decisions.
Contents:
1. Overview of Cost and Management Accounting
(i) Introduction to Cost and Management Accounting
(a) Objectives and Scope of Cost and Management Accounting,
(b) The users of Cost and Management accounting information,
Functions of management accounting.
(c) Role of cost accounting department in an organisation and its
relation with other departments.
(d) Installation of Costing System

(e) Relationship of Cost Accounting, Financial Accounting,
Management Accounting and Financial Management.
(f) Cost terms and Concepts

(g) Cost Reduction and Cost Control

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(h) Elements of Costs
(i) Cost behavior pattern, Separating the components of fixed,
variable, semi-variable and step costs.
(j) Methods of Costing, Techniques of Costing.
(k) Digital Costing.
(ii) Elements of Cost and Preparation of Cost Sheets
(a) Functional classification and ascertainment of cost
(b) Preparation of Cost Sheets for Manufacturing sector and for
Service sector
2. Ascertainment of Cost and Cost Accounting System
(i) Material Cost
(a) Introduction to procurement procedures. Valuation of receipts,
issue and closing stock of Material, Stock verification.
(b) Material requirement analysis through digital costing including
Government e-Marketplace (GeM). Introduction to Costing
through Enterprise Resource Planning (ERP). Process of tender
and quotation.
(c) Inventory control-
- Techniques of fixing level of stocks- minimum, maximum,
re-order point, safety stock, determination of optimum stock
level,
- Determination of Optimum Order quantity- Economic Order
Quantity (EOQ),
- Techniques of Inventory control- ABC Analysis, Fast, Slow
moving and Non moving (FSN), High, Medium, Low (HML),
Vital, Essential, Desirable (VED), Just-in-Time (JIT)- Stock
taking and perpetual inventory system, use of inventory
control ratios, Digital Inventory control
(d) Treatment of Normal/Abnormal Losses w.r.t. waste, scrap,
spoilage, defective, obsolescence.

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(ii) Employee Cost

(a) Introduction to Attendance and Payroll procedures
4.
(b) Elements of wages- Basic pay, Dearness Allowance, Overtime,
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Bonus, Holiday and leave wages, Allowances and perquisites.
(c) Employee Cost Control
(d) Employee Turnover- Methods of calculating employee turnover,
causes of employee turnover, effects of employee turnover.
(e) Remuneration systems and incentive schemes- Premium Bonus
Method (Halsey Plan and Rowan Plan)
(iii) Direct Expenses

Identification of direct expenses with the main product or service and
its treatment.
(iv) Overheads
(a) Functional analysis- Factory, Administration, Selling, Distribution,
Research and Development.
(b) Behavioral analysis- Fixed, Variable and Semi- Variable.
(c) Allocation and Apportionment of overheads using Absorption
Costing Method.
(d) Factory Overheads- Primary and secondary distribution,
(e) Administration Overheads- Method of allocation to cost centres
or products,
(f) Selling & Distribution Overheads- Analysis and absorption of the
expenses in products/ customers, impact of marketing
strategies, cost effectiveness of various methods of sales
promotion.
(g) Treatment of Research and development cost in cost accounting.
(v) Concepts of Activity Based Costing (ABC)
(vi) Integration of cost and financial data

(a) Recording of financial data and its segregation.
(b) Introduction to Non- integrated and Integrated Accounting
system.

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(c) Items included in cost accounts only but financial accounts and
vice versa.
(d) Reconciliation of profit as per Cost and Financial Accounts
(under Non-Integrated Accounting System).
3. Methods of Costing
(i) Single Output/ Unit Costing
(ii) Job Costing: Job cost cards and databases, collecting direct costs of
each job, attributing overheads to jobs, Application of job costing.
(iii) Batch Costing: Determination of optimum batch quantity,
Ascertainment of cost for a batch, Preparation of batch cost sheet,
Treatment of spoiled and defective work.
(iv) Process/ Operation Costing
(a) Process cost recording, Process loss, Abnormal gains and losses,
Equivalent units of production, Inter-process profit, Valuation of
work in process.
(b) Joint Products- Apportionment of joint costs, Methods of
apportioning joint cost over joint products,
(c) By-Products- Methods of apportioning joint costs over by-
products, treatment of By-product cost.
(v) Costing of Service Sectors
Determination of Costs and Prices of services.
4. Cost Control and Analysis
(i) Standard Costing
(a) Setting up of Standards, Types of Standards, Standard Costing as
method of performance measurement.
(b) Calculation and Reconciliation of Material Cost, Labour cost,
Variable Overhead, Fixed Overhead
(ii) Marginal Costing
(a) Basic concepts of marginal costing, Contribution margin, Break-
even analysis, Break –even and profit volume charts,
Contribution to sales ratio, Margin of Safety, Angle of Incidence,
Cost-Volume-Profit Analysis (CVP),

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(b) Determination of Cost of a product/ service under marginal

costing method, determination of cost of finished goods, work-
in-progress, 4.
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(c) Comparison of Marginal costing with absorption costing
method- Reconciliation of profit under both the methods,
(d) Short term decision making -
• Make or buy decision
• Discontinuation decision
• Multiproduct break-even analysis
• Limiting factor (key factor)
(iii) Budget and Budgetary Control
(a) Meaning of Budget, Essentials of Budget, Budget Manual,
Budget setting process, Preparation of Budget and monitoring
procedures.
(b) The use of budget in planning and control
(c) Flexible budget, Preparation of Functional budget for operating
and non- operating functions, Cash budget, Master budget,
(d) Introduction to Principal/ Key budget factor, Zero Based

Budgeting (ZBB), Performance budget, Control ratios and Budget
variances.
(e) Budgets and motivation
(f) Feedback and Feedforward controlling in budgeting.

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

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DETAILED CONTENTS: MODULE-1

4.
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CHAPTER-1 : INTRODUCTION TO COST AND MANAGEMENT

ACCOUNTING .............................................................................1.1-1.46
Learning Outcomes .............................................................................................................................. 1.1

Chapter Overview.................................................................................................................................. 1.2
1. Introduction ............................................................................................................................ 1.2

1.1 Meaning and Definition ...................................................................................... . 1.2
2. Objectives of Cost Accounting ........................................................................................ 1.4
2.1 Difference between Cost Control and Cost Reduction ............................ .1.6
3. Scope of Cost Accounting .................................................................................. 1.7
4. Relationship of Cost and Management Accounting with
other related disciplines ...................................................................................................... 1.8
4.1 Cost Accounting with Management Accounting ........................................ 1.8
4.2 Cost Accounting with Financial Accounting ................................................. 1.9
4.3 Cost and Management Accounting with Financial Management ......1.10
5. Role & Functions of Cost and Management Accounting ................................... 1.11
6. Users of Cost and Management Accounting ...........................................................1.12
7. Essentials of a Good Cost Accounting System..........................................................1.14

8. Installation of Costing System .......................................................................................1.15
9. Cost Accounting with the use of Information Technology (IT) .........................1.17
9.1 Digital Costing System ........................................................................................1.18

10. Cost Objects ..........................................................................................................................1.19
10.1 Cost Units .................................................................................................................1.20
10.2 Cost Driver ...............................................................................................................1.21
11. Responsibility Centres .......................................................................................................1.22

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12. Limitations of Cost Accounting .....................................................................................1.23
13. Classification of Costs .......................................................................................................1.24
13.1 By Nature or Element ..........................................................................................1.24
13.2 By Functions ............................................................................................................1.26
13.3 By Variability or Behaviour ................................................................................1.27
13.3.1 Methods of segregating Semi-variable Costs into Fixed
and Variable Costs .................................................................................1.29
13.4 By Controllability ...................................................................................................1.33
13.5 By Normality ...........................................................................................................1.33
13.6 By Costs used in Managerial Decision Making ..........................................1.34
14. Methods of Costing ...........................................................................................................1.36
15. Techniques of Costing ......................................................................................................1.38
Summary ................................................................................................................................................1.40
Test Your Knowledge .......................................................................................................................1.43
Multiple Choice Questions (MCQs) .............................................................................................1.43
Theoretical Questions ......................................................................................................................1.45

Answers to the MCQs ........................................................................................................................1.46
Answers to the Theoretical Questions .......................................................................................1.46
CHAPTER-2 : MATERIAL COST .......................................................................2.1-2.96

Chapter Overview ................................................................................................................................ 2.2
1. Introduction ............................................................................................................................ 2.2
2. Material Control .................................................................................................................... 2.3

2.1 Objectives of System of Material Control ..................................................... 2.4
2.2 Requirements of Material Control ................................................................... 2.4
2.3 Elements of Material Control ............................................................................. 2.5

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3. Materials Procurement Procedure .................................................................................. 2.6

3.1 Bill of Materials ....................................................................................................... 2.7
4.
3.2 Material Requisition
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Difference between Bill of Materials and Material

Requisition Note .................................................................................................... 2.8
3.3 Purchase Requisition ............................................................................................ 2.8
3.4 Inviting Quotation/Request for Proposal (RFP)/ Notification
Inviting Tender (NIT) .............................................................................................. 2.9
3.5 Selection of Quotation / Proposal .................................................................2.11
3.6 Preparation and Execution of Purchase Orders .......................................2.11
3.7 Receipt and Inspection of Materials ..............................................................2.12
3.7.1 Goods Received Note ........................................................................2.12
3.7.2 Material Returned Note .................................................................... 2.12
3.8 Checking and Passing of Bills for Payment .............................................. 2.13
4. Valuation of Material Receipts .......................................................................................2.13
5. Material Storage & Records ..................................................................................... …. 2.18

5.1 Duties of Store Keeper ........................................................................................2.18
5.2 Store Records ........................................................................................................2.19
5.3 Difference between Bin Card & Stores Ledger .......................................2.21
6. Inventory Control ......................................................................................................... ……2.21
6.1 Inventory Control- By Setting Quantitative Levels ................................ 2.22
6.2 Inventory Stock-Out........................................................................................... 2.31
6.3 Just In Time (JIT) Inventory Management .................................................. 2.35
6.4 Inventory Control- On the basis of Relative Classification ....................2.35
1. ABC Analysis ...........................................................................................2.35

2. Fast Moving, Slow Moving and Non-
Moving (FSN) Inventory .......................................................................2.40
3. Vital, Essential and Desirable (VED).................................................2.41

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4. High Cost, Medium Cost, Low Cost (HML) Inventory ...............2.42
6.5 Using Ratio Analysis ............................................................................................2.42
6.6 Physical Control .....................................................................................................2.45
7. Material Issue Procedure ...................................................................................................2.47
8. Valuation of Material Issues .............................................................................................2.49
8.1 Cost Price Methods .............................................................................................2.50
1. Specific Price Method ...........................................................................2.50
2. First-in First-out (FIFO) Method ........................................................2.50
3. Last-in First-out (LIFO) Method ........................................................2.52
4. Base Stock Method................................................................................2.59
8.2 Average Price Methods .....................................................................................2.59
1. Simple Average Price Method...........................................................2.59
2. Weighted Average Price Method.....................................................2.60
8.3 Market Price Methods .........................................................................................2.61
1. Replacement Price Method ................................................................2.61
2. Inflataed Price Method.........................................................................2.61

8.4 Notional Price Methods ......................................................................................2.62
1. Standard Price Method ........................................................................2.62
2. Inflated Price Method ...........................................................................2.62
3. Re-use Price Method ............................................................................2.62
9. Valuation of Returns & Shortages .................................................................................2.63
9.1 Valuation of Materials Returned to the Vendor ........................................2.63
9.2 Valuation of Materials Returned to Stores ..................................................2.63
9.3 Valuation of Shortages during Physical Verification................................2.63
10. Treatment of Normal and Abnormal Loss of Materials ........................................2.64

Difference between Waste and Scrap ..........................................................................2.66
Difference between Scrap and Defectives ..................................................................2.67

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11. Consumption of Materials ................................................................................................2.70

11.1 Identification of Materials ..................................................................................2.70
4.
11.2 Monitoring Consumption
xx of Materials .........................................................2.71
11.3 Basis for Consumption Entries in Financial Accounts ..............................2.72
Summary ................................................................................................................................................2.73
Practical Problems .............................................................................................................................2.79
Answers to the Practical Problems ..............................................................................................2.84
CHAPTER-3 : EMPLOYEE COST AND DIRECT EXPENSES ..............................3.1-3.66

1. Introduction ............................................................................................................................ 3.2
2. Employee (Labour Cost) ..................................................................................................... 3.3
Distinction between Direct and Indirect Employee Cost ........................................ 3.3
3. Employee (Labour) Cost Control .................................................................................... 3.4
3.1 Important Factors for the Control of Employee Cost .............................. 3.5
3.2 Collection of Employee Costs .......................................................................... 3.6
4. Attendance & Payroll Procedures.................................................................................... 3.6
4.1 Attendance Procedure / Time-keeping .......................................................... 3.6

4.2 Time-Booking ........................................................................................................... 3.9
4.3 Payroll Procedure ..................................................................................................3.11
5. Idle Time .................................................................................................................................3.13

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6. Overtime ................................................................................................................................ 3.17
7. Labour Utilisation ................................................................................................................3.26
7.1 Identification of Utilisation of labours with Cost Centres .....................3.26
7.2 Identification of labour hours with work order or batches or
capital job.................................................................................................................3.26
8. Systems of Wage Payment and Incentives ..............................................................3.27
8.1 Time Based (Time Rate System) .....................................................................3.27
8.2 Output Based (Piece Rate System) ................................................................3.28
8.3 Premium Bonus Method ....................................................................................3.28
1. Halsey Premium Plan ...........................................................................3.28
2. Rowan Premium Plan ..........................................................................3.29
9. Absorption of Wages ........................................................................................................3.38
9.1 Elements of Wages ...............................................................................................3.38
9.2 Component of Wages Cost or Wages for Costing Purposes ...............3.39
9.3 Holiday and Leave Wages..................................................................................3.41
9.4 Night Shift Allowance ..........................................................................................3.42

9.5 Absorption Rates of Employee Cost ..............................................................3.42
10. Efficiency Rating Procedures ..........................................................................................3.43
10.1 Need for Efficiency Rating .................................................................................3.43
11. Employee (Labour) Turnover ......................................................................................... 3.45
11.1 Employee (Labour) Turnover .......................................................................... 3.45
11.2 Causes of Employee (Labour) Turnover...................................................... 3.48
11.3 Effects of Employee (Labour) Turnover....................................................... 3.50
12. Direct Expenses .................................................................................................................. 3.52
12.1 Direct Expenses ................................................................................................... 3.52

12.2 Measurement of Direct Expenses ................................................................ 3.53

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12.3 Treatment of Direct Expenses ....................................................................... 3.53

Summary ................................................................................................................................................3.54
4.
Test Your Knowledge .......................................................................................................................
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Practical Problems ..............................................................................................................................3.60
Answers to the Theoretical Questions ........................................................................................3.61
CHAPTER-4 : OVERHEADS-ABSORPTION COSTING METHOD ....................4.1-4.98

Chapter Overview ................................................................................................................................ 4.2
1. Introduction ............................................................................................................................ 4.2
2. Classification of Overheads ............................................................................................... 4.3
2.1 Advantages of Classification of Overheads into Fixed and Variable .. 4.6
3. Accounting and Control of Manufacturing Overheads ......................................... 4.7
4. Steps for the Distribution of Overheads ................................................................... 4.11
4.1 Estimation and Collection of Overheads ................................................... 4.11
4.2 Allocation of Overheads over Various Departments or
Departmentalisation of Overheads ............................................................. 4.12
4.3 Apportioning Overhead Expenses Over Various Departments ........ 4.13
Difference between Allocation and Apportionment ........................... 4.16
4.4 Re-apportionment of Service Department Overheads over

Production Departments ................................................................................. 4.16
4.5 Absorbing Overheads over Cost Units, Products, etc. ......................... 4.27

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5. Methods of Absorbing Overheads to various Products or Jobs ......................4.29
5.1 Percentage of Direct Material Cost ..............................................................4.30
5.2 Percentage of Prime Cost Method ................................................................4.30
5.3 Percentage of Direct Labour Cost .................................................................4.32
5.4 Labour Hour Rate Method ...............................................................................4.32
5.5 Machine Hour Rate Method ............................................................................4.33
5.6 Rate Per Unit of Output Method ...................................................................4.35
6. Types of Overhead Rates ................................................................................................ 4.36
7. Treatment of Under-Absorbed and Over-Absorbed Overheads in Cost
Accounting ............................................................................................................................4.41
8. Accounting and Control of Administrative Overheads .......................................4.46
8.1 Accounting of Administrative Overheads ...................................................4.47
8.2 Control of Administrative Overheads ...........................................................4.48
9. Accounting and Control of Selling and Distribution Overheads .......................4.53
9.1 Accounting of Selling and Distribution Overheads ................................4.53
9.2 Control of Selling and Distribution Overheads ........................................4.55

10. Concepts related to Capacity. .........................................................................................4.58
11. Treatment of Certain Items in Costing ......................................................................4.59
Summary ................................................................................................................................................4.63

Answers to the Practical Problems ...............................................................................................4.78

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CHAPTER-5 : ACTIVITY BASED COSTING ......................................................5.1-5.57
Learning Outcomes ..............................................................................................................................

4. 5.1
xxiv
1. Introduction.............................................................................................................................. 5.2
1.1 Factors prompting the development of ABC .............................................. 5.2
1.2 Usefulness/Suitability of ABC ............................................................................ 5.3
2. Meaning and Definition ..................................................................................................... 5.3
3. Meaning of terms used in ABC ......................................................................................... 5.4

4. Cost Allocation under ABC ................................................................................................. 5.5
5. Traditional Absorption Costing vs ABC ......................................................................... 5.6
Difference between Activity Based Costing and Traditional Absorption
Costing ....................................................................................................................................... 5.7
6. Level of Activities under ABC Methodology/ Cost Hierarchy................................ 5.8
7. Stages in Activity Based Costing (ABC) ......................................................................... 5.9
8. Advantages of Activity Based Costing ........................................................................5.17
9. Limitations of Activity Based Costing ......................................................................... 5.18
10. Requirements in ABC Implementation....................................................................... 5.18
11. Practical Applications of Activity Based Costing ....................................................5.19
11.1 As a Decision-Making Tool ..............................................................................5.19
11.2 As Activity Based Management ......................................................................5.19
11.3 Facilitate Activity Based Budgeting ...............................................................5.21
Summary ...............................................................................................................................................5.30


xxv
xxv v
CHAPTER-6 : COST SHEET ..............................................................................6.1-6.33

1. Introduction ............................................................................................................................ 6.1
2. Functional Classification of Elements of Cost ............................................................ 6.2
3. Cost Heads in a Cost Sheet ................................................................................................ 6.2

3.1 Prime Cost.................................................................................................................. 6.3
3.2 Cost of Production.................................................................................................. 6.4
3.3 Cost of Goods Sold ............................................................................................... 6.6
3.4 Cost of Sales ............................................................................................................ 6.6
4. Cost Sheet/Statement ......................................................................................................... 6.8
4.1 Presentation of Cost Information .................................................................... 6.8
4.2 Treatment of various items of Cost in Cost Sheet/Statement .............. 6.9
4.3 Advantages of Cost Sheet or Cost Statements ........................................6.10
Summary ................................................................................................................................................6.19
Test Your Knowledge .........................................................................................................................6.20
Multiple Choice Questions (MCQs) ..............................................................................................6.20
Theoretical Questions........................................................................................................................6.22


xxvi
CHAPTER 7- COST ACCOUNTING SYSTEMS ..................................................7.1-7.61
Learning Outcomes ..............................................................................................................................

4. 7.1
xxvi
1. Introduction ............................................................................................................................ 7.2
2. Non-Integrated Accounting System .............................................................................. 7.2
2.1 Principal Accounts ................................................................................................. 7.3
2.2 Scheme of Accounting Entries .......................................................................... 7.5
3. Integrated (or Integral) Accounting System .............................................................7.19

3.1 Advantages .............................................................................................................7.20
3.2 Essential pre-requisites for Integrated Accounts .....................................7.20
3.3 Features of Integrated Accounting System ................................................7.21
4. Reconciliation of Cost and Financial Accounts .........................................................7.31
4.1 Causes of differences in Financial and Cost Accounts ...........................7.31
4.2 Procedure forReconciliation..............................................................................7.33
Summary ...............................................................................................................................................7.43
Test Your Knowledge .........................................................................................................................7.43
Multiple Choice Questions (MCQs) ..............................................................................................7.43
Theoretical Questions........................................................................................................................7.45

CHAPTER
1
INTRODUCTION TO
COST AND
MANAGEMENT
ACCOUNTING
LEARNING OUTCOMES
After studying this chapter, you would be able to-
♦ State the meaning, objective and importance of Cost and
Management Accounting.
♦ Discuss the functions and role of Cost Accounting Department in an
organization.
♦ Discuss the installation of a Cost Accounting System in an
organization.
♦ Differentiate between Cost Accounting, Financial Accounting and
Management Accounting.
♦ List the various elements and classifications of cost.
♦ Explain the methods of segregating semi-variable costs into fixed and
variable cost.
♦ Discuss the concept of cost reduction and cost control.
♦ Discuss the methods and techniques of costing.
♦ A brief discussion on Digital Costing System.

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

(i) Cost- Cost is the amount of resource given up in exchange of some goods
or services. It can be expressed as a noun as well as a verb. As a noun, it

INTRODUCTION TO COST AND MANAGEMENT 1.3
1.3
ACCOUNTING
can be defined as the amount of expenditure (actual or notional) incurred
on or attributable to a specified article, product or activity.
As a verb, it can be as an action to ascertain the cost of a specified thing or
activity.
(ii) Costing- Costing is defined as “the technique and process of ascertaining
costs”.
According to CIMA “an organisation’s costing system is the foundation of

the internal financial information system for managers. It provides the
information that management needs to plan and control the organisation’s
activities and to make decisions about the future.”
(iii) Cost Accounting- Cost Accounting is defined as "the process of
accounting for cost which begins with the recording of income and
expenditure or the bases on which they are calculated and ends with the
preparation of periodical statements and reports for ascertaining and con-
trolling costs."
(iv) Cost Accountancy- Cost Accountancy has been defined as “the
application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the
ascertainment of profitability. It includes the presentation of information
derived there from for the purpose of managerial decision making.”
(v) Management Accounting- As per CIMA Official Terminology “Management
Accounting is the application of the principles of accounting and
financial management to create, protect, preserve and increase value for
the stakeholders of for-profit and not-for-profit enterprises in the public
and private sectors.”
Management Accounting is an integral part of management function. It
assists management by provision of relevant information for planning,
organising, controlling, decision making etc.
(vi) Cost Management- It is an application of management accounting
concepts, methods of collections, analysis and presentation of data to
provide the information needed to plan, monitor and control costs.

2. OBJECTIVES OF COST ACCOUNTING
Objectives of Cost Accounting
Determination Assisting
Ascertainment of Cost
of Selling Price Cost Control Management in
Cost Reduction
and Profitability Decision Making
Determination of pre-determined standard
Measurement of actual performance
Comparison
Analysis of variance and action
The main objectives of Cost and Management Accounting are explained as below:
(i) Ascertainment of Cost: The main objective of Cost Accounting is
accumulation and ascertainment of cost. Costs are accumulated, assigned
and ascertained for each cost object. This cost object may be a unit, job,
operation, process, department or service.
(ii) Determination of Selling Price and Profitability: The Cost Accounting
System helps in determination of selling price and thus profitability of a cost
object. Though in a competitive business environment selling prices are
determined by external factors but cost accounting system provides a basis
for price fixation and rate negotiation.
(iii) Cost Control: Maintaining discipline in expenditure is one of the main
objectives of a good cost accounting system. It ensures that expenditures
are in consonance with predetermined set standard and any variation
from these set standards is noted and reported on continuous basis. To
exercise control over cost, following steps are followed:
(a) Determination of pre-determined standard or results: Standard cost or
performance targets for a cost object or a cost centre are set before

1.5
ACCOUNTING
initiation of production or service activity. These are desired cost or result
that need to be achieved.
(b) Measurement of actual performance: Actual cost or result of the cost
object or cost centre is measured. Performance should be measured in
the same manner in which the targets are set i.e., if the targets are set up
operation-wise, and then the actual costs should also be collected and
measured operation-wise to have a common basis for comparison.
(c) Comparison of actual performance with set standard or target: The actual
performance so measured is compared against the set standard and
desired target. Any deviation (variance) between the two is noted and
reported to the appropriate person or authority.
(d) Analysis of variance and action: The variance in results so noted is further
analysed to know the reasons for variance and appropriate action is
taken to ensure compliance in future. If necessary, the standards are
further amended to take developments into account.
(iv) Cost Reduction: It may be defined "as the achievement of real and
permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or
diminution in the quality of the product."
Cost Reduction is an approach of management where cost of an object is
believed to have a scope of further reduction. No cost is termed as lowest
and every possibility of cost reduction is explored. To do cost reduction, the
following action is taken:
(a) Each activity within an entity is segmented to analyse and identify value
added and non- value added activities. All non-value added activities are
eliminated without affecting the essential characteristics of the product
or process. Value Chain Analysis, a strategic tool, developed by Michael
Porter, is one of the method to do value analysis.
(b) Conducting continuous research and study to know the most optimal
way to manufacture a product or render a service.
The three-fold assumptions involved in the definition of cost reduction may
be summarised as under:
(a) There is a saving in unit cost.

(b) Such saving is of permanent nature.

(c) The utility and quality of the goods and services remain unaffected, if not
improved.
(v) Assisting Management in Decision Making: Cost and Management
Accounting by providing relevant information, assist management in
planning, implementing, measuring, controlling and evaluating of various
activities. A robust cost and management accounting system provides
internal and external information to the industry which will be relevant for
decision making.
2.1 Difference between Cost Control and Cost Reduction

Cost Control Cost Reduction
1. Cost control aims at maintaining 1. Cost reduction is concerned with

the costs in accordance with the reducing costs. It challenges all standards
established standards. and endeavours to improvise them
continuously
2. Cost control seeks to attain 2. Cost reduction recognises no condition as

lowest possible cost under permanent, since a change will result in
existing conditions. lower cost.
3. In case of cost control, emphasis 3. In case of cost reduction, it is on present

is on past and present and future.
4. Cost control is a preventive 4. Cost reduction is a corrective function. It

function operates even when an efficient cost
control system exists.
5. Cost control ends when targets 5. Cost reduction has no visible end and is a
are achieved. continuous process.

1.7
ACCOUNTING
3. SCOPE OF COST ACCOUNTING

Costing
Cost Accounting
Cost Analysis
Scope of
Cost Cost Comparisons
Accounting
Cost Control
Cost Reports
Statutory Compliances
Scope of Cost Accounting consists of the following functions:

(i) Costing: Costing is the technique and process of ascertaining costs of
products or services. The cost ascertainment procedure is governed by
some cost accounting principles and rules. Generally, cost is ascertained
using historical costs, standard costs, process cost, operation cost etc.
(ii) Cost Accounting: This is a process of accounting for cost which begins
with the recording of expenditure and ends with the preparation of
periodical statement and reports for ascertaining and controlling cost. Cost
Accounting is a formal mechanism of cost ascertainment.
(iii) Cost Analysis: It involves the process of finding out the factors
responsible for variance in actual costs from the budgeted costs and
accordingly fixation of responsibility for cost differences. This also helps in
taking better cost management and strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost
involved in alternative courses of action such as use of different
technology for production, cost of making different products and activities,
and cost of same product/ service over a period of time.
(v) Cost Control: It involves a detailed examination of each cost in the light
of advantage received from the incurrence of the cost. Thus, we can state

that cost is analyzed to know whether cost is not exceeding its budgeted cost
and whether further cost reduction is possible or not.
(vi) Cost Reports: This is the ultimate function of cost accounting. These
reports are primarily prepared for use by the management at different
levels. Cost Reports helps in planning and control, performance appraisal and
managerial decision making.
(vii) Statutory Compliances: Maintaining cost accounting records as per the

rules prescribed by the statute to maintain cost records relating to
utilization of materials, labour and other items of cost as applicable to the
production of goods or provision of services as provided in the Act and
these rules.
4. RELATIONSHIP OF COST AND

MANAGEMENT ACCOUNTING WITH OTHER
RELATED DISCIPLINES
Cost and Management Accounting as a discipline is interrelated and dependent
on other disciplines of accounting.
4.1 Cost Accounting with Management Accounting

As we have already studied that though Cost Accounting and Management
Accounting is used synonymously but there are a few differences. Management
Accounting is an open-ended discipline which enables managers to take informed
decisions. Management Accounting takes inputs from cost accounts, financial
accounts, statistical and operation management tools etc.
Difference between Cost Accounting and Management Accounting
Basis Cost Accounting Management Accounting

(i) Nature It records the quantitative It records both qualitative and
aspect only. quantitative aspect.
(ii) Objective It records the cost of It provides information to
producing a product and management for planning
providing a service. and co-ordination.

1.9
ACCOUNTING
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past and It is focused with the
data present figures. projection of figures for
future.
(v) Development Its development is related Its development is related to

to industrial revolution. the need of modern business
world.
(vi) Rules and It follows certain It does not follow any specific
Regulation principles and procedures rules and regulations.
for recording costs of
different products.
4.2 Cost Accounting with Financial Accounting

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

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

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

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

information accounting statements are information is generally

shareholders, creditors, used by internal

financial analysts and management. But
government and its agencies, sometimes regulatory
etc. authorities also.
(v) Analysis of It shows profit or loss of the It provides the cost details
cost and organization either segment for each cost object i.e.
profit wise or as a whole. product, process, job,
operation, contracts etc.
(vi) Time period Financial Statements are Reports and statements are
prepared usually for a year. prepared as and when
required.
(vii) Presentation A set format is used for In general, no set formats for
of presenting financial presenting cost information
information information. is followed.
4.3 Cost and Management Accounting with Financial

Management
Cost and Management Accounting is an application of Financial Management
for decision making purposes.
The relationship among Cost Accounting, Management Accounting, Financial
Accounting and Financial Management can be understood with the help of the
following diagram.
Financial Management
Accounting Accounting
Cost
Accounting
Financial Management

1.11
ACCOUNTING
5. ROLE & FUNCTIONS OF COST AND

MANAGEMENT ACCOUNTING
The role of a cost and management accounting system is to:
• Provide relevant information to management for decision making,

• Assist management for planning, measurement, evaluation and controlling of
business activities,
• Help in allocation of cost to products and inventories for both external and
internal users.
Though the term Cost Accounting and Management Accounting is used by
various authors synonymously but in actual practice, Cost Accounting is
concerned with accumulation and allocation of costs to different cost
objects, whereas, Management Accounting concerned with provision of
information to internal users for decision making.
The functions of Cost and Management Accounting include:
(i) Collection and accumulation of cost for each element of cost.
(ii) Assigning costs to cost objects to ascertain cost.
(iii) Cost and Management Accounting Department (whatever nomenclature
may be used to denote the department) sets budget and standards for a
particular period or activity beforehand and these are compared with the
assigned and ascertained cost. Any deviation with the set standards are
analysed and reported. All this exercise is done to control costs.
(iv) The main function of Cost and Management Accounting is provision of
relevant information to the management for decision making. An
Information system environment is set up which is popularly known as
Management Information System (MIS). The MIS provides relevant and
timely information related to both internal and external to the organisation
to enable management at all levels to take decisions. Decisions include cost
optimisation, price fixation, implementation of any plan related with
product, process, marketing etc.

(v) The performance of a responsibility centre is measured and evaluated

against the set standards. The function of Cost and Management
Accounting is to gather data like time taken, wastages, process idleness etc.,
analyse the data, prepare reports and take necessary actions.
6. USERS OF COST AND MANAGEMENT

ACCOUNTING
Cost and Management Accounting information which is generated or collected is
used by different stakeholders. The users of the information can be broadly
categorised into internal and external to the entity.
Internal users External users
Policy makers Regulatory Authorities
Managers Auditors
Operational level staffs Shareholders
Employees Creditors and Lenders
Internal Users
Internal users, who use the Cost and Management Accounting information may
include the followings:
(a) Policy Makers- The policy makers are those who formulate strategies
(i) to achieve the goals (short & long term both) to fulfil the objectives of
the organisation.
(ii) to position the organisation into the competitive market environment.
(iii) to design the organisational structure to get the policy and strategies
implemented. Etc.
(b) Managers- The managers use the information
(i) to know the cost of a cost object and cost centre
(ii) to know the price for the product or service

1.13
ACCOUNTING
(iii) to measure and evaluate performance of responsibility centres
(iv) to the know the profitability-product-wise, department-wise,
customer-wise etc.
(v) to evaluate the strategic options and to make decisions
(c) Operational level staff- The operational level staff like supervisors,
foreman, team leaders require information
(i) to know the objectives and performance goals for them
(ii) to know product and service specifications like volume, quality and
process etc.
(iii) to know the performance parameters against which their performance
is measured and evaluated.
(iv) to know divisional (responsibility centre) profitability etc.
(d) Employees- Employees are concerned with the information related with
time and attendance, incentives for work, performance standards etc.
External Users
External users, who use the Cost and Management Accounting information may
include the followings:
(a) Regulatory Authorities- Regulatory Authorities are concerned with cost
accounting data and information for different purpose which includes tariff
determination, providing subsidies, rate fixation etc. To do this the regulatory
bodies require information on the basis of some standards and format in
this regard.
(b) Auditors- The auditors while conducting audit of financial accounts or for
some other special purpose audit like cost audit etc. require information
related with costing and reports reviewed by management etc.
(c) Shareholders- Shareholders are concerned with information that effect
their investment in the entity. Management communicates to the
shareholders through periodic communique, annual reports etc. regarding
new orders received, product expansion, market share for products etc.

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

SYSTEM
Trust on Informative
the system and simple
Accurate
Flexible and
and
adaptive
authentic
Integrated Uniformity
and and
inclusive consistency
Essential features of a good Cost Accounting System
The essential features, which a good Cost Accounting System should possess, are
as follows:
(a) Informative and simple: Cost accounting system should be tailor-made,

practical, simple and capable of meeting the requirements of a business
concern. The system of costing should not sacrifice the utility by introducing
inaccurate and unnecessary details.

1.15
ACCOUNTING
(b) Accurate and authentic: The data to be used by the cost accounting
system should be accurate and authenticated; otherwise it may distort the
output of the system and a wrong decision may be taken.
(c) Uniformity and consistency: There should be uniformity and consistency
in classification, treatment and reporting of cost data and related
information. This is required for benchmarking and comparability of the
results of the system for both horizontal and vertical analysis.
(d) Integrated and inclusive: The cost accounting system should be integrated
with other systems like financial accounting, taxation, statistics and
operational research etc. to have a complete overview and clarity in results.
(e) Flexible and adaptive: The cost accounting system should be flexible enough
to make necessary amendment and modifications in the system to incorporate
changes in technological, reporting, regulatory and other requirements.
(f) Trust on the system: Management should have trust on the system and its
output. For this, an active role of management is required for the
development of such a system that reflects a strong conviction in using
information for decision making.
8. INSTALLATION OF COSTING SYSTEM

As in the case of every other form of activity, it should be considered whether it
would be profitable to have a Cost Accounting System. Management of an
organisation needs complete and accurate information to make decisions. A well-
established costing system should provide all relevant information as and when
required by management as well as various stakeholders.
Before setting up a system of cost accounting the factors mentioned below should be
studied:
(a) Objective: The objective of setting up the costing system, for example
whether it is being introduced for fixing prices or for establishing a system
of cost control.
(b) Nature of Business or Industry: The industry in which the business is
operating. Every business or industry has its own uniqueness and objectives.
According to its cost information requirement, cost accounting methods are

followed. For example, an oil refinery maintains process wise cost accounts
to find out the cost incurred on a particular process, say in crude refinement
process etc.
(c) Organisational Hierarchy: Costing system should fulfil the information
requirements of different levels of management. Top management is
concerned with the corporate strategy, strategic level management is
concerned with marketing strategy, product diversification, product pricing
etc. Operational level management needs the information on standard
quantity to be consumed, report on idle time etc.
(d) Knowing the product: Nature of the product determines the type of
costing system to be implemented. The product which has by-products
requires costing system which accounts for by-products as well. In case of
perishable or short self- life products, marginal costing is appropriate to
know the contribution and minimum price at which products could be sold.
(e) Knowing the production process: A good costing system can never be
established without the complete knowledge of the production process.
Cost apportionment can be done on the most appropriate and scientific
basis if a cost accountant can identify degree of effort or resources
consumed in a particular process. This also includes some basic technical
know-how and process peculiarity.
(f) Information synchronisation: Establishment of a department or a system
requires substantial amount of organisational resources. While drafting a
costing system, information needs of various other departments should be
taken into account. For example, in a typical business organisation accounts
department needs to submit monthly stock statement to its lender bank,
quantity wise stock details at the time of filing returns to tax authorities etc.
(g) Method of maintenance of cost records: The organization must
determine beforehand the manner in which Cost and Financial Accounts
could be inter-locked into a single integral accounting system and how the
results of separate sets of accounts i.e. cost and financial, could be
reconciled by means of control accounts.
(h) Statutory compliances and audit: Records are to be maintained to comply
with statutory requirements and applicable cost accounting standards
should be followed.

1.17
ACCOUNTING
(i) Information Attributes: Information generated from the Costing system
should possess all the attributes of useful information i.e. it should be
complete, accurate, timely, relevant. to have an effective management
information system (MIS).
9. COST ACCOUNTING WITH THE USE OF

INFORMATION TECHNOLOGY (IT)
With the expansion of e-commerce and increasing competitive business
environment, information technology is becoming an integral part of each activity
in an organisation including Cost and Management Accounting. Information
technology has changed the Cost and Management Accounting functions
dramatically with the introduction of Enterprise Resource Planning (ERP)
system. Cost Accounting and Management Information System has become
automated and improved. The new industrial revolution in the form of digital
innovation which is popularly known as Industry 4.0, has more emphasis on
digitisation and automation of business process to have a better control over cost to
maintain market competitiveness. Cost Accounting System has seen lots of savings
in terms of time, money and efforts. The impact of IT in Cost Accounting may
include the following:
(i) After the introduction of ERPs, different functional activities get
integrated and as a consequence, a single entry into the accounting system
provides custom made reports for every purpose and saves an organisation
from preparing different sets of documents. Reconciliation process of
results of both cost and financial accounting systems becomes simpler and
less cumbersome.
(ii) A move towards paperless environment can be seen where documents like
Bill of Material, Material Requisition Note, Goods Received Note, labour
utilisation report etc. are no longer required to be prepared in multiple
copies, the related department can get e-copy from the system.
(iii) Information Technology with the help of internet (including intranet and
extranet) are helping in resource procurement and mobilisation. For
example, production department can get materials from the stores without
issuing material requisition note physically. Similarly, purchase orders can

be initiated to the suppliers with the help of extranet. This enables an entity
to shift towards Just-in-Time (JIT) approach of inventory management and
production.
(iv) Cost information for a cost centre or cost object is ascertained with accuracy
in timely manner. Each cost centre a cost object is codified and all related
costs are assigned to the cost objects or cost centres using assigned codes.
This automates the cost accumulation and ascertainment process. The cost
information can be customised as per the requirement. For example, when an
entity manufactures or provides services, managers are able to receive
information job-wise, batch-wise, process-wise, cost centre wise etc.
(v) Uniformity in preparation of report, budgets and standards can be achieved
with the help of IT. ERP software plays an important role in bringing
uniformity irrespective of location, currency, language and regulations.
(vi) Cost and revenue variance reports are generated in real time basis which
enables the management to take control measures immediately.
(vii) IT enables an entity to monitor and analyse each process of manufacturing
or service activity closely to eliminate non value-added activities.
The above are examples of few areas where Cost Accounting is done with the
help of IT.
9.1 Digital Costing System

Like the conventional cost accounting system, Digital costing system too collects
data, classify the data, account the data to get and process information to make
decisions, but the difference is the method of collection, medium of storage, forms
of analysis and reporting. Digital costing system links different business functions
such as production, procurement, inventory management with the digital costing
system of its suppliers, customers and the market through data sharing and
network interaction.
Digital Costing System provides data to get the following information:
(i) Cost incurred on a cost object.

(ii) Data on time spent.
(iii) Data on resource consumption.
(iv) Data on current market price of final product and raw materials.

1.19
ACCOUNTING
(v) Data on lead time and availability of materials.
(vi) Data on product demand and trend.
Benefits of Digital Costing System

With the help of Artificial Intelligence (AI) and Machine learnings (ML) which helps
in analysis of the Big data and apprehend the consumption and demand pattern,
the following benefits can be achieved:
(i) Ascertainment of cost with certainty on a cost object (the cost object is
discussed in later paragraph). This helps to analyse the activities for cost
allocation and apportionment.
(ii) Analysis of data on time spent on each activity to study and formulate
incentive plans.
(iii) Helps in material requirement planning and scheduling the material
procurement. Data on resource consumption can be analysed for resource
optimisation and finding the possibilities for zero wastage and Just-in Time
(JIT).
(iv) Helps to identify and eliminate the non-value-added activities.
(v) Data on resource consumption is helpful in setting the standards and

measurement of variances on real time basis.
(vi) Data on current market prices of material and consumables helps to
estimate cost and setting standards on Marked to Market (M2M) basis.
(vii) Extrapolation of data on customer behaviour towards the products to
predict the market demand. It is helpful is preparation of budgets and
planning of production.
(viii) A better analysis of cost behaviour improves the cost benefit analysis and
equipping the management in informed decision making.
10. COST OBJECTS

Cost object is anything for which a separate measurement of cost is required.
Cost object may be a product, a service, a project, a customer, a brand category,
an activity, a department or a programme etc.

Examples of cost objects are:
Product Smart phone, Tablet computer, SUV Car, Book etc.
Service An airline flight from Delhi to Mumbai, Concurrent audit

assignment, Utility bill payment facility etc.
Project Metro Rail project, Road projects etc.
Activity Quality inspection of materials, Placing of orders etc.
Process Refinement of crudes in oil refineries, melting of billets or ingots

in rolling mills etc.
Department Production department, Finance & Accounts, Safety etc.
Cost object remains in nucleus of cost classification and analysis of the cost
behaviour. Classification of a cost element as direct, indirect, fixed or variable, all
depends on cost object.
10.1 Cost Units

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

1.21
ACCOUNTING
Power Kilo-watt hour (kWh)
Steel Ton
Transport Passenger- kilometer
Gas Cubic feet
Some examples from the CIMA terminology are as follows:
Industry Sector Cost unit

Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Engineering Contract, job
Oil Barrel, tonne, litre
Hotel/Catering Room/meal
Professional services Chargeable hour, job, contract
Education Course, enrolled student, successful student
Hospitals Patient day
Activity Cost unit
Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material
movement, value issued/received
Personnel administration Personnel record
10.2 Cost Driver

A Cost driver is a factor or variable which effect level of cost. Generally, it is an
activity which is responsible for cost incurrence. Level of activity or volume of
production is the example of a cost driver. An activity may be an event, task, or
unit of work etc.

CIMA Official terminology defines cost driver as “Factor influencing the level of
cost” Often used in the context of Activity Based Costing to denote the factor which
links activity resource consumption to product outputs, for example the number of
purchase orders would be a cost driver for procurement cost.”
Examples of cost drivers are number of machine set ups, number of purchase
orders, hours spent on product inspection, number of tests performed etc.
11. RESPONSIBILITY CENTRES

As the organization grows, its functions, organisational structure and other related
functions also grow in terms of volume and complexity. To have a better control over
the organisation, management delegates its responsibility and authority to various
departments or persons. These departments or persons are known as responsibility
centres and are held responsible for performance in terms of expenditure, revenue,
profitability and return on investment. Performance of these responsibility centres
are measured against some set standards (input-output ratio, budgets etc.) and
evaluated against organisational goal and performance targets.
Types of Responsibility Centres
Revenue Investment
Cost Centres Profit Centres
Centres Centres
(i) Cost Centres: The responsibility centre which is held accountable for
incurrence of costs which are under its control. The performance of this
responsibility centre is measured against pre-determined standards or
budgets. The cost centres are of two types:
(a) Standard Cost Centre and (b) Discretionary Cost Centre
(a) Standard Cost Centre: Cost Centre where output is measurable and
input required for the output can be specified. Based on a well-established
study, an estimate of standard units of input to produce a unit of output
is set. The actual cost for inputs is compared with the standard cost. Any
deviation (variance) in cost is measured and analysed into controllable

1.23
ACCOUNTING
and uncontrollable cost. The manager of the cost centre is expected to
comply with the standard and held responsible for adverse cost
variances. The input-output ratio for a standard cost centre is clearly
identifiable.
(b) Discretionary Cost Centre: The cost centre whose output cannot be
measured in financial terms, thus input-output ratio cannot be defined.
The cost of input is compared with allocated budget for the activity.
Examples of discretionary cost centres are Research & Development
department, Advertisement department where output of these
department cannot be measured with certainty and co-related with cost
incurred on inputs.
(ii) Revenue Centres: The responsibility centres which are accountable for
generation of revenue for the entity. Sales Department for example, is
responsible for achievement of sales target and revenue generation.
Though, revenue centres do not have control on expenditures it incurs but
sometimes expenditures related with selling activities like commission to
sales person etc. are incurred by revenue centres.
(iii) Profit Centres: These are the responsibility centres which have both
responsibility of generation of revenue and incurrence of expenditures. Since,
managers of profit centres are accountable for both costs as well as
revenue, profitability is the basis for measurement of performance of these
responsibility centres. Examples of profit centres are decentralised branches
of an organisation.
(iv) Investment Centres: These are the responsibility centres which are not only
responsible for profitability but also have the authority to make capital
investment decisions. The performance of these responsibility centres are
measured on the basis of Return on Investment (ROI) besides profit.
Examples of investment centres are Maharatna, Navratna and Miniratna
companies of Public Sector Undertakings of Central Government.
12. LIMITATIONS OF COST ACCOUNTING

Like other branches of accounting, cost accounting also has certain limitations.
The limitations of cost accounting are as follows:

1. Expensive: It is expensive because analysis, allocation and absorption of

overheads requires considerable amount of additional work, and hence
additional money.
2. Requirement of reconciliation: The results shown by cost accounts differ
from those shown by financial accounts. Thus preparation of reconciliation
statements is necessary to verify their accuracy.
3. Duplication of work: It involves duplication of work as organization has to

maintain two sets of accounts i.e. Financial Accounts and Cost Accounts.
13. CLASSIFICATION OF COSTS

It means the grouping of costs according to their common characteristics. The
important ways of classification of costs are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making
13.1 By Nature or Element

Under this type of classification of cost, total cost of a cost object is classified on
the basis of element of cost i.e., material, labour, other expenses and overheads.
A diagram as given below shows the elements of cost described as under:

1.25
ACCOUNTING
ELEMENTS OF COST
Material Cost Employee (Labour) Cost Other Expenses
Direct Material Indirect Material Direct Direct Indirect

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

Overheads Overheads Distribution Overheads
(i) Material: Material cost means cost of raw material required to make a
product into finished goods. The materials can be directly attributable to a
cost object or allocable on some reasonable basis where direct attribution is
not possible. Materials which are present in the finished product (cost
object) or can be economically identified in the product are termed as direct
materials. For example, cloth in dress making; materials purchased for a
specific job etc. However, in some cases a material may be direct but it is
treated as indirect; because it is used in small quantities, it is not
economically feasible to identify that quantity. Those materials which are
used for purposes ancillary to the business are also treated as Indirect
Materials.

(ii) Labour: Wages paid to workers for converting the raw materials into
finished goods, is called labour cost/ labour which can be economically
identified or attributed wholly to a cost object is termed as direct labour. For
example, employee engaged on the actual production of the product or in
carrying out the necessary operations for converting the raw materials into
finished product.
(iii) Other Expenses: All expenses other than material or labour which are
incurred for a particular cost object are termed as other Expenses. For
example, hire charges for some special machinery, cost of defective work
etc.
(iv) Overheads: The aggregate of indirect material costs, indirect labour costs
and indirect expenses is termed as Overheads. The main groups into which
overheads may be subdivided are as follows:
• Production or Works Overheads: Indirect expenses which are
incurred in the factory and for the running of the factory. E.g.: rent,
power etc.
• Administration Overheads: Indirect expenses related to management
and administration of business. E.g.: office rent, lighting, telephone
etc.
• Selling Overheads: Indirect expenses incurred for marketing of a
commodity. E.g.: Advertisement expenses, commission to sales
persons etc.
• Distribution Overheads: Indirect expenses incurred for dispatch of
the goods E.g.: warehouse charges, packing(secondary) and loading
charges.
13.2 By Functions
Under this classification, costs are divided according to the function for which
they have been incurred. It includes the following:
(i) Production/ Manufacturing Cost
(ii) Administration Cost
(iii) Selling Cost

1.27
ACCOUNTING
(iv) Distribution Cost
(v) Research and Development cost etc.
The below chart shows the flow of costs in a cost sheet under functional
classification:
Direct Materials
Direct Employees Prime Cost

(Labours)
Direct Expenses
Factory Overheads
Indirect Material
Factory Cost or
Works Cost
Indirect Labour
Administration Overheads
Indirect Expenses Cost of Goods Sold
Selling and Distribution Overheads
Cost of Sales
13.3 By Variability or Behaviour

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

Fixed Cost
40000
35000
30000
25000
Cost (`)
20000
15000
Fixed Cost
10000
5000
0
0 100 200 300 400 500 600
Output (in units)
(b) Variable Costs– These costs tend to vary with the volume of activity. Any
increase in the activity results in an increase in the variable cost and vice-
versa. For example, cost of direct material, cost of direct labour, etc.
Variable Cost
60000
50000
40000
Cost (`)
30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)
(c) Semi-variable costs– These costs contain both fixed and variable
components and are thus partly affected by fluctuations in the level of
activity. Examples of semi variable costs are telephone bills, gas and
electricity etc. Such costs are depicted graphically as follows:

1.29
ACCOUNTING
13.3.1 Methods of segregating Semi-variable costs into fixed and
variable costs
Semi- Variable Cost

100000
80000
60000
Cost (`)
40000
20000
0
0 100 200 300 400 500 600
Output (in units)
The segregation of semi-variable costs into fixed and variable costs can be carried
out by using the following methods:
(a) Graphical method
(b) High-Low method

(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method
(a) Graphical Method: Under this method, the following steps are followed:
(i) A large number of observations regarding the total costs at different
levels of output are plotted on a graph.
(ii) The output is plotted on the X-axis and the total cost is plotted on the Y-
axis.
(iii) Then, by judgment, a line of “best-fit”, which passes through all or most
of the points, is drawn.
(iv) The point at which this line cuts the Y-axis indicates the total fixed cost
component in the total cost.
(v) If a line is drawn at this point parallel to the X-axis, this indicates the fixed
cost.

(vi) The variable cost, at any level of output, is derived by deducting this fixed
cost element from the total cost.
The following graph illustrates this:
Fixed Overheads Line
(b) High- Low Method: Under this method, difference between the total cost
at highest and lowest volume is divided by the difference between the sales
value at the highest and lowest volume. The quotient thus obtained gives us
the rate of variable cost in relation to sales value.
ILLUSTRATION 1: (Segregation of fixed cost and variable cost)
Sales value Total cost

(`) (`)
At the Highest volume 1,40,000 72,000
At the Lowest volume 80,000 60,000
60,000 12,000
Thus, Variable Cost (` 12,000/` 60,000)
= 1/5 or 20% of sales value = ` 28,000 (at highest volume)
Fixed Cost ` 72,000 – ` 28,000 i.e., (20% of ` 1,40,000) = ` 44,000.
Alternatively, ` 60,000 – ` 16,000 (20% of ` 80,000) = ` 44,000.
(c) Analytical Method: Under this method an experienced cost accountant
tries to judge empirically what proportion of the semi-variable cost would
be variable and what would be fixed. The degree of variability is ascertained

1.31
ACCOUNTING
for each item of semi-variable expenses. For example, some semi-variable
expenses may vary to the extent of 20% while others may vary to the extent
of 80%. Although it is very difficult to estimate the extent of variability of an
expense, the method is easy to apply. (Go through the following illustration
for clarity).
Suppose last month the total semi-variable expenses amounted to ` 3,000.
If the degree of variability is assumed to be 70%, then variable cost = 70%
of ` 3,000 = ` 2,100.
Fixed cost = ` 3,000 – ` 2,100 = ` 900.

Now in the future months, the fixed cost will remain constant, but the
variable cost will vary according to the change in production volume.
Thus, if in the next month production increases by 50%, the total semi-
variable expenses will be:
Fixed cost of ` 900, plus variable cost viz., ` 3,150 i.e., (` 2,100 (V.C.) plus
50% increase of V.C. i.e., ` 1,050) =, ` 4,050.
(d) Comparison by period or level of activity method: Under this method,
the variable overhead may be determined by comparing two levels of
output with the amount of expenses at those levels. Since the fixed element
does not change, the variable element may be ascertained with the help of
the following formula.
Change in the amount of expense
Change in the quantity of output
Suppose the following information is available:
Production Units Semi-variable expenses

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

The variable cost:

Change in Semi-variable expenses ` 40
= = ` 1/unit
Change in production volume 40 units
Thus, in January, the variable cost will be 100 × ` 1 = ` 100
The fixed cost element will be (` 260 – ` 100) or ` 160.

In February, the variable cost will be 140 × ` 1 = ` 140
whereas the fixed cost element will remain the same, i.e., ` 160.
(e) Least Square Method: This is the best method to segregate semi-variable
costs into its fixed and variable components. This is a statistical method and is
based on finding out a line of best fit for a number of observations.
The method uses the linear equation y = mx + c, where
‘m’ represents the variable element of cost per unit,
‘c’ represents the total fixed cost,
‘y’ represents the total cost,
‘x’ represents the volume of output.
The total cost is thus split into its fixed and variable elements by solving this
equation.
Level of activity
Capacity % 60% 80%
Volume (Labour hours) or ‘x’ 150 200
Semi-variable expenses (maintenance of plant) or ‘y’ ` 1,200 ` 1,275
Substituting the values of ‘x’ and ‘y’ in the equation, y = mx + c, at both the
levels of activity, we get
1,200 = 150 m + c
1,275 = 200 m + c
On solving the above equations, we get the value of ‘c’
Fixed cost or ‘c’ = ` 975 and Variable cost or ‘m’ = ` 1.50 per labour hour.

1.33
ACCOUNTING
13.4 By Controllability
Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profit
or investment centre manager is called controllable cost. Controllable costs
incurred in a particular responsibility centre can be influenced by the action
of the manager heading that responsibility centre. For example, direct costs
comprising direct labour, direct material, direct expenses and some of the
overheads are generally controllable by the shop floor supervisor or the
factory manager.
(b) Uncontrollable Costs - Costs which cannot be influenced by the action of a
specified member of an undertaking are known as uncontrollable costs. For
example, expenditure incurred by say, the tool room is controllable by the
foreman in-charge of that section but the share of the tool-room
expenditure which is apportioned to a machine shop is not controlled by
the machine shop foreman.
Distinction between Controllable Cost and Uncontrollable Cost: The
distinction between controllable and uncontrollable costs is not very prominent
and is sometimes left to individual judgement. In fact, no cost is uncontrollable; it
is only in relation to a particular individual that we may specify a particular cost to
be either controllable or uncontrollable.
13.5 By Normality
According to this basis, cost may be categorised as follows:
(a) Normal Cost - It is the cost which is normally incurred at a given level of
output under the conditions in which that level of output is normally
attained.
(b) Abnormal Cost - It is the cost which is not normally incurred at a given
level of output in the conditions in which that level of output is normally
attained. It is charged to Costing Profit and loss Account.

13.6 By Costs used in Managerial Decision Making

According to this basis, cost may be categorised as follows:
(a) Pre-determined Cost - A cost which is computed in advance before produc-

tion or operations start, on the basis of specification of all the factors
affecting cost, is known as a pre-determined cost.
(b) Standard Cost - A pre-determined cost, which is calculated from

managements ‘expected standard of efficient operation’ and the relevant
necessary expenditure. It may be used as a basis for price fixation and for
cost control through variance analysis.
(c) Marginal Cost - The amount at any given volume of output by which
aggregate costs increases if the volume of output is increased or decreased
by one unit.
(d) Estimated Cost - Kohler defines estimated cost as “the expected cost of
manufacture, or acquisition, often in terms of a unit of product computed
on the basis of information available in advance of actual production or
purchase”. Estimated costs are prospective costs since they refer to
prediction of costs.
(e) Differential Cost - (Incremental and decremental costs). It represents the
change (increase or decrease) in total cost (variable as well as fixed) due to
change in activity level, technology, process or method of production, etc.
For example, if any change is proposed in the existing level or in the
existing method of production, the increase or decrease in total cost or in
specific elements of cost as a result of this decision will be known as
incremental cost or decremental cost.
(f) Imputed Costs - These costs are notional costs which do not involve any
cash outlay. Interest on capital, the payment for which is not actually made,
is an example of imputed cost. These costs are similar to opportunity costs.
(g) Capitalized Costs -These are costs which are initially recorded as assets and
subsequently treated as expenses. Example, installation expenses on the
erection of a machine are added to the cost of a machine.

1.35
ACCOUNTING
(h) Product Costs - These are the costs which are associated with the purchase
and sale of goods (in the case of merchandise inventory). In the production
scenario, such costs are associated with the acquisition and conversion of
materials and all other manufacturing inputs into finished product for sale.
Hence, under marginal costing, variable manufacturing costs and under
absorption costing, total manufacturing costs (variable and fixed) constitute
inventoriable or product costs.
(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefit
of opportunity foregone in accepting an alternative course of action. For
example, a firm financing its expansion plan by withdrawing money from its
bank deposits. In such a case the loss of interest on the bank deposit is the
opportunity cost for carrying out the expansion plan.
(j) Out-of-pocket Cost - It is that portion of total cost, which involves cash
outflow. This cost concept is a short-run concept and is used in decisions
relating to fixation of selling price in recession, make or buy, etc. Out–of–
pocket costs can be avoided or saved if a particular proposal under
consideration is not accepted.
(k) Shut down Costs - Those costs, which continue to be, incurred even when a
plant is temporarily shut-down e.g. rent, rates, depreciation, etc. These costs
cannot be eliminated with the closure of the plant. In other words, all fixed
costs, which cannot be avoided during the temporary closure of a plant, will be
known as shut down costs.
(l) Sunk Costs - Historical costs incurred in the past are known as sunk costs.
They play no role in decision making in the current period. For example, in
the case of a decision relating to the replacement of a machine, the written
down value of the existing machine is a sunk cost and therefore, not
considered.
(m) Absolute Cost - These costs refer to the cost of any product, process or unit in
its totality. When costs are presented in a statement form, various cost
components may be shown in absolute amount or as a percentage of total
cost or as per unit cost or all together. Here the costs depicted in absolute
amount may be called absolute costs and are base costs on which further
analysis and decisions are made.

(n) Discretionary Costs – Such costs are not tied to a clear cause and effect
relationship between inputs and outputs. They usually arise from periodic
decisions regarding the maximum outlay to be incurred. Examples include
advertising, public relations, executive training etc.
(o) Period Costs - These are the costs, which are not assigned to the products
but are charged as expenses against the revenue of the period in which they
are incurred. All non-manufacturing costs such as general & administrative
expenses, selling and distribution expenses are recognised as period costs.
(p) Engineered Costs - These are costs that result specifically from a clear
cause and effect relationship between inputs and outputs. The relationship is
usually personally observable. Examples of inputs are direct material costs,
direct labour costs etc. Examples of output are cars, computers etc.
(q) Explicit Costs - These costs are also known as out-of-pocket costs and refer
to costs involving immediate payment of cash. salaries, wages, postage and
telegram, printing and stationery, interest on loan etc. are some examples of
explicit costs involving immediate cash payment.
(r) Implicit Costs - These costs do not involve any immediate cash payment. They
are not recorded in the books of account. They are also known as economic
costs.
14. METHODS OF COSTING

Different industries follow different methods of costing because of the differences
in the nature of their work. The various methods of costing are as follows:
Methods Description
Single or Output Under this method, the cost of a product is ascertained, the
Costing product being the only one produced like bricks, coals, etc.
Batch Costing This method is the extension of job costing. A batch may
represent a number of small orders passed through the
factory in batch. Each batch here is treated as a unit of cost
and thus separately costed. Here cost per unit is
determined by dividing the cost of the batch by the number
of units produced in the batch.

1.37
ACCOUNTING
Job Costing Under this method of costing, cost of each job is

ascertained separately. It is suitable in all cases where work
is undertaken on receiving a customer’s order like a
printing press, motor workshop, etc.
Contract Costing Under this method, the cost of each contract is ascertained
separately. It is suitable for firms engaged in the
construction of bridges, roads, buildings etc.
Process Costing Under this method, the cost of completing each stage of
work is ascertained, like cost of making pulp and cost of
making paper from pulp. In mechanical operations, the cost
of each operation may be ascertained separately; the name
given is operation costing.
Operating Costing It is used in the case of concerns rendering services like

transport, supply of water, retail trade etc.
Multiple Costing It is a combination of two or more methods of costing

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

different industries:
Nature of Output Method Cost Examples of

Industries
A Series of Processes Process costing For each Sugar
or Operation process
Costing
Construction of building Contract For each Real estate
Costing contract

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

Costing
Customer Specifications: Job Costing For each order/ Advertising

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

varieties of activities and Costing any method Assembly
processes
15. TECHNIQUES OF COSTING

For ascertaining cost, following types of costing are usually used.
Techniques Description
Uniform When a number of firms in an industry agree among

Costing themselves to follow the same system of costing in details,
adopting common terminology for various items and proc-
esses they are said to follow a system of uniform costing.
Advantages of such a system are:
(i) A comparison of the performance of each of the firms
can be made with that of another, or with the average
performance in the industry.
(ii) Under such a system, it is also possible to determine
the cost of production of goods which is true for the
industry as a whole. It is found useful when tax-relief or
protection is sought from the Government.

1.39
ACCOUNTING
Marginal It is defined as the ascertainment of marginal cost by

Costing differentiating between fixed and variable costs. It is used to
ascertain effect of changes in volume or type of output on profit.
Standard It is the name given to the technique whereby standard

Costing and costs are pre-determined and subsequently compared with
Variance the recorded actual costs. It is thus a technique of cost
Analysis ascertainment and cost control. This technique may be used
in conjunction with any method of costing. However, it is
especially suitable where the manufacturing method
involves production of standardised goods of repetitive
nature.
Historical It is the ascertainment of costs after they have been

Costing incurred. This type of costing has limited utility.
• Post Costing : It means ascertainment of cost after
production is completed.
• Continuous costing : Cost is ascertained as soon as the
job is completed or even when the job is in progress.
Absorption It is the practice of charging all costs, both variable and

Costing fixed to operations, processes or products. This differs from
marginal costing where fixed costs are excluded.

SUMMARY
♦ Cost:
 The amount of expenditure (actual or notional) incurred on or
attributable to a specified article, product or activity. (as a noun)
 To ascertain the cost of a specified thing or activity. (as a verb)
♦ Costing: It is the technique and process of ascertaining costs.
♦ Cost Accounting: It is the process of accounting for cost which begins with
the recording of income and expenditure or the bases on which they are
calculated and ends with the preparation of periodical statements and
reports for ascertaining and controlling costs.
♦ Cost Accountancy: It has been defined as “the application of costing and
cost accounting principles, methods and techniques to the science, art and
practice of cost control and the ascertainment of profitability. It includes the
presentation of information derived there from for the purpose of
managerial decision making.”
♦ Management Accounting: As per CIMA Official Terminology “Management
Accounting is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for the
stakeholders of for-profit and not-for-profit enterprises in the public and
private sectors.”
♦ Cost Management: It is an application of management accounting
concepts, methods of collections, analysis and presentation of data to
provide the information needed to plan, monitor and control costs.
♦ Cost Control: Maintaining discipline in expenditure is one of the main
objective of a good cost and management accounting system. It ensures
that expenditures are in consonance with predetermined set standard and
any variation from these set standards is noted and reported on continuous
basis.
♦ Cost Reduction: It may be defined "as the achievement of real and
permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or
diminution in the quality of the product."

1.41
ACCOUNTING
♦ Cost Objects: Cost object is anything for which a separate measurement of
cost is required. Cost object may be a product, a service, a project, a
customer, a brand category, an activity, a department or a programme etc.
♦ Cost Units: It is a unit of product, service or time (or combination of these)
in relation to which costs may be ascertained or expressed.
♦ Cost Drivers: A Cost driver is a factor or variable which effect level of cost.
Generally, it is an activity which is responsible for cost incurrence. Level of
activity or volume of production is the example of a cost driver. An activity
may be an event, task, or unit of work etc.
♦ Responsibility Centres: To have a better control over the organisation,
management delegates its responsibility and authority to various
departments or persons. These departments or persons are known as
responsibility centres and are held responsible for performance in terms of
expenditure, revenue, profitability and return on investment.
♦ Cost Centres: The responsibility centre which is held accountable for
incurrence of costs which are under its control. The performance of this
responsibility centre is measured against pre-determined standards or
budgets.
♦ Revenue Centres: The responsibility centres which are accountable for

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

♦ Classification of Costs:
Classification of Costs
By Nature or By Costs for

By Functions By Variability By By Normality
Element Managerial
or Behaviour Controllability Decision Making*
Direct Material
Materials
Cost
Fixed Cost Controllable
Normal Cost
Direct Employee Cost
Labour
(Labour) Cost
Variable Uncontrollable Abnormal
Other Cost Cost Cost
Direct Expenses
Expenses
Semi-
Overheads Production/ variable
Manufacturing Cost
Overheads
Administration
Overheads
Selling Overheads
Distribution
Overheads
Research and
Development costs
etc.
By Costs for
Managerial
Decision Making* Opportunity Cost Out-of-pocket Cost
Pre-determined Cost Product Cost Shut down Cost Implicit Cost
Standard Cost Capitalized Cost Sunk Cost Explicit Cost
Marginal Cost Imputed Cost Absolute Cost Engineered Cost
Estimated Cost Differential Cost Discretionary Cost Period Cost

1.43
ACCOUNTING
TEST YOUR KNOWLEDGE

Multiple Choice Questions (MCQs)
1. ……………….. is anything for which a separate measurement is required.
(a) Cost unit

(b) Cost object
(c) Cost driver
(d) Cost centre
2. Which of the following is true about Cost control:
(a) It is a corrective function
(b) It challenges the set standards
(c) It ends when targets achieved
(d) It is concerned with future
3. Cost units used in power sector is:

(a) Kilometer (K.M)
(b) Kilowatt-hour (kWh)
(c) Number of electric points

(d) Number of hours
4. Process Costing method is suitable for
(a) Transport sector
(b) Chemical industries
(c) Dam construction
(d) Furniture making

5. Which of the following is Not true about the cost control and cost reduction:
(a) Cost control seeks to attain lowest possible cost under best conditions.
(b) Cost control emphasises on past and present.

(c) Cost reduction is a corrective function. It operates even when an efficient

cost control system exists.
(d) Cost control ends when targets are achieved.
6. The advantage of using IT in Cost Accounting does not include:
(a) Integration of various functions

(b) Stock needs to be reconciled with Goods Received Note
(c) Reduction in multicity of documents
(d) Customised reports can be prepared.
7. A taxi provider charges minimum ` 80 thereafter ` 12 per kilometer of distance
travelled, the behaviour of conveyance cost is:
(a) Fixed Cost
(b) Semi-variable Cost
(c) Variable Cost
(d) Administrative cost.
8. A Ltd. has three production department, and each department has two machines,
which of the following cannot be treated as cost centre for cost allocation:
(a) Machines under the production department
(b) Production departments
(c) Both Production department and machines
(d) A Ltd.
9. Which of the following is an example of functional classification of cost:
(a) Direct Material Cost
(b) Fixed Cost
(c) Administrative Overheads
(d) Indirect Overheads.

1.45
ACCOUNTING
10. Ticket counter in a Railway Station is an example of
(a) Cost Centre
(b) Revenue Centre
(c) Profit Centre

(d) Investment Centre
Theoretical Questions
1. DESCRIBE the main objectives of introduction of a Cost and Management
Accounting System in a manufacturing organization.
2. DISCUSS the different cost centres that on organization can have.
3. DISCUSS cost classification based on variability and controllability.
4. DISCUSS the essential features of a good cost accounting system.
5. DESCRIBE the factors which are to be considered before installing a system of
cost accounting.
6. DISCUSS the four different methods of costing along with their applicability to
concerned industry.
7. STATE the method of costing and the suggested unit of cost for the following
industries:
(a) Transport (b) Power (c) Hotel
(d) Hospital (e) Steel (f) Coal
(g) Bicycles (h) Bridge Construction (i) Interior Decoration
(j) Advertising (k) Furniture (l) Brick-works
8. WRITE a note on the following, indicating in which kinds of industries or
undertakings, the different methods could be suitably applied:
(a) Single or Output Costing (b) Batch Costing
(c) Process Costing (d) Operating Costing
(e) Contract Costing (f) Multiple Costing

ANSWERS
Answers to the MCQs
1. (b) 2. (c) 3. (b) 4. (b) 5. (a) 6. (b)
7. (b) 8. (d) 9. (c) 10. (b)
Answers to the Theoretical Questions

1. Please refer paragraph 2

7. Please refer paragraph 14 & 10

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

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

MATERIAL COST 2.3
2.3
management attention. Cost control starts from here, and for this purpose it is
necessary that the principle of 3Es (Economy, Efficiency and Effectiveness) i.e.
economy in procurement, efficiency in handling and processing the material and
effectiveness in producing desired output as per the standard, is also applied for
this cost element. Importance of proper recording and control of material are as
follows:
(a) Quality of final product: The quality of output depends on the quality of
inputs.
(b) Price of the final product: Material constitutes a significant part of any
product and the cost of final product is directly related with cost of materials
used to produce the product.
(c) Production continuity: The production firms need to ensure that
production process runs smoothly and should not be paused for the want
of materials. In order to avoid production interruptions, an adequate level
of stock of materials should be maintained.
(d) Cost of Stock holding and stock-out: An entity has to incur stock holding
costs in the form of interest and/or opportunity cost for the fund used, stock
handling losses like evaporation, obsolescence etc. Under-stocking causes in
loss of revenue due to stock-out and breach of commitment.
(e) Wastage and other losses: While handling and processing of materials,
some wastage and loss arise. Based on the nature of material and process,
these are classified as normal and abnormal for efficient utilisation and
control.
(f) Regular information about resources: Regular and updated information
on availability and utilisation of materials are necessary for the entity for
timely and informed decision making.
2. MATERIAL CONTROL
In the previous chapter, we have discussed the term Cost Control, which means all
activities and control mechanism which are necessary to keep the cost in
adherence to the set standards. Material, being one of the total cost elements, are
also required to be controlled so that the overall cost control objective can be
fulfilled.

2.1 Objectives of System of Material Control

The objectives of a system of material control are as following:
(i) Minimising interruption in production process: Material Control system
ensures that no activity, particularly production, suffers from interruption for
want of materials and stores. It should be noted that this requires constant
availability of every item that may be needed in production process,
howsoever, small its cost may be.
(ii) Optimisation of Material Cost: The overall material costs includes price,
ordering costs and holding costs. Since all the materials and stores are
acquired at the lowest possible price considering the required quality and
other relevant factors like reliability in respect of delivery, etc., holding cost
too needs to be minimized.
(iii) Reduction in Wastages: Material Control System has an objective of
avoidance of unnecessary losses and wastages that may arise from
deterioration in quality due to defective or long storage or from
obsolescence. It may be noted that losses and wastages in the process of
manufacture are a concern of the production department.
(iv) Adequate Information: The system of material control maintains proper
records to ensure that reliable information is available for all items of materials
and stores. This not only helps in detecting losses and pilferages but also
facilitates proper production planning.
(v) Completion of order in time: Proper material management is very
necessary for fulfilling orders of the firm. This adds to the goodwill of the
firm.
2.2 Requirements of Material Control

Material control requirements can be summarised as follows:
1. Proper co-ordination of all departments involved viz., finance, purchasing,

receiving, inspection, storage, accounting and payment.
2. Determining purchase procedure to see that purchases are made, after
making suitable enquiries, at the most favourable terms to the firm.

MATERIAL COST 2.5
2.5
3. Use of standard forms for placing the order, noting receipt of goods,
authorising issue of the materials etc.
4. Preparation of budgets concerning materials, supplies and equipment to
ensure economy in purchasing and use of materials.
5. Operation of a system of internal check so that all transactions involving
materials, supplies and equipment purchases are properly approved and
automatically checked.
6. Storage of all materials and supplies in a well designated location with
proper safeguards.
7. Operation of a system of perpetual inventory together with continuous stock
checking so that it is possible to determine, at any time, the amount and the
value of each kind of material in stock.
8. Operation of a system of stores control and issue so that there will be delivery
of materials upon requisition to departments in the right amount at the time
they are needed.
9. Development of system of controlling accounts and subsidiary records which
exhibit summary and detailed material costs at the stage of material receipt
and consumption.
10. Regular reports of materials purchased issue from stock, inventory balances,
obsolete stock, goods returned to vendors, and spoiled or defective units
are required.
2.3 Elements of Material Control

Material control is a systematic control over the procurement, storage and usage
of material so as to maintain an even flow of material.
Material Control
Material
Material Storage Material Usage
Procurement Control Control
Control

Material control involves efficient functioning of the following operations:

• Purchasing of materials
• Receiving of materials
• Inspection of materials
• Storage of materials
• Issuing materials
• Maintenance of inventory records
• Stock audit
3. MATERIALS PROCUREMENT PROCEDURE

Material procurement procedure can be understood with help of the following
diagram. Documents required and the departments who initiate these documents
are shown sequentially.
Diagram: Material Procurement Procedure

[The name of the departments and documents shown in the diagram are for illustrative purpose only]

MATERIAL COST 2.7
2.7
3.1 Bill of Materials

It is also known as Materials Specification List or Materials List. It is a detailed
list specifying the standard quantities and qualities of materials and
components required for producing a product or carrying out of any job. The
materials specification list is prepared by the product development team
commonly known as engineering or planning department in a standard form. This
is shared with other concerned departments like Marketing, Production, Store, and
Cost/ Accounting department.
Format and content of a Bill of Materials vary on the basis of industrial
peculiarities, management information system (MIS) and accounting system in
place.
Uses of Bill of Material
Marketing Production Dept. Stores Dept. Cost/ Accounting

(Purchase) Dept.
Dept.
Materials are Production is planned It is used as a It is used to estimate

procured according to the reference cost and profit. Any
(purchased) on nature, volume of the document while purchase, issue and
the basis of materials required to issuing materials usage are
specifications be used. Accordingly, to the compared/verified
mentioned in it. material requisition requisitioning against this
lists are prepared. department. document.
3.2 Material Requisition Note

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

Format of a Material requisition note may vary on the basis of Industrial

Peculiarities, Management Information System (MIS) and Accounting System in
place.
Difference between Bill of Materials and Material Requisition Note
Bill of Materials Material Requisition Note
1. It is the document prepared by the 1. It is prepared by the production

engineering or planning dept. or other consuming department.
2. It is a complete schedule of 2. It is a document asking

component parts and raw materials Store-keeper to issue materials
required for a particular job or work to the consuming department.
order.
3. It often serves the purpose of a 3. It cannot replace a bill of

material requisition as it shows the materials.
complete schedule of materials
required for a particular job i.e. it can
replace material requisition.
4. It can be used for the purpose of 4. It is useful in arriving historical

quotations. cost only.
5. It helps in keeping a quantitative 5. It shows the material actually

control on materials drawn through drawn from stores.
material requisition.
3.3 Purchase Requisition

This document authorises the purchase department to order for the materials
specified in the note. Since the materials purchased will be used by the production
departments, there should be constant co-ordination between the purchase and
production departments. A purchase requisition is a form used for making a
formal request to the purchasing department to purchase materials. This
form is usually filled up by the store keeper for regular materials and by the
departmental head for special materials (not stocked as regular items).

MATERIAL COST 2.9
2.9
At the beginning a complete list of materials and stores required should be drawn
up, which should be reviewed periodically for any addition or deletion. On the
basis of standing order, once an item is included in the standard list, it becomes
the duty of the purchase department to arrange for fresh supplies before existing
stocks are exhausted. Any change in the consumption pattern should be informed
to the purchase department for necessary action from their end.
For control over buying of regular store materials, Inventory control system is to
determine stock levels to be maintained and the number of quantities to be
ordered. In respect of special materials, required for a special order or purpose, it
is desirable that the concerned technical department should prepare materials
specifications list specifying the quantity, size and order for the materials.
Purchase requisition note may either be originated by the stores department in
connection with regular materials or by the production planning or other technical
departments in respect of special materials.
Format of a purchase requisition note may vary on the basis of Industrial
Peculiarities, Management Information System (MIS) and Accounting System in
place.
3.4 Inviting Quotation/ Request for Proposal (RFP)/

Notification Inviting Tender (NIT)
Materials purchase department has to answer the following question before
initiating purchasing of materials:
(i) What to purchase?
(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase?
(v) At what price to purchase?
The following are the few suggestive steps to answer to the questions:
(i) What to purchase?
Materials are purchased as per the requisition received from the stores or
user departments. In case of materials used regularly, the materials are
purchased as per the standard operating procedures (SOP).

(ii) When to purchase?
Materials are purchased considering the need for the materials for
production and safety, however, the timing of placing the order is very
important to get the materials replenished before the requirement arise and
without affecting the production schedule. Supply of materials i.e., how
easily the materials are available in the market, Lead time i.e., time required
to get the order from supplier’s place to production place, consumption
pattern of materials are the important factors which affects the timing of
purchase. Related to the question, later in this chapter Re-order Stock Level
will be learnt. Further the concept of just-in-time (JIT), which is briefly
discussed in this chapter is also associated with the question ‘when’ to
purchase.
(iii) How much to purchase?
The quantity of materials to be ordered depends on the factors like material

consumption pattern, minimum order size as offered by the supplier,
quantity discount, storage cost and capacity and working capital
requirement etc. The concept of Economic Order Quantity (EOQ) will be
discussed later in this chapter.
(iv) Where to purchase?
This is the process of selecting supplier of materials to be purchased. This is

a very sensitive and crucial process, though for every organization but
specifically for the organizations where public money is involved i.e., public
sector undertakings (PSUs). Selection process of supplier could be a grey area
which attracts special attention of regulators like CVC (Central Vigilance
Commission), CAG (Comptroller and Auditor General of India), Auditors and
others. The question is why this is so sensitive to attract attention of
watchdogs. The answer to this question is in a line from Preamble of the
Constitution of India, which reads as to secure to all its citizens: “Equality of
status and of opportunity”. This means the supplier selection process be such
transparent and fair that all suppliers are treated equal to get opportunity in
participation in Tender process.

MATERIAL COST 2.11
2.11
The selection process starts with Enquiry/Request for Proposals (RFP)/

Notification Inviting Tender (NIT). The geographical area for an enquiry/ RFP
or NIT can be local or global depending on the propriety, availability and
government guidelines for materials to be purchased. The RFP or NIT can be
floated offline i.e., manual process or online by publishing on website or
designated electronic market places. One of the examples of electronic
market place is GeM (Government e Marketplace).
Government e Marketplace (GeM): A dedicated e-market for different
goods & services procured by Government Organisations / Departments /
PSUs. It aims to enhance transparency, efficiency and speed in public
procurement. It provides the tools of e-bidding, reverse e-auction and
demand aggregation to facilitate the government users, achieve the best
value for their money. The purchases through GeM by Government users
have been authorised and made mandatory by Ministry of Finance.
(v) At what price to purchase?
The answer to the question is discussed in the following paragraph where
the Lowest bidder (also called L1 bidder) for the material is selected.
3.5 Selection of Quotation/ Proposal

After invitation of tender from the vendors, interested vendors who are fulfilling
all the criteria mentioned in the tender notice send their price quotations/
proposals to the purchase department. On the receipt of quotations, a
comparative statement is prepared. For selecting material suppliers, the factors
which the purchase department keeps in its mind are—price, quantity, quality
offered, time of delivery, mode of transportation, terms of payment, reputation of
supplier etc. In addition to the above listed factors purchase manager obtains
other necessary information for final selection of material suppliers.
3.6 Preparation and Execution of Purchase Orders

Having decided on the best quotation that should be accepted, the purchase
manager or concerned officer proceeds to issue the formal purchase order. It is a
written request to the supplier to supply specified materials at specified rates and
within a specified period. Generally, copies of purchase order are given to Store or

order indenting department, receiving department and cost accounting

department. A copy of the purchase order with relevant purchase requisitions, is
held in the file of the department to facilitate the follow-up of the delivery and
also for approval of the invoice for payment.
3.7 Receipt and Inspection of Materials

After execution of purchase order and advance payment (if terms of quotation so
specify), necessary arrangement is made to receive the delivery of materials After
receipt of materials along with relevant documents or/ and invoice, receiving
department (store dept.) arrange to inspect the materials for its conformity with
purchase order. After satisfactory inspection, materials are received and Goods
Received Note is issued. If some materials are not found in good condition or are
not in conformity with the purchase order are returned back to the vendor along
with a Material Returned Note.
3.7.1 Goods Received Note

If everything is in order and the supply is considered suitable for acceptance, the
Receiving department prepares a Receiving Report or Material Inward Note or
Goods Received Note. Generally, it is prepared in quadruplicate, the copies being
distributed to purchase department, store or order indenting department,
receiving department and accounting department.
3.7.2 Material Returned Note
Sometimes materials have to be returned to suppliers after these have been
received in the factory. Such returns may occur before or after the preparation of
the receiving report. If the return takes place before the preparation of the
receiving report, such material obviously would not be included in the report and
hence not shown in the stores ledgers. In that case, no adjustment in the account
books would be necessary. But if the material is returned after its entry in the
receiving report, a suitable document must be drawn up in support of the issue so
as to exclude from the Stores of Material Account the value of the materials
returned back. This document usually takes the form of a Material Returned Note
or Material outward return note.

MATERIAL COST 2.13
2.13
3.8 Checking and Passing of Bills for Payment

The invoice received from the supplier is sent to the accounts section to check
authenticity and mathematical accuracy. The quantity and price are also checked
with reference to goods received note and the purchase order respectively. The
accounts section after checking its accuracy finally certifies and passes the invoice
for payment.
4. VALUATION OF MATERIAL RECEIPTS

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

Discounts and Subsidy
(i) Trade Trade discount is deducted from the purchase

Discount price if it is not shown as deduction in the invoice.
(ii) Quantity Like trade discount quantity discount is also shown

Discount as deduction from the invoice. It is deducted from
the purchase price if not shown as deduction.
(iii) Cash Discount Cash discount is not deducted from the purchase
price. It is treated as interest and finance item. It is
ignored.
(iv) Subsidy/ Any subsidy/ grant/ incentive received from the

Grant/ Government or from other sources deducted from
Incentives the cost of purchase.

Duties and Taxes
(v) Road Tax/ Toll Road tax/ Toll tax, if paid by the buyer, is included
Tax with the cost of purchase.
(vi) Goods and Goods and Service Tax (GST) is paid on supply of
Service Tax goods and provision of services and collected from
(GST) the buyers. It is excluded from the cost of
purchase if credit for the same is available. Unless
mentioned specifically it should not form part of
cost of purchase.
(vii) Custom Duty Custom duty is paid on import of goods from

outside India. It is added with the purchase cost.
Penalty and Charges
(viii) Demurrage Demurrage is a penalty imposed by the transporter

for delay in uploading or offloading of materials. It
is an abnormal cost and not included with cost of
purchase
(ix) Detention Detention charges/ fines imposed for

charges/ Fine non-compliance of rule or law by any statutory
authority. It is an abnormal cost and not included
with cost of purchase
(x) Penalty Penalty of any type is not included with the cost of
purchase
Other expenditures
(xi) Insurance Insurance charges are paid for protecting goods

charges during transit. It is added with the cost of purchase.
(xii) Commission or Commission or brokerage paid is added with the

brokerage paid. cost of purchase.
(xiii) Freight inwards It is added with the cost of purchase as it is directly

attributable to procurement of material.

MATERIAL COST 2.15
2.15
(xiv) Cost of Treatment of cost of containers are as follows:

containers • Non-returnable containers: The cost of
containers is added with the cost of purchase
of materials.
• Returnable Containers: If the containers are
returned and their costs are refunded, then
cost of containers should not be considered in
the cost of purchase.
• If the amount of refund on returning the
container is less than the amount paid, then,
only the short fall is added with the cost of
purchase.
(xv) Shortage Shortage in materials is treated as follows:
Shortage due to normal reasons: Good units
absorb the cost of shortage due to normal reasons.
Losses due to breaking of bulk, evaporation, or due
to any unavoidable conditions etc. are the reasons
of normal loss.
Shortage due to abnormal reasons: Shortage
arises due to abnormal reasons such as material
mishandling, pilferage, or due to any avoidable
reasons are not absorbed by the good units. Losses
due to abnormal reasons are debited to costing
profit and loss account.
ILLUSTRATION 1
An invoice in respect of a consignment of chemicals A and B provides the following
information:
(`)
Chemical A: 10,000 kgs. at ` 10 per kg. 1,00,000
Chemical B: 8,000 kgs. at ` 13 per kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240

A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to
normal breakages. You are required to COMPUTE the rate per kg. of each chemical,
assuming a provision of 2% for further deterioration.
SOLUTION
Working:
Computation of effective quantity of each chemical available for use
Chemical A (kg.) Chemical B (kg.)
Quantity purchased 10,000 8,000
Less: Shortage due to normal breakages 500 320
9,500 7,680
Less: Provision for deterioration 2% 190 153.6
Quantity available 9,310 7,526.4
Statement showing the computation of rate per kg. of each chemical
Chemical A (`) Chemical B (`)
Purchase price 10,000@ `10 per kg, 1,00,000 1,04,000

8,000@`13 per kg
Add: Basic Custom Duty @10% 10,000 10,400
Add: Railway freight

(in the ratio of quantity purchased i.e., 5:4) 2,133 1,707
Total cost (A) 1,12,133 1,16,107
Effective Quantity (see working) (B) 9,310 kg. 7,526.4 kg.
Rate per kg. (A ÷ B) 12.04 15.43
ILLUSTRATION 2
At WHAT price per unit would Part No. A 32 be entered in the Stores Ledger, if the
following invoice was received from a supplier:

MATERIAL COST 2.17
2.17
Invoice (` )
200 units Part No. A 32 @ ` 5 1,000.00
Less: 20% discount (200.00)
800.00
Add: GST @ 12% 96.00
896.00
Add: Packing charges (5 non-returnable boxes) 50.00
946.00
(i) A 2 per cent cash discount will be given if payment is made in 30 days.
(ii) Documents substantiating payment of GST are enclosed for claiming Input
credit.
SOLUTION
Computation of cost per unit
(`)
Net purchase Price 800.00
Add: Packing charges (5 non-returnable boxes) 50.00
850.00
No. of units purchased 200 units
Cost per unit 4.25
Note: (i) Cash discount is treated as interest and finance charges, hence, it is not
considered for valuation of material.
(ii) Input credit is available for GST paid; hence it will not be added to
purchase cost.

5. MATERIAL STORAGE & RECORDS

5
Proper storing of materials is of primary importance. It is not enough only to
purchase material of the required quality. If the purchased material subsequently
deteriorates in quality because of bad storage, the loss is even more than what
might arise from purchase of bad quality of materials. Apart from preservation of
quality, the store-keeper also ensures safe custody of the material. It should be
the function of store-keeper that the right quantity of materials always should be
available in stock.
5.1 Duties of Store Keeper

These can be briefly set out as follows:
(i) General control over store: Store keeper should keep control over all
activities in Stores department. He should check the quantities as mentioned
in Goods received note and with the purchased materials forwarded by the
receiving department and to arrange for the storage in appropriate places.
(ii) Safe custody of materials: Store keeper should ensure that all the materials
are stored in a safe condition and environment required to preserve the
quality of the materials.
(iii) Maintaining records: Store keeper should maintain proper record of
quantity received, issued, balance in hand and transferred to/ from other
stores.
(iv) Initiate purchase requisition: Store keeper should initiate purchase
requisitions for the replacement of stock of all regular stores items whenever
the stock level of any item of store approaches the re-order level fixed.
(v) Maintaining adequate level of stock: Store keeper should maintain
adequate level of stock at all time. He/ she should take all the necessary
action so that production could not be interrupted due to lack of stock.
Further he/ she should take immediate action for stoppage of further
purchasing when the stock level approaches the maximum limit. He also
needs to reserve a particular material for a specific job when so required.

MATERIAL COST 2.19
2.19
(vi) Issue of materials: Store keeper should issue materials only against the
material requisition slip approved by the appropriate authority. He/ she
should also refer to bill of materials while issuing materials to requisitioning
department.
(vii) Stock verification and reconciliation: Store keeper should verify the book
balances with the actual physical stock at frequent intervals by way of
internal control and check the any irregular or abnormal issues, pilferage,
etc.
5.2 Store Records

The record of stores may be maintained in three forms:
 Bin Cards
 Stock Control Cards
 Store Ledger
Bin Cards: It is a quantitative record of inventory which shows the quantity of
inventory available in a particular bin. Bin refers to a box/ container/ space where
materials are kept. Card is placed with each of the bin (space) to record the details
of material like receipt, issue and return. It is maintained by store department.
Stock Control Cards: It is also a quantitative record of inventory maintained by
stores department for every item of material. In other words, it is a record which
shows the overall inventory position in store. Recording includes receipt, issue,
return, in hand and order given.
Advantages and Disadvantages of Bin Cards
Advantages:
(i) There would be fewer chances of mistakes being made as entries are made
at the same time as goods received or issued by the person actually
handling the materials.
(ii) Control over stock can be more effective, as comparison of the actual
quantity in hand at any time with the book balance is possible.
(iii) Identification of the different items of materials is facilitated by reference to
the Bin Card, the bin or storage receptacle.

Disadvantages
(i) Store records are dispersed over a wide area.
(ii) The cards are liable to be smeared with dirt and grease because of proximity
to material and also because of handling materials.
(iii) People handling materials are not ordinarily suitable for the clerical work
involved in writing Bin Cards.
Advantages and Disadvantages of Stock Control Cards
Advantages:
(i) Records are kept in a more compact manner so that reference to them is
facilitated.
(ii) Records can be kept in a neat and clean way by men solely engaged in
clerical work so that a division of workers between record keeping and
actual material handling is possible.
(iii) As the records are at one place, it is possible to get an overall idea of the
stock position without the necessity of going round the stores.
Disadvantages:
(i) On the spot comparison of the physical stock of an item with its book
balance is not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the case
of bin cards, as the Stock Control Cards are housed in cabinets or trays.
Stores Ledger: A Stores Ledger is maintained to record both quantity and cost
of materials received, issued and those in stock. It is a subsidiary ledger to the
main cost ledger; it is maintained by the Cost/ Accounts Department. The source
documents for posting the ledger are Goods received notes, Materials requisition
notes etc.
The first two forms are records of quantities received, issued and those in balance,
but in the third record i.e. store ledger, value of receipts, issues and closing
balance is also maintained. Usually, records of quantities i.e. Bin cards and Store
Control Cards are kept by the store keeper in store department while record of both
quantity and value is maintained by cost accounting department.

MATERIAL COST 2.21
2.21
Difference between Bin Card & Stores Ledger
Bin Card Stores Ledger
It is maintained by the storekeeper in It is maintained in cost accounting

the store. department.
It contains only quantitative details of It contains information both in

material received, issued and quantity and value.
returned to stores.
Entries are made when transaction It is always posted after the

takes place. transaction.
Each transaction is individually Transactions may be summarized and

posted. then posted.
Inter-department transfers do not Material transfers from one job to

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

Inventory Control
By Setting On the basis of

Using Ratio
Quantitative Relative Physical Control
Analysis
Levels Classification
6.1 Inventory Control- By Setting Quantitative Levels

Re-order Stock Level •When to Order
Re-order Quantity/ EOQ •How Much to Order
Maximum Stock Level •Upto How much to stock
Minimum Stock Level •Atleast How much to stock
Average Stock Level •Stock normally kept
Danger Stock Level •Kept for emergency requirement
Buffer Stock •To meet sudden demand
(i) Re-order Stock Level (ROL): This level lies between minimum and the
maximum levels in such a way that before the material ordered is received
into the stores, there is sufficient quantity in hand to cover both normal and
abnormal consumption situations. In other words, it is the level at which
fresh order should be placed for replenishment of stock.
It is calculated as:
ROL = Maximum Consumption × Maximum Re-order Period
Maximum Consumption = The maximum rate of material

consumption in production activity
Maximum Re-order period = The maximum time to get order from
supplier to the stores

MATERIAL COST 2.23
2.23
This can also be calculated alternatively as below:

ROL = Minimum Stock Level + (Average Rate of Consumption × Average
Re-order period)
Minimum Stock Level = Minimum Stock level that must be
maintained all the time.
Average Rate of Consumption = Average rate of material consumption in
production activity. It is also known as
normal consumption/ usage
Average Re-order period = Average time to get an order from
supplier to the stores. It is also known as
normal period.
(Re-order period is also known as Lead time)

(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which
purchase requisition is made by the store department. While setting the
quantity to be re-ordered, consideration is given to the maintenance of
minimum level of stock, re-order level, minimum delivery time and the most
important the cost. Hence, the quantity should be where, the total of
carrying cost and ordering cost is at minimum. For this purpose, an
economic order quantity should be calculated.
Economic Order Quantity (EOQ): The size of an order for which total of
ordering and carrying cost are minimum.
Ordering Cost: Ordering costs are the costs which are associated with the
purchase or order of materials such as cost to invite quotations,
documentation works like preparation of purchase orders, employee cost
directly attributable to the procurement of material, transportation and
inspection cost etc.
Carrying Cost: Carrying costs are the costs for holding/ carrying of
inventories in store such as the cost of fund invested in inventories, cost of
storage, insurance cost, obsolescence etc.

The Economic Order Quantity (EOQ) is calculated as below:
2 × Annual Requirement (A) ×Cost per order (O)

EOQ =
Carrying Costper unitper annum (C)
Annual Requirement (A)- It represents demand for raw material or Input for a
year.
Cost per Order (O) - It represents cost of placing an order for purchase.
Carrying Cost (C) – It represents cost of carrying average inventory on annual
basis.
Assumptions underlying E.O.Q. : The calculation of economic order of
material to be purchased is subject to the following assumptions:
(i) Ordering cost per order and carrying cost per unit per annum are
known and they are fixed.
(ii) Anticipated usage of material in units is known.

(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the lead
time is zero.
ILLUSTRATION 3
CALCULATE the Economic Order Quantity from the following information. Also
state the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg.

MATERIAL COST 2.25
2.25
Order placing cost per order : ` 50

Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory
SOLUTION
2× A ×O
EOQ =
C
A = Units consumed during year = 10,000
O = Ordering cost per order = 50
C = Inventory carrying cost per unit per annum. = 8% of ` 2
2 ´ 10,000 ´ 50 2×10,000×50×25
EOQ = = = 2,500 kg
2´ 8 4
100
No. of orders to be placed in a year
= Total consumption of materials per annum

EOQ
= 10,000 kg. = 4 Orders per year

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

(ii) DETERMINE the total cost that would result for the items if a new price
of ` 12.80 is used.

SOLUTION
(i) Carrying cost (C) = Storage rate = 2%
Interest Rate = 12%
Obsolescence Rate = 6%
Total = 20% per annum
C= 20% of `Rs 20 = `Rs 4 per unit per annum.
2AO 2×5000×16
E.O.Q = = = 40,000 = 200 units
C 4
Total cost:
Purchase price of 5,000 units @ ` 20.00 per unit = ` 1,00,000
5000
Ordering cost = =25 orders @ ` 16 = ` 400
200
Carrying cost of average Inventory

200
= =100 units @ ` 4 = ` 400
2
Total cost ` 1,00,800

(ii) If the new price of ` 12.80 is used:
C = 20% of 12.80 = ` 2.56 per unit per annum.
2×5,000×16
E.O.Q. = = 250 units
2.56
Total cost:
Purchase price of 5,000 units @ ` 12.80 per unit = ` 64,000

5,000
Ordering cost = = 20 orders @ ` 16 = ` 320
250
Carrying cost (of average inventory) = 250 =125 units @ ` 2.56= ` 320
2
Total variable cost ` 64,640

MATERIAL COST 2.27
2.27
(iii) Minimum Stock Level: It is lowest level of material stock, which must be
maintained in hand at all times, so that there is no stoppage of production
due to non-availability of inventory.
It is calculated as below:
Minimum Stock Level = Re-order Stock Level - (Average Consumption Rate
× Average Re-order Period)
(iv) Maximum Stock Level: It is the highest level of quantity for any material
which can be held in stock at any time. Any quantity beyond this level cause
extra amount of expenditure due to engagement of fund, cost of storage,
obsolescence etc.
It can be calculated as below:
Maximum Stock Level = Re-order Level + Re-order Quantity - (Minimum
Consumption Rate × Minimum Re-order Period)
Here, Re-order Quantity may be EOQ
(v) Average Inventory Level: This is the quantity of material that is normally
held in stock over a period. It is also known as normal stock level.
Average Stock Level = Minimum Stock Level + 1/2 Re-order Quantity
Alternatively, it can be calculated as below:
Maximum Stock Level + Minimum StockLevel
Average Stock Level =
2
(vi) Danger level: It is the level at which normal issues of the raw material
inventory are stopped and emergency issues are only made.
Danger Level = Average Consumption* × Lead time for emergency purchase
*Some time minimum consumption is also used.
(vii) Buffer Stock: Some quantity of stock may be kept for contingency to be
used in case of sudden order, such stock is known as buffer stock.

All the above stock levels can be understood with the help of the following
diagram:
Stock Control Chart
When the materials are purchased, the level keeps rising. It may reach maximum
level if the rate of issuance is less. As the materials are consumed, the stock level
starts declining. At re-order level, reorder quantity is ordered and fresh supplies
are normally received when stocks reach minimum level. The time interval
between re-order level, when the fresh order is placed, and the time of actual
receipt of materials is known as lead time.
ILLUSTRATION 5
Two components, A and B are used as follows:
Normal usage 50 per week each

Maximum usage 75 per week each
Minimum usage 25 per week each
Re-order quantity A: 300; B: 500

Re-order period A: 4 to 6 weeks
B: 2 to 4 weeks

MATERIAL COST 2.29
2.29
CALCULATE for each component (a) Re-ordering level, (b) Minimum level, (c)
Maximum level, (d) Average stock level.
SOLUTION
(a) Re-ordering level:
Maximum usage per week × Maximum delivery period.
Re-ordering level for component A = 75 units × 6 weeks = 450 units

Re-ordering level for component B = 75 units × 4 weeks = 300 units
(b) Minimum level:
Re-order level – (Normal usage × Average period)
Minimum level for component A = 450 units – (50 units × 5 weeks) = 200 units
Minimum level for component B = 300 units – (50 units × 3 weeks) = 150 units
(c) Maximum level:
Re-order level + Re-order quantity – (Min. usage × Minimum period)
Maximum level for component A = (450 units + 300 units) – (25 units × 4
weeks) = 650 units
Maximum level for component B = (300 units + 500 units) – (25 units × 2
weeks) = 750 units
(d) Average stock level:
½ (Minimum + Maximum) stock level
Average stock level for component A = ½ (200 units + 650 units) =425 units.
Average stock level for component B = ½ (150 units + 750 units) =450 units.
ILLUSTRATION 6
From the details given below, CALCULATE:
(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level

(iv) Danger level.

Re-ordering quantity is to be calculated on the basis of following information:

Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time : Average- 10 days, Maximum- 15 days, Minimum- 5 days.
For emergency purchases- 4 days.

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

MATERIAL COST 2.31
2.31
(iv) Danger level = Average consumption × Lead time for emergency

purchases
= 15 units per day × 4 days
= 60 units
Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X units/day + 20 units per day
15 units per day = or X = 10 units per day.
2
2. Re-order Quantity (ROQ) or Economic Order Quantity (EOQ) =

2×5,000 units×` 20
= 200 units
5
6.2 Inventory Stock-Out

Stock out is said to be occurred when an inventory item could not be supplied
due to insufficient stock in the store. The stock- out situation costs to the entity
not only in financial terms but in non-financial terms also. Due to stock out an
entity not only loses overheads costs and profit but reputation (goodwill) also due
to non-fulfilment of commitment. Though it may not be a monetary loss in short
term but in long term it could be a reason for financial loss.
While deciding on the level of inventory, a trade-off between the stock out cost
and carrying cost is made so that overall inventory cost can be minimized.
ILLUSTRATION 7
M/s Tyrotubes trades in four-wheeler tyres and tubes. It stocks sufficient quantity of
tyres of almost every vehicle. In year end 2022-23, the report of sales manager
revealed that M/s Tyrotubes experienced stock-out of tyres.

The stock-out data is as follows:
Stock-out of Tyres No. of times of Stock Out

100 2
80 5
50 10
20 20
10 30
0 33
M/s Tyrotubes loses ` 150 per unit due to stock-out and spends ` 50 per unit on
carrying of inventory.
DETERMINE optimum safest stock level.
SOLUTION
Computation of Stock-out and Inventory carrying cost
Safety Stock- Probability Stock- Expected Inventory Total

Stock out (3) out cost stock-out carrying cost cost (`)
Level (units) (`) cost (`) (`) (7) =
(units) (2) (4) = (2) (5)=(3)x(4) (6) =(1)x` 50 (5)+(6)
(1) x ` 150
100 0 0.33 0 0 5,000 5,000
80 20 0.02 3,000 60 4,000 4,060
50 50 0.02 7,500 150
30 0.05 4,500 225
12,000 375 2,500 2,875
20 80 0.02 12,000 240
60 0.05 9,000 450
30 0.10 4,500 450
25,500 1,140 1,000 2,140
10 90 0.02 13,500 270
70 0.05 10,500 525

MATERIAL COST 2.33
2.33
40 0.10 6,000 600

10 0.20 1,500 300
31,500 1,695 500 2,195
0 100 0.02 15,000 300 2,700
80 0.05 12,000 600
50 0.10 7,500 750
20 0.20 3,000 600
10 0.30 1,500 450
39,000 2,700 0 2,700
At safety stock level of 20 units, total cost is least i.e., ` 2,140.

Working Note:
Computation of Probability of Stock-out
Stock-out (units) 100 80 50 20 10 0 Total

Nos. of times 2 5 10 20 30 33 100
Probability 0.02 0.05 0.10 0.20 0.30 0.33 1.00
Explanation:
Stock-out means the demand of an item that could not be fulfilled because of
insufficient stock level.
Safety stock is the level of stock of any item which is maintained in excess of
lead time consumption. It is kept as cushion against any unexpected demand
for that item.
Safety stock Impact

level
100 units Any unexpected demand up-to 100 units can be met.
80 units Stock out will only arise if unexpected demand will be for 100
units. In this case 20 units will remain unsatisfied. The
probability of any unexpected demand for 100 units is 0.02.

50 units Any unexpected demand beyond 50 units will be remain

unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02) 50 units will be unsatisfied. Similarly, if
unexpected demand for 80 units arises (probability is 0.05), 30
units will be unsatisfied.

(probability is 0.02), 80 units will remain unsatisfied. If
units will remain unsatisfied. Similarly, when unexpected
demand for 50 units arises (probability is 0.10), 30 units will
remain unsatisfied.

units will remain unsatisfied. If unexpected demand for 50 units
arises (probability is 0.10), 40 units will remain unsatisfied.
Similarly, when unexpected demand for 20 units arises
(probability is 0.20), 10 units will remain unsatisfied.
0 unit When no safety stock level is maintained, any unexpected

demand cannot be satisfied. If unexpected demand for 100
units arises (probability is 0.02), 100 units will remain
units will remain unsatisfied. If unexpected demand for 20 units
arises (probability is 0.20), 20 units will remain unsatisfied.
Similarly, unexpected demand for 10 units (probability is 0.30),
10 units will remain unsatisfied.

MATERIAL COST 2.35
2.35
6.3 Just In Time (JIT) Inventory Management

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

Supplier
Demand starts to requirement is raw
sends the
for final process the sent to the materials
material for
product demand for Purchase sent to
production
product department supplier
6.4 Inventory Control- On the basis of Relative

Classification
ABC Analysis •On the basis of value and frequency of inventory
•On the basis of inventory turnover

Fast, Slow and Non Moving (FSN)
Vital, Essential and Desirable (VED) •On the basis of importance of inventory
High, Medium and Low (HML) •On the basis of price of an item of inventory
(1) ABC Analysis: This system exercises discriminating control over different
items of inventory on the basis of the investment involved. Usually the items are
classified into three categories according to their relative importance, namely,
their value and frequency of replenishment during a period.

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

MATERIAL COST 2.37
2.37
ILLUSTRATION 8
From the following details, DRAW a plan of ABC selective control:
Item Units Unit cost (`)
1 7,000 5.00
2 24,000 3.00
3 1,500 10.00
4 600 22.00
5 38,000 1.50
6 40,000 0.50
7 60,000 0.20
8 3,000 3.50
9 300 8.00
10 29,000 0.40
11 11,500 7.10
12 4,100 6.20
SOLUTION
Statement of Total Cost and Ranking
Item Units % of Total Unit cost Total % of Total Ranking

units (`) cost (`) cost
1 7,000 3.1963 5.00 35,000 9.8378 4
2 24,000 10.9589 3.00 72,000 20.2378 2
3 1,500 0.6849 10.00 15,000 4.2162 7
4 600 0.2740 22.00 13,200 3.7103 8
5 38,000 17.3516 1.50 57,000 16.0216 3
6 40,000 18.2648 0.50 20,000 5.6216 6

7 60,000 27.3973 0.20 12,000 3.3730 9
8 3,000 1.3699 3.50 10,500 2.9513 11
9 300 0.1370 8.00 2,400 0.6746 12
10 29,000 13.2420 0.40 11,600 3.2605 10
11 11,500 5.2512 7.10 81,650 22.9502 1
12 4,100 1.8721 6.20 25,420 7.1451 5
2,19,000 100 3,55,770 100
Basis for selective control (Assumed)

` 50,000 & above -- ‘A’ items
` 15,000 to 50000 -- ‘B’ items
Below ` 15,000 -- ‘C’ items
On this basis, a plan of A B C selective control is given below:
Ranking Item % of Total Cost (`) % of Total Category

Nos. units Cost
1 11 5.2512 81,650 22.9502
2 2 10.9589 72,000 20.2378
3 5 17.3516 57,000 16.0216
Total 3 33.5617 2,10,650 59.2096 A
4 1 3.1963 35,000 9.8378
5 12 1.8721 25,420 7.1451
6 6 18.2648 20,000 5.6216
7 3 0.6849 15,000 4.2162
Total 4 24.0181 95,420 26.8207 B
8 4 0.2740 13,200 3.7103
9 7 27.3973 12,000 3.3730
10 10 13.2420 11,600 3.2605

MATERIAL COST 2.39
2.39
11 8 1.3699 10,500 2.9513
12 9 0.1370 2,400 0.6746
Total 5 42.4202 49,700 13.9697 C
Grand Total 12 100 3,55,770 100
Advantages of ABC analysis: The advantages of ABC analysis are the following:
(i) Continuity in production: It ensures that, without there being any danger of
interruption of production for want of materials or stores, minimum
investment will be made in inventories of stocks of materials or stocks to be
carried.
(ii) Lower cost: The cost of placing orders, receiving goods and maintaining
stocks is minimised specially if the system is coupled with the determination
of proper economic order quantities.
(iii) Less attention required: Management time is saved since attention need to
be paid only to some of the items rather than all the items, as would be the
case if the ABC system was not in operation.
(iv) Systematic working: With the introduction of the ABC system, much of the
work connected with purchases can be systematized on a routine basis, to
be handled by subordinate staff.
ILLUSTRATION 9
A factory uses 4,000 varieties of inventory. In terms of inventory holding and
inventory usage, the following information is compiled:
No. of varieties of % % value of % of inventory

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

SOLUTION
Classification of the items of inventory as per ABC analysis
1. 15 number of varieties of inventory items should be classified as ‘A’ category
items because of the following reasons:
(i) Constitute 0.375% of total number of varieties of inventory handled by
stores of factory, which is minimum as per given classification in the
table.
(ii) 50% of total use value of inventory holding (average), which is
maximum, according to the given table.
(iii) Highest in consumption, about 85% of inventory usage (in
end-product).
2. 110 number of varieties of inventory items should be classified as ‘B’
category items because of the following reasons:
(i) Constitute 2.750% of the total number of varieties of inventory items
handled by stores of factory.
(ii) Requires moderate investment of about 30% of total use value of
inventory holding (average).
(iii) Moderate in consumption, about 10% of inventory usage (in end–
product).
3. 3,875 number of varieties of inventory items should be classified as ‘C’
category items because of the following reasons:
(i) Constitute 96.875% of total varieties of inventory items handled by

stores of factory.
(ii) Requires about 20% of total use value of inventory holding (average).
(iii) Minimum inventory consumption, i.e., about 5% of inventory usage (in

end-product).
(2) Fast Moving, Slow Moving and Non-Moving (FSN) Inventory: It is also
known as FNS (Fast, Normal and Slow moving) classification of inventory analysis.
Under this system, inventories are controlled by classifying them on the basis of
frequency of usage. The classification of items into these three categories

MATERIAL COST 2.41
2.41
depends on the nature and managerial discretion. A threshold range on the basis
of inventory turnover is decided and classified accordingly.
(i) Fast Moving- This category of items is placed nearer to store issue point
and the stock is reviewed frequently for making of fresh orders.
(ii) Slow Moving- This category of items is stored little far and stock is
reviewed periodically for any obsolescence, and may be shifted to
Non-moving category.
(iii) Non-Moving- This category of items is kept for disposal. This category of
items is reported to the management and an appropriate provision for loss
may be created.
Some of the reasons for slow moving and non-moving inventories are stated
below:
(i) Failure of production management to communicate the updated
requirement to the stores management
(ii) Technological upgradation in terms of new machine requiring new kind of
material or existing material becoming obsolete.
(iii) Lack of periodic review of inventories.
By careful observation, timely identification and adoption of inventory
management techniques such as maintenance of minimum level or just in time
approach, one can manage slow moving and non-moving inventories. We may
calculate inventory turnover ratio and present the reports of comparison of actual
and standards with variations, if any to the management.
(3) Vital, Essential and Desirable (VED): Under this system of inventory
analysis, inventories are classified on the basis of its criticality for the
production function and final product. Generally, this classification is done for
spare parts which are used for production.
(i) Vital- Items are classified as vital when its unavailability can interrupt the
production process and cause a production loss. Items under this category
are strictly controlled by setting re-order level.
(ii) Essential- Items under this category are essential but not vital. The
unavailability may cause sub standardisation and loss of efficiency in
production process. Items under this category are reviewed periodically and
get the second priority.

(iii) Desirable- Items under this category are optional in nature, unavailability
does not cause any production or efficiency loss.
For instance, in hospital administration, stock of medicines and essential chemicals
are categorized as VED or FSN inventory. In case of life saving, rare and critical
drugs, they are being categorized as vital inventory. They are the ones whose
unavailability can interrupt smooth service. Those inventories which are optional
or substitutes, not leading to loss in efficiency would be categorized as desirable
inventories. FNS categorization helps the store keepers in hospitals to keep a
check on medicines whose expiry date is close and needs to be disposed off at the
earliest. The quantity of slow-moving drugs are maintained accordingly.
(4) High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
A range of cost is used to classify the inventory items into the three categories.
High-Cost inventories are given more priority for control, whereas Medium-cost
and Low-cost items are comparatively given lesser priority.
6.5 Using Ratio Analysis

(i) Input-Output Ratio: Inventory control can also be exercised by the use of
input- output ratio analysis. Input-output ratio is the ratio of the
quantity of input of material to production and the standard material
content of the actual output.
This type of ratio analysis enables comparison of actual consumption and

standard consumption, thus indicating whether the usage of material is
favourable or adverse.
(ii) Inventory Turnover Ratio: Computation of inventory turnover ratios for

different items of material and comparison of the turnover rates provides a
useful guidance for measuring inventory performance. High inventory
turnover ratio indicates that the material in the question is a fast moving one.
A low turnover ratio indicates over-investment and locking up of the working
capital in inventories. Inventory turnover ratio may be calculated by using
the following formulae: -

MATERIAL COST 2.43
2.43
Inventory Turnover Ratio = Cost of materials consumed during the period

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

365 days /12months
Average no. of days of Inventory holding =
Inventory Turnover Ratio
By comparing the number of days in the case of two different materials, it is
possible to know which is fast moving and which is slow moving. On this basis,
attempt should be made to reduce the amount of capital locked up, and prevent
over-stocking of the slow-moving items.
ILLUSTRATION 10
The following data are available in respect of material X for the year ended 31st
March, 2023.
(`)
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000
CALCULATE:
(i) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.
SOLUTION
Inventory turnover ratio
(Refer to working note) = Cost of stock of raw material consumed
Average stock of raw material
`2,50,000
= = 2.5
`1,00,000
Average number of days for which the average inventory is held

365 365 days
= = = 146 days
Inventory turnover ratio 2.5

Working Note:
(`)
Opening stock of raw material 90,000
Add: Material purchases during the year 2,70,000
Less: Closing stock of raw material 1,10,000
Cost of stock of raw material consumed 2,50,000
ILLUSTRATION 11
From the following data for the year ended 31st March, 2023, CALCULATE the
inventory turnover ratio of the two items and put forward your comments on them.
Material A (`) Material B (`)

Opening stock 1.04.2022 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.03.2023 6,000 11,000
SOLUTION
First of all, it is necessary to find out the material consumed:
Cost of materials consumed Material A Material B

(`) (`)
Opening stock 10,000 9,000
Add: Purchases 52,000 27,000
62,000 36,000
Less: Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory: (Opening Stock + Closing Stock) ÷ 2 8,000 10,000
Inventory Turnover ratio: (Consumption ÷ Average 7 times 2.5 times
inventory)
Inventory Turnover (Number of Days in a year/IT ratio) 52 days 146 days
Comments: Material A is moving faster than Material B.

MATERIAL COST 2.45
2.45
6.6 Physical Control

(i) Two Bin System: Under this system, each bin is divided into two parts –
(I) smaller part to stock the quantity equal to the minimum stock or even
the re-ordering level, and
(II) the other part to keep the remaining quantity.
Issues are made out of the larger part; but as soon as it becomes necessary
to use quantity out of the smaller part of the bin, fresh order is placed. “Two
Bin System” is supplemental to the record of respective quantities on the bin
card and the stores ledger card.
(ii) Establishment of system of budgets: To control investment in the
inventories, it is necessary to know in advance about the inventories
requirement during a specific period (usually a year). The exact quantity of
various types of inventories and the time when they would be required can
be known by studying carefully production plans and production schedules.
Based on this, inventories requirement budget can be prepared. Such a
budget will discourage the unnecessary investment in inventories.
(iii) Perpetual inventory records and continuous stock verification:
Perpetual inventory represents a system of records maintained by the stores
department. It, in fact, comprises of: (i) Bin Cards, and (ii) Stores Ledger.
The success of perpetual inventory depends upon the following:
(a) The Stores Ledger showing quantities and amount of each item.
(b) Stock Control cards (or Bin Cards).
(c) Reconciling the quantity balances shown by (a) & (b) above.
(d) Checking the physical balances of a number of items every day
systematically and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, between
physical balances and the book figures.
(f) Making corrective entries wherever required after step (e) and
(g) Removing the causes of the discrepancies referred to in step (e)

Advantages of perpetual inventory: The main advantages of perpetual

inventory are as follows:
(1) Physical stocks can be counted and book balances adjusted as and
when desired without waiting for the entire stock-taking to be done.
(2) Quick compilation of Profit and Loss Account (for interim period) due
to prompt availability of stock figures.
(3) Discrepancies are easily located and thus corrective action can be
promptly taken to avoid their recurrence.
(4) A systematic review of the perpetual inventory reveals the existence of

surplus, dormant, obsolete and slow-moving materials, so that
remedial measures may be taken in time.
(5) Fixation of the various stock levels and checking of actual balances in
hand with these levels assist the store keeper in maintaining stocks
within limits and in initiating purchase requisitions for correct quantity
at the appropriate time.
(iv) Continuous Stock Verification: The checking of physical inventory is an

essential feature of every sound system of material control. The system of
continuous stock-taking consists of physical verification of items of
inventory. The stock verification may be done by internal audit department
but are independent of the store and production staff. Stock verification is
done at appropriate interval of time without prior notice. The element of
surprise is essential for effective control of the system.
Disadvantages of Annual/ Periodic Stock Taking: Annual stock-taking,

however, has certain inherent shortcomings which tend to detract from the
usefulness of such physical verification. For instance, since all the items have
to be covered in a given number of days, either the production department
has to be shut down during those days to enable thorough checking of
stock or else the verification must be of limited character.
On the contrary, continuous stock taking is holding more advantages. Some

of them are discussed below:

MATERIAL COST 2.47
2.47
Advantages of continuous stock-taking:

1. Closure of normal functioning is not necessary.
2. Stock discrepancies are likely to be brought to the notice and
corrected much earlier than under the annual stock-taking system.
3. The system generally has a sobering influence on the stores staff
because of the element of surprise present therein.
4. The movement of stores items can be watched more closely by the
stores auditor so that chances of obsolescence buying are reduced.
5. Final Accounts can be ready quickly. Interim accounts are possible
quite conveniently.
7. MATERIAL ISSUE PROCEDURE

Issue of material must not be made except under properly authorised requisition
slip. Usually, it is the foreman of a department who has the authority to draw
materials from the store. Issue of material must be made on the basis of first in
first out, that is, out of the earliest lot in hand. If care is not exercised in this
regard, quality of earliest lot of material may deteriorate for having been kept for
a long period.
(i) Issue against Material Requisition Note: It is the voucher of the
authority as regards to the issue of materials for use in the factory or in
any of its departments. After receipt of material requisition slip, store keeper
ensures that requisition is properly authorized and requisitioned quantity is
within the quantity specified in bill of materials. After satisfied with the
documents, store keeper issue materials and keeps one copy of the MRN to
maintain the necessary records.
(ii) Transfer of Material: The surplus material arising on a job or other units
of production may sometime be unsuitable for transfer to store because of
its bulk, heavy weight, brittleness or some other reason. It may, however, be
possible to find some alternative use for such materials by transferring them
to some other job instead of returning them to the store.

It must be stressed that generally transfer of material from one job to

another is irregular, if not improper; in so far, it is not conducive to correct
allocation and control of material, cost of jobs or other units of production.
It is only in the circumstances envisaged above, that such direct transfer
should be made. At the time of material transfer, a material transfer note
should be made in duplicate. The disposition of the copies of this note being
are as follows:
Material Transfer
Cost Accounting Department

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

peculiarities, management information system (MIS) and accounting system
in place.
(iii) Return of Material: Sometimes, it is not possible before hand to make any
precise estimate of the material requirements or units of production.
Besides, at times, due to some technical issues or other difficulties, it is not
practicable to measure the exact quantity of material required by a
department. In either case, material may have to be issued from stores in
bulk, often in excess of the actual quantity required. Where such a condition
exists, it is of the utmost importance from the point of view of materials
control that any surplus material left over on the completion of a job
should be promptly hand over to the storekeeper for safe and proper
custody.
Unless this is done, the surplus material may be misappropriated or misap-
plied to some purpose, other than that for which it was intended. The

MATERIAL COST 2.49
2.49
material cost of the job against which the excess material was originally
drawn in that case, would be overstated, unless the job is given credit for the
surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be
accompanied by a document known as a Shop Credit Note or alternatively
as a Stores Debit Note. This document should be made out; by the
department returning the surplus material and it should be in triplicate to be
used as follows:
Store Room
Shop Credit Note Cost Accounting Department
Department Returnign it
Format of a shop credit note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
8. VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are
carried in stock. But there can be a situation where the material may have been
purchased at different times and at different prices with varying discounts, taxes
etc. Because of this the problem arises as to how the material issues to production
are to be valued. There are several methods for tackling this situation. The cost
accountant should select the proper method based on following factors:
1. The frequency of purchases, price fluctuations and its range.
2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and the type of production process.
5. Management policy relating to the valuation of closing stock.

Several methods of pricing material issues have been evolved in an attempt to

satisfactorily answer the problem. These methods may be grouped and explained
as follows:
8.1 Cost Price Methods

(i) Specific Price Method: This method is useful, especially when materials
are purchased for a specific job or work order, as such materials are
issued subsequently to that specific job or work order at the price at which
they were purchased.
To use this method, it is necessary to store each lot of material separately
and maintain its separate account.
Advantages and Disadvantages
Advantages Disadvantages
• The cost of materials issued for • This method is difficult to

production purposes to specific operate, specially when
jobs represent actual and correct purchases and issues are
costs. numerous.
• This method is best suited for

non-standard and specific
products.
(ii) First-in First-out (FIFO) Method: It is a method of pricing the issues of

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

MATERIAL COST 2.51
2.51
Advantages and disadvantages
• It is simple to understand and • If the prices fluctuate frequently,

easy to operate. this method may lead to clerical
error.
• Material cost charged to • Since each issue of material to

production represents actual production is related to a specific
cost with which the cost of purchase price, the costs charged
production should have been to the same job are likely to show
charged. a variation from period to period.
• In the case of falling prices, the • In the case of rising prices, the real
use of this method gives better profits of the concern being low,
results. while the profits in the books will
appear high. This may lead to
inability of the firm to meet the
materials purchase demand at the
current market price.
• Closing stock of material will be

represented very closely at
current market price.
The application of FIFO method is illustrated below:

Material Received and Issued
Lot Date Quantity Lot Rate Amount

No. Kg. No. (`) (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00

July 12 200 Kgs. out of (1) 1.00 200.00

July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00
400 Kgs. out of (4) 1.10 440.00
200 Kgs. out of (5) 0.80 160.00
The stock in hand after 8th August will be 1,000 kgs. This will be out of lot
number (5) and its value will be ` 800, i.e., @ ` 0.80 per kg.
(iii) Last-in-First-out (LIFO) Method: It is a method of pricing the issues of
materials on the basis of assumption that the items of the last batch (lot)
purchased are the first to be issued. Therefore, under this method the
prices of the last batch (lot) are used for pricing the issues, until it is
exhausted, and so on. If however, the quantity of issue is more than the
quantity of the latest lot, then earlier (lot) and its price will also be taken into
consideration.
During inflationary period or period of rising prices, the use of LIFO
would help to ensure that the cost of production determined on the above
basis is approximately the current one. This method is also useful specially
when there is a feeling that due to the use of FIFO or average methods, the
profits shown and tax paid are too high.
Advantages and Disadvantages
• The cost of materials issued will • Calculation under LIFO system

be either nearer to and or will becomes complicated and
reflect the current market price. cumbersome when frequent
Thus, the cost of goods produced purchases are made at highly
will be related to the trend of the fluctuating rates.
market price of materials. Such a
trend in price of materials enables
the matching of cost of production
with current sales revenues.

MATERIAL COST 2.53
2.53
• The use of the method during the • Costs of different similar

period of rising prices does not batches of production carried
reflect undue high profit in the on at the same time may differ
income statement as it was under a great deal.
the first-in-first-out or average
method. In fact, the profit shown
here is relatively lower because the
cost of production takes into
account the rising trend of material
prices.
• In the case of falling prices profit • In time of falling prices, there

tends to rise due to lower material will be need for writing off
cost, yet the finished products stock value considerably to
appear to be more competitive stick to the principle of stock
and are at market price. valuation, i.e., the cost or the
market price whichever is lower.
• Over a period, the use of LIFO • This method of valuation of

helps to iron out the fluctuations material is not acceptable to
in profits. the income tax authorities.
• In the period of inflation LIFO will

tend to show the correct profit and
thus avoid paying undue taxes to
some extent.
It may be noted that Last in First out (LIFO) is not permitted under
Accounting Standard (AS)-2: Valuation of Inventories and Ind AS- 2:
Inventories. However, for the purpose of academic knowledge LIFO
method is included in this Study Material
ILLUSTRATION 12
The following transactions in respect of material Y occurred during the six months
ended 30th September, 2022:

Month Purchase Price per unit Issued

(units) (` ) Units
April 200 25 Nil
May 300 24 250
June 425 26 300
July 475 23 550
August 500 25 800
September 600 20 400
Required:
(a) The Chief Accountant argues that the value of closing stock remains the same
no matter which method of pricing of material issues is used. Do you agree?
Why or why not? EXPLAIN. Detailed stores ledgers are not required.
(b) STATE when and why would you recommend the LIFO method of pricing
material issues?
SOLUTION
(a) Total number of units purchased = 2,500
Total number of units issued = 2,300

The closing stock at the end of six months’ period i.e., on 30th September,
2022 will be 200 units
Upto the end of August 2022, total purchases coincide with the total issues
i.e., 1,900 units. It means that at the end of August 2022, there was no
closing stock. In the month of September 2022, 600 units were purchased
out of which 400 units were issued. Since there was only one purchase and
one issue in the month of September, 2022 and there was no opening stock
on 1st September 2022, the Closing Stock of 200 units is to be valued at ` 20
per unit.
In the view of this, the argument of the Chief Accountant appears to be
correct. Where there is only one purchase and one issue in a month with no
opening stock, the method of pricing of material issues becomes irrelevant.
Therefore, in the given case one should agree with the argument of the

MATERIAL COST 2.55
2.55
Chief Accountant that the value of closing stock remains the same no matter
which method of pricing the issue is used.
It may, however, be noted that the argument of Chief Accountant would not
stand if one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material
issues due to the following advantages:
(i) The cost of the materials issued will be either nearer or will reflect the
current market price. Thus, the cost of goods produced will be related
to the trend of the market price of materials. Such a trend in price of
materials enables the matching of cost of production with current
sales revenues.
(ii) The use of the method during the period of rising prices does not
reflect undue high profit in the income statement, as it was under the
first-in-first-out or average method. In fact, the profit shown here is
relatively lower because the cost of production takes into account the
rising trend of material prices.
(iii) In the case of falling prices, profit tends to rise due to lower material
cost, yet the finished products appear to be more competitive and are
at market price.
(iv) During the period of inflation, LIFO will tend to show the correct profit
and thus, avoid paying undue taxes to some extent.
ILLUSTRATION 13
The following information is provided by Sunrise Industries for the fortnight of April,
2023:
Material Exe:
Stock on 1-4-2023 100 units at ` 5 per unit.
Purchases
5-4-2023, 300 units at ` 6
8-4-2023, 500 units at ` 7
12-4-2023, 600 units at ` 8

Issues
6-4-2023, 250 units
10-4-2023, 400 units
14-4-2023, 500 units
Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-2023.
(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different
under the two methods of pricing of material issues used. You need not draw
up the Stores Ledgers.
SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-2023 to 15-4-2023 by using FIFO method.
Date Description Units Qty. (Units) Rate Amount

(`) (`)
1-4-2023 Opening balance 100 5 500
5-4-2023 Purchased 300 6 1,800
6-4-2023 Issued 100 5

1,400
150 6
8-4-2023 Purchased 500 7 3,500
10-4-2023 Issued 150 6

2,650
250 7
12-4-2023 Purchased 600 8 4,800
14-4-2023 Issued 250 7

3,750
250 8
15-4-2023 Balance 350 8 2,800

MATERIAL COST 2.57
2.57
Total value of material Exe consumed during the period under FIFO
method comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on
15-4-2023 is of ` 2,800.
Value of material Exe consumed during the period 01-4-2023 to
15-4-2023 by using LIFO method
Date Description Qty. Rate Amount

(Units) (`) (`)
1-4-2023 Opening balance 100 5 500
5-4-2023 Purchased 300 6 1,800
6-4-2023 Issued 250 6 1,500
8-4-2023 Purchased 500 7 3,500
10-4-2023 Issued 400 7 2,800
12-4-2023 Purchased 600 8 4,800
14-4-2023 Issued 500 8 4,000
15-4-2023 Balance 350 — 2,300*
Total value of material Exe issued under LIFO method comes to

(` 1,500 + ` 2,800 + ` 4,000) ` 8,300.
*The balance 350 units on 15-4-2023 of ` 2,300, relates to opening
balance on 1-4-2023 and purchases made on 5-4-2023, 8-4-2023 and
12-4-2023. (100 units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100
units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-2023:
Under FIFO method ` 2,800
Under LIFO method ` 2,300
(B) Total value of material Exe issued to production under FIFO and LIFO
methods comes to ` 7,800 and ` 8,300 respectively. The value of closing
stock of material Exe on 15-4-2023 under FIFO and LIFO methods comes to
` 2,800 and ` 2,300 respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the
following table in the value of material Exe, issued to production under FIFO
and LIFO is as follows:

Date Quantity Value Total Value Total

Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6-4-2023 250 1,400 1,500
10-4-2023 400 2,650 2,800
14-4-2023 500 3,750 7,800 4,000 8,300
1. On 6-4-2023, 250 units were issued to production. Under FIFO their

value comes to ` 1,400 (100 units × ` 5 + 150 units × ` 6) and under
LIFO ` 1,500 (250 × ` 6). Hence, ` 100 more was charged to production
under LIFO.
value comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800
(400 × ` 7). Hence, ` 150 more was charged to production under LIFO.
value comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000
(500 × ` 8). Hence, ` 250 more was charged to production under LIFO.
Thus, the total excess amount charged to production under LIFO comes to
` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of 350
units of Closing Stock of material Exe under FIFO and LIFO are as follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to the
purchase of material made on 12-4-2023, whereas under LIFO these
units were from opening balance and purchases made on 5-4-2023,
8-4-2023 and 12-4-2023.
2. Due to different purchase price paid by the concern on different days
of purchase, the value of closing stock differed under FIFO and LIFO.
Under FIFO 350 units of closing stock were valued @ ` 8 p.u. Whereas
under LIFO first 100 units were valued @ ` 5 p.u., next 50 units @ ` 6
p.u., next 100 units @ ` 7 p.u. and last 100 units @ ` 8 p.u.
Thus, under FIFO, the value of closing stock increased by ` 500.

MATERIAL COST 2.59
2.59
(iv) Base Stock Method: Minimum quantity of stock under this method is
always held at a fixed price as reserve in the stock, to meet the state of
emergency, if it arises. This minimum stock is known as base stock and is
valued at a price at which the first lot of materials is received and remains
unaffected by subsequent price fluctuations.
This method of valuing inventory is different from other methods of valuing
issues, as the base stock of materials are valued at the original cost, whereas,
materials other than the base are valued using other methods like FIFO, LIFO
etc. This method is not an independent method as it uses FIFO or LIFO.
Advantages and disadvantages of this method depend upon the use of the
other method viz., FIFO or LIFO.
8.2 Average Price Methods

(i) Simple Average Price Method: Under this method, materials issued are
valued at average price, which is calculated by dividing the total of rates at
which different lot of materials are purchased by total number of lots. In this
method quantity purchased in each lot is ignored. However, the price of
stock of that lot which is completely sold out is not considered for taking
average price.
Example - 1: During the month of April, a company has made five purchases
as follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ ` 11 each.
The issue price under Simple Average Price Method would be calculated as
below:
`10 + `12 + `12 + `15 + `11
= ` 12 each
5 lots
This method is suitable when the materials are received in uniform lots of
similar quantity, and prices do not fluctuate considerably.

Advantages and Disadvantages:
• This method is simple to use for • This method does not provide right
an entity which orders materials stock valuation when standard
in a lot of standard quantity, as quantity for purchase in a lot is not
only price per lot is taken to specified.
calculate average price
• In a stable price environment, • When price of materials fluctuates
this method gives a price which and the entity chooses to
approximates to the current customise the order quantity, the
market price. price under this method may differ
substantially from the current
market price.
(ii) Weighted Average Price Method: Unlike Simple Average Price method,
this method gives due weightage to quantities also. Under this method,
issue price is calculated by dividing sum of products of price and quantity by
total number quantities.
Example - 2: During the month of April, a company has made five purchases
as follows:
1st April, 200 units @ `10 each;
21st April, 50 units @ `15 each and

28th April, 140 units @ ` 11 each.
The issue price under Weightage Average Price Method would be calculated
as below:
{( ` 10×200 units)+( ` 12×150 units)+( ` 12×210 units)
+( ` 15×50 units)+( ` 11×140 units)}
=
(200+150+210+50+140) units
` 8,610
= = ` 11.48 each
750 units

MATERIAL COST 2.61
2.61
This method is useful in case when quantity purchased under each lot is
different and price fluctuates frequently.
Advantages and Disadvantages:
• It smoothens the price • Material cost does not represent
fluctuations, if at all it is there, actual cost price and therefore, a
due to material purchases. different profit or loss will arise
out of such a pricing method.
• Issue prices need not be • It may be difficult to compute,

calculated for each issue unless since every time lot is received,
new lot of materials is received. it would require re-computation
of issue prices.
8.3 Market Price Methods

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

8.4 Notional Price Methods

(i) Standard Price Method: Under this method, materials are priced at some
predetermined rate or standard price irrespective of the actual purchase
cost of the materials. Standard cost is usually fixed after taking into
consideration the following factors:
(i) Current prices,
(ii) Anticipated market trends, and

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

MATERIAL COST 2.63
2.63
9. VALUATION OF RETURNS & SHORTAGES

9.1 Valuation of Materials Returned to the Vendor
Generally, materials are checked for quality, before dispatching to the store; and if
any issues arise such as not meeting the quality requirements or any specification
or are considered unfit for production due to any reason, due notice is made and
materials are returned to the vendor. However, even if any substandard quality is
noticed, before or after reaching the store, such materials can also be returned to
the vendor.
The price of the materials to be returned to the vendor should include its invoice
price plus freight, receiving and handling charges etc. Strictly speaking, the
materials returned to the vendor should be returned at the stores ledger price and
not at invoice price. But in practice, only invoice price is considered and the gap
between the invoice price and stores ledger price is charged as overhead. In stores
ledger, the defective or sub-standard materials are shown in the issue column at
the rate shown in the ledger, and the difference between issue price and invoice
cost is debited to an inventory adjustment account.
9.2 Valuation of Materials Returned to Stores

When materials requisitioned for a specific job or work-in progress are found to
be in excess of the requirement or are unsuitable for the purpose, they are
returned to the stores. There are two ways of treating such returns.
(1) Such returns are entered in the receipt column at the price at which they
were originally issued, and the materials are kept in suspense account, to be
issued at the same price, against the next requisition.
(2) Include the materials in stock, as if they were fresh purchases at the original
issue price.
9.3 Valuation of Shortages during Physical Verification

Materials found short during physical verification should be entered in the issue
column and valued at the rate as per the method adopted, i.e., FIFO or any other.
[Kindly refer Illustration 14 at Page no. 2.68]

10. TREATMENT OF NORMAL AND ABNORMAL

LOSS OF MATERIALS
Loss of materials during handling, storage, process may occur any of the following
forms:
Loss of Material
Waste Scrap Spoilage Defectives Obsolescence
(i) Waste: The portion of raw material which is lost during storage or
production and discarded. The waste may or may not have any value.
Treatment of Waste
Normal- Cost of normal waste is absorbed by good production units.
Abnormal- The cost of abnormal loss is transferred to Costing Profit and
loss account.
(ii) Scrap: The materials which are discarded and disposed-off without further
treatment. Generally, scrap has either no value or insignificant value.
Sometimes, it may be reintroduced into the process as raw material.
Treatment of Scrap
Normal- The cost of scrap is borne by good units and income arises on
account of realisable value is deducted from the cost.
Abnormal- The scrap account should be charged with full cost. The credit is
given to the job or process concerned. The profit or loss in the scrap
account, on realisation, will be transferred to the Costing Profit and Loss
Account.
(iii) Spoilage: It is the term used for materials which are badly damaged in
manufacturing operations, and they cannot be rectified economically and
hence taken out of the process to be disposed off in some manner without
further processing.

MATERIAL COST 2.65
2.65
Treatment of Spoilage
Normal- Normal spoilage (i.e., which is inherent in the operation) costs are
included in costs, either by charging the loss due to spoilage to the
production order or by charging it to the production overhead so that it is
spread over all the products.
Any value realised from spoilage is credited to production order or

production overhead account, as the case may be.
Abnormal- The cost of abnormal spoilage (i.e., arising out of causes not
inherent in manufacturing process) is charged to the Costing Profit and Loss
Account. When spoiled work is the result of rigid specification, the cost of
spoiled work is absorbed by good production while the cost of disposal is
charged to production overhead.
(iv) Defectives: It signifies those units or portions of production which do not

meet the quality standards. Defectives arise due to sub-standard materials,
bad-supervision, bad-planning, poor workmanship, inadequate-equipment
and careless inspection.
The defectives which can be re-made as per the quality standard by using
additional materials are known as reworks. Reworks include repairs,
reconditioning and refurbishing.
Defectives which cannot be brought up to the quality standards are known

as rejects. The rejects may either be disposed-off or re-cycled for production
process.
Treatment of Defectives:
Normal- An amount equal to the cost less realisable value on sale of

defectives are charged to material cost of good production.
Abnormal- Material cost of abnormal defectives are not included in material

cost but treated as loss after giving credit to the realisable value of such
defectives. The material cost of abnormal loss is transferred to costing profit
and loss account.

Reclamation of loss from defective units
In the case of articles that have been spoiled, it is necessary to take steps to
reclaim as much of the loss as possible. For this purpose:
(i) All defective units should be sent to a place fixed for the purpose;
(ii) These should be dismantled;
(iii) Goods and serviceable parts should be separated and taken back into
the stock;
(iv) Parts which can be made serviceable by further work should be

separated and sent to the workshop for the purpose and taken into
stock after the defects have been removed; and
(v) Parts which cannot be made serviceable should be collected in one

place for being melted or sold off.
Printed forms should be used to record quantities for all purposes

aforementioned.
Difference between Waste and Scrap
Waste Scrap
1. It is connected with raw 1. It is the loss connected with the

material or inputs to the output
production process.
2. Waste of materials may be 2. Scraps are generally

visible or invisible. identifiable and has physical
substance.
3. Generally, waste has no 3. Scraps are termed as

recoverable value. by-products and has small
recoverable value.

MATERIAL COST 2.67
2.67
Difference between Scrap and Defectives
Scrap Defectives
1. It is the loss connected with the 1. This type of loss is connected
output with the output as well as the
input.
2. Scraps are not intended but 2. Defectives also are not
cannot be eliminated due to intended but can be eliminated
the nature of material or through a proper control
process itself. system.
3. Generally, scraps are not used 3. Defectives can be used after
or rectified. rectification.
4. Scraps have insignificant 4. Defectives are sold at a lower
recoverable value. value from that of the good
one.
Distinction between Spoilage and Defectives: The difference between

spoilage and defectives is that while spoilage cannot be repaired or
reconditioned, defectives can be rectified and transferred, either back to the
standard production or to the seconds.
The problem of accounting for defective work is in relation to the costs of
rectification or rework.
(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of
an asset due to its supersession”. In simple words, obsolescence refers to the
loss in the value of an asset due to technological advancements.
Treatment: Materials may become obsolete under any of the following

circumstances:
(i) where it is a spare part or a component of a machinery that is used in
manufacturing and is now obsolete;
(ii) where it is used in the manufacturing of a product which has now
become obsolete;
(iii) where the material itself is replaced by another material due to either
improved quality or fall in price.

In all the three cases, the value of the obsolete material held in stock is a
total loss and immediate steps should be taken to dispose it off at the best
available price. The loss arising out of obsolete materials is an abnormal loss
and it does not form part of the cost of manufacture.
ILLUSTRATION 14
Imbrios India Ltd. is recently incorporated start-up company back in the year 2019.
It is engaged in creating Embedded products and Internet of Things (IoT) solutions
for the Industrial market. It is focused on innovation, design, research and
development of products and services. One of its embedded products is LogMax, a
system on module (SoM) Carrier board for industrial use. It is a small, flexible and
embedded computer designed as per industry specifications. In the beginning of the
month of September 2022, company entered into a job agreement of providing 4800
LogMax to NIT, Mandi. Following details w.r.t. issues, receipts, returns of Store
Department handling Micro-controller, a component used in the designated
assembling process have been extracted for the month of September, 2022:
Sep. 1 Opening stock of 6,000 units @ ` 285 per unit

Issued 4875 units to mechanical division vide material requisition no.
Sep. 8
Mech 009/22
Received 17,500 units @ ` 276 per unit vide purchase order no.
Sep. 9
159/22
Issued 12,000 units to technical division vide material requisition no.
Sep. 10
Tech 012/22
Returned to stores 2375 units by technical division against material
Sep. 12
requisition no. Tech 012/22.
Received 9,000 units @ ` 288 per units vide purchase order no. 160/
Sep. 15
2222
Returned to supplier 700 units out of quantity received vide purchase
Sep. 17
order no. 160/22.
Issued 9,500 units to technical division vide material requisition no.
Sep. 20
Tech 165/22
On 25th September, 2022, the stock manager of the company expressed his need to
leave for his hometown due to certain contingency and immediately left the job
same day. Later, he also switched his phone off.

MATERIAL COST 2.69
2.69
As the company has the tendency of stock-taking every end of the month to check
and report for the loss due to rusting of the components, the new stock manager, on
30th September, 2022, found that 900 units of Micro-controllers were missing which
was apparently misappropriated by the former stock manager. He, further, reported
loss of 300 units due to rusting of the components.
From the above information you are required to prepare the Stock Ledger account
using ‘Weighted Average’ method of valuing the issues.
SOLUTION
Store Ledger of Imbrios India Ltd. (Weighted Average Method)
Date Receipts Issues Balance of Stock
Qty Rate Amount Qty Rate Amount Qty Rate Amount

Sep.
(kg.) (`) (`) (kg.) (`) (`) (kg.) (`) (`)
1 - - - - - - 6,000 285.00 17,10,000
8 - - - 4,875 285.00 13,89,375 1,125 285.00 3,20,625
9 17,500 276.00 48,30,000 - - - 18,625 276.54 51,50,625
10 - - - 12,000 276.54 33,18,480 6,625 276.54 18,32,145
12 2,375 276.54 6,56,783 - - - 9,000 276.54 24,88,928
15 9,000 288.00 25,92,000 - - - 18,000 282.27 50,80,928
17 - - - 700 288.00 2,01,600 17,300 282.04 48,79,328
20 - - - 9,500 282.04 26,79,380 7,800 282.04 2199948
30 - - - 900* 282.04 2,53,836 6,900 282.04 19,46,112
30 - - - 300** - - 6,600 294.87 19,46,112
* 900 units is abnormal loss, hence it will be transferred to Costing Profit & Loss
A/c.
** 300 units is normal loss; hence it will be absorbed by good units.

11. CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like
material, labour etc. The management for planning and control must know the
cost of using these resources in manufacturing process. The consumption of
materials takes place when it is used in the manufacturing of the product.
It is important to note that the amount of materials consumed in a period by a
cost object need not be equal to the amount of material available with the
concern. For example, during any period, the total of raw material stock available
for use in production may not be equal to the amount of materials actually
consumed and assigned to the cost object of the production. The difference
between the material available and material consumed represents the surplus
stock or stock of material at the end of the period.
11.1 Identification of Materials

For the identification of consumption of materials with products of cost centres
the followings points should be noted:
1. It is required that the concern should follow coding system for all materials,
so that each material is identified by unique code number.
2. It is required that each product of a cost centre should be given a unique
code number so that the direct material issued for production of particular
product of a cost centre can be collected against the code number of that
product.
However, it may not be possible to allocate all materials directly to
individual product of a cost centre e.g. maintenance materials, inspection
and testing materials etc. The consumption of these materials are collected
for cost centre and then charged to individual product by adopting suitable
overhead absorption rate of cost centre.
Cost for cost centre
Overhead absorption rate of cost centre =
Base relating to cost centre
(e.g. labour hrs. or machine hrs.)

MATERIAL COST 2.71
2.71
3. Each issue of materials should be recorded. One way of doing this is to use a
material requisition note. This note shows the details of materials issued for
the product of cost centre or the cost centre which is to be charged with
cost of materials.
4. A material return note is required for recording the excess materials
returned to the store. This note is required to ensure that original product of
cost centre is credited with the cost of material which was not used and that
the stock records are updated.
5. A material transfer note is required for recording the transfer of materials
from one product of cost centre to other or from one cost centre to other
cost centre.
6. The cost of materials issued would be determined according to stock
valuation method used.
11.2 Monitoring Consumption of Materials

For monitoring consumption of materials, a storekeeper should periodically
analyse the various material requisitions, material return notes and material
transfer notes. Based on this analysis, a material abstracts or material issue
analysis sheet is prepared, which shows at a glance the value of material
consumed in manufacturing each product. This statement is also useful for
ascertaining the cost of material issued for each product.
Format of Material Abstract
Week Ending............
Material Amount Product Nos. Total Overheads

requisition (`) for (Indirect
or Transfer Product Material
Note or charged)
Returned 101 102 103 104 105 106
Note No. (`) (`) (`) (`) (`) (`) (`)
— — — — — — — — —
Total

The material abstract statement serves a useful purpose. It, in fact, shows the
amount of material to be debited to various products & overheads. The total
amount of stores debited to various products & overheads should be the same as
the total value of stores issued in any period.
11.3 Basis for Consumption Entries in Financial Accounts

Every manufacturing organisation assigns material costs to the products for two
purposes.
Firstly, for external financial accounting requirements, in order to allocate the

material costs incurred during the period between cost of goods produced and
inventories; secondly to provide useful information for managerial
decision-making requirements. In order to meet external financial accounting
requirements, it may not be necessary to accurately trace material costs to
individual products.
Some products costs may be overstated and others may be understated. But this
may not matter for financial accounting purposes, as long as total of individual
materials costs transactions are recorded i.e., transactions between cost centre
within the firm are recorded in a manner that facilitates analysis of costs for
assigning them to cost units.
The consumption entries in financial accounts are made on the basis of total cost of
purchases of materials after adjustment for opening and closing stock of materials.
Following equation is applicable here:
Consumption of Materials = Opening Stock of materials + Purchases – Closing Stock

of materials
The stock of materials is taken at cost or net realisable value, whichever is less.

MATERIAL COST 2.73
2.73
SUMMARY
♦ Material Control: It is the systematic control over the procurement, storage
and usage of materials to maintain even flow of materials and avoiding at the
same time excessive investment in inventories.
♦ Material Requisition Note: Document used to authorize and record the issue
of materials from store.
♦ Purchase Requisition Note: Document is prepared by the storekeeper to
initiate the process of purchases.
♦ Purchase Order: It is a written request to the supplier to supply certain
specified materials at specified rates and within a specified period.
♦ Goods Received Note: This document is prepared by receiving department
which unpacks the goods received and verify the quantities and other details.
♦ Material Transfer Note: This document is prepared when the material is
transferred from one department to another.
♦ Material Return Note: It is a document given with the goods being returned
from factory back to the stores.
♦ Bin Card: A prime entry record of the quantity of stocks, kept on
in/out/balance, held in designated storage areas.
♦ Stores Ledger: A ledger containing a separate account for each item of
material and component stocked in store giving details of the receipts, issues
and balance both in terms of quantity and value.
♦ Minimum Level: It is the minimum quantity, which must be retained in stock
ROL- (Avg. consumption × Avg. Lead time)
♦ Maximum Level: It is the maximum limit up to which stock can be stored at
any time
ROL + ROQ – (Min consumption × Min Lead Time)

♦ Re order Level: It is the level at which new order needs to be placed

Maximum lead time × Maximum Usage
Or
Minimum level + (Average rate of consumption × Average time to obtain fresh
supplies).
♦ Average Inventory Level = Minimum level + 1/2 Re-order quantity
Or
Maximum level+Minimum level
=
2
♦ Danger Level: The level where normal issue of materials is stopped, and only
emergency materials are issued.
Danger level = Average consumption × Lead time for emergency purchases.
♦ Stock-out = Stock out is said to be occurred when an inventory item could not
be supplied due to insufficient stock in the store.
♦ Just-in-time (JIT) Inventory management: JIT is a system of inventory
management with an approach to have zero inventories in stores. According to
this approach material should only be purchased when it is actually required for
production.
♦ ABC analysis: Items are classified into the following categories:
A Category: Quantity less than 10 % but value more than 70 %
B Category: Quantity less than 20 % but value about 20 %
C Category: Quantity about 70 % but value less than 10%
♦ Fast Moving, Slow Moving and Non-Moving (FSN) Inventory: Under this
system, inventories are controlled by classifying them on the basis of frequency
of usage.
♦ Vital, Essential and Desirable (VED): Under this system of inventory analysis,
inventories are classified on the basis of its criticality for the production function
and final product.

MATERIAL COST 2.75
2.75
♦ High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
♦ Two bin system: If one bin items exhausts, new order is placed and in the mean
time, quantity from pthe smaller bin is used or issued.
♦ First-in First-out method: The materials received first are to be issued first when
material requisition is received. Materials left as closing stock will be at the price
of the latest purchases.
♦ Last-in First-out method: The materials purchased last are to be issued first
when material requisition is received. Closing stock is valued at the oldest
available stock price.
♦ Simple Average Method: Material Issue Price
Total of unit price of each purchase
=
Total number of Purchases
♦ Weighted Average Price Method: This method gives due weightage to
quantities purchased and the purchase price to determine the issue price.
Total cost of material in stock
Weighted Average Price =
Total quantity of materials
♦ Various Material Losses

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

TEST YOUR KNOWLEDGE

1. Direct material can be classified as
(a) Fixed cost
(b) Variable cost
(c) Semi-variable cost.
(d) Prime Cost
2. In most of the industries, the most important element of cost is
(a) Material
(b) Labour
(c) Overheads
(d) Administration Cost
3. Which of the following is considered to be the normal loss of materials?
(a) Loss due to accidents
(b) Pilferage
(c) Loss due to breaking the bulk
(d) Loss due to careless handling of materials.
4. In which of following methods of pricing, costs lag behind the current
economic values?
(a) Last-in-first out price
(b) First-in-first out price

(c) Replacement price
(d) Weighted average price

MATERIAL COST 2.77
2.77
5. Continuous stock taking is a part of
(a) Annual stock taking
(b) Perpetual inventory
(c) ABC analysis.
(d) Bin Cards
6. In which of the following methods, issues of materials are priced at

pre-determined rate?
(a) Inflated price method
(b) Standard price method
(c) Replacement price method
(d) Market price method.
7. When material prices fluctuate widely, the method of pricing that gives absurd
results is
(a) Simple average price
(b) Weighted average price
(c) Moving average price
(d) Inflated price.
8. When prices fluctuate widely, the method that will smooth out the effect of
fluctuations is
(a) Simple average
(b) Weighted average
(c) FIFO
(d) LIFO

9. Under the FSN system of inventory control, inventory is classified on the basis
of:
(a) Volume of material consumption
(d) Frequency of usage of items of inventory
(c) Criticality of the item of inventory for production
(d) Value of items of inventory
10. Form used for making a formal request to the purchasing department to
purchase materials is a - :
(a) Material Transfer Note
(b) Purchase Requisition Note
(c) Bill of Materials
(d) Material Requisition Note
1. STATE how normal and abnormal loss of material arising during storage are
treated in Cost Accounts?
2. DISTINGUISH clearly between Bin cards and Stores Ledger.
3. DISCUSS the accounting treatment of defectives in Cost Accounts.
4. EXPLAIN the concept of "ABC Analysis" as a technique of inventory control.
5. DISTINGUISH between Re-order level and Re-order quantity.
6. EXPLAIN how is slow moving and non-moving item of stores detected and
what steps are necessary to reduce such stocks?
7. WRITE short notes on any three of the following:
(i) Danger Level

(ii) Just in Time Inventory Management
(iii) Maximum stock level and Minimum Stock level
(iv) Obsolescence

MATERIAL COST 2.79
2.79
Practical Problems
1. Anil & Company buys its annual requirement of 36,000 units in 6 instalments.
Each unit costs ` 1 and the ordering cost is `25. The inventory carrying cost is
estimated at 20% of unit value. FIND the total annual cost of the existing
inventory policy. CALCULATE, how much money can be saved by Economic
Order Quantity?
2. A Company manufactures a special product which requires a component
‘Alpha’. The following particulars are collected for the year 2022-23:
(i) Annual demand of Alpha 8,000 units

(ii) Cost of placing an order ` 200 per order
(iii) Cost per unit of Alpha ` 400
(iv) Carrying cost p.a. 20%
The company has been offered a quantity discount of 4 % on the purchase of
‘Alpha’ provided the order size is 4,000 components at a time.
Required:
(i) COMPUTE the economic order quantity
(ii) STATE whether the quantity discount offer can be accepted.
3. The complete Gardener is deciding on the economic order quantity for two
brands of lawn fertilizer - Super Grow and Nature’s Own. The following
information is collected:
FERTILIZER
Super Grow Nature’s Own
Annual demand 2,000 bags 1,280 bags
Relevant ordering cost per purchase ` 1,200 ` 1,400
order
Annual relevant carrying cost per bag ` 480 ` 560
Required:
(i) COMPUTE EOQ for Super Grow and Nature’s own.

(ii) For the EOQ, WHAT is the sum of the total annual relevant ordering
costs and total annual relevant carrying costs for Super Grow and
Nature’s own?
(iii) For the EOQ, COMPUTE the number of deliveries per year for Super
Grow and Nature’s own.
4. A Company uses three raw materials A, B and C for a particular product for
which the following data apply:
Raw Usage per Re-order Price Delivery period Re- Minimum

Material unit of quantity per (in weeks) order level
Product (Kgs.) Kg. level (Kgs.)
(Kgs.) (Kgs)
Minimum Average Maximum
A 10 10,000 10 1 2 3 8,000 ?
B 4 5,000 30 3 4 5 4,750 ?
C 6 10,000 15 2 3 4 ? 2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the
said product. COMPUTE the following quantities:
(i) Minimum stock of A,
(ii) Maximum stock of B,
(iii) Re-order level of C,
(iv) Average stock level of A.
5. (a) EXE Limited has received an offer of quantity discounts on its order of
materials as under:
Price per ton (` ) Ton (Nos.)
1,200 Less than 500

1,180 500 and less than 1,000
1,160 1,000 and less than 2,000
1,140 2,000 and less than 3,000
1,120 3,000 and above.

MATERIAL COST 2.81
2.81
The annual requirement for the material is 5,000 tons. The ordering cost
per order is `R 1,200 and the stock holding cost is estimated at 20% of
material cost per annum. You are required to COMPUTE the most
economical purchase level.
(b) WHAT will be your answer to the above question if there are no
discounts offered and the price per ton is ` 1,500?
6. From the details given below, CALCULATE:
(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level.
Re-ordering quantity is to be calculated on the basis of following information:
Cost of placing a purchase order is ` 4,000
Number of units to be purchased during the year is 5,00,000
Purchase price per unit, inclusive of transportation cost is ` 50
Annual cost of storage per unit is ` 10.
Details of lead time : Average - 10 days, Maximum - 15 days Minimum- 5 days,
for emergency purchases- 4 days.
Rate of consumption: Average: 1,500 units per day,
Maximum: 2,000 units per day.
7. G. Ltd. produces a product which has a monthly demand of 4,000 units. The
product requires a component X which is purchased at ` 20. For every finished
product, one unit of component is required. The ordering cost is
` 120 per order and the holding cost is 10% p.a.

You are required to CALCULATE:

(i) Economic order quantity.
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra
cost, the company has to incur?
(iii) What is the minimum carrying cost, the company has to incur?
8. ‘AT’ Ltd. furnishes the following store transactions for September, 2022:
1-9-22 Opening balance 25 units value ` 162.50
4-9- 22 Issues Req. No. 85 8 units

6-9- 22 Receipts from B & Co. GRN No. 26 50 units @ ` 5.75 per unit
10-9- 22 Return to B & Co. 10 units

15-9- 22 Receipts from M & Co. GRN. No. 33 25 units @ ` 6.10 per unit
19-9- 22 Received replacement from B & Co.
GRN No. 38 10 units
20-9- 22 Returned from department, material
of M & Co. MRR No. 4 5 units
22-9- 22 Transfer from Job 182 to Job 187 in
the dept. MTR 6 5 units
29-9- 22 Transfer from Dept. “A” to
Dept. “B” MTR 10 5 units
30-9- 22 Shortage in stock taking 2 units
PREPARE the priced stores ledger on FIFO method and STATE how would you
treat the shortage in stock taking.

MATERIAL COST 2.83
2.83
9. The following information is extracted from the Stores Ledger:

Material X
Opening Stock Nil
Purchases:
Jan. 1 100 @ ` 1 per unit
Jan. 20 100 @ ` 2 per unit
Issues:
Jan. 22 60 for Job W 16
Jan. 23 60 for Job W 17
Complete the receipts and issues valuation by adopting the First-In-First-Out,
Last-In-First-Out and the Weighted Average Method. TABULATE the values
allocated to Job W 16, Job W 17 and the closing stock under the methods
aforesaid and discuss from different points of view which method you would
prefer.
ANSWERS
Answers to the MCQs
1. (b) 2. (a) 3. (c) 4. (b) 5. (b) 6. (b)
7. (a) 8. (b) 9. (b) 10. (b)

2. Please refer paragraph 5.2

7. Please refer paragraph 6.1, 6.3, 6.1, 10

Answers to the Practical Problems

1. (a) Total Annual Cost in Existing Inventory Policy
(`)
Ordering cost (6 orders @ ` 25) 150
Carrying cost of average inventory (36,000 ÷ 6) = 6,000

units per order
Average inventory = 3,000 units
Carrying cost = 20% of ` 1 × 3,000 = 3,000 × 0.20 600
Total cost A 750
(b) Total Annual Cost in E.O.Q
2×36,000×25
EOQ = = 3000 units
` 1×20%
(`)
No. of orders = 36,000 ÷3,000 units = 12 orders
Ordering cost (12 × `Rs 25) = 300
Carrying cost of average inventory (3,000 × 0.20) ÷ 2 = 300
Total Cost B 600
Savings due to E.O.Q ` (750 – 600) (A – B) 150

Note: As the units purchase cost of ` 1 does not change in both the
computation, the same has not been considered to arrive at total cost
of inventory for the purpose of savings.
2. (i) Calculation of Economic Order Quantity
2AO 2 ×8,000 units × `200
EOQ = = = 200 units
C ` 400×20 / 100

MATERIAL COST 2.85
2.85
(ii) Evaluation of Profitability of Different Options of Order Quantity

(a) When EOQ is ordered
(`)
Purchase Cost (8,000 units × ` 400) 32,00,000
Ordering Cost [(8,000 units/200 units) × ` 200] 8,000
Carrying Cost (200 units × `400 × ½ × 20/100) 8,000
Total Cost 32,16,000
(b) When Quantity Discount is accepted
(`)
Purchase Cost (8,000 units × ` 384*) 30,72,000
Ordering Cost [(8,000 units/4000 units) × ` 400
200]
Carrying Cost (4000 units × ` 384 × ½ × 1,53,600
20/100)
Total Cost 32,26,000
*Unit Cost `400

Less Quantity Discount @ 4% = 16
Purchase Cost = 400- 16 = `384
Advise – The total cost of inventory is lower if EOQ is adopted.
Hence, the company is advised not to accept the quantity
discount.
2AO
3. EOQ =
C
Where,
A = Annual Demand
O = Ordering cost per order

C = Inventory carrying cost per unit per annum

(i) Calculation of EOQ
2 × 2,000 × 1,200 2 × 1,280 × 1,400

EOQ = EOQ =
480 560
= 10,000 or 100 bags = 6,400 or or 80 bags
(ii) Total annual relevant cost = Total annual relevant ordering costs +
Total annual relevant carrying cost
Number of Orders 2,000/100 =20 orders 1,280/80 =16 orders

= Annual Require-
ment ÷EOQ
Ordering Cost 20 × 1200 = ` 24000 16 × 1400 = `22,400
Carrying Cost ½ × 100 × 480 = ½ × 80 × 560 =

`24,000 `22,400
Total of Ordering =` 24,000+ ` 24,000 = ` 22,400 + ` 22,400 =

and Carrying Cost ` 48,000 ` 44,800
(iii) Number of deliveries for Super Grow and Nature’s own fertilizer per
Annual demand for fertilizer bags
year =
EOQ

2,000 bags = 1,280 bags = 16 orders.
= = 20 orders
100 bags 80 bags
4. (i) Minimum stock of A
Re-order level – (Average rate of consumption × Average time

required to obtain fresh delivery)
= 8,000 – (200 × 10 × 2) = 4,000 kgs.

MATERIAL COST 2.87
2.87
(ii) Maximum stock of B

Re-order level + Re-order quantity – (Minimum consumption ×
Minimum delivery period)
= 4,750 + 5,000 – (175 × 4 × 3)
= 9,750 – 2,100 = 7,650 kgs.
(iii) Re-order level of C
Maximum delivery period × Maximum usage
= 4 × 225 × 6 = 5,400 kgs.
OR
Re-order level of C
= Minimum level of C + [Average rate of consumption × Average
time required to obtain fresh delivery]
= 2,000 + [(200 × 6) × 3] kgs = 5,600 kgs.

(iv) Average stock level of A
= Minimum stock level of A + ½ Re-order quantity of A
= 4,000 + ½ × 10,000 = 4,000 + 5,000 = 9,000 kgs
OR
Average Stock level of A
Minimum stock level of A + Maximum stock level of A
=
2
(Refer to working note)
4,000 + 16,250
= 10,125 kgs
2
Working note:
Maximum stock of A = ROL+ ROQ – (Minimum consumption ×
Minimum re-order period)
= 8,000 + 10,000 – [(175 × 10) × 1] = 16,250 kgs

5. (a)
Total Order No. Cost of Ordering Carrying cost Total Cost

annual size of inventory cost p.t. p.a (4+5+6)
require (Tonne) orders A × Per tonne A/q × 1/2× q × 20% (`)
ment (q) A/q cost ` 1200 of cost p.t.
(A) (`) (`) (`)
1 2 3 4 5 6 7
5,000 400 12.5 60,00,000 15,600 48,000 60,63,600
(13)*
Ton (5,000×`1200) (200 × ` 240)
500 10 59,00,000 12,000 59,000 59,71000
(5,000 × ` 1180) (250 × ` 236)
1,000 5 58,00,000 6,000 1,16,000 59,22,000
(5,000× ` 1160) (500 × ` 232)
2,000 2.5 57,00,000 2,28,000
(3)* 3,600 59,31,600
(5,000×` 1140) (1,000×`228)
3,000 1.666 56,00,000 3,36,000
(2)* 2,400
(5,000×` 1120) (1,500×`224) 59,38,400
* Since number of orders cannot be in decimals, thus 12.5 orders are

taken as 13 orders, 2.5 are taken as 3 order and 1.66 orders are taken
as 2 orders.
The above table shows that the total cost of 5,000 units including
ordering and carrying cost is minimum (` 59,22,000) when the order size
is 1,000 units. Hence the most economical purchase level is 1,000 units.
(b) If there will are no discount offer then the purchase quantity should be
equal to EOQ. The EOQ is as follows:
2AO
EOQ =
C
where A = annual inventory requirement,

MATERIAL COST 2.89
2.89
O = ordering cost per order and

C = carrying cost per unit per annum.
2×5,000 units × `1,200

= = 200 units
20% × `1,500
6. Basic Data:
A (Number of units to be purchased annually) = 5,00,000 units
O (Ordering cost per order) = ` 4,000
C (Annual cost of storage per unit) = ` 10

Purchase price per unit inclusive of transportation cost = ` 50
Computations:
(i) Re-ordering level = Maximum usage per period × Maximum
(ROL) lead time
= 2,000 units per day × 15 days
= 30,000 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption ×
Min. lead time] (Refer to working notes 1 and 2)
= 30,000 units + 20,000 units – [1,000 units per
day×5 days]
= 45,000 units
(iii) Minimum level = ROL–Average rate of consumption×

Average re-order-period
= 30,000 units – (1,500 units per day × 10
days)
= 15,000 units
(iv) Danger level = Average consumption × Lead time for
emergency purchases
= 1,500 units per day × 4 days
= 6,000 units

Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X units / day + 2,000 units per day

1,500 units per day = or X
2
= 1,000 units per day.
2 × 5, 00, 000 units × ` 4, 000

2. Re-order Quantity (ROQ)= =20,000 units
10
7. (a) (i) Economic order quantity:

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

E.O.Q. = = = 2,400 units
C 10%of `20
i
(ii) Extra cost incurred by the company:

A. Total cost when order size is equal 4,000 units:
Total cost = Total ordering cost + Total carrying cost
A
= × O + 1 Q (Ci)
Q 2
=  48,000 units ×`120  +  1 × 4,000 units ×10% × ` 20 

 4,000 units  2 
= ` 1,440 + ` 4,000 = ` 5,440

MATERIAL COST 2.91
2.91
B. Total cost when order size is equal EOQ i.e. 2,400 units:
Total cost =  48,000 units 1

×`120  +  × 2,400 units × 10% × ` 20 
 

 2,400 units  2 
= ` 2,400 + ` 2,400 = ` 4,800

Extra cost that the company has to incur = (A) – (B)
= ` 5,440 – ` 4,800
= ` 640
(iii) Minimum carrying cost: Carrying cost depends upon the size of
the order. It will be minimum on the least order size. (In this part
of the question the two order sizes are 2,400 units and 4,000
units. Here 2,400 units is the least of the two order sizes. At this
order size carrying cost will be minimum.)
The minimum carrying cost in this case can be computed as
under:
1
Minimum carrying cost = × 2,400 units × 10% × ` 20 = ` 2,400.
2
8. Working Notes:
1. The material received as replacement from vendor is treated as fresh
supply.
2. In the absence of any information, the price of the material returned
from a user department on 20-9-22 has been taken at the price of the
latest issue made on 17-9-22. In FIFO method, physical flow of the
material is irrelevant, and issue price is based on first in first out.
3. The issue of material on 26-9-22 is made out of the material received
from a user department on 20-9-22.
4. The entries for transfer of materials from one job and department to
another on 22-9-22 and 29-9-22 respectively, do not affect the store
ledger. However, adjustment entries to calculation of cost of respective
jobs and departments are made in cost accounts.
5. The material found short as a result of stock taking has been written
off at relevant issue price.

2.92
2.92
Stores Ledger of AT Ltd. for the month of September, 2022 (FIFO Method)
RECEIPT ISSUE BALANCE
Date GRN Qty. Rate Amount Requisi- Qty. Rate Amount Qty. Rate Amount
No Units (`) (`) tion No Units (`) (`) Units (`) (`)
MRR
No.
1 2 3 4 5 6 7 8 9 10 11 12
1-9-22 — — — — — — — — 25 6.50 162.50
4-9-22 — — — — 85 8 6.50 52 17 6.50 110.50
17 6.50
6-9-22 26 50 5.75 287.50 — — — — 398.00
50 5.75
5 6.50
7-9-22 — — — — 97 12 6.50 78 320.00
50 5.75
6.50
10-9-22 — — — — Return 10 5.75 57.50 262.50
40 5.75
5 6.50
12-9-22 — — — — 108 90 30 5.75 172.50
10 5.75
13-9-22 — — — — 110 20 5.75 115 10 5.75 57.50
10 5.75
2.71
15-9-22 33 25 6.10 152.50 — — — — 210.00
25 6.10

2.93
17-9-22 — — — — 121 10 5.75 57.50 25 6.10 152.50
25 6.10
19-9-22 38 10 5.75 57.50 — — — — 210.00
10 5.75
5 5.75
20-9-22 4 5 5.75 28.75 — — — — 25 6.10 238.75
10 5.75
5 5.75 20 6.10
26-9-22 — — — — 146 59.25 179.50
5 6.10 10 5.75
18 6.10
30-9-22 — — — — Shortage 2 6.10 12.20 167.30
10 5.75

2.94
2.94
9. From the point of view of cost of material charged to each job, it is minimum
under FIFO and maximum under LIFO (Refer to Tables). During the period of
rising prices, the use of FIFO give rise to high profits and that of LIFO low
profits. In the case of weighted average, there is no significant adverse or
favourable effect on the cost of material as well as on profits.
From the point of view of valuation of closing stock, it is apparent from the
above statement, that it is maximum under FIFO, moderate under weighted
average and minimum under LIFO.
It is clear from the tables that the use of weighted average evens out the
fluctuations in the prices. Under this method, the cost of materials issued to
the jobs and the cost of material in hands reflects greater uniformity than
under FIFO and LIFO. Thus, from different points of view, weighted average
method is preferred over LIFO and FIFO.

2.95
2.95
Statement of receipts and issues by adopting First-in-First-Out Method
Date Particulars Receipts Issues Balance
Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
100 1 100
Jan. 20 Purchase 100 2 200 — — —
100 2 200
40 1 40
Jan. 22 Issue to Job W 16 — — — 60 1 60
100 2 200
40 1 40
Jan. 23 Issue to Job W 17 — — — 80 2 160
20 2 40
Statement of receipts and issues by adopting Last-In-First-Out method
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
100 1 100
Jan. 20 Purchase 100 2 200 — — —
100 2 200
100 1 100
Jan. 22 Issue to Job W 16 — — — 60 2 120
40 2 80
Jan. 23 Issue to Job W 17 — — — 40 2 80 80 1 80
20 1 20

2.96
Statement of Receipt and Issues by adopting Weighted Average method

No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 200 1.50 300
Jan. 22 Issue to Job W 16 — — — 60 1.50 90 140 1.50 210
Jan. 23 Issue to Job W 17 — — — 60 1.50 90 80 1.50 120
Statement of Material Values allocated to Job W 16, Job 17 and Closing Stock, under aforesaid methods
FIFO LIFO Weighted Average
(`) (`) (`)
Material for Job W 16 60 120 90
Material for Job W 17 80 100 90
Closing Stock 160 80 120
300 300 300

3
CHAPTER
3
EMPLOYEE COST AND
DIRECT EXPENSES
LEARNING OUTCOMES
♦ State the meaning and importance of Employee (Labour)
Cost in an organisation.
♦ Discuss the attendance and payroll procedures.
♦ State the meaning and treatment of idle time and overtime
cost.
♦ Compute employee (labour) turnover, discuss its meaning,
reasons, methods of measurement and cost impacts.
♦ Discuss and apply the various methods of remuneration and
incentive system in calculation of wages, bonus etc.
♦ Discuss the efficiency rating procedures.
♦ Discuss the measurement and treatment of Direct expenses.

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

3.3 3.3
EMPLOYEE COST AND DIRECT EXPENSES
be monitored, measured, and compensated appropriately to achieve economy in

cost, efficiency in performance and effectiveness in desired output.
2. EMPLOYEE (LABOUR) COST

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

of employees who are directly employees who are not directly
engaged in the production engaged in the production
process. process.

2. Direct employee cost can be easily 2. Indirect employee cost is

identified and allocated to cost apportioned on some
unit. appropriate basis.
3. Direct employee cost varies with 3. Indirect employee cost may not
the volume of production and vary with the volume of
has positive relationship with the production.
volume.
3. EMPLOYEE (LABOUR) COST CONTROL

Employee costs are associated with human beings. To control employee costs one
has to understand human behavior. Employee cost control means control over the
cost incurred on employees. Control over employee costs does not imply control
over the size of the wage bill; it also does not imply that wages of each employee
should be kept as low as possible.
The aim should be to keep the wages per unit of output as low as possible.
This can only be achieved by giving employees appropriate compensation to
encourage efficiency so that optimum output can be achieved in effective
manner.
A well-motivated team of employees can bring about wonders. Each concern
should, therefore, constantly strive to raise the productivity of employee. The
efforts for the control of employee costs should begin from the very beginning.
There has to be a concerted effort by all the concerned departments.
Department Functions
1. Personnel Department (i) On receipt of employee requisition from the

various departments it searches for the
required skills and qualification.
(ii) It ensures that the persons recruited possess
the requisite qualification and skills required
for the job.
(iii) Arranges proper training for the newly
recruited employees and workshops for
existing employees.

3.5 3.5
(iv) Maintains all personal and job related

records of the employees.
(v) Evaluation of performance from time to time
2. Engineering and Work (i) Prepares plans and specifications for each
Study Department job.
(ii) Providing training and guidance to the
employees.
(iii) Supervises production activities.
(iv) Conducts time and motion studies.
(v) Undertakes job analysis.
(vi) Conducts job evaluation.
3. Time-keeping (i) Concerned with the maintenance of

Department attendance records i.e. time keeping and
(ii) Time spent by an employee on various jobs
i.e. time booking etc.
4. Payroll Department (i) The preparation of payroll of the employees.

(ii) It disburses salary and wage payments.
5. Cost Accounting (i) Accumulation and classification of employee

Department costs.
(ii) Analysis and allocation of costs to various
cost centres or cost objects
3.1 Important Factors for the Control of Employee Cost

To exercise an effective control over the employee costs, the essential requisite is
efficient utilisation of employee and allied factors. The main points which need
consideration for controlling employee costs are the following:
(i) Assessment of manpower requirements.

(ii) Control over time-keeping and time-booking.
(iii) Time & Motion Study.
(iv) Control over idle time and overtime.

(v) Control over employee turnover.

(vi) Wage and Incentive systems.
(vii) Job Evaluation and Merit Rating.
(viii) Employee productivity.
3.2 Collection of Employee Costs

The task of collecting employee costs is performed by the Cost Accounting
Department which record separately wages paid to direct and indirect employee.
It is the duty of this department to ascertain the effective wages paid per hour in
each department and to analyse the total payment of wages of each department
into:
(i) the amount included in the direct cost of goods produced or jobs
completed;
(ii) the amount treated as indirect employee cost and thus included in
overheads; and
(iii) the amount treated as the cost of idle time and hence loss.
(iv) the amount treated as abnormal loss/ gain and to be transferred to profit
and loss account.
Through this process costs of various jobs are ascertained. Naturally, in this the
proper recording of time spent by the employees is essential.
4. ATTENDANCE & PAYROLL PROCEDURES

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

3.7 3.7
Where payment is made by results viz; straight piece work, it would still be
necessary to correctly record attendance for the purpose of ensuring that proper
discipline and adequate rate of production are maintained. The objectives of
time-keeping are as follows:
(i) For the preparation of payrolls.
(ii) For calculating overtime.

(iii) For ascertaining and controlling employee cost.
(iv) For ascertaining idle time.
(v) For disciplinary purposes.

(vi) For overhead distribution.
Methods of Time-keeping: There are various methods of time-keeping, which
may be categorized into manual and mechanical methods. The choice of a
particular method depends upon the requirements and policy of an entity; but
whichever method is followed, it should make a correct record of the time by
incurring minimum possible expenditure and it should minimise the risk of
fraudulent payments of wages. The examples of time keeping methods are
follows:
1. Manual Methods
(a) Attendance Register Method- Under this method, an attendance
register is kept to record the arrival and departure time of an
employee. This method is simple and inexpensive and is suitable for
small organisations. However, this method may lead to dishonest
practice of time manipulation by way of recording wrong time and
back date entry in collusion with time keeper.
(b) Metal Disc/ Token Method- This method of time recording is very
old and is almost obsolete in practice. Under this method, each
employee is allotted a metal disc or a token with a hole bearing his
identification number. The token is kept or handed to the time keeper
who record the token number in his register. Like attendance register
method, this method also has some disadvantages like error in
recording, proxy attendance etc.

2. Mechanical/ Automated Methods

(a) Punch Card Attendance- Under this method, each employee is
provided a card for marking attendance. A punch card contains data
related with the employee in digital form. In punch card attendance
system, an employee needs to either insert or wave his card to a card
reader which then ensures whether the correct person is logging in
and/or out. This system does not require to employ any time keeper
and minimises the risk of recording error and time manipulation.
(b) Bio-Metric Attendance system- Under bio-metric attendance system
attendance is marked by recognizing an employee on the basis of
physical and behavioural traits. An employee’s unique identity like
finger print, face and retina image etc. are kept in a database which is
matched at the time of marking of attendance before the attendance
device for this purpose. Bio-metric attendance system includes
fingerprint recognition system, face recognition system, Time and
attendance tracking technology etc. This system reduces the risk of
time manipulation and proxy attendance. However, it may not be
suitable for small organisations due to cost associated with set-up and
maintenance.
Requisites of a Good Time-Keeping System: A good time-keeping system
should have following requisites:
1. System of time-keeping should be such which should not allow proxy

for another employee under any circumstances.
2. There should also be a provision of recording of time of piece
employees so that regular attendance and discipline may be
maintained. This is necessary to maintain uniformity of flow of
production.
3. Time of arrival as well as time of departure of employees should be
recorded so that total time of employees may be recorded and wages
may be calculated accordingly.
4. As far as possible, method of recording of time should be mechanical

so that chances of disputes regarding time may not arise between
employees and the time-keeper.

3.9 3.9
5. Late-comers should record late arrivals. Any relaxation by the time-

keeper in this regard will encourage indiscipline.
6. The system should be simple, smooth and quick. Unnecessary queuing

for marking attendance should be avoided.
7. The system should be reviewed and maintained periodically to prevent
any error.
4.2 Time-Booking
Time keeping just records the time spent by an employee in the premises for
production but it does not show how much time a person spent on a particular
job. Time booking refers to a method wherein each activity of an employee is
recorded. This data recorded is further used for measure the time spent on a
particular job for costing, measurement of efficiency, fixation of responsibility etc.
Time booking for costing: The time spent on a particular job or activity is used
to compute the cost of the job or activity.
Time booking to measure efficiency: The efficiency of the employees is

measures by comparing the actual time taken by an employee with the standard
time that should have been taken.
Time booking for fixation of responsibility: The time booked data is used to
analyse the variance in time taken by an employee on a particular job or process
with respect to standard time to see the reasons for the variance. The reasons for
variance is further classified as controllable and uncontrollable. The controllable
reasons are those which can be avoided by due care and efficiency. On the other
hand, uncontrollable reasons cannot be avoided under the normal circumstances.
Employees or any other concerned person or departments are made accountable
for variance under controllable reasons.
For the collection of all such data, a separate record, generally known as Time (or
Job) card, is kept.

The time (or job) card can be of two types:
• One containing analysis of time with reference to each job: A separate

job card is employed in respect of a job undertaken; where a job involves
several operations, a separate entry is made in respect of each operation.
Thus, the job card would record the total time spent on a particular job or
operation. If a number of people are engaged on the same job or operation,
the time of all those employees would be booked on the same card.
One advantage of this method is that it provides complete data on the

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

3.11
3.11
4.3 Payroll Procedure

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

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

Cost/ Accounting contributions
Department
4. Payment after deductions and

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

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

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

on the details provided by the time keeping department and personnel
department calculate wages/ salary to be paid to the employees. Payroll
department prepares pay slip for all employees authorized by the personnel
department and forward the same to the cost/ accounting department for
further deductions and payment.
4. Payment to the employees: Cost/ accounting department deduct all
statutory deduction such as employee’s contribution to provident fund and
employee state insurance (ESI) scheme, TDS on salary etc. After all
deductions wages/ salary is paid to the employees.
5. Deposit of all statutory liabilities: All statutory deduction made from
wages/ salary of the employees alongwith employer’s contributions such as
provident fund and employee state insurance scheme are paid to the
respective statutory bodies.
The followings are generally deducted from the payroll
Type of deductions Description
Statutory Deductions
1. Provident fund Employee’s contribution to the Provident

fund is deducted from the salary/ wages of
the concerned employee.
2. Employee State Insurance Employee’s contribution to the ESI is

Scheme (ESI) deducted from the salary/ wages.
3. Tax Deduction at Source Employer is obliged to deduct tax at source if

(TDS) it will be paying to the employee net salary
exceeding maximum exemption limit, in equal
monthly instalments to the income tax
department.
4. Professional Tax Professional tax is a state level tax imposed for

carrying on business, profession or service.

3.13
3.13
Other Deductions
1. Voluntary contribution to If any employee so desires may contribute

Provident fund over and above the contribution payable by
the employer.
2. Contribution to any An employee may contribute to any
benevolent fund. benevolent fund voluntarily by putting a
request to the payroll department.
3. Loan deductions Instalments of any loan taken by the
employee.
4. Other advances and dues Other advances like festival advance and
unadjusted advances taken.
5. IDLE TIME
The time during which no production is carried-out because the worker remains
idle but are paid. In other words, it is the difference between the time paid and the
time booked. Idle time can be normal or abnormal. The time for which employees are
paid includes holidays, paid leaves, allowable rest or off time etc.
Normal idle time: It is the time which cannot be avoided or reduced in the normal
course of business.
Causes Treatment
1. The time lost between factory gate It is treated as a part of cost of

and the place of work, production. Thus, in the case of direct
workers an allowance for normal idle
time is considered setting of
standard hours or standard rate.
In case of indirect workers, normal

2. The interval between one job and idle time is considered for the
another, computation of overhead rate.
3. The setting up time for the machine,
4. Normal rest time, break for lunch etc.

Abnormal idle time: Apart from normal idle time, there may be factors which give
rise to abnormal idle time.
Causes Treatment
1. Idle time may also arise due to Abnormal idle time cost is not included
abnormal factors like lack of as a part of production cost and is
coordination shown as a separate item in the Costing
2. Power failure, Breakdown of Profit and Loss Account.
machines The cost of abnormal idle time should
3. Non-availability of raw materials, be further categorised into controllable
strikes, lockouts, poor and uncontrollable. For each category,
supervision, fire, flood etc. the break-up of cost due to various
factors should be separately shown.
4. The causes for abnormal idle
This would help the management in
time should be further analysed
fixing responsibility for controlling idle
into controllable and uncontroll-
time.
able.
Management should aim at eliminating
(i) Controllable abnormal idle
controllable idle time and on a long-
time refers to that time
term basis reducing even the normal
which could have been put
idle time. This would require a detailed
to productive use had the
analysis of the causes leading to such
management been more
idle time.
alert and efficient. All such
time which could have been
avoided is controllable idle
time.
(ii) Uncontrollable abnormal idle
time refers to time lost due
to abnormal causes, over
which management does not
have any control e.g.,
breakdown of machines,
flood etc. may be cha-
racterised as uncontrollable
idle time.

3.15
3.15
ILLUSTRATION 1
‘X’ an employee of ABC Co. gets the following emoluments and benefits:
(a) Basic pay ` 10,000 p.m.
(b) Dearness allowance ` 2,000 p.m.
(c) Bonus 20% of salary and D.A.
(d) Other allowances ` 2,500 p.m.
(e) Employer’s contribution to P.F. 10% of salary and D.A.
‘X’ works for 2,400 hours per annum, out of which 400 hours are non-productive
and treated as normal idle time. You are required to COMPUTE the effective hourly
cost of employee ‘X’.
SOLUTION
Statement showing computation of effective hourly cost of employee ‘X’
Per month (`) Per annum (`)

(A) Earning of Employee ‘X’:
Basic pay 10,000 1,20,000
Dearness Allowance 2,000 24,000
Bonus 2,400 28,800
Employer’s contribution to provident fund 1,200 14,400
Other allowances 2,500 30,000
18,100 2,17,200
(B) Effective working hours (refer workings) 2,000 hours
(C) Effective hourly cost {(A) ÷ (B)} `108.60
Workings:
Calculation of effective working hours:
Annual working hours less Normal idle time = 2,400 hours – 400 hours = 2,000 hours.

ILLUSTRATION 2
In a factory working six days in a week and eight hours each day, a worker is paid
at the rate of ` 100 per day basic plus D.A. @ 120% of basic. He is allowed to take
30 minutes off during his hours shift for meals-break and a 10 minutes recess for
rest. During a week, his card showed that his time was chargeable to :
Job X 15 hrs.
Job Y 12 hrs.
Job Z 13 hrs.
The time not booked was wasted while waiting for a job. In Cost Accounting, STATE
how would you allocate the wages of the workers for the week?
SOLUTION
Working notes:
(i) Total effective hours in a week:

[(8 hrs. – (30 mts. + 10 mts.)] × 6 days = 44 hours
(ii) Total wages for a week:
(` 100 + 120% of ` 100) × 6 days = ` 1,320

(iii) Wage rate per hour = 1320 ÷ 44 hours = ` 30
(iv) Time wasted waiting for job (Abnormal idle time):
= 44 hrs. – (15 hrs. + 12 hrs. + 13 hrs.) = 4 hrs.

Allocation of wages in Cost Accounting
(`)
Allocated to Job X : 15 hours × ` 30 450
Allocated to Job Y : 12 hours × ` 30 360
Allocated to Job Z : 13 hours × ` 30 390
Charged to Costing Profit & Loss A/c : 4 hours × ` 30 120
Total 1,320

3.17
3.17
6. OVERTIME
Work done beyond normal working hours is known as ‘overtime work’.
Overtime payment is the amount of wages paid for working beyond normal working
hours. Overtime payment consist of two elements- (i) Normal wages for overtime work
and (ii) Premium payment for overtime work.
Overtime Payment = Wages paid for overtime at normal rate + Premium

(extra) payment for overtime work
Overtime premium: The rate for overtime work is higher than the normal time rate;
usually it is at double the normal rates. The extra amount so paid over the normal rate
is called overtime premium.
Rate and conditions for overtime premium may either be fixed by an entity itself or it
may be required by any statute in force. The overtime premium should not be less
than the premium calculated as per the statute.
As per the Factories Act 1948 “Where a worker works in a factory for more than
nine hours in any day or for more than fourty eight hours in any week, he shall, in
respect of overtime work, be entitled to wages at the rate of twice his ordinary rate
of wages.”
Where any workers in a factory are paid on a piece-rate basis, the time rate shall
be deemed to be equivalent to the daily average of their full-time earnings for the
days on which they actually worked on the same or identical job during the month
immediately preceding the calendar month during which the overtime work was
done, and such time rates shall be deemed to be the ordinary rates of wages of
those workers
Ordinary rate of wages means the basic wages plus such allowances, including the
cash equivalent of the advantage accruing through the concessional sale to workers
of food grains and other articles, as the worker is for the time being entitled to, but
does not include a bonus and wages for overtime work.
Occasional overtime is a healthy sign as it indicates that the firm has the optimum
capacity and that the capacity is being fully utilised. But persistent overtime is rather a
bad sign because it may indicate either (a) that the firm needs larger capacity in men
and machines, or (b) that men have got into the habit of postponing their ordinary

work towards the evening so that they can earn extra money in the form of overtime
wages.
Causes of Overtime and Treatment of Overtime premium in cost accounting
Causes Treatment
(1) The customer may agree to (1) If overtime is resorted to at the

bear the entire charge of desire of the customer, then
overtime because urgency of overtime premium may be
work. charged to the job directly.
(2) Overtime may be called for to (2) If overtime is required to cope

make up any shortfall in with general production
production due to some programmes or for meeting
unexpected development. urgent orders, the overtime
premium should be treated as
overhead cost of the particular
department or cost centre which
works overtime.
(3) Overtime work may be (3) If overtime is worked in a

necessary to make up a department due to the fault of
shortfall in production due to another department, the overtime
some fault of management. premium should be charged to the
latter department.
(4) Overtime work may be resorted (4) Overtime worked on account of

to, to secure an out-turn in abnormal conditions such as
excess of the normal output to flood, earthquake etc., should not
take advantage of an be charged to cost, but to Costing
expanding market or of rising Profit and Loss Account.
demand
ILLUSTRATION 3
CALCULATE the earnings of A and B from the following particulars for a month and
allocate the employee cost to each job X, Y and Z:

3.19
3.19
A B
(i) Basic Wages (`) 10,000 16,000
(ii) Dearness Allowance 50% 50%
(iii) Contribution to provident Fund (on basic wages) 8% 8%
(iv) Contribution to Employee’s State Insurance (on basic wages) 2% 2%
(v) Overtime (Hours) 10 --

The normal working hours for the month are 200. Overtime is paid at double the
total of normal wages and dearness allowance. Employer’s contribution to state
Insurance and Provident Fund are at equal rates with employees’ contributions.
The two workers were employed on jobs X, Y and Z in the following proportions:
Jobs X Y Z
Worker A 40% 30% 30%
Worker B 50% 20% 30%

Overtime was done on job Y.
SOLUTION
Statement showing Earnings of Workers A and B
A (`) B (`)
Basic wages 10,000 16,000
Dearness Allowance (50% of Basic Wages) 5,000 8,000
Overtime wages (Refer to Working Note 1) 1,500 --
Gross wages earned 16,500 24,000
Less: Contribution to Provident fund (800) (1,280)
Less: Contribution to ESI (200) (320)
Net wages earned 15,500 22,400

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

3.21
3.21
ILLUSTRATION 4
It is seen from the job card for repair of the customer’s equipment that a total of 154
labour hours have been put in as detailed below:
Worker ‘A’ paid Worker ‘B’ paid Worker ‘C’ paid

at ` 200 per day at ` 100 per at ` 300 per day
of 8 hours day of 8 hours of 8 hours
Monday (hours) 10.5 8.0 10.5
Tuesday (hours) 8.0 8.0 8.0
Wednesday (hours) 10.5 8.0 10.5
Thursday (hours) 9.5 8.0 9.5
Friday (hours) 10.5 8.0 10.5
Saturday (hours) -- 8.0 8.0
Total (hours) 49.0 48.0 57.0
In terms of an award in employee conciliation, the workers are to be paid dearness allowance
on the basis of cost of living index figures relating to each month which works out @ ` 968
for the relevant month. The dearness allowance is payable to all workers irrespective of
wages rate if they are present or are on leave with wages on all working days.
Each worker has to work for 8 hours on weekdays. Saturday and Sunday will be weekly
holiday, however workers may work on Saturdays due to exigency of work for 4 hours,
though full payment of 8 hours will be made with no other payments.
Overtime is paid twice of ordinary wage rate if a worker works for more than nine
hours in a day. Excluding holidays, the total number of hours works out to 176 in the
relevant month. The company’s contribution to Provident Fund and Employees State
Insurance Premium are absorbed into overheads.
CALCULATE the wages payable to each worker.

SOLUTION
(1) Calculation of hours to be paid for worker A:
Normal Extra Overtime Equivalent normal Total

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

hours hours hours hours for overtime normal
worked hours
Monday 8 --- --- --- 8
Tuesday 8 --- --- --- 8
Wednesday 8 --- --- --- 8
Thursday 8 --- --- --- 8
Friday 8 --- --- --- 8
Saturday 4 4* --- --- 8
Total 44 4 --- --- 48

(*Worker-B has not worked more than 9 hours in any day)

3.23
3.23
Calculation of hours to be paid for worker C:

hours hours hours hours for overtime normal
worked hours
Monday 8 1 1½ 3 12
Tuesday 8 --- --- --- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday 8* --- --- --- 8
Total 48 4 5 10 62
(*Worker-C will be paid for equivalent 8 hours, though 4 hours of working is
required on Saturday. Further, no overtime will be paid for working beyond 4
hours since it is paid for working beyond 9 hours.)
Wages payable:
A B C
Basic Wages per hour (`) 25.00 12.50 37.50
Dearness allowance per hour (`) 5.50 5.50 5.50
Hourly rate (`) 30.50 18.00 43.00
Total normal hours 54.00 48.00 62.00
Total Wages payable (`) 1,647.00 864.00 2,666.00

ILLUSTRATION 5
In a factory, the basic wage rate is `100 per hour and overtime rates are as follows:
Before and after normal working hours 175% of basic wage rate
Sundays and holidays 225% of basic wage rate
During the previous year, the following hours were worked
- Normal time 1,00,000 hours
- Overtime before and after working hours 20,000 hours
Overtime on Sundays and holidays 5,000 hours
Total 1,25,000 hours

The following hours have been worked on job ‘Z’
Normal 1,000 hours
Overtime before and after working hrs. 100 hours.
Sundays and holidays 25 hours.
Total 1,125 hours

You are required to CALCULATE the labour cost chargeable to job ‘Z’ and overhead in
each of the following instances:
(a) Where overtime is worked regularly throughout the year as a policy due to the
workers’ shortage.
(b) Where overtime is worked irregularly to meet the requirements of production.
(c) Where overtime is worked at the request of the customer to expedite the job.
SOLUTION
Workings
Basic wage rate : ` 100 per hour
Overtime wage rate before and after working hours : ` 100 × 175%
= ` 175 per hour

3.25
3.25
Overtime wage rate for Sundays and holidays : ` 100 × 225%

= ` 225 per hour
Computation of average inflated wage rate (including overtime premium):
Particulars (`)
Annual wages for the previous year for normal time 1,00,00,000
(1,00,000 hrs. × `100)
Wages for overtime before and after working hours 35,00,000

(20,000 hrs. × `175)
Wages for overtime on Sundays and holidays 11,25,000

(5,000 hrs. × `225)
Total wages for 1,25,000 hrs. 1,46,25,000
` 1, 46,25,000
Average inflated wage rate = = `117
1,25,000 hours
(a) Where overtime is worked regularly as a policy due to workers’ shortage:

The overtime premium is treated as a part of employee cost and job is charged
at an inflated wage rate. Hence, employee cost chargeable to job Z
= Total hours × Inflated wage rate = 1,125 hrs. × ` 117 = ` 1,31,625

(b) Where overtime is worked irregularly to meet the requirements of
production:
Basic wage rate is charged to the job and overtime premium is charged to
factory overheads as under:
Employee cost chargeable to Job Z: 1,125 hours @ `100 per hour =
` 1,12,500
Factory overhead: {100 hrs. × ` (175 – 100)} + {25 hrs. × ` (225 – 100)} =
{`7,500 + `3,125} = `10,625

(c) Where overtime is worked at the request of the customer, overtime premium
is also charged to the job as under:
(`)
Job Z Employee cost 1,125 hrs. @ ` 100 = 1,12,500
Overtime premium 100 hrs. @ ` (175 – 100) = 7,500
25 hrs. @ ` (225 – 100) = 3,125
Total 1,23,125
7. LABOUR UTILISATION
For identifying utilisation of labour a statement is prepared (generally weekly) for
each department / cost centre. This statement should show the actual time paid
for, the standard time (including normal idle time) allowed for production and the
abnormal idle time analysed for causes thereof.
7.1 Identification of Utilisation of labours with Cost

Centres
For the identification of utilisation of labour with the cost centre, a wage analysis
sheet is prepared. Wage analysis sheet is a statement in which total wages paid
are analysed according to cost centre, jobs, work orders etc. The data for analysis is
provided by wage sheet, time card, piece work cards and job cards.
The preparation of such sheet serves the following purposes:
(i) It analyse the labour time into direct and indirect labour by cost centres,
jobs, work orders.
(ii) It provides details of direct labour cost comprises of wages, overtime to be
charged as production cost of cost centre, jobs or work orders.
(iii) It provides information for treatment of indirect labour cost as overhead
expenses.
7.2 Identification of labour hours with work order or

batches or capital job
For identification of labour hours with work order or batches or capital jobs or
overhead work orders the following points are to be noted:

3.27
3.27
(i) The direct labour hours can be identified with the particular work order or
batches or capital job or overhead work orders on the basis of details
recorded on source document such as time sheet or job cards.
(ii) The indirect labour hours cannot be directly identified with the particular
work order or batches or capital jobs or overhead work orders. Therefore,
they are traced to cost centre and then assigned to work order or batches
or capital jobs or overhead work orders by using overhead absorption rate.
8. SYSTEMS OF WAGE PAYMENT AND

INCENTIVES
There exist several systems of employee wage payment and incentives, which can
be classified under the following heads:
Time based
Output based
System of Wages
Combination of time and output based

Payment
Premium Bonus method
Group Bonus scheme
Incentives for indirect workers
8.1 Time Based (Time Rate System)

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

Wages under time rate system is calculated as under:
Wages = Time Worked (Hours/ Days/ Months) × Rate for the time
8.2 Output Based (Piece Rate System)

Straight Piece Rate System: Under this system, each operation, job or unit of
production is termed a piece. A rate of payment, known as the piece rate or piece
work rate is fixed for each piece. The wages of the worker depend upon his
output and rate of each unit of output; it is in fact independent of the time taken
by him. The wages paid to a worker are calculated as:
Wages = Number of units produced × Rate per unit
8.3 Premium Bonus Method

Under these methods, standard time is established for performing a job. The
worker is guaranteed his daily wages (except in Barth System), if his output is
below and upto standard. In case the task is completed in less than the standard
time, the saved time is shared between the employee and the employer.
(i) Halsey Premium Plan: Under Halsey premium plan a standard time is fixed
for each job or process. If there is no saving on this standard time allowance,
the worker is paid only his day rate. He gets his time rate even if he exceeds
the standard time limit, since his day rate is guaranteed.
If, however, he does the job in less than the standard time, he gets a bonus
equal to 50 percent of the wages of time saved; the employer benefits by
the other 50 percent. The scheme also is sometimes referred to as the Halsey
fifty percent plan. Earnings under Halsey Premium plan is calculated as
under:
Wages = Time taken × Time rate + 50% of time saved × Time rate

3.29
3.29
Advantages and Disadvantages of Halsey Premium Plan
1. Time rate is guaranteed while 1. Incentive is not so strong as

there is opportunity for increasing with piece rate system. In fact
earnings by increasing the harder the worker works,
production. the lesser he gets per piece.
2. The system is equitable in as 2. The sharing principle may not
much as the employer gets a be liked by employees.
direct return for his efforts in
improving production methods
and providing better equipment.
ILLUSTRATION 6
CALCULATE the earnings of a worker under Halsey System. The relevant data is as
below:
Time Rate (per hour) ` 60
Time allowed 8 hours
Time taken 6 hours
Time saved 2 hours
SOLUTION
Calculation of total earnings:
= Time taken × Time rate + 50% (Time Allowed – Time Taken) × Time rate
= 6 hrs. × `60 + 1/2 × (2 hrs. × `60) or `360 + `60 = `420
Of his total earnings, `360 is on account of the time worked and `60 is on
account of his share of the premium bonus.
(ii) Rowan Premium Plan: According to this system a standard time allowance
is fixed for the performance of a job and bonus is paid if time is saved.
Under Rowan System the bonus is that proportion of the time wages as
time saved bears to the standard time.

Time Saved
Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
Advantages and Disadvantages of Rowan Premium Plan
1. It is claimed to be a fool-proof 1. The system is a bit

system in as much as a worker can complicated.
never double his earnings even if
there is bad rate setting.
2. It is admirably suitable for 2. The incentive is weak at a

encouraging moderately efficient high production level where
workers as it provides a better the time saved is more than
return for moderate efficiency than 50% of the time allowed.
under the Halsey Plan.
3. The sharing principle appeals to 3. The sharing principle is not

the employer as being equitable. generally welcomed by
employees.
ILLUSTRATION 7
CALCULATE the earnings of a worker under Rowan System. The relevant data is
given as below:
Time rate (per Hour) ` 60
Time allowed 8 hours.
Time taken 6 hours.
Time saved 2 hours.
SOLUTION
Calculation of total earnings:
Time Saved
=Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
2 hours
= 6 hours × `60 + × 6 hours × ` 60 = ` 360 + ` 90 = ` 450
8 hours

3.31
3.31
ILLUSTRATION 8
Two workmen, ‘A’ and ‘B’, produce the same product using the same material.
Their normal wage rate is also the same. ‘A’ is paid bonus according to the
Rowan system, while ‘B’ is paid bonus according to the Halsey system. The
time allowed to make the product is 50 hours. ‘A’ takes 30 hours while ‘B’
takes 40 hours to complete the product. The factory overhead rate is ` 5 per
man-hour actually worked. The factory cost for the product for ‘A’ is ` 3,490
and for ‘B’ it is ` 3,600.
Required:
(a) COMPUTE the normal rate of wages;
(b) COMPUTE the cost of materials cost;
(c) PREPARE a statement comparing the factory cost of the products as made
by the two workmen.
SOLUTION
Step 1 : Let X be the cost of material and Y be the normal rate of wages per
hour.
Step 2 : Factory Cost of Workman ‘A’
(`)
A. Material Cost X
B. Wages (Rowan Plan) 30 Y
30 12 Y
C. Bonus = × (50 - 30) × Y
50
D. Overheads (30 × `5) 150
E. Factory Cost 3,490
Or, X + 42 Y = `3,490 (Given) – `150 = `3,340……………………...equation (i)

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

3Y = `60
Y = `60/3 = `20 per hour.
(a) The normal rate of wages: `20 per hour
(b) The cost of material: X + 45 × ` 20 = ` 3,400 or, X = ` 3,400 – ` 900 =
` 2,500
(c) Comparative Statement of the Factory Cost of the product made by
the two workmen.
‘A’ (`) ‘B’ (`)
Material cost 2,500 2,500
Direct Wages 600 800

(30 × `20) (40 × `20)
Bonus 240 100

(12 × `20) (5 × `20)
Factory Overhead 150 200
Factory Cost 3,490 3,600

3.33
3.33
ILLUSTRATION 9
(a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved
equals the bonus paid under the Rowan System. When will this statement
hold good? (Your answer should contain the proof).
(b) The time allowed for a job is 8 hours. The hourly rate is ` 8. PREPARE a statement
showing:
(i) The bonus earned
(ii) The total earnings of employee and
(iii) Hourly earnings.
Under the Halsey System with 50% bonus for time saved and Rowan System for
each hour saved progressively.
SOLUTION
50
(a) Bonus under Halsey Plan = × (SH - AH) × R (i)
100
AH
Bonus under Rowan Plan : = × (SH - AH) × R (ii)
SH
Bonus under Halsey Plan will be equal to the bonus under Rowan Plan
when the following condition holds good:
50 AH
× (SH - AH) × R = × (SH - AH) × R
100 SH
50 AH
=
100 SH
Hence, when the actual time taken (AH) is 50% of the time allowed
(SH), the bonus under Halsey and Rowan Plans is equal.
(b) Statement of Bonus, total earnings of Employee and hourly earnings

under Halsey and Rowan Systems.

SH AH Time Basic Bonus Bonus Total Total Hourly Hourly

saved wages under under Earnings Earnings Earnings Earnings
(AH x`8) Halsey Rowan under under under under
(B x `8) System system Halsey Rowan Halsey Rowan
 50  B  System System System System

 100 × C × 8  A × C × 8 D+E D+F G/B H/B
A B C= D E F G H I J
Hours Hours (A-B)
(`) (`) (`) (`) (`) (`) (`)
Hours
8 8 - 64 - - 64 64 8.00 8.00
8 7 1 56 4 7 60 63 8.57 9.00
8 6 2 48 8 12 56 60 9.33 10.00
8 5 3 40 12 15 52 55 10.40 11.00
8 4 4 32 16 16 48 48 12.00 12.00
8 3 5 24 20 15 44 39 14.67 13.00
8 2 6 16 24 12 40 28 20.00 14.00
8 1 7 8 28 7 36 15 36.00 15.00
ILLUSTRATION 10
A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of ` 30 per hour. The
standard time per unit for a particular product is 4 hours. Mr. P, a machine man, has
been paid wages under the Rowan Incentive Plan and he had earned an effective
hourly rate of ` 37.50 on the manufacture of that particular product.
STATE what could have been his total earnings and effective hourly rate, had he
been put on Halsey Incentive Scheme (50%)?
SOLUTION
Total earnings (under 50% Halsey Scheme) = Hours worked × Rate per hour +
½ × time saved × Rate per hour
= 3 hours × ` 30 + ½ × 1 hour × `30

= `105

3.35
3.35
Total earnings
Effective hourly rate = = ` 105 = `35
Hours taken 3 hours
Working Note:
Let T hours be the total time worked in hours by the skilled workers (machine
man P), `30 is the rate per hour; standard time is 4 hours per unit and effective
hourly earnings rate is `37.50 then
Time saved
Earning (under Rowan plan) = Hours worked × Rate per hr + ×
Time allowed
Time taken × Rate per hr

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

` 37.5 = ` 30 + (4 – T) × ` 7.5
` 37.5 = ` 30 + `30 - 7.5T

or, ` 7.5 T = `60-`37.5
or, ` 7.5 T = ` 22.5
or, T = 3 hours.
ILLUSTRATION 11
A factory having the latest sophisticated machines wants to introduce an incentive
scheme for its workers, keeping in view the following:
(i) The entire gains of improved production should not go to the workers.
(ii) In the name of speed, quality should not suffer.
(iii) The rate setting department being newly established are liable to commit
mistakes.
You are required to PREPARE a suitable incentive scheme and DEMONSTRATE by an
illustrative numerical example how your scheme answers to all the requirements of
the management.

SOLUTION
Rowan Scheme of premium bonus (variable sharing plan) is a suitable incentive
scheme for the workers of the factory. If this scheme is adopted, the entire
gains due to time saved by a worker will not pass to him.
Another feature of this scheme is that a worker cannot increase his earnings or
bonus by merely increasing its work speed. The reason for this is that the bonus
under Rowan Scheme is maximum when the time taken by a worker on a job is
half of the time allowed. As this fact is known to the workers, therefore, they
work at such a speed which helps them to maintain the quality of output too.
Lastly, Rowan System provides a safeguard in the case of any loose fixation of the
standards by the rate-setting department. It may be observed from the following
illustration that in the Rowan Scheme the bonus paid will be low due to any loose
fixation of standards. Workers cannot take undue advantage of such a situation.
The above three features of Rowan Plan can be discussed with the help of the
following illustration:
(i) Time allowed = 4 hours
Time taken = 3 hours
Time saved = 1 hour
Rate = `5 per hour
Time taken
Bonus = × Time saved × Rate
Time allowed
3 hours
= × 1 hour × `5 = `3.75
4 hours
In the above illustration time saved is 1 hour and, therefore, total gain is
` 5. Out of `5 according to Rowan Plan only ` 3.75 is given to the worker
in the form of bonus and the remaining ` 1.25 remains with the
management. In other words, a worker is entitled for 75 percent of the
time saved in the form of bonus.
(ii) The figures of bonus in the above illustration when the time taken is 2
hours and 1 hour respectively are as below:
Time taken
Bonus = × Time saved × Rate
Time allowed

3.37
3.37
2 hours
= × 2 hours × `5 = `5
4 hours
1 hours
= × 3 hours × `5 = `3.75
4 hours
The above figures of bonus clearly show that when time taken is half of
the time allowed, the bonus is maximum. When the time taken is reduced
from 2 to 1 hour, the bonus figure fell by `1.25. Hence, it is quite
apparent to workers that it is of no use to increase speed of work. This
feature of Rowan Plan thus protects the quality of output.
(iii) If the rate-setting department erroneously sets the time allowed as 10 hours
instead of 4 hours, in the above illustration; then the bonus paid will be as
follows:
3 hours
Bonus = × 7 hours × `5 = `10.50
10 hours
The bonus paid for saving 7 hours thus is `10.50 which is approximately equal
to the wages of 2 hours. In other words, the bonus paid to the workers is low.
Hence workers cannot take undue advantage of any mistake committed by the
time setting department of the concern.

9. ABSORPTION OF WAGES
9.1 Elements of Wages
In common parlance, the term ‘wages’ represents monetary payment which an
employee receives at regular intervals for the services rendered. Strictly speaking,
however, from the point of view of the employer and the cost to the industry,
wages should be taken to include also non-monetary benefits which an employee
receives by virtue of employment. Such non-monetary benefits may include:
(i) Medical facilities;
(ii) Educational and training facilities;
(iii) Recreational and sports facilities;
(iv) Housing and social welfare; and
(v) Cost of subsidised canteen and co-operative societies.

Such benefits are generally given in an industrial establishment. In some cases,
the provision of benefits is compulsory. Therefore, while computing the wage cost
per worker, the monetary value of such non-monetary benefits should also be
taken into account.
The monetary part of a worker’s remuneration includes the basic wages, dearness
allowance, overtime wages, other special allowance, if any, production bonus,

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3.39
employer’s contribution to the provident fund, Employees State Insurance scheme

premium, contribution to pension fund, leave pay, etc.
The basic wage is the payment for work done, measured in terms of hours
attended or the units produced, as the case may be. The basic wage rate is not
normally altered unless there is a fundamental change in the working conditions
or methods of manufacture.
Dearness allowance is an allowance provided to cover the increase in cost of
living from one period to another. This allowance is calculated either as
percentage of the basic wage or as a fixed amount for the days worked. In either
case, the percentage or the fixed amount is subject to revision whenever the cost
of living index or consumer price Index rises or falls by a certain figure as agreed
to by the employer with the Employee union. When permanent rise in the cost of
living index occurs, a part of the dearness allowance is often absorbed in the
basic wage.
Overtime allowance is an allowance paid for the extra hours worked at the rates
laid down in the Factories Act. In certain industries, where special allowance for
the working conditions, tool maintenance, etc., are paid they are also considered
as part of wages.
Production Bonus is an incentive payment made to workers for efficiency that
results in production above the standard. There are different methods of
computing incentives. Under the Payment of Bonus Act, a worker is entitled to
compulsory bonus of 8.33% wages earned in the relevant year or `100 (whichever
is greater). The bonus may be upto 20% of wages depending upon the quantum
of profits calculated as per the Act.
9.2 Component of Wages Cost or Wages for Costing

Purposes
In addition to wages (including allowances, such as D.A.) that are paid to workers,
a firm may have to spend on many other items (such as premium to the ESI or
provident fund or bonus).
Further, the worker does not spend all the time for which he is paid on productive
work.

This is because he is entitled to weekly holiday and various type of leave. There is
also a certain amount of unavoidable idle time. The question is to what extent
such additional payment or cost in respect of Employee can be charged directly
to unit of cost as part of direct Employee cost? Of course, in the case of indirect
Employee, all such payments as also the wages paid to them, must be treated as
part of overheads.
But in the case of direct workers, two alternatives are possible. The additional
charges may be treated as overheads. Alternatively, the wage rates being charged
to job may be computed by including such payments; automatically then, such
payments will be charged to the work done along with wages of the worker. (It
should be remembered that such wage rate will be only for costing purposes and
not for payment to workers). The total of wages and additional payment should
be divided by effective hours of work to get such wage rates for costing purposes.
ILLUSTRATION 12
A worker is paid `10,000 per month and a dearness allowance of `2,000 p.m.
Worker contribution to provident fund is @ 10% and employer also contributes the
same amount as the employee. The Employees State Insurance Corporation
premium is 6.5% of wages of which 1.75% is paid by the employees. It is the firm’s
practice to pay 2 months’ wages as bonus each year.
The number of working days in a year are 300 of 8 hours each. Out of these the worker is
entitled to 15 days leave on full pay. CALCULATE the wage rate per hour for costing
purposes.
SOLUTION
(`)
Wages paid to worker during the year {(` 10,000 +2,000) × 12} 1,44,000
Add: Employer Contribution to:
Provident Fund @ 10% 14,400
E.S.I. Premium @ 4.75% (6.5 – 1.75) 6,840
Bonus at 2 months’ wages (Basic + DA) 24,000
Total 1,89,240

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3.41
Effective hours per year: 285 days × 8 hours = 2,280 hours

Wage-rate per hour (for costing purpose): `1,89,240/2,280 hours = `83
9.3 Holiday and Leave Wages

One alternative to account for wages paid on account of paid holiday and leave
can be to include them as departmental overheads. In such a case, it is necessary
to record such wages separately from “worked for wages”. Such a segregation can
be made possible by providing a separate column in the payroll for holiday and
leave wages in the same way as there are columns for dearness allowance,
provident fund deductions, etc. If, however, a separate or additional column
cannot be provided for this purpose it would be necessary to analyse the payroll
periodically to ascertain how much of the total payment pertains to “worked for
wages” and how much is attributed to leave and holiday wages.
Another way could be to inflate the wage rate for costing purposes to include
holiday and leave wages. This can be done only in the case of direct workers.
ILLUSTRATION 13
CALCULATE the Employee hour rate of a worker X from the following data:
Basic pay ` 10,000 p.m.

D.A. ` 3,000 p.m.
Fringe benefits ` 1,000 p.m.
Number of working days in a year 300. 20 days are availed off as holidays on full pay
in a year. Assume a day of 8 hours.
SOLUTION
(i) Effective working days in a year 300
Less: Leave days on full pay 20
Effective working days 280 days
Total effective working hours (280 days × 8 hours) 2,240

(ii) Total wages paid in a year (`)

Basic pay 1,20,000
D.A. 36,000
Fringe benefits 12,000

Total wages 1,68,000
(iii) Hourly rate : `1,68,000/2,240 hours `75.00
9.4 Night Shift Allowance

In some cases, workers get extra payment if they work at night. Since the extra
payment is not for any particular job, therefore such a payment should be treated
as part of overheads.
9.5 Absorption Rates of Employee Cost

Employee cost as stated above include monetary compensation and non-monetary
benefits to workers.
Monetary benefits include, basic wages, D.A., overtime pay, incentive or
production bonus contribution to employee provident fund, House Rent
Allowance, Holiday and vacation pay etc.
The non-monetary benefits include medical facilities, subsidized canteen services,
subsidized housing, education and training facilities.
Accounting of monetary and non-monetary benefits to indirect workers does not
pose any problems because the total of monetary and non-monetary benefits are
treated as overhead and absorbed on the basis of rate per direct employee hour,
if overheads are predominantly employee oriented.
For direct workers, the ideal method is to charge jobs or units produced by
supplying per hour rate calculated as below:
Total estimated monetary benefits and cost of non monetary benefits
Rate per hour =
Budgeted direct employee hour -Normal idle time
Another alternative method is to treat the monetary benefits other than basic
wages and dearness allowance as well as cost of non-monetary benefits as
overheads.

3.43
3.43
10. EFFICIENCY RATING PROCEDURES

Efficiency is usually related with performance and may be computed by
comparing the time taken with the standard time allotted to perform the given
job/task.
If the time taken by a worker on a job equals or less than the standard time,
then he is rated efficient.
In case he takes more time than the standard time he is rated as inefficient.
Time allowed as per standard
Efficiency in % = ×100
Time Taken
For efficiency rating of employees the following procedures may be followed:
1. Determining standard time/performance standards: The first step is to
determine the standard time taken by a worker for performing a particular
job/task. The standard time can be determined by using Time & Motion study
or Work study techniques. While determining the standard time for a
job/task a heterogeneous group of workers is taken and contingency
allowances are added for determining standard time.
2. Measuring Actual Performance of workers: For computing efficiency
rating it is necessary to develop a procedure for recording the actual
performance of workers. The system developed should record the output of
each worker along with the time taken by him.
3. Computation of efficiency rating: The efficiency rating of each worker can
be computed by using the above mentioned Formula.
10.1 Need for Efficiency Rating

1. As discussed earlier when a firm follows a system of payment by results, the
payment has a direct relationship with the output given by a worker. The
firm for making payment to worker is required to ascertain his efficiency
level.
2. The efficiency rating also helps the management in preparing employee
requirement budget or for preparing manpower requirements.

Example - 1: P Ltd. manufactures two products by using one grade of

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

(units)
Standard hours allowed 17,400 16,000 33,400

for budgeted production (3,480 units × 5 hours) (4,000 units × 4 hours)
Since efficiency ratio is given as 80% therefore standard employee hours

 100 
required for 100% efficiency level is  33, 400 hours×  = 41,750 hours.
 80 
Employee Productivity: Productivity is generally determined by the input/output

ratio. In case of employees, it is calculated as below:
Standard timefor doing actual work
Actual timetaken
Employee productivity is used for measuring the efficiency of individual workers.

It is an index of efficiency in the utilisation of human resources, materials, capital,
power and all kinds of services and facilities.
It is measured by the output in relation to input. Productivity can be improved by
reducing the input for a certain quantity or value of output or by increasing the
output from the same given quantity or value of input.
Factors for increasing Employee Productivity: The important factors which
must be taken into consideration for increasing employee productivity are as
follows:

3.45
3.45
1. Employing only those workers who possess the right type of skill.
2. Placing a right type of person to a right job.
3. Training young and old workers by providing them the right types of opportunities.
4. Taking appropriate measures to avoid the situation of excess or shortage of
employees.
5. Carrying out work study for fixation of wages and for the simplification and
standardisation of work.
11. EMPLOYEE (LABOUR) TURNOVER

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

organisation are not included in number of replacements.
(ii) Separation Method: In this method employee turnover is measured by
dividing the total number of employees separated during the period by the
average total number of employees on payroll during the same period.
Employee Turnover under this method is calculated as under:

Number of employees separated during the period

×100
(iii) Flux Method: This method takes both the number of replacements as well
as the number of separations during the period into account for calculation
of employee turnover. Employee Turnover under this method is calculated as
under:
 Number of employees Number of employees 
 + 
 separated replaced during the period 
 
  ×100
Employee turnover due to new recruitment: Generally, employees recruited on

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

No.of employees at begining +No. of employees at end of the period
=
2

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3.47
Equivalent Employee (Labour) Turnover rate:

If in the above computations, the data given is for a period other than a year, the
employee turnover rate so computed may be converted into equivalent annual
employee turnover rate by using the following formula:
Employee Turnover rate for the period
×365
Number of days in the period
ILLUSTRATION 14
The Accountant of Y Ltd. has computed employee turnover rates for the quarter ended
31st March, 2023 as 10%, 5% and 3% respectively under ‘Flux method’, ‘Replacement
method’ and ‘Separation method’ respectively. If the number of workers replaced
during that quarter is 30, FIND OUT the number of workers for the quarter
(i) recruited and joined and (ii) left and discharged and (iii) Equivalent employee
turnover rates for the year.
SOLUTION
Working Note:
Average number of workers on roll (for the quarter):

Employee Turnover rate using Replacement method
No. of replacements
= ×100
Average number of workers on roll
5 30
Or, =
100 Average number of workers on roll
30×100
Or, Average number of workers on roll = = 600
5
(i) Number of workers recruited and joined:
Employee turnover rate (Flux method)

No. of Separations * (S)+No. of Accessions(A)
=
Average number of workers on roll
10 18 *+A  6000 
Or, = Or, A = − 80  = 42
100 600  100 
No. of workers recruited and joined 42.

(ii) Number of workers left and discharged:

Employee turnover rate (Separation method)
No. of Separations(S) 3 S
= × 100 = = Or, S* = 18
Average number of workers on roll 100 600
Hence, number of workers left and discharged comes to 18

(iii) Calculation of Equivalent employee turnover rates:
Employee Turnover rate for the quarter(s)
= ×4 quarters
Number of quarter(s)
10%
Using Flux method = ×4 = 40%
1
5%
Using Replacement method = ×4 = 20%
1
3%
Using Separation method = ×4 = 12%
1
11.2 Causes of Employee (Labour) Turnover

The reasons for employee turnover in an organisation can be classified under the
following three heads:
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.
(a) Personal causes: All the personal reasons which induce or compel an
employee to leave his job; such causes include the following:
(i) Change of jobs for betterment.
(ii) Premature retirement due to ill health or old age.

(iii) Domestic problems and family responsibilities.
(iv) Discontent over the jobs and working environment.

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3.49
In all the above cases the employee leaves the organisation at his will and,
therefore, it is difficult to suggest any possible remedy in the first three
cases.
But the last one can be overcome by creating conditions leading to a
healthy working environment. For this, officers should play a positive role
and make sure that their subordinates work under healthy working
conditions.
(b) Unavoidable Causes: Unavoidable causes are those under which it
becomes obligatory on the part of management to ask one or more of their
employees to leave the organisation; such causes are summed up as listed
below:
(i) Seasonal nature of the business;
(ii) Shortage of raw material, power, slack market for the product etc.;
(iii) Change in the plant location;
(iv) Disability, making a worker unfit for work;
(v) Disciplinary measures;
(c) Avoidable Causes: Avoidable causes are those which require the attention
of management on a continuous basis so as to keep employee turnover
ratio as low as possible. The main causes under this case are indicated
below:
(i) Dissatisfaction with job, remuneration, hours of work, working conditions,
etc.,
(ii) Strained relationship with management, supervisors or fellow workers;
(iii) Lack of training facilities and promotional avenues;

(iv) Lack of recreational and medical facilities;
(v) Low wages and allowances.
Proper and timely management action can reduce the employee turnover
appreciably so far as avoidable causes are concerned.

11.3 Effects of Employee (Labour) Turnover

High employee turnover increases the cost of production in the following ways:
(i) Even flow of production is disturbed;

(ii) Efficiency of new workers is low; productivity of new but experienced workers is
low in the beginning;
(iii) There is increased cost of training and induction;

(iv) New workers cause increased breakage of tools, wastage of materials, etc.
(v) Cost of recruitment and training increases.
Cost of Employees (Labour) Turnover: Two types of costs which are associated
with employee turnover are:
(a) Preventive Costs: The cost incurred to prevent employee turnover or keep
it as lowest as possible. Cost incurred for prevention of employee turnover
includes the following:
(i) Cost of medical benefit provided to the employees;
(ii) Cost incurred on employees’ welfare like pension etc.

(iii) Cost on other benefits with an objective to retain employees.
(b) Replacement Costs: These are the costs which arise due to employee
turnover. If employees leave soon after they acquire the necessary training
and experience of good work, additional costs will have to be incurred on
new workers, i.e., cost of recruitment, training and induction, abnormal
breakage and scrap and extra wages and overheads due to the inefficiency
of new workers.
It is obvious that a company will incur very high replacement costs if the rate of
employee turnover is high. Similarly, only adequate preventive costs can keep
Employee turnover at a low level. Each company must, therefore, work out the
optimum level of Employee turnover keeping in view its personnel policies and
the behaviour of replacement cost and preventive costs at various levels of
Employee turnover rates.

3.51
3.51
ILLUSTRATION 15
The management of B.R Ltd. is worried about their increasing employee turnover in
the factory and before analyzing the causes and taking remedial steps; it wants to
have an idea of the profit foregone as a result of employee turnover in the last year.
Last year sales amounted to ` 83,03,300 and P/V ratio was 20 per cent. The total number
of actual hours worked by the direct employee force was 4.45 lakhs. The actual direct
employee hours included 30,000 hours attributable to training new recruits, out of which
half of the hours were unproductive. As a result of the delays by the Personnel Department
in filling vacancies due to employee turnover, 1,00,000 potentially productive hours
(excluding unproductive training hours) were lost.
The costs incurred consequent on employee turnover revealed, on analysis, the
following:
Settlement cost due to leaving ` 43,820
Recruitment costs ` 26,740
Selection costs ` 12,750
Training costs ` 30,490
Assuming that the potential production lost as a consequence of employee turnover
could have been sold at prevailing prices, FIND the profit foregone last year on
account of employee turnover.
SOLUTION
Workings:
(i) Computation of productive hours
Actual hours worked (given) 4,45,000
Less: Unproductive training hours 15,000
Actual productive hours 4,30,000
(ii) Productive hours lost:
Loss of potential productive hours + Unproductive training hours

= 1,00,000 + 15,000 = 1,15,000 hours

(iii) Loss of contribution due to unproductive hours:

Sales value
= ×Total unproductive hours
Actual productive hours
` 83,03,300
= × 1,15,000 hours = `22,20,650
4,30,000 hrs
` 22,20,650
Contribution lost for 1,15,000 hours = ×20 = `4,44,130
100
Computation of profit forgone on account of employee turnover
(`)
Contribution foregone (as calculated above) 4,44,130
Settlement cost due to leaving 43,820
Recruitment cost 26,740
Selection cost 12,750
Training costs 30,490
Profit foregone 5,57,930
12. DIRECT EXPENSES

12.1 Direct Expenses
Expenses other than direct material cost and direct employee cost, which are
incurred to manufacture a product or for provision of service and can be directly
traced in an economically feasible manner to a cost object. The following costs
are examples for direct expenses:
(i) Royalty paid/ payable for production or provision of service;

(ii) Hire charges paid for hiring specific equipment;
(iii) Cost for product/ service specific design or drawing;
(iv) Cost of product/ service specific software;

(v) Other expenses which are directly related with the production of goods or
provision of service.

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The above list of expenses is not exhaustive, any other expenses which are
directly attributable to the production or service are also included as direct
expenses.
12.2 Measurement of Direct Expenses

The direct expenses are measured at invoice or agreed price net of rebate or
discount but includes duties and taxes (for which input credit not available),
commission and other directly attributable costs.
In case of sub-contracting, where goods are get manufactured by job workers
independent of the principal entity, are measured at agreed price. Where the
principal supplies some materials to the job workers, the value of such materials
and other incidental expenses are added with the job charges paid to the job
workers.
12.3 Treatment of Direct Expenses

Direct Expenses form part of the prime cost for the product or service to which it
can be directly traceable and attributable. In case of lump-sum payment or one-
time payment, the cost is amortised over the estimated production volume or
benefit derived.
If the expenses incurred are of insignificant amount i.e. not material, it can be
treated as part of overheads.
ILLUSTRATION 16
Aditya Ltd. is an engineering manufacturing company producing job order on the
basis of specification given by the customers. During the last the month it has
completed three job works namely A, B and C. The following are the items of
expenditures which are incurred apart from direct materials and direct employee
cost:
(i) Office and administration cost- ` 3,00,000.

(ii) Product blueprint cost for job A – ` 1,40,000
(iii) Hire charges paid for machinery used for job work B- ` 40,000
(iv) Salary to office attendants- ` 50,000

(v) One time license fee paid for software used to make computerised graphics
for job C- ` 50,000.
(vi) Salary paid to marketing manager- ` 1,20,000.
Required:
CALCULATE direct expenses attributable to each job.
SOLUTION
Calculation of Direct expenses
Particulars Job A (`) Job B (`) Job C (`)
Product blueprint cost 1,40,000 -- --
Hire charges paid for -- 40,000 --

machinery
license fee paid for -- -- 50,000

software
Total Direct expenses 1,40,000 40,000 50,000
Note:
(i) Office and administration cost is classified as overheads.
(ii) Salary paid to office attendants is classified under office and administration
cost.
(iii) Salary paid to marketing manager is classified under selling overheads
SUMMARY
♦ Employee Cost: Benefits paid or payable to the employees of an entity,
whether permanent or temporary for the services rendered by them.
Employee cost includes payments made in cash or kind.
♦ Direct Employee (Labour) Cost: Benefits paid or payable to the employees
which can be attributed to a cost object in an economically feasible manner.

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♦ Indirect Employee (Labour) Cost: Benefits paid or payable to the

employees, which cannot be directly attributable to a particular cost object
in an economically feasible manner.
♦ Idle Time: The time for which the employer pays but obtains no direct
benefit or for no productive purpose.
♦ Normal Idle Time: Time which cannot be avoided or reduced in the normal
course of business. The cost of normal idle time should be charged to the
cost of production.
♦ Abnormal Idle Time: It arises on account of abnormal causes and should
be charged to Costing Profit and Loss account.
♦ Time Keeping: It refers to recording and keeping of the employees’
attendance time.
♦ Time Booking: It is basically recording the details of work done and the
time spent by an employee on each job or process.
♦ Overtime: Payment to employees, when an employee works beyond the
normal working hours. Usually overtime has to be paid at double the rate of
normal hours.
♦ Overtime Premium: It’s the amount of extra payment paid to an employee
for extra work.
♦ Employee (Labour) Turnover: It is the rate of change in employee force
during a specified period due to resignation, retirement and retrenchment.
If the employee turnover is high, it’s a sign of instability and may affect the
profitability of the firm.
♦ Employee (Labour) turnover can be measured through the following
methods:
(i) Replacement Method:
Number of employees replaced
×100
Average number of employees on roll

(ii) Separation Method:

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

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

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

Number of new employees joining in a period (excluding replacements)
×100
Average number of employees on the roll in a period
OR
Number of separations + number of accessions
×100
Average number of employees
♦ Time Rate System: The system of wage payment where wages to an

employee is paid on the basis of time irrespective of production volume.
♦ Straight Piece Work: The system of wage payment where wages is paid on
the basis of number of units produced irrespective of time spent for
production. Calculation takes number of units produced by the employee
multiplied by rate per unit.
♦ Halsey System: Time taken × Time rate + 50% of time saved × Time rate.
Time saved
♦ Rowan System: Time taken × Rate per hour + × Time taken ×
Time allowed
Rate per hour

3.57
3.57
TEST YOUR KNOWLEDGE

1. Idle time is the time under which-
(a) Full wages are paid to workers
(b) No productivity is given by the workers
(c) Both (a) and (b)
(d) None of the above
2. Cost of idle time due to non- availability of raw material is-
(a) Charged to overhead costs
(b) Charged to respective jobs
(c) Charged to costing profit and loss account
3. Time and motion study is conducted by-
(a) Time keeping department
(b) Personnel department
(c) Payroll department
(d) Engineering department
4. Identify, which one of the following, does not account for increasing labour
productivity-
(a) Job satisfaction
(b) Motivating workers

(c) High labour turnover
(d) Proper supervision and control
5. Labour turnover is measured by-

(a) Number of persons replaced/ average number of workers

(b) Numbers of persons separated / number of workers at the beginning of the year
(c) (Number of persons replaced + number of persons separated)/(number of
persons at the beginning + the number of persons at the end of the year)
6. Time booking refers to a method wherein ……………… of an employee is recorded.
(a) Attendance
(b) Food expenses
(c) Health status
(d) Time spent on a particular job
7. Employee Cost includes-
(a) Wages and salaries
(b) Allowances and incentives
(c) Payment for overtime
(d) All of the above
8. If the time saved is less than 50% of the standard time, then the wages under
Rowan and Halsey premium plan on comparison gives-
(a) More wages to workers under Rowan plan than Halsey plan
(b) More wages to workers under Halsey plan than Rowan plan
(c) Equal wages under two plans

9. Standard time of a job is 60 hours and guaranteed time rate is `0.30 per hour.
What is the amount of wages under Rowan plan if job is completed in 48 hours?
(a) ` 16.20
(b) ` 17.28
(c) ` 18.00
(d) ` 14.40

3.59
3.59
10. Important factors for control of employee cost can be-
(a) Time and Motion Study

(b) Control over idle time and overtime
(c) Control over employee turnover
11. Out of the following methods attendance is marked by recognizing an employee
based on physical and behavioural traits-
(a) Punch Card Attendance method
(b) Bio- Metric Attendance system
(c) Attendance Register method
(d) Token Method
12. If overtime is required for meeting urgent orders, the overtime premium should
be charged as-
(a) Respective job
(b) Overhead cost
(c) Costing P& L A/c
(d) None of above
1. DISCUSS the accounting treatment of Idle time and overtime wages.
2. DISCUSS the effect of overtime payment on productivity.
3. STATE the circumstances in which time rate system of wage payment can be
preferred in a factory.
4. DISCUSS the objectives of time keeping & time booking.
5. DISCUSS the two types of cost associated with labour turnover.
6. DESCRIBE briefly, how wages may be calculated under the following systems:
(i) Rowan system
(ii) Halsey system

Practical Problems
1. Mr. A. is working by employing 10 skilled workers. He is considering the
introduction of some incentive scheme - either Halsey Scheme (with 50% bonus)
or Rowan Scheme - of wage payment for increasing the Employee productivity to
cope with the increased demand for the product by 25%. He feels that if the
proposed incentive scheme could bring about an average 20% increase over the
present earnings of the workers, it could act as sufficient incentive for them to
produce more and he has accordingly given this assurance to the workers.
As a result of the assurance, the increase in productivity has been observed as
revealed by the following figures for the current month:
Hourly rate of wages (guaranteed) `40

Average time for producing 1 piece by one worker at the 2 hours
previous performance (This may be taken as time allowed)
No. of working days in the month 25
No. of working hours per day for each worker 8
Actual production during the month 1,250 units
Required:
(i) CALCULATE effective rate of earnings per hour under Halsey Scheme and
Rowan Scheme.
(ii) CALCULATE the savings to Mr. A in terms of direct labour cost per piece
under the schemes.
2. Wage negotiations are going on with the recognised employees’ union, and
the management wants you as an executive of the company to formulate an
incentive scheme with a view to increase productivity.
The case of three typical workers A, B and C who produce respectively 180,
120 and 100 units of the company’s product in a normal day of 8 hours is
taken up for study.
Assuming that day wages would be guaranteed at ` 75 per hour and the
piece rate would be based on a standard hourly output of 10 units,
CALCULATE the earnings of each of the three workers and the employee cost

3.61
3.61
per 100 pieces under (i) Day wages, (ii) Piece rate, (iii) Halsey scheme, and (iv)
The Rowan scheme.
Also CALCULATE under the above schemes the average cost of labour for the
company to produce 100 pieces.
3. The following expenditures were incurred in Aditya Ltd. For the month of
March 2023:
(`)
(i) Paid for power & fuel 4,80,200
(ii) Wages paid to factory workers 8,44,000
(iii) Bill paid to job workers 9,66,000
(iv) Royalty paid for production 8,400
(v) Fee paid to technician hired for the job 96,000
(vi) Administrative overheads 76,000
(vii) Commission paid to sales staffs 1,26,000

You are required to CALCULATE direct expenses for the month.
ANSWERS
Answers to the MCQs
1. (c) 2. (c) 3. (d) 4. (c) 5. (a) 6. (d)
7. (d) 8. (a) 9. (b) 10. (d) 11. (b) 12. (a)

1. Please refer paragraph 5 & 6

4. Please refer paragraph 4.1 & 4.2


1. Working Notes:
1. Actual time taken to produce 1,250 pieces
= No. of working days in the month × No. of working hours per day
of each worker × No. of workers
= 25 days × 8 hrs. × 10 workers = 2,000 hours

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

3.63
3.63
5. Bonus under Rowan Scheme to be paid to 10 workers:

Time taken
Bonus = × Time saved × hourly rate
Time allowed
2,000 hours
= × 500 hours × ` 40 = `16,000
2,500 hours
Total wages to be paid to 10 workers are (`80,000 + `16,000)

` 96,000, if Mr. A considers the introduction of Rowan Incentive Scheme
to increase the Employee productivity.
(i) (a) Effective hourly rate of earnings under Halsey scheme:
(Refer to Working Notes 1, 2, 3 and 4)
Total time wages of 10 workers+Total bonus under Halsey scheme
=
Total hours worked
` 80,000 + ` 10,000
= = `45
2,000 hours
(b) Effective hourly rate of earnings under Rowan scheme:
(Refer to Working Notes 1, 2, 3 and 5)
Total time wages of Total bonus under
+
10 workers Rowan scheme
=
Total hours worked
` 80,000+`16,000
= = `48
2,000 hours
(ii) (a) Saving in terms of direct Employee cost per piece under
Halsey scheme:
(Refer to Working Note 4)
Employee cost per piece (under time wage scheme)
= 2hours × `40 = `80.
Employee cost per piece (under Halsey scheme)
Total wages paid under the scheme ` 90,000
= = = `72
Total number of units produced 1,250
Saving per piece: (`80 – `72) = `8

(b) Saving in terms of direct Employee cost per piece

under Rowan Scheme:
(Refer to Working Note 5)
Employee cost per piece under Rowan scheme
= `96,000/1,250 units = `76.80
Saving per piece = `80 – `76.80 = `3.20
2. Calculation of earnings under different wage schemes:
(i) Day wages
Worker Day wages (`) Actual Output Labour cost per

(Units) 100 pieces (`)
A 600 180 333.33
B 600 120 500.00
C 600 100 600.00
Total 1,800 400

Average labour cost to produce 100 pieces:
Total wages paid ` 1,800
= × 100 = ×100 = `450
Total output 400 units
(ii) Piece rate
Worker Actual Output Piece Wages Labour cost per

(Units) rate (`) earned (`) 100 pieces (`)
A 180 7.50 1,350 750.00
B 120 7.50 900 750.00
C 100 7.50 750 750.00
Total 400 3,000

3.65
3.65
Average cost of labour for the company to produce 100 pieces:

` 3,000
= ×100 = `750
400 units
(iii) Halsey Scheme
Worker Actual Std. Actual Time Bonus Rate Total wages Labour cost
Output time time saved hours per (`) per 100
(Units) (Hrs.) (Hrs.) (Hrs.) (50% of hour pieces (`)
time (`)
saved)
A B C D=B-C E F G = F x (C+E) H=G/A*100
A 180 18 8 10 5 75 975 541.67
B 120 12 8 4 2 75 750 625.00
C 100 10 8 2 1 75 675 675.00
Total 400 2,400

Average cost of labour for the company to produce 100 pieces =
` 2, 400
×100 = ` 600
400 units
(iv) Rowan Scheme:
Worker Actual Std. Actual Time Bonus Rate Total wages Labour cost
Output time time saved hours* per including per 100
(Units) (Hrs.) (Hrs.) (Hrs.) hour bonus (`) pieces (`)
(`)
A B C D=B-C E F G=F×(C+E) H=G/A*100
A 180 18 8 10 4.44 75 933 518.33
B 120 12 8 4 2.67 75 800 666.67
C 100 10 8 2 1.60 75 720 720.00
Total 400 2,453

TimeSaved
* Bonus hours = ×Actualtime
Std. Time

Average cost of labour for the company to produce 100 pieces

` 2, 453
= ×100 = ` 613.25
400 units
3. Calculation of Direct Expenses
(`)
(i) Paid for power & fuel 4,80,200
(ii) Bill paid to job workers 9,66,000
(iii) Royalty paid for production 8,400
(iv) Fee paid to the technician 96,000
Total Direct expenses 15,50,600

Notes:
(i) Wages paid to factory workers is direct employee cost.
(ii) Administrative overhead is indirect expense.

(iii) Commission paid to sales staffs comes under selling expenses.

CHAPTER
4
OVERHEADS-
ABSORPTION
COSTING METHOD
LEARNING OUTCOMES
♦ Discuss the meaning of Overheads-Production,
Administrative and Selling & Distribution.
♦ Discuss the meaning and methods of allocation,
apportionment and absorption of overheads.
♦ Discuss the meaning and treatment of under-absorption
and over-absorption of overheads and apply the same in
cost computation.
♦ State the accounting and control of administrative, selling
and distribution overheads.
♦ Discuss and apply the various methods to calculate
overhead rate.

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

OVERHEADS-ABSORPTION COSTING METHOD 4.3
2. CLASSIFICATION OF OVERHEADS
Description Example
By Function
Factory or Manufacturing overhead is (i) Stock keeping expenses,
Manufacturing the indirect cost incurred for (ii) Repairs and
or Production manufacturing or production maintenance of plant,
Overhead activity in a factory. (iii) Depreciation of factory
Manufacturing overhead building,
includes all expenditures (iv) Indirect labour,
incurred from the (v) cost of primary packing
procurement of materials to (vi) Insurance of plant and
the completion of finished machinery etc.
product. Production overhead
include administration
costs relating to
production, factory,
works or manufacturing.
Office and Office and Administrative (i) Salary paid to office
Administrative overheads are expenditures staffs,
Overheads incurred on all activities (ii) Repairs and maintenance
relating to general of office building,
management and (iii) Depreciation of office
administration of an building
organisation. It includes (iv) postage and stationery,
formulating the policy, (v) Lease rental in case of
directing the organisation operating lease (in case
and controlling the of finance lease, lease
operations of an undertaking rental excluding finance
which is not related directly cost)
to production, selling, (vi) accounts and audit
distribution, research or expenses etc.
development activity or
function.

Selling and (i) Selling overhead: (i) Salesmen commission,

Distribution expenses related to sale (ii) Advertisement cost,
Overheads of products and include (iii) Sales office expenses etc.
all indirect expenses in
sales management for
the organisation. (i) Delivery van expenses,
(ii) Distribution overhead: (ii) Transit insurance,
cost incurred on making
(iii) warehouse and cold
product available for sale
storage expenses,
in the market.
(iv) secondary packing
expenses etc.
By Nature
Fixed These are the costs which are (i) Salary paid to permanent
Overhead incurred for a period, and employees,
which, within certain output (ii) Depreciation of building
and turnover limits, tend to and plant and equipment,
be unaffected by fluctuations (iii) Interest on capital,
in the levels of activity (iv) Insurance.
(output or turnover). They do
not tend to increase or de-
crease with the changes in
output.
Variable These costs tend to vary with (i) Indirect materials,
Overhead the volume of activity. Any (ii) Power and fuel,
increase in the activity results (iii) lubricants,
in an increase in the variable (iv) tools and spares etc.
cost and vice-versa.
Semi-Variable These costs contain both fixed (i) Electricity cost,
Overheads and variable components and (ii) water cost,
are thus partly affected by (iii) telephone and internet
fluctuations in the level of expenses etc.
activity.

By Element
Indirect Materials which do not (i) Stores used for
materials normally form part of the maintaining machines
finished product (cost object) and buildings (lubricants,
are known as indirect cotton waste, bricks etc.)
materials. (ii) Stores used by service
departments like power
house, boiler house,
canteen etc.
Indirect Employee costs which cannot (i) Salary paid to foreman
employee cost be allocated but can be and supervisor.
apportioned to or absorbed (ii) Salary paid to
by cost units or cost centres administration staff etc.
is known as indirect
employee.
Indirect Expenses other than direct (i) Rates & taxes,
expenses expenses are known as (ii) insurance,
indirect expenses, that (iii) depreciation,
cannot be directly, (iv) advertisement expenses
conveniently and wholly etc.
allocated to cost centres.
By Control
Controllable These are those costs which (i) Materials cost,
costs can be controlled by the (ii) wages and salary,
implementation of (iii) power and fuel etc.
appropriate managerial
influence and proper policies.
Uncontrollable Overhead costs which cannot (i) Rates and taxes,
costs be controlled by the (ii) Depreciation,
management even after the (iii) Interest on borrowings.
implementation of appro-
priate managerial influence
and proper polices are known
as uncontrollable costs.

2.1 Advantages of Classification of Overheads into Fixed

and Variable
The primary objective of segregating semi-variable expenses into fixed and
variable is to ascertain marginal costs. Besides this, it has the following
advantages also.
(a) Controlling Expenses: The classification of expenses into fixed and variable
components helps in controlling expenses. Fixed costs are generally policy
costs, which cannot be easily reduced. They are incurred irrespective of the
output and hence are more or less non controllable. Variable expenses vary
with the volume of activity and the responsibility for incurring such expenditure
is determined in relation to the output. The management can control these
costs by giving proper allowances in accordance with the output achieved.
(b) Preparation of Budget Estimates: The segregation of overheads into fixed
and variable part helps in the preparation of flexible budget. It enables a firm
to estimate costs at different levels of activity and make comparison with the
actual expenses incurred.
Suppose in October, 2022 the output of a factory was 1,000 units and the
expenses were:
(`)
Fixed 5,00,000
Variable 4,00,000
Semi-variable (40% fixed) 6,00,000
15,00,000
In November, 2022 the output was likely to increase to 1,200 units. In that case
the budget or estimate of expenses will be:
(`)
Fixed 5,00,000
 ` 4,00,000 ×1,200 units 
Variable   4,80,000
 1,000 units 

Semi-variable
Fixed, 40% of ` 6,00,000 2,40,000
 ` 3,60,000 ×1,200 units 

Variable:   4,32,000
 1,000 units 
16,52,000
It would be a mistake to think that with the output going up from 1,000 units
to 1,200 units the expenses would increase proportionately to ` 18,00,000. This
would be wrong budgeting.
(c) Decision Making: The segregation of semi variable cost between fixed and
variable overhead also helps the management to take many important
decisions. For example, decisions regarding the price to be charged during
depression or recession or for export market. Likewise, decisions on make or
buy, shut down or continue, etc., are also taken after separating fixed costs
from variable costs.
In fact, when any change is contemplated, say, increase or decrease in production,
change in the process of manufacture or distribution, it is necessary to know the total
effect on cost (or revenue) and that would be impossible without a correct
segregation of fixed and variable costs. The technique of marginal costing, cost
volume profit relationship and break-even analysis are all based on such segregation.
3. ACCOUNTING AND CONTROL OF

MANUFACTURING OVERHEADS
We have already seen that overheads are by nature those costs which cannot be
directly related to a product or to any other cost unit. Yet for working out the
total cost of a product or a unit of service, the overheads must be included. Thus,
we have to find out a way by which the overheads can be distributed over the
various units of production.
One method of working out the distribution of overheads over the various
products could be to ascertain the amount of actual overheads and distribute
them over the products. This, however, creates a problem since the actual amount
of overheads can be known only after the financial accounts are closed. If we wait
that long, the cost sheets lose their main advantages and utility to the

management. All the decisions for which cost sheets are prepared are immediate
decisions and cannot be postponed till the actual overheads are known.
Therefore, some method has to be found by which overheads can be included in
the cost of the products, as soon as prime cost, the cost of raw materials, direct
employees and other direct expenses, is ascertained.
One method is to work out pre-determined rates for absorbing overheads.
These rates are worked out before an accounting period begins by estimating the
amount of overheads and the level of activity in the ensuing period. Thus, as soon
as the prime cost of a product or a job is available, the various overheads are
charged by these rates. Of course, this implies that the overheads are charged on
an estimated basis. Later, when the actual overheads are known, the difference
between the overheads charged to the products and actual overheads is worked
out and adjusted.
Manufacturing Overheads: Generally manufacturing overheads form a

substantial portion of the total overheads. It is important, that such overheads
should be properly absorbed over the cost of production. The following
procedure may be adopted in this regard. The steps given below shows how
factory overhead rates are estimated and overheads absorbed on that basis and
the last one show how actual are compared with the absorbed amount.
1. Estimation and Collection of Manufacturing Overheads: The first stage is
to estimate the amount of overheads, keeping in view the past figures and
adjusting them for known future changes. The sources available for the
collection of factory overheads may include (a) Invoices, (b) Stores requisition,
(c) Wage analysis book (d) Journal entries. etc.
2. Assignment of Manufacturing Overheads: The guiding principle for
assignment of manufacturing overheads to a cost object is the traceability
of the overheads in an economically feasible manner.
Assignment of the manufacturing overhead is done on the basis of either of
the following two principles:
(i) Cause and Effect: Cause is the process or operation or activity and
effect is the incurrence of cost.
(ii) Benefit received: Manufacturing overheads are to be apportioned to
various cost objects in proportion to the benefits received by them.

(a) Cost Allocation: The term ‘allocation’ refers to the direct

assignment of cost to a cost object which can be traced directly. It
implies relating overheads directly to the various departments. The
estimated amount of various items of manufacturing overheads
should be allocated to various cost centres or departments. For
example- if a separate power meter has been installed for a
department, the entire power cost ascertained from the meter is
allocated to that department. The salary of the works manager cannot
be directly allocated to any one department since he looks after the
whole factory. It is, therefore, obvious that many overhead items will
remain unallocated after this step.
(b) Cost Apportionment: There are some items of estimated overheads
(like the salary of the works manager) which cannot be directly
allocated to the various departments and cost centres. Such
unallocable expenses are to be spread over the various departments
or cost centres on the basis of two principles. This is called
apportionment. Thus, apportionment implies “the allotment of
proportions of items of cost to cost centres or departments”. After this
stage, all the overhead costs would have been either allocated to or
apportioned over the various departments.
(c) Re-apportionment: Upto the last stage all overheads are allocated
and apportioned to all the departments- both production and service
departments. Service departments are those departments which do
not directly take part in the production of goods or providing
services. Such departments provide auxiliary services across the entity
and renders services to other cost centres and in some cases to
outside parties. Examples of such departments are engineering,
quality control and assurance, laboratory, canteen, stores, time office,
dispensary etc. The overheads of these departments are to be shared
by the production departments since service departments operate
primarily for the purpose of providing services to production
departments. The process of assigning service department
overheads to production departments is called reassignment or
re-apportionment. At this stage, all the factory overheads are col-
lected under production departments.

3. Absorption: After completing the distribution as stated above the overheads

charged to department are to be recovered from the output produced in
respective departments. This process of recovering overheads of a
department or any other cost center from its output is called recovery or
absorption.
Absorption of manufacturing overheads shall be as follows:

(i) Variable Manufacturing overheads: The variable manufacturing
overheads shall be absorbed on the basis of actual production.
(ii) Fixed Manufacturing overheads: The fixed manufacturing overhead
shall be absorbed on the basis of normal capacity.
The overhead expenses can be absorbed by estimating the overhead (as

assigned above) and then working out an absorption rate. When overheads
are estimated, their absorption is carried out by adopting a pre-determined
overhead absorption rate. This rate can be calculated by using any one
method as discussed in this chapter at the end.
As the actual accounting period begins, each unit of production
automatically absorbs a certain amount of factory overheads through pre-
determined rates. During the year a certain amount will be absorbed over
the various products. This is known as the total amount of absorbed
overheads.
4. Treatment of over and under absorption of overheads: After the year

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

4. STEPS FOR THE DISTRIBUTION OF

OVERHEADS
The various steps for the distribution of overheads have been discussed in detail
as below:
Estimation of overheads:
Allocation of overheads:
By standing
Orders Apportionment of overheads:
Directly
Through Re-apportionment
apportionment of
attributable to
budgeting department/ On the basis of overheads:
process cost cenres Benefit Absorption:
received Service
department to
On the basis of Production By actual units
cause & effect departments at
predetermined
Other suitable
rate
basis
4.1 Estimation and Collection of Overheads

The amount of overheads is required to be estimated. The estimation is usually
done with reference to past data adjusted for known future changes. The
overhead expenses are usually collected through a system of standing
orders.
Standing Orders: In every manufacturing business, expenses are incurred on

direct materials and direct labour in respect of several jobs or other units of
production. Incurrence of these expenses are authorised by production orders or
work orders. The term “Standing Order” denotes sanction for indirect expenses
under various heads of expenditure.

In large factories, usually the classification of indirect expenditures is combined

with a system of Standing Orders (sometimes also referred as Service “Orders”). It
is a system under which a number is allotted to each item of expense for the
purpose of identification, and the same is continued from year to year. The
extent of such analysis and the nomenclature adopted are settled by the
management according to the needs of the industry.
4.2 Allocation of Overheads over Various Departments or

Departmentalisation of Overheads
Most of the manufacturing processes functions are performed in different
departments of a factory. Some of the departments of the factory are engaged in
production process while few may function as ancillary departments. The ancillary
departments are service departments supporting the production departments in
manufacturing, administration, selling & distribution of goods or services.
Factory overheads which are related to any of the production or service

departments are allocated to these departments.
A department may be sub-divided into various cost centres for better cost control
and performance evaluation. It is thus obvious that the principal object of setting
up cost centres is to collect data, in respect of similar activities more conveniently.
This avoids a great deal of cost analysis. When costs are collected by setting up
cost centres, several items can be ascertained definitely and the element of
estimation is reduced considerably. For instance, the allowance of the normal idle
time or the amount to be spent on consumable stores, etc. There are two main
types of cost centres - machine or personnel - depending on whether the process
of manufacture is carried on at a centre by man or machine. For the convenience
of recording of expenditure, cost centres are sometimes allotted a code number.
Advantages of Departmentalisation: The collection of overheads department

wise gives rise to the following advantages:
(a) Better Estimation of Expenses: Some expenses which relate to the

departments will be estimated almost on an exact basis and, to that extent,
the accuracy of estimation of overheads will be higher.

(b) Better Control: For the purpose of controlling expenses in a department, it is

obviously necessary that the figures in relation to each department should
be separately available. It is one of the main principles of control that one
should know for each activity how much should have been spent and how
much is actually spent. If information about expenses is available only for
factory as a whole, it will not be possible to know which department has
been over spending.
(c) Ascertainment of Cost for each department: From the point of view of
ascertaining the cost of each job, the expenses incurred in the departments
through which the job or the product has passed should be known. It is only
then that the cost of the job or the product can be charged with the
appropriate share of indirect expenses. It is not necessary that a job must
pass through all the departments or that the work required in each
department should be the same for all jobs. It is, therefore, necessary that
only appropriate charge in respect of the work done in the department is
made. This can be done only if overheads for each department are known
separately.
(d) Suitable Method of Costing: A suitable method of costing can be followed
differently for each department e.g., batch costing when a part is manu-
factured, but single or output costing when the product is assembled.
4.3 Apportioning Overhead Expenses over Various

Departments
Overheads which are related to more than one department are required to be
distributed between/ among the departments. This distribution of overheads
between/ among the departments is called apportionment. The example of
overheads may include e.g. rent of building, power, lighting, insurance,
depreciation etc. To apportioning these overheads over different departments
benefiting thereby, it is necessary at first to determine the proportion of benefit
received by each department and then distribute the total expenditure
proportionately on that basis. But the same basis of apportionment cannot be
followed for different items of overheads since the benefit of service to a
department in each case has to be measured differently. Some of the bases that
may be adopted for the apportionment of expenses are stated below:

Overhead Cost Bases of Apportionment

1. (i) Rent and other building Floor area, or volume of department
expenses
(ii) Lighting and heating
(conditioning)
(iii) Fire precaution service
(iv) Air- conditioning
2. (i) Perquisites Number of workers
(ii) Labour welfare expenses
(iii) Time keeping
(iv) Personnel office
(v) Supervision
3. (i) Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Perquisites
4. General overhead Direct labour hour, or Direct wages, or
Machine hours.
5. (i) Depreciation of plant and Capital values
machinery
(ii) Repairs and maintenance
of plant and machinery
(iii) Insurance of stock
6. (i) Power/steam Technical estimates
consumption
(ii) Internal transport
(iii) Managerial salaries
7. Lighting expenses (light) No. of light points, or Area or Metered
units
8. Electric power (machine Horse power of machines, or Number
operation) of machine hour, or value of machines
or units consumed.
9. (i) Material handling Weight of materials, or volume of
(ii) Stores overhead materials, or value of materials or unit
of materials.

Some other basis of apportioning overhead costs: We have considered already

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

A concern may have predominantly only one criterion or may use all (including
the service or benefit criterion) for different phases of its activity.
(a) Analysis or Survey of existing conditions: At times it may not be possible to

determine the advantage of an item of expenses without undertaking an
analysis of expenditure. For example, lighting expenses can be distributed over
departments only on the basis of the number of light points fixed in each
department.
(b) Ability to pay: It is a principle of taxation which has been applied in cost
accounting as well for distributing the expenditure on the basis of income of
the paying department, on a proportionate basis. For example, if a company is
selling three different products in a territory, it may decide to distribute the
expenses of the sales organisation to the amount of sales of different articles in
these territories. This basis, though simple to apply, may be inequitable since
the expenditure charged to an article may have no relation to the actual effort
involved in selling it. Easy selling lines thus may have to bear the largest
proportion of expenses while, on the other hand, these should bear the lowest
charge.
(c) Efficiency or Incentives: Under this method, the distribution of overheads

is made on the basis of pre-determined levels of production or sales. When
distribution of overhead cost is made on this basis and if the level of
production exceeds the pre-determined level of production the incidence of
overhead cost gets reduced and the total cost per unit of production or of
sales, lowered. The opposite is the effect if the assumed levels are not
reached.

Thus, the department whose sales are increasing is able to show a greater profit
and thereby is able to earn greater goodwill and appreciation of the management
than it would have if the distribution of overheads was made otherwise.
Difference between Allocation and Apportionment
The difference between the allocation and apportionment is important to
understand because the purpose of these two methods is the identification of the
items of cost to cost units or centers. However, the main difference between the
above methods is given below.
Allocation Apportionment
Allocation deals with the whole items Apportionment deals with the
of cost, which are identifiable with proportions of an item of cost for
any one department. For example, example; the cost of the benefit of a
indirect wages of three departments service department will be divided
are separately obtained and hence between those departments which has
each department will be charged by availed those benefits.
the respective amount of wages
individually.
Allocation is a direct process of Apportionment is an indirect process
charging expenses to different cost because there is a need for the
centres identification of the appropriate
portion of an expense to be borne by
the different departments benefited.
• The allocation or apportionment of an expense is not dependent on its
nature, but the relationship between the expense and the cost centre decides
that whether it is to be allocated or apportioned.
• Allocation is a much wider term than apportionment.
4.4 Re-apportionment of Service Department Overheads

over Production Departments
The re-apportionment of the service department cost to the production
department is known as secondary distribution. The suggestive bases that may be
adopted for re-apportionment are given below:

Cost of the Service Departments: Basis
1. Maintenance and Repair shop Direct labour hours, Machine hours,

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

5. Hospital and Dispensary No. of employees etc.
6. Personnel Department
7. Time-keeping No. of card punched, No. of employees
8. Computer Section Computer hours, Specific allocation to

departments
9. Power House (electric lighting Floor area, Cubic content, No. of

cost) electric Points, Wattage.
10. Power House (electric power cost) Horse power, Kwh, Horse power ×
Machine hours, Kwh × Machine hours
11. Stores Department No. of requisitions, Weight or value of

Materials issued.
12. Transport Department Crane hours, Truck hours, Truck

mileage, Truck tonnage, Truck ton-
hours, Tonnage handled. No. of
packages of Standard size
13. Fire Protection Capital values
14. Inspection Inspection hours
Notes:
(1) Repairs included in repairs shop cost, building maintenance cost included in
maintenance shop cost etc. should be apportioned on the basis of capital values.
(2) Economy, practicability, equitability and reliability are the matters of
consideration for selection of the base.

Methods for Re-apportionment: The re-apportionment of service department

expenses over the production departments may be carried out by using any one
of the following methods:
(i) Direct re-distribution method.
(ii) Step method of secondary distribution or non-reciprocal method.
(iii) Reciprocal Service method.
Direct re-distribution
method
Methods for Re- Step method or non- Simultaneous Equation

apportionment reciprocal method. method
Reciprocal Service
Trial and error method
method.
Repeated distribution
method
(i) Direct Re-Distribution Method: Service department costs under this method
are apportioned over the production departments only, ignoring the services
rendered by one service department to the other. To understand the
applications of this method, go through the illustration which follows.
ILLUSTRATION 1
XL Ltd., has three production departments and four service departments. The expenses
for these departments as per Primary Distribution Summary are as follows:
Production Departments: (`) (`)

Dept.-A 30,00,000
Dept.-B 26,00,000
Dept.-C 24,00,000 80,00,000
Service Departments: (`) (`)
Stores 4,00,000
Time-keeping and Accounts 3,00,000
Power 1,60,000
Canteen 1,00,000 9,60,000

The following information is also available in respect of the production departments:
Dept. A Dept. B Dept. C

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

production departments using direct re-distribution method.
SOLUTION
Secondary Overhead Distribution Statement
Items of cost Basis of Total Production Departments

(as per primary apportionment (`) A (`) B (`) C (`)
distribution
summary)
Cost as per primary 80,00,000 30,00,000 26,00,000 24,00,000

distribution
summary
Stores (5:3:2) Value of Store 4,00,000 2,00,000 1,20,000 80,000

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

Accounts (4:3:3)
Power (3:3:2) H.P. of Machine 1,60,000 60,000 60,000 40,000
Canteen (4:3:3) No. of workers 1,00,000 40,000 30,000 30,000
89,60,000 34,20,000 29,00,000 26,40,000
(ii) Step Method or Non-Reciprocal Method: This method gives cognizance to

the services rendered by service department to another service department.
Therefore, as compared to previous method, this method is more complicated
because a sequence of apportionments has to be selected here. The sequence
here begins with the department that renders maximum number of
services to the other service department(s). In other words, the cost of the

service department that serves the largest number of services to the other
service department(s) and production department(s) is distributed first. After
this, the cost of service department serving the next largest number of
departments is apportioned.
This process continues till the cost of last service department is apportioned.
The cost of last service department is apportioned among production
departments only.
Some authors are of the view that the cost of service department with
largest amount of cost should be distributed first.
ILLUSTRATION 2
Suppose the expenses of two production departments A and B and two service
departments X and Y are as under:
Department Amount (`) Apportionment Basis
Y A B
Dept.-X 2,00,000 25% 40% 35%
Dept.-Y 1,50,000 — 40% 60%
Dept.-A 3,00,000
Dept.-B 3,20,000
PREPARE a statement apportioning the costs of service departments over the

production departments using step method.
SOLUTION
Summary of Overhead Distribution
Departments X (`) Y (`) A (`) B (`)

Amount as given above 2,00,000 1,50,000 3,00,000 3,20,000
Expenses of service (2,00,000) 50,000 80,000 70,000
dept.-X is apportioned
among other
departments- Y, A and B
in the ratio (5:8:7)
2,00,000 3,80,000 3,90,000

Expenses of Dept.-Y - (2,00,000) 80,000 1,20,000

apportioned between
department A and B in
the ratio (2:3)
Total Nil Nil 4,60,000 5,10,000
(iii) Reciprocal Service Method: This method recognises the fact that where there
are two or more service departments they may render services to each other
and, therefore, these inter-departmental services are to be given due
weight while re-distributing the expenses of the service departments.
The methods available for dealing with reciprocal services are:
(a) Simultaneous equation method;
(b) Trial and error method;

(c) Repeated distribution method.
Reciprocal Service Method
Simultaneous Trial and Error Repeated

Equation Method Method Distribution Method
(a) Simultaneous Equation Method:

According to this method firstly, the costs of service departments are
ascertained. These costs are then re-distributed to production departments
on the basis of given percentages. (Refer to the following illustration to
understand the method)

ILLUSTRATION 3
Service departments’ expenses
(`)
Boiler house 3,00,000
Pump room 60,000
Total 3,60,000
The allocation basis is:
Production Department Service Department

A B Boiler House Pump Room
Boiler House 60% 35% - 5%
Pump Room 10% 40% 50% -
SOLUTION
The total expenses of the two service departments will be determined as follows:
Let B stand for Boiler House expenses and P for Pump Room expenses.
Then
B = 3,00,000 + 0.50 P
P = 60,000 + 0.05 B
Substituting the value of B,
P = 60,000 + 0.05 (3,00,000 + 0.5 P)
= 60,000 + 15,000 + 0.025 P
= 75,000 + 0.025 P
P - 0.025P = 75,000
 75,000 
P =   = ` 76,923
 0.975 
The total of expenses of the Pump Room is `76,923 and that of the Boiler House
is `3,38,462 i.e., `3,00,000 + 0.5 × ` 76,923.

The expenses will be allocated to the production departments as under:
Production Department
Dept.-A Dept.-B
Boiler House (60% and 35% of ` 3,38,462) 2,03,077 1,18,462
Pump Room (10% and 40% of ` 76,923) 7,692 30,769
Total 2,10,769 1,49,231
The total of expenses apportioned to A and B is ` 3,60,000.

(b) Trial and Error Method:
According to this method the cost of one service cost centre is apportioned to
another service cost centre. The cost of another service centre plus the share
received from the first cost centre is again apportioned to the first cost centre.
This process is repeated till the amount to be apportioned becomes negligible,
that means repeated distribution method is followed to the extent of
service departments only. All apportioned amounts for each service cost
centre are added to get the total apportioned cost. These total service cost
centre costs are redistributed to the production departments. Trial and
error method and Simultaneous equation method gives the same result. (Refer
to the following illustration to understand this method.)
ILLUSTRATION 4
Sanz Ltd., is a manufacturing company having three production departments, ‘A’, ‘B’ and
‘C’ and two service departments ‘X’ and ‘Y’. The following is the budget for December 2022:
Total (`) A (` ) B (`) C (`) X (` ) Y (` )
Direct material 1,00,000 2,00,000 4,00,000 2,00,000 1,00,000

Direct wages 5,00,000 2,00,000 8,00,000 1,00,000 2,00,000
Factory rent 4,00,000
Power 2,50,000
Depreciation 1,00,000
Other overheads 9,00,000

Additional information:
Area (Sq. ft.) 500 250 500 250 500
Capital value of assets 20 40 20 10 10
(` lakhs)
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25
A technical assessment of the apportionment of expenses of service departments is as

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

Service Dept. ‘Y’ (%) 60 35 – 5 –
Required:
(i) PREPARE a statement showing distribution of overheads to various departments.
(ii) PREPARE a statement showing re-distribution of service departments expenses to
production departments using Trial and error method.
SOLUTION
(i) Overhead Distribution Summary
Basis Total (`) A (`) B (`) C (`) X (`) Y (`)
Direct Direct – – – – 2,00,000 1,00,000

materials
Direct wages Direct – – – – 1,00,000 2,00,000
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000

(2:1:2:1:2)
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000

Machine
(10:16:16:3:5)*
Hrs.

Depreciation Capital 1,00,000 20,000 40,000 20,000 10,000 10,000

value
(2:4:2:1:1)
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000

overheads hrs.
(1:2:4:1:1)
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
*{(1000×50) : (2000×40) : (4000×20) : (1000×15) : (1000×25)}
(50000 : 80000 : 80000 : 15000 : 25000)
(ii) Redistribution of Service Department’s expenses:
Service Departments
X (`) Y (`)
Overheads as per primary distribution 4,75,000 5,35,000
(i) Apportionment of Dept-X expenses to Dept-Y

--- 47,500
(10% of ` 4,75,000)
--- 5,82,500
(ii) Apportionment of Dept-Y expenses to Dept-X

29,125 ---
[5% of (` 5,35,000 + ` 47,500)]
(i) Apportionment of Dept-X expenses to Dept-Y

--- 2,913
(10% of ` 29,125)
(ii) Apportionment of Dept-Y expenses to Dept-X

146 ---
(5% of ` 2,913)
Total 5,04,271 5,85,413

Distribution of Service departments’ overheads to Production departments
Production Departments
A (`) B (`) C (`)
Overhead as per primary distribution 2,70,000 3,70,000 6,00,000
Dept- X (90% of ` 5,04,300) 2,26,900 75,600 1,51,300
Dept- Y (95% of ` 5,85,400) 3,51,300 2,04,900 ---
8,48,200 6,50,500 7,51,300
(c) Repeated Distribution Method:
Under this method, service departments’ costs are distributed to other

service and production departments on agreed percentages and this
process continues to be repeated, till the figures of service departments are
either exhausted or reduced to too small a figure. (Refer to the following
illustration to understand this method)
ILLUSTRATION 5
Taking all the information from Illustration 4 above, PREPARE a statement showing re-
distribution of service departments’ expenses to production departments using repeated
distribution method. Also CALCULATE machine hour rates of the production
departments ‘A’, ‘B’ and ‘C’.
SOLUTION
Redistribution of Service Department’s expenses using ‘repeated distribution
method’:
A (`) B (`) C (`) X (`) Y (`)
Total overheads {Refer (i) of 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000

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

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

in the ratio (45:15:30: —:10)
Dept. Y overhead apportioned 1,747 1,019 − 146 (2,912)
in the ratio (60:35: —:5: —)
Dept. X overhead apportioned 65 22 44 (146) 15
in the ratio (45:15:30: —:10)
Dept. Y overhead apportioned 9 6 - - (15)
in the ratio (60:35: —:5: —)
8,48,177 6,50,541 7,51,282 − −
Calculation of machine hour rate:
A B C
A Total overheads (`) 8,48,177 6,50,541 7,51,282
B Machine hours 1,000 2,000 4,000
C Machine hour rate (`) [A ÷ B] 848.18 325.27 187.82
4.5 Absorbing Overheads over Cost Units, Products, etc.

Collection of the figure of overheads for the factory as a whole or for various
departments is not enough. It is clearly necessary to ascertain how much of the
overheads is to be debited to the cost of the various jobs, products etc. This process
is called absorbing the overhead to cost units. We take up below the various
implications of this process. However, if only one uniform type of work is done,
the task is easy and under such a situation the overhead expenses to be absorbed
may be calculated by dividing actual overheads by the number of units of work
done or estimated overheads by the estimated output.
The whole process of overhead distribution and absorption to units produced is
depicted in the synopsis as below:


5. METHODS OF ABSORBING OVERHEADS TO

VARIOUS PRODUCTS OR JOBS
The method selected for charging overheads to products or jobs should be such
as will ensure:
(i) that the total amount charged (or recovered) in a period does not differ
materially from the actual expenses incurred in the period. and
(ii) that the amount charged to individual jobs or products is equitable. In case of
factory overhead, this means:
(a) that the time spent on completion of each job should be taken into
consideration;
(b) that a distinction should be made between jobs done by skilled workers
and those done by unskilled workers. and
(c) that jobs done by manual labour and those done by machines should be
distinguished.
In addition, the methods should be capable of being used conveniently; and yield
uniform result from period to period as far as possible; any change that is
apparent should reflect a change in the underlying situation such as substitution
of human labour by machines.
Several methods are commonly employed either individually or jointly for
computing the appropriate overhead rate. The more common of these are:
Methods of Absorption of Overheads
Percentage Percentage Percentage Labour Machine Rate per

of direct of prime of direct hour hour unit of
materials cost labour cost rate rate output

(1) Percentage of direct materials,

(2) Percentage of prime cost,
(3) Percentage of direct labour cost,
(4) Labour hour rate,

(5) Machine hour rate and
(6) Rate per unit of Output
5.1 Percentage of Direct Material Cost

Under this method, the cost of direct material consumed is the base for calculating the
amount of overhead absorbed. This overhead rate is computed by the following
formula:
Total Production Overheads of a Department
Overhead rate = ×100
Budgeted Direct Material cost of all products
5.2 Percentage of Prime Cost Method

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

Prime cost
Example for the above two methods:

Suppose for a given period, actual figures are estimated as follows:
`
Direct materials 2,00,000
Direct labour 1,00,000
Factory overheads 90,000

The percentage of factory overheads to direct materials will be 45%, to prime cost
30%. If, on a job, material cost is ` 10,000 and direct labour is `7,000 the cost,
after absorbing factory overhead, will be as follows:
(i) ` 17,000 + 45% ` 10,000 or ` 21,500,
(ii) ` 17,000 + 30% ` 17,000 or ` 22,100, and
One can see how, with a different method, the works cost comes out to be
different. Of these methods, the first and second are generally considered to be
unsuitable on account of the following reasons:
(i) Manufacturing overhead expenses are mostly a function of time i.e., time is the
determining factor for the incurrence and application of manufacturing
overhead expenses. That they are so would be clear if we recall that overhead
expenses, specially manufacturing expenses, can in the ultimate analysis be
regarded as expenditure incurred in providing the necessary facilities and
service to workers employed in the productive process. The question of
facilities and service made available to workers naturally is dependent on the
length of time during which workers make use of the facilities. It may,
therefore, be said that the job or product on which more time has been spent
would entail larger manufacturing expenses than the job requiring less time. The
factor is ignored altogether by the first method and largely by the second
method.
(ii) Overheads are neither related to the prime cost nor to direct material cost
except to a very small extent. Thus, if the percentage of material cost is used
when there are two jobs requiring the same operational time but using
material having varying prices, their manufacturing overhead cost would be
different whereas this should not normally be so.
The method of absorbing overhead costs on the basis of prime cost also does
not take into consideration the time factor. The fact that the amount includes
labour cost in addition to material cost does not render the prime cost to be
more suitable; infact, the results are liable to be more misleading because of
the cumulative error of using both the labour and material cost as the basis of
allocation of overhead expenses, on neither of which they are already
dependent.

(iii) Since material prices are prone to frequent and wide fluctuations, the
manufacturing overheads, if based on material cost or prime cost, also would
fluctuate violently from period to period.
(iv) The skill of the workers involved and whether machines were used or not, are
ignored when these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of
absorbing material handling and store overheads.
5.3 Percentage of Direct Labour Cost

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

This method is an improvement on the percentage of direct wage basis, as it fully
recognises the significance of the element of time in the incurring and absorption of
manufacturing overhead expenses. This method is admirably suited to operations
which do not involve any large use of machinery. To calculate labour hour rate,

the amount of factory overheads is divided by the total number of direct labour
hours. Suppose factory overheads are estimated at `90,000 and labour hours at
1,50,000. The overhead absorption rate will be `0.60. If 795 direct labour hours
are spent on a job, `477 will be absorbed as overhead. It can be calculated for
each category of workers.
Formula to be used under this method is:
Direct Labour Hour Rate = ×100
Direct Labour Hour
5.5 Machine Hour Rate Method
Machine hour rate implies, cost of running a machine for an hour to produce
goods. There are two methods of computing machine hour rates:
(i) Direct Machine hour rate: According to the first method, only the
expenses directly or immediately connected with the operation of the
machine are taken into account e.g., power, depreciation, repairs and
maintenance, insurance, etc. The rate is calculated by dividing the estimated
total of these expenses for a period by the estimated number of operational
hours of the machines during the period.
(ii) Comprehensive Machine hour rate: It will be obvious, however, that in
addition to the expenses stated above there may still be other
manufacturing expenses such as supervision charges, shop cleaning and
lighting, consumable stores and shop supplies, shop general labour, rent
and rates, etc. incurred for the department as a whole and, hence, not
charged to any particular machine or group of machines. In order to see
that such expenses are not left out of production costs, one should include
a portion of such expenses to compute the machine hour rate. Alternatively,
the overheads not directly related to machines may be absorbed on the
basis of Productive Labour Hour Rate Method or any other suitable method.
Note: Sometimes even it is prefered to add the wages paid to the machine
operator in order to get a comprehensive rate of working a machine for one hour.
By the machine hour rate method, manufacturing overhead expenses are charged
to production on the basis of number of hour machines are used on jobs or work
orders. Here each machine or group of machines is treated as a cost centre.

Overheads apportioned to a production department are further apportioned to

machines or group of machines. These apportioned costs are divided by the
estimated productive machine hour to get machine hour rate.
The steps involved in determining of Machine hour rate are as follows:
Step1: Calculate total of overheads apportioned to a production department (as

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

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

and divide it by Estimated total productive hours
Step 6: The resultant figure is machine hour rate
The above costs are further divided into fixed cost or standing charges and variable
cost. Costs which remain constant irrespective of operation of machine are treated
as fixed cost or standing charges. Examples of fixed cost include insurance
premium for machine, rent for premises, supervisor’s salary, depreciation (if
relates to effluxion of time) etc.

Costs which vary with the operation of the machine are treated as variable cost.
Examples of variable cost include cost for power, cost for consumables (lubricants,
oils etc.), repairs and maintenance, depreciation (if it relates to activity) etc.
Advantages and disadvantages of Machine hour rate:
(1) Where machines are the main (1) Additional data concerning the
factor of production, it is usually operation time of machines, not
the best method of charging otherwise necessary, must be
machine operating expenses to recorded and maintained.
production.
(2) The under-absorption of (2) As general department rates for

machine overheads would all the machines in a depart-
indicate the extent to which the ment may be suitable, the
machines have been idle. computation of a separate
machine hour rate for each
machine or group of machines
would mean further additional
work.
(3) It is particularly advantageous

where one operator attends to
several machines (e.g. automatic
screw manufacturing machine),
or where several operators are
engaged on the machine e.g.
the belt press used in making
conveyer belts.
5.6 Rate Per Unit of Output Method

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

6. TYPES OF OVERHEAD RATES

The overhead rates may be of the following types:
Type of Overhead Rates
1. Normal 2. Pre-determined 3. Blanket 4. Departmental

Rate Rate Rate Rate
1. Normal Rate: This rate is calculated by dividing the actual overheads by

actual base. It is also known as actual rate.
It is calculated by the following formula:
Actual amount of overheads

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

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

Pre-determined Rate =
Budgeted base
The amount of overhead rate of expenses for absorbing them to production

may be estimated on the following three bases.
(1) The figure of the previous year or period may be adopted as the
overhead rate to be charged to production in the current year. The
assumption is that the value of production as well as overheads will
remain constant or that the two will change, proportionately.
(2) The overhead rate for the year may be determined on the basis of
estimated expenses and anticipated volume of production activ-
ity.
For instance, if expenses are estimated at `10,000 and output at 4,000
units, the overhead rate will be `2.50 per unit.

(3) The overhead rate for a year may be fixed on the basis of the
normal volume of the business.
3. Blanket Overhead Rate: Blanket overhead rate refers to the computation
of one single overhead rate for the whole factory. It is to be
distinguished from the departmental overhead rate which refers to a
separate rate for each individual cost centre or department. The use of
blanket rate may be proper in certain factories producing only one major
product in a continuous process or where the work performed in every
department is fairly uniform or standardised.
This overhead rate is computed as follows:
Total overheads for the factory

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

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

Departmental overhead Rate =
Corresponding base

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

Depreciation (Refer working note-1) 75,833
Rent (`30,000 × ¼ ) 7,500
Lighting charges {(`8,000 × 2 points) ÷ 10 points} 1,600
Foreman’s salary (`19,200 × 1/6) 3,200
Sundry expenses (oil etc.) 900
Insurance {(1% of ` 1,00,00,000) ÷ 12 months} 8,333
97,366 266.76
Variable costs:
Repairs (Refer working note -2) 41.10
Electricity (15 units × ` 5) 75.00
Machine Hour rate 382.86

Working Notes:
Cost of Machine-Scrap value
(1) Depreciation per month =
Life of the machine
` 1,00,00,000 - ` 9,00,000
= =` 75,833
(10 years ×12months) *
*In the question the life of the machine is given as 10 years and it is also
mentioned the machine will run for 4,380 hours per annum. The depreciation
can be calculated either on the basis of time i.e. 10 years or on the basis of
activity of 43,800 hours (4,380 hours p.a.)
(2) Repairs for the whole life is ` 18,00,000, which can be linked to activity level of
`18,00,000
43,800 hours. Thus, Repairs cost per hour = = ` 41.10
43,800 hours
ILLUSTRATION 7
A machine shop cost centre contains three machines of equal capacities. To
operate these three machines nine operators are required i.e. three operators on
each machine. Operators are paid ` 20 per hour. The factory works for fourty eight
hours in a week which includes 4 hours set up time. The work is jointly done by
operators. The operators are paid fully for the fourty eight hours. In additions they
are paid a bonus of 10 per cent of productive time. Costs are reported for this
company on the basis of thirteen four-weekly period.
The company for the purpose of computing machine hour rate includes the direct
wages of the operator and also recoups the factory overheads allocated to the
machines. The following details of factory overheads applicable to the cost centre
are available:
 Depreciation 10% per annum on original cost of the machine. Original cost of
the each machine is `52,000.
 Maintenance and repairs per week per machine is `60.
 Consumable stores per week per machine are `75.
 Power: 20 units per hour per machine at the rate of 80 paise per unit. No
power is used during the set-up hours.

 Apportionment to the cost centre: Rent per annum `5,400, Heat and Light per
annum `9,720, foreman’s salary per annum `12,960 and other miscellaneous
expenditure per annum `18,000.
Required:
CALCULATE the cost of running one machine for a four week period.
SOLUTION
Effective Machine hour for four-week period
= Total working hours – unproductive set-up time
= {(48 hours × 4 weeks) – {(4 hours × 4 weeks)}
= (192 – 16 hours) =176 hours.
(i) Computation of cost of running one machine for a four week period
(`) (`)
(A) Standing charges (per annum)
Rent 5,400
Heat and light 9,720
Forman’s salary 12,960
Other miscellaneous expenditure 18,000
Standing charges (per annum) 46,080
Total expenses for one machine for four 1,181.54
week period
 ` 46,080 
 
 3 machines ×13 four - week period 
Wages (48 hours × 4 weeks × ` 20 × 3 11,520.00
operators)
Bonus {(176 hours × ` 20 × 3 operators) × 1,056.00
10%}
Total standing charges 13,757.54

(B) Machine Expenses

Depreciation 400.00
 1 
 `52,000 ×10% × 
 13four - week period 
Repairs and maintenance (`60 × 4 weeks) 240.00

Consumable stores (`75 × 4 weeks) 300.00
Power (176 hours × 20 units ×` 0.80)
2,816.00
Total machine expenses 3,756.00
(C) Total expenses (A) + (B) 17,513.54
` 17,513.54
(ii) Machine hour rate = = `99.51
176 hours
7. TREATMENT OF UNDER-ABSORBED AND

OVER–ABSORBED OVERHEADS IN COST
ACCOUNTING
Overhead expenses are usually applied to production on the basis of pre-
determined rates. Production overheads are to be determined in advance for
fixing selling price, quote tender price and to formulate budgets etc.
Estimated / Normal overheads for the period
Pre-determined overhead rate =
Budgeted Number of units during the period
The actual overhead rate will rarely coincide with the pre-determined overhead
rate, due to variation in pre-determined overhead rate and actual overhead rate.
Such a variation may arise due to any one of the following situations:
(i) Estimated overheads for the period under consideration may remain the
same or they coincide with actual overheads but the number of units
produced during the period is either more or less in comparison with
budgeted figure. In the former case actual overhead rate will be less and in
the latter case, actual overhead rate will be more than the pre-determined

overhead rate, hence over-absorption and under-absorption will occur

respectively.
(ii) Similarly, if the number of units actually produced during the period
remains the same as budgeted figure but the actual overheads incurred
are more or less than the estimated overheads for the period, then a
situation of under-absorption or over-absorption will arise respectively.
(iii) If changes occur in different proportion both in the actual overheads and
in the number of units produced during the period, then a situation of
under or over-absorption (depending upon the situation) will arise.
(iv) If the changes in the numerator (i.e. in actual overheads) and denominator
(i.e. in number of units produced) occur uniformly (without changing the
proportion between the two) then a situation of neither under nor of over-
absorption will arise.
Such over or under-absorption as arrived at under different situations may also
be termed as overhead variance. The amount of over-absorption being
represented by a credit balance in the accounts and the amount of under-
absorption as a debit balance.
The situations of under/ over absorption can be summarized as below:
When the absorbed amount is less than the actual amount it is called under-
absorption. Similarly, when the absorbed amount is more than the actual
amount it is called over-absorption.
Budgeted Figure Actual Figure Absorbed Difference Result

Amount
(`) Units (`) Units Under/Over
(`) (`) absorption
1 2 3 4 5=1/2×4 6=3-5
100 100 110 100 100 10 Under-absorption
100 100 90 100 100 -10 Over-absorption
100 100 100 110 110 -10 Over-absorption

100 100 90 90 90 0 No under/over-

absorption
100 100 110 110 110 0 No under/over-

absorption
100 100 90 110 110 -20 Over-absorption
`100
In above example Pre-determined rate is =`1
100units
Treatment of under/ over absorption of overheads in cost accounting:

Treatment of such under/ over absorption of overheads can be understood with
the help of the following flow chart:
Costing
P&L A/c

As regards the treatment of such debit or credit balances, the general view is
that if the balances are small they should be transferred to the Costing Profit
and Loss Account and the cost of individual products should not be increased or
reduced as these would be representing normal cost.
Where, however the difference is large and due to wrong estimation (estimation is
wrong due to unavoidable reasons), it would be desirable to adjust the cost of
products manufactured, as otherwise the cost figures would convey a misleading
impression. Such adjustments usually take the form of supplementary rates.
Supplementary rate is calculated as below:
Under / Over - absorbed OH

Supplementary rate =
Units produced
Supplementary overhead rate as calculated above is applied to finished goods,

semi-finished goods (WIP) and goods finished and sold. Therefore, under/ over
absorbed overheads are distributed among the unsold stock of finished goods,
semi-finished goods (WIP) and cost of sales (goods produced and sold).
The accounting is done as follows:

In case of Under-absorption:
Accounts Dr/Cr Calculation of amount

1. Stock of Finished goods A/c Debit Units of Finished stock ×
Supplementary rate per unit
2. Stock of Semi-finished goods Debit Equivalent completed units ×
(WIP) A/c Supplementary rate per unit
3. Cost of Sales A/c Debit Units sold × Supplementary
rate per unit
In case of Over-absorption:
Accounts Dr/Cr Calculation of amount

1. Stock of Finished goods A/c Credit Units of Finished stock ×
Supplementary rate per unit
2. Stock of Semi-finished goods Credit Equivalent completed units ×
(WIP) A/c Supplementary rate per unit
3. Cost of Sales A/c Credit Units sold × Supplementary
rate per unit

However, over or under recovery of overheads due to abnormal reasons (such as

abnormal over or under capacity utilisation) should be transferred to the Costing
Profit and Loss Account.
ILLUSTRATION 8
The total overhead expenses of a factory is ` 4,46,380. Taking into account the normal
working of the factory, overhead was recovered in production at ` 1.25 per hour. The
actual hours worked were 2,93,104. STATE how would you proceed to close the books
of accounts, assuming that besides 7,800 units produced of which 7,000 were sold,
there were 200 equivalent units in work-in-progress?
On investigation, it was found that 50% of the unabsorbed overhead was on

account of increase in the cost of indirect materials and indirect labour and the
remaining 50% was due to factory inefficiency.
SOLUTION
Calculation of under/ over- absorption of overhead
(`)
Actual factory overhead expenses incurred 4,46,380
Overheads absorbed (2,93,104 hours × ` 1.25) 3,66,380
Under-absorption of overhead 80,000
Reasons for unabsorbed overheads

(i) 50% of the unabsorbed overhead was on account of increase in the cost of
indirect material and indirect labour.
(ii) 50% of the unabsorbed overhead was due to factory inefficiency.
Treatment of unabsorbed overheads in Cost Accounting
1. Unabsorbed overhead amounting to ` 40,000, which were due to increase in

the cost of indirect material and labour should be charged to units produced by
using a supplementary rate.
` 40,000
Supplementary rate = = ` 5 per unit
(7,800 + 200) units

The sum of ` 40,000 (unabsorbed overhead) should be distributed by using a

supplementary rate among cost of sales, finished goods and work-in progress
A/cs. The amount to be debited is calculated as below:
(`)
Stock of finished goods 4,000

[(7,800-7,000) × ` 5]
Work-in progress 1,000

(200 units × ` 5)
Cost of sales 35,000

(7,000 units × ` 5)
Total 40,000
1. The use of cost of sales figure, would reduce the profit for the period by
` 35,000 and will increase the value of stock of finished goods and work-
in-progress by ` 4,000 and ` 1,000 respectively.
2. The balance amount of unabsorbed overheads of ` 40,000 due to factory
inefficiency should be debited to Costing Profit & Loss Account, as this is
an abnormal loss.
8. ACCOUNTING AND CONTROL OF ADMINIS-

TRATIVE OVERHEADS
Definition - According to CIMA Terminology, Administrative overhead is defined
as “The sum of those costs of general management and of secretarial accounting
and administrative services, which cannot be directly related to the production,
marketing, research or development functions of the enterprise.” According to this
definition, administrative overhead constitutes the expenses incurred in
connection with the formulation of policy directing the organisation and
controlling the operations of an undertaking. These overheads are also collected
and classified in the same way as the factory overheads.

8.1 Accounting of Administrative Overheads

There are three distinct methods of accounting of administrative overheads,
which are briefly discussed below:
(a) Apportioning Administrative Overheads between Production and Sales
Departments: According to this method administrative overheads are
apportioned over production and sales departments. The reason for the
apportionment of overhead expenses over these departments, recognises
the fact that administrative overheads are incurred for the benefit of both of
these departments. Therefore, each department should be charged with the
proportionate share of the same. When this method is adopted, administra-
tive overheads lose their identity and get merged with production and
selling and distribution overheads.
Disadvantages:
(1) It is difficult to find suitable bases of administrative overhead
apportionment over production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.
(3) It is not justified to apportion total administrative overheads only over
production and sales departments when other equally important
department like finance is also there.
(b) Charging to Profit and Loss Account: According to this method
administrative overheads are charged to Costing Profit & Loss Account. The
reason for charging to Costing Profit & Loss are firstly, the administrative
overheads are concerned with the formulation of policies and thus are not
directly concerned with either the production or the selling and distribution
functions. Secondly, it is difficult to determine a suitable basis for
apportioning administrative overheads over production and sales depart-
ments. Lastly, these overheads are the fixed costs. In view of these
arguments, administrative overheads should be charged to Profit and Loss
Account.
Disadvantages:
(1) Cost of products is understated as administrative overheads are not
charged to costs.

(2) The exclusion of administrative overheads from cost of products is

against sound accounting principle.
(c) Treating Administrative Overheads as a separate addition to Cost of
Production/ Sales: This method considers administration as a separate
function like production and sales and, as such costs relating to formulating
the policy, directing the organisation and controlling the operations are
taken as a separate charge to the cost of the jobs or a product, sold along
with the cost of other functions. The bases which are generally used for
apportionment are:
(i) Works cost

(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced

(v) Conversion cost, etc.
8.2 Control of Administrative Overheads

Mostly administrative overheads are of fixed nature, and they arise as a result of
management policies. These fixed overheads are generally non-controllable. But
at the same time these overheads should not be allowed to grow
disproportionately. Some degree of control has to be exercised over them. The
methods usually adopted for controlling administrative overheads are as follows:
(i) Classification and analysis of overheads by administrative departments
according to their functions, and a comparison with the accomplished
results: According to this method the expenses incurred by each
administrative department are collected under a standing order for each
class of expenditure. These are compared with similar figures of the
previous period in relation to accomplishment. Such a comparison will
reveal efficiency or inefficiency of the concerned department.
However, this method provides only a limited degree of control and
comparison does not give useful results if the level of activity is not
constant during the periods under comparison. To overcome this difficulty,
overhead absorption rates may also be compared from period to period; the

extent of over or under absorption will reveal the efficiency or otherwise of

the department. It may be possible to compare the cost of a service
department with that of similar services obtainable from outside and a
decision may be taken whether it is economical to continue the department
or entrust the work to outsiders.
(ii) Control through Budgets: According to this method, administration
budgets (monthly or annually) are prepared for each department. The
budgeted figures are compared with actual ones to determine variances.
The variances are analysed and responsibility assigned to the concerned
department to control these variances.
(iii) Control through Standard: Under this method, standards of performance
are fixed for each administrative activity, and the actual performance is
compared with the standards set. In this way, standards serve not only as
yardstick of performance but also facilitate control of costs.
ILLUSTRATION 9 (Reverse Calculation of Factory Overhead and
Administrative overheads)
In an engineering company, the factory overheads are recovered on a fixed
percentage basis on direct wages and the administrative overheads are absorbed on
a fixed percentage basis on factory cost.
The company has furnished the following data relating to two jobs undertaken by it
in a period:
Job 101 Job 102
(` ) (` )
Direct materials 54,000 37,500

Direct wages 42,000 30,000
Selling price 1,66,650 1,28,250
Profit percentage on Total Cost 10% 20%
Required:
(i) COMPUTATION of percentage recovery rates of factory overheads and
administrative overheads.

(ii) CALCULATION of the amount of factory overheads, administrative overheads

and profit for each of the two jobs.
(iii) Using the above recovery rates DETERMINE the selling price of job 103. The
additional data being:
Direct materials ` 24,000
Direct wages ` 20,000
Profit percentage on selling price 12-½%
SOLUTION
(i) Computation of percentage recovery rates of factory overheads and
administrative overheads.
Let the factory overhead recovery rate as percentage of direct wages be F and
administrative overheads recovery rate as percentage of factory cost be A.
Factory Cost of Jobs:
Direct materials + Direct wages + Factory overhead
For Job 101 = ` 54,000 +` 42,000 + ` 42,000F
For Job 102 = ` 37,500 +` 30,000 + ` 30,000F
Total Cost of Jobs:
Factory cost + Administrative overhead
For Job 101 = (` 96,000 + ` 42,000F) + (` 96,000+ ` 42,000F) A = ` 1,51,500*
For Job-102 = (` 67,500 + ` 30,000F) + (` 67,500+ ` 30,000F) A = ` 1,06,875**
The value of F & A can be found using following equations
` 96,000 + ` 42,000F + ` 96,000A +

` 42,000AF = ` 1,51,500 …eqn (i)
` 67,500 + ` 30,000F + ` 67,500A +

` 30,000AF = ` 1,06,875 …eqn (ii)

Multiply equation (i) by 5 and equation (ii) by 7
` 4,80,000 + ` 2,10,000F + ` 4,80,000A +

` 2,10,000AF = ` 7,57,500 …eqn (iii)
` 4,72,500 + ` 2,10,000F + ` 4,72,500A +

` 2,10,000AF = ` 7,48,125 …eqn (iv)
- - - - -
` 7,500 + ` 7,500A = ` 9,325

` 7,500 A = ` 9,325 – ` 7,500
A = 0.25
Now put the value of A in equation (i) to find the value of F
` 96,000 + ` 42,000F + ` 24,000 + ` 10,500F = ` 1,51,500
` 52,500F = ` 1,51,500 – ` 1,20,000
F = 0.6
On solving the above relations: F = 0.60 and A = 0.25
Hence, percentage recovery rates of:
Factory overheads = 60% of wages and
Administrative overheads = 25% of factory cost.
Working note:
Selling price
Total Cost =
(100% + Percentage of profit)
`1,66,650
*For Job 101= = ` 1,51,500
(100% + 10%)
`1,28,250
**For Job 102= = ` 1,06,875
(100% + 20%)

(ii) Statement of jobs, showing amount of factory overheads, administrative

overheads and profit:
Job 101 Job 102
(`) (`)
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Prime cost 96,000 67,500
Factory overheads
60% of direct wages 25,200 18,000
Factory cost 1,21,200 85,500
Administrative overheads
25% of factory cost 30,300 21,375
Total cost 1,51,500 1,06,875
Profit (10% & 20% respectively) 15,150 21,375
Selling price 1,66,650 1,28,250
(iii) Selling price of Job 103
(`)
Direct materials 24,000
Direct wages 20,000
Prime cost 44,000
Factory overheads (60% of Direct Wages) 12,000
Factory cost 56,000
Administrative overheads (25% of factory cost) 14,000
Total cost 70,000
Profit margin (balancing figure) 10,000
 Total Cost 
Selling price  
 87.5%  80,000

9. ACCOUNTING AND CONTROL OF SELLING

AND DISTRIBUTION OVERHEADS
Selling cost or overhead expenses are the expenses incurred for the purpose of
promoting the marketing and sales of different products. Distribution expenses, on
the other hand, are expenses relating to delivery and dispatch of goods sold.
Examples of selling and distribution expenses have been considered earlier in this
booklet. From the definitions it is clear that the two types of expenses represent
two distinct type of functions. Some concerns group together these two types of
overhead expenses into one composite class, namely, selling and distribution
overhead, for the purpose of Cost Accounting.
9.1 Accounting of Selling and Distribution Overheads

The collection and accumulation of each expense is made by means of
appropriate standing orders in the usual way. Where it is decided to apportion a
part of the administrative overhead to the selling division the same should also
be collected through appropriate standing orders.
As in the case of administrative overheads, it is not easy to determine an entirely
satisfactory basis for computing the overhead rate for absorbing selling
overheads. The bases usually adopted are:
(a) Sales value of goods;
(b) Cost of goods sold;
(c) Gross Profit on sales; and
(d) Number of orders or units sold.
It is considered that the sale value is ordinarily the most logical basis, there being
some connection between the amount of sales and the amount of expenses
incurred to achieve them. The cost of production, however, is not as satisfactory
basis as it may not have any direct relationship with the selling and distribution
cost.
The basis of gross profit on sales results in a larger share of the selling overhead
being applied to goods yielding a large margin of profit and vice versa. The basis
therefore follows the principle of ‘ability to pay, it may not reflect costs or in-
curred efforts.

An estimated amount per unit - The best method for absorbing selling and
distributing expenses over various products is to separate fixed expenses from
variable expenses. Apportion the fixed expenses according to the benefit derived
by each product and thus ascertaining the fixed expenses per unit. We give below
some of the fixed expenses and the basis of apportionment:
Expenses Basis
Salaries in the Sales Department Estimated time devoted to the sale of
and of the sales men. various products.
Advertisement Actual amount incurred for each product
since these days it is usual to advertise
each product separately; common
expenses, such as in an exhibition,
should be apportioned on the basis of
advertisement expenditure on each
product.
Show Room expenses Average space occupied by each
product.
Rent of finished goods godowns Average quantities delivered during a
and Expenses on own delivery period.
vans
If a suitable basis for apportioning expenses does not exist it may be apportioned
in the proportion of sales of various products.
The total of fixed expenses apportioned in this manner, divided by the number of
units sold or likely to be sold, will give the fixed expenses per unit. To this should
be added the variable expenses which will be different for each product. These
expenses are, packaging, freight outwards, insurance in transit, commission
payable to salesmen, rebate allowed to customers, etc. All these items will be
worked out per unit for each product separately. These items added to fixed
expenses per unit will give an estimated amount of the selling and distribution
expenses per unit.

9.2 Control of Selling and Distribution Overheads

Control of selling and distribution expenses is a difficult task. The reasons for this
are as follows:
1. The incidence of selling and distribution overheads depends mainly on
external factors, such as distance of market, extent and nature of
competition, terms of sales, etc. which are beyond the control of
management.
2. These overheads are dependent upon the customers, behaviour, their liking
and disliking, tastes etc. Therefore, as such control over the overheads may
result in loss of customers.
3. These expenses being of the nature of policy costs are not amenable to
control.
In spite of the above difficulties, the following methods may be used for
controlling them.
(a) Comparison with past performance - According to this method, selling and
distribution overheads are compared with the figures of the previous period.
Alternatively, the expenses may be expressed as a percentage of sales, and the
percentages may be compared with those of the past period. This method is
suitable for small concerns.
(b) Budgetary Control - A budget is set up for selling and distribution expenses.
The expenses are classified into fixed and variable. If necessary, a flexible
budget may be prepared indicating the expenses at different levels of sales.
The actual expenses are compared with the budgeted figures and in the case of
variances suitable actions are taken.
(c) Standard Costing - Under this method standards are set up in relation to the
standard sales volume. Standards may be set up for salesmen, territories,
products etc. Once the standards are set up, comparison is made between the
actuals and standards: variances are enquired into and suitable action taken.

ILLUSTRATION 10
A company which sells four products, some of these are unprofitable. Company
proposes to discontinue to sale one of these products. The following information is
available regarding income, costs and activity for the year ended 31st March.
Products
A B C D
Sales (`) 30,00,000 50,00,000 25,00,000 45,00,000
Cost of goods sold (`) 20,00,000 45,00,000 21,00,000 22,50,000
Area of storage (Sq.ft.) 50,000 40,000 80,000 30,000
Number of parcels sent 1,00,000 1,50,000 75,000 1,75,000
Number of invoices sent 80,000 1,40,000 60,000 1,20,000
Selling and Distribution overheads and the basis of allocation are:
Amount (`) Basis of allocation

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

SOLUTION
Statement of Profit or Loss on Various Products during the year ended March 31st.
Total (`) Products

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

10. CONCEPTS RELATED TO CAPACITY

(i) Installed/ Rated capacity: It refers to the maximum capacity of producing
goods or providing services. Installed capacity is determined either on the
basis of technical specification or through a technical evaluation. It is also
known as theoretical capacity and is could not be achieved in normal
operating circumstances.
(ii) Practical capacity: It is defined as actually utilised capacity of a plant. It
is also known as operating capacity. This capacity takes into account loss
of time due to repairs, maintenance, minor breakdown, idle time, set up
time, normal delays, Sundays and holidays, stock taking etc. Generally,
practical capacity is taken between 80 to 90% of the rated capacity. It is also
used as a base for determining overhead rates. Practical capacity is also
called net capacity or available capacity.
(iii) Normal capacity: Normal capacity is the volume of production or
services achieved or achievable on an average over a period under normal
circumstances taking into account the reduction in capacity resulting from
planned maintenance.
Normal capacity is determined as under:
Installed capacity xxx

Adjustments for:
(i) Time lost due to scheduled preventive or planned xxx
maintenance
(ii) Number of shifts or machine hours or man hours
(iii) Holidays, normal shut down days, normal idle time xxx
(iv) Normal time lost in batch change over xxx xxx
Normal Capacity xxx
(iv) Actual capacity: It is the capacity actually achieved during a given period. It
is presented as a percentage of installed capacity.
(v) Idle capacity: It is that part of the capacity of a plant, machine or

equipment which cannot be effectively utilised in production.

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

COSTING
(i) Interest and financing charges: It includes any payment in nature of
interest for use of non- equity funds and incidental cost that an entity incurs
in arranging those funds. Example of interest and financing charges are

interest on borrowings, financing charges in respect of finance leases, cash

discount allowed to customers. The term interest and financing charges,
finance costs and borrowing costs are used interchangeably. It does not
include imputed costs.
Interest and financing charges shall be presented in the cost statement as a
separate item of cost of sales.
(ii) Depreciation: Depreciation “is the diminution in the intrinsic value of an

asset due to use and/or the lapse of time.” Depreciation is thus the result of
two factors viz., the use, and the lapse of time. We know that each fixed
asset loses its intrinsic value due to their continuous use and as such the
greater the use the higher is the amount of depreciation. The loss in the
intrinsic value may also arise even if the asset in question is not in service.
Assignment of Depreciation:
It shall be traced to the cost object to the extent economically feasible.
Where it is not directly traceable it should be assigned using either or two
principles i.e. (i) Cause and Effect and (ii) Benefit received.
(iii) Packing expenses: Cost of primary packing necessary for protecting the
product or for convenient handling, should become a part of the
production cost. The cost of packing to facilitate the transportation of
the product from the factory to the customer should become a part of the
distribution cost. If the cost of special packing is at the request of the
customer, the same should be charged to the specific work order or the job.
The cost of fancy packing necessary to attract customers is an advertising
expenditure. Hence, it is to be treated as a selling overhead.
(iv) Fringe benefits: These are the additional payments or facilities provided to
the workers apart from their salary and direct cost-allowances like house
rent, dearness and city compensatory allowances. These benefits are given
in the form of overtime, extra shift duty allowance, holiday pay, pension
facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of
employees towards the organisation. If the amount of fringe benefit is
considerably large, it may be recovered as direct charge by means of a

supplementary wage or labour rate; otherwise these may be collected as

part of production overheads.
(v) Expenses on removal and re-erection of machines: Expenses are
sometime incurred on removal and re-erection of machinery in factories.
Such expenses may be incurred due to factors like change in the method of
production; an addition or alteration in the factory building, change in the
flow of production, etc. All such expenses are treated as production
overheads. When amount of such expenses is large, it may be spread over a
period of time.
If such expenses are incurred due to faulty planning or some other

abnormal factor, then they may be charged to costing Profit and Loss
Account.
(vi) Bad debts: There is no unanimity among different authors of Cost
Accounting about the treatment of bad debts. One view is that ‘bad debts’
should be excluded from cost. According to this view bad debts are financial
losses and therefore, they should not be included in the cost of a particular
job or product.
According to another view it should form part of selling and distribution
overheads, especially when they arise in the normal course of trading.
Therefore bad debts should be treated in cost accounting in the same way as
any other selling and distribution cost. However extra ordinarily large bad
debts should not be included in cost accounts.
(vii) Training expenses: Training is an essential input for industrial workers.
Training expenses in fact includes wages of workers, costs incurred in
running training department, loss arising from the initial lower production,
extra spoilage etc. Training expenses of factory workers are treated as part of
the cost of production. The training expenses of office; sales or distribution workers
should be treated as office; sales or distribution overhead as the case may be. These
expenses can be spread over various departments of the concern on the basis of the
number of workers on roll.
Training expenses would be abnormally high in the case of high labour
turnover such expenses should be excluded from costs and charged to the
costing profit and loss account.

(viii) Canteen expenses: The subsidy provided or expenses borne by the firm in
running the canteen should be regarded as a production overhead. If the
canteen is meant only for factory workers therefore this expenses should be
apportioned on the basis of the number of workers employed in each
department. If office workers also take advantage of the canteen facility, a
suitable share of the expenses should be treated as office overhead.
(ix) Carriage and cartage expenses: It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and
goods. Transportation expenses related to direct material may be included in
the cost of direct material and those relating to indirect material (stores) may
be treated as factory overheads. Expenses related to the transportation of
finished goods may be treated as distribution overhead.
(x) Expenses for welfare activities: All expenses incurred on the welfare
activities of employees in a company are part of general overheads. Such
expenses should be apportioned between factory, office, selling and
distribution overheads on the basis of number of persons involved.
(xi) Night shift allowance: Workers in the factories, which operate during night
time are paid some extra amount known as ‘night shift allowance’. This extra
amount is generally incurred due to the general pressure of work beyond
normal capacity level and is treated as production overhead and recovered
as such.
If this allowance is treated as part of direct wages, the jobs/production

carried at night will be costlier than jobs/production performed during the
day. However, if additional expenditure on night shift is incurred to meet
some specific customer order, such expenditure may be charged directly to
the order concerned. If night shifts are run due to abnormal circumstances,
the additional expenditure should be charged to the costing profit and loss
account.
(xii) Research and Development Expenses: The Terminology defines research
expenses as “the expenses of searching for new or improved products, new
application of materials, or new or improved methods.” Similarly,
development expenses are defined as “the expenses of the process which
begins with the implementation of the decision to produce a new or improved
product.”

If research is conducted in the methods of production, the research

expenses should be taken separately while computing cost of production;
while the expenditure becomes a part of the administration overhead if
research relates to administration. Similarly, market research expenses are
charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product should
be charged directly to that product. Such expenses are usually treated as
“deferred revenue expenses,” and recovered as a cost per unit of the
product when production is fully established.
General research expenses of a routine nature incurred on new or improved

methods of manufacture or the improvement of the existing products
should be charged to the general overhead.
Even in this case, if the amount involved is substantial it may be treated as a
deferred revenue expenditure, and spread over the period during which the
benefit would accrue. Expenses on fundamental research, not relating to any
specific product, are treated as a part of the administration overhead.
Where research proves a failure, the cost associated with it should be
excluded from costs and charged to the costing Profit and Loss Account.
SUMMARY
♦ Overheads: Overheads represent expenses that have been incurred in
providing certain ancillary facilities or services which facilitate or make
possible the carrying out of the production process; by themselves these
services are not of any use.
♦ Cost allocation: The term ‘allocation’ refers to assignment or allotment of
an entire item of cost to a particular cost center or cost unit.
♦ Cost apportionment: Apportionment implies the allotment of proportions

of items of cost to cost centres or departments.
♦ Re-apportionment: The process of assigning service department overheads
to production departments is called reassignment or re-apportionment.
♦ Absorption- The process of recovering overheads of a department or any
other cost center from its output is called recovery or absorption.

♦ Direct re-distribution method: Under this method service department

costs are apportioned over the production departments only, ignoring the
services rendered by one service department to the other.
♦ Step method or Non-reciprocal method: This method gives cognizance to
the service rendered by service department to another service department.
The sequence here begins with the department that renders service to the
maximum number of other service departments.
♦ Reciprocal service method: These methods are used when different service
departments render services to each other, in addition to rendering services
to production departments. In such cases various service departments have
to share overheads of each other. The methods available for dealing with
reciprocal services are
(a) Simultaneous equation method;
(b) Repeated distribution method;
(c) Trial and error method.
♦ Blanket overhead rates: Blanket overhead rate refers to the computation
of one single overhead rate for the whole factory. It is to be distinguished
from the departmental overhead rate which refers to a separate rate for
each individual cost centre or department.
Overhead costs for the whole factory
Blanket Overhead rate = ×100
Total units of the selected base
TEST YOUR KNOWLEDGE

1. “Fixed overhead costs are not affected in monetary terms during a given period by a
change in output”. But this statement holds good provided:
(a) Increase in output is not substantial
(b) Increase in output is substantial
(c) Both (a) and (b)


2. ………….. capacity is defined as actually utilised capacity of a plant.

(a) Theoretical
(b) Installed
(c) Practical
(d) Normal
3. The allotment of whole items of cost to cost centres or cost units is called:
(a) Overhead absorption
(b) Cost apportionment
(c) Cost allocation
4. Primary packing cost is a part of:
(a) Direct material cost
(b) Production Cost
(c) Selling overheads
(d) Distribution overheads
5. Director’s remuneration and expenses form part of:
(a) Production overhead
(b) Administration overhead
(c) Selling overhead
(d) Distribution overhead
6. Which of the following is not the classification of overhead based on its
functionality?
(a) Factory Overhead
(b) Administrative Overhead
(c) Fixed Overhead
(d) Selling Overhead

7. Bad debt is an example of:

(a) Distribution overhead
(b) Production overhead
(c) Selling overhead

(d) Administration overhead
8. Normal capacity of a plant refers to the difference between:
(a) Maximum capacity and practical capacity
(b) Practical capacity and normal capacity
(c) Practical capacity and estimated idle capacity as revealed by long term sales trend.
(d) Maximum capacity and actual capacity
9. The difference between actual factory overhead and absorbed factory overhead will be
usually at the minimum level, provided pre- determined overhead rate is based on:
(a) Maximum capacity
(b) Direct labour hours
(c) Machine hours
(d) Normal capacity
10. Which of the following overhead cost may not be apportioned on the basis of direct
wages?
(a) Worker’s Holiday Pay

(b) Perquisites to worker
(c) ESI contribution
(d) Managerial Salaries
1. STATE what is blanket overhead rate. In which situations, blanket rate is to be
used and why?

2. DISCUSS the step method and reciprocal service method of secondary

distribution of overheads.
3. DISCUSS the problems of controlling the selling and distribution overheads.
4. DISTINGUISH between cost allocation and cost absorption.
5. EXPLAIN Single and Multiple Overhead Rates.
6. EXPLAIN how would you treat the idle capacity costs in Cost Accounts.
7. DISCUSS the difference between allocation and apportionment of overhead.
8. EXPLAIN what are the methods of re-apportionment of service department
expenses over the production departments? Discuss.
Practical Problems
1. The ABC Company has the following account balances and distribution of direct
charges on 31st March.
Total Production Depts. Service Depts.
Machine Packin Gen. Store &

shop g Plant Maintenance
(` ) (` ) (` ) (` ) (` )
Allocated Overheads:
Indirect labour 14,650 4,000 3,000 2,000 5,650
Maintenance 5,020 1,800 700 1,020 1,500

material
Misc. supplies 1,750 400 1,000 150 200
Superintendent’s 4,000 – – 4,000 –

salary
Cost & payroll 10,000 – – 10,000 –

salary

Overheads to be apportioned:
Power 8,000
Rent 12,000
Fuel and heat 6,000
Insurance 1,000
Trade License fees 2,000
Depreciation 1,00,000
1,64,420 6,200 4,700 17,170 7,350

The following data were compiled by means of the factory survey made in the
previous year:
Floor Space Radiator No. of Investment H.P

(Sqft) Sections Employees (` ) hours
Machine Shop 2,000 45 20 6,40,000 3,500
Packing 800 90 10 2,00,000 500
General Plant 400 30 3 10,000 -
Store & 1,600 60 5 1,50,000 1,000

Maintenance
4,800 225 38 10,00,000 5,000

Expenses charged to the stores and maintenance departments are to be
distributed to the other departments by the following percentages:
Machine shop 50%; Packing 20%; General Plant 30%; General Plant overheads is
distributed on the basis of number of employees:
PREPARE
(a) An overhead distribution statement.
(b) Distribution of the service departments’ expense to production
departments.

2. Modern Manufactures Ltd. has three Production Departments P1, P2, P3 and two
Service Departments S1and S2 details pertaining to which are as under:
P1 P2 P3 S1 S2
Direct wages (`) 3,000 2,000 3,000 1,500 195
Working hours 3,070 4,475 2,419 - -
Value of machines (`) 60,000 80,000 1,00,000 5,000 5,000
H.P. of machines 60 30 50 10 -
Light points 10 15 20 10 5
Floor space (sq. ft.) 2,000 2,500 3,000 2,000 500
The following figures extracted from the Accounting records are relevant:
(` )
Rent and Rates 5,000
General Lighting 600
Indirect Wages 1,939
Power 1,500
Depreciation on Machines 10,000
Sundries 9,695
The expenses of the service departments are allocated as under:

P1 P2 P3 S1 S2
S1 20% 30% 40% - 10%
S2 40% 20% 30% 10% -
DETERMINE the total cost of product X which is processed for manufacture in

Departments P1, P2 and P3 for 4, 5 and 3 hours respectively, given that its Direct
Material Cost is ` 50 and Direct Labour Cost is ` 30.

3. Deccan Manufacturing Ltd., have three departments which are regarded as

production departments. Service departments’ costs are distributed to these
production departments using the “Step Ladder Method” of distribution.
Estimates of factory overhead costs to be incurred by each department in the
forthcoming year are as follows. Data required for distribution is also shown
against each department:
Department Factory overhead Direct labour No. of Area in

(` ) hours employees sq.m.
Production:
X 1,93,000 4,000 100 3,000
Y 64,000 3,000 125 1,500
Z 83,000 4,000 85 1,500
Service:
P 45,000 1,000 10 500
Q 75,000 5,000 50 1,500
R 1,05,000 6,000 40 1,000
S 30,000 3,000 50 1,000
The overhead costs of the four service departments are distributed in the same
order, viz. P, Q, R and S respectively on the following basis.
Department Basis
P Number of employees
Q Direct labour hours

R Area in square metres
S Direct labour hours
You are required to:

(a) PREPARE a schedule showing the distribution of overhead costs of the four
service departments to the three production departments; and

(b) CALCULATE the overhead recovery rate per direct labour hour for each of
the three production departments.
4. Gemini Enterprises undertakes three different jobs A, B and C. All of them require
the use of a special machine and also the use of a computer. The computer is
hired and the hire charges work out to ` 4,20,000 per annum. The expenses
regarding the machine are estimated as follows:
(`)
Rent for a quarter 17,500
Depreciation per annum 2,00,000
Indirect charges per annum 1,50,000
During the first month of operation the following details were taken from the job
register:
Job
A B C
Number of hours the machine was used:
(a) Without the use of the computer 600 900 —
(b) With the use of the computer 400 600 1,000
You are required to COMPUTE the machine hour rate:
(a) For the firm as a whole for the month when the computer was used and
when the computer was not used.
(b) For the individual jobs A, B and C.
5. A machine shop has 8 identical Drilling machines manned by 6 operators. The
machine cannot be worked without an operator wholly engaged on it. The
original cost of all these machines works out to ` 8 lakhs. These particulars are
furnished for a 6 months period:
Normal available hours per month 208
Absenteeism (without pay) hours 18
Leave (with pay) hours 20

Normal idle time unavoidable-hours 10

Average rate of wages per worker for 8 hours a day. `800
Production bonus estimated 15% on wages
Value of power consumed `80,500
Supervision and indirect labour `33,000
Lighting and electricity `12,000
These particulars are for a year
Repairs and maintenance including consumables- 3% of value of machines.
Insurance- ` 40,000
Depreciation- 10% of original cost.

Other sundry works expenses- ` 12,000
General management expenses allocated- ` 54,530.
You are required to COMPUTE a comprehensive machine hour rate for the
machine shop.
6. Job No. 198 was commenced on October 10, 2022 and completed on
November 1, 2022. Materials used were ` 6,000 and labour charged directly
to the job was ` 4,000. Other information is as follows:
Machine No. 215 used for 40 hours, the machine hour rate being ` 35.
Machine No. 160 used for 30 hours, the machine hour rate being ` 40. Six
welders worked on the job for five days of 8 hours each: the Direct labour
hour per welder is ` 20.
General expenses related to production not included for calculating either the
machine hour or direct labour hour rate totaled `20,000, total direct wages
for the period being `2,00,000. COMPUTE the works costs for job No. 198.
7. In a factory, overheads of a particular department are recovered on the basis
of ` 5 per machine hour. The total expenses incurred and the actual machine
hours for the department for the month of August were ` 80,000 and 10,000
hours respectively. Of the amount of ` 80,000, ` 15,000 became payable due
to an award of the Labour Court and ` 5,000 was in respect of expenses of the

previous year booked in the current month (August). Actual production was
40,000 units, of which 30,000 units were sold. On analysing the reasons, it
was found that 60% of the under-absorbed overhead was due to defective
planning and the rest was attributed to normal cost increase. SHOW the
treatment of over/under-absorbed overhead in the cost accounts?
8. In a manufacturing unit, factory overhead was recovered at a pre-determined
rate of ` 25 per man-day. The total factory overhead expenses incurred and
the man-days actually worked were ` 41.50 lakhs and 1.5 lakh man-days
respectively. Out of the 40,000 units produced during a period, 30,000 were
sold.
On analysing the reasons, it was found that 60% of the unabsorbed overheads
were due to defective planning and the rest were attributable to increase in
overhead costs.
EXPLAIN how would unabsorbed overheads be treated in Cost Accounts?
9. A factory has three production departments. The policy of the factory is to
recover the production overheads of the entire factory by adopting a single
blanket rate based on the percentage of total factory overheads to total
factory wages. The relevant data for a month are given below:
Department Direct Direct Factory Direct Machine

Materials Wages Overheads Labour hours hours
(` ) (` ) (` )
Budget:
Machining 6,50,000 80,000 3,60,000 20,000 80,000

Assembly 1,70,000 3,50,000 1,40,000 1,00,000 10,000
Packing 1,00,000 70,000 1,25,000 50,000 −
Actual:
Machining 7,80,000 96,000 3,90,000 24,000 96,000
Assembly 1,36,000 2,70,000 84,000 90,000 11,000
Packing 1,20,000 90,000 1,35,000 60,000 −

The details of one of the representative jobs produced during the month are as
under:
Job No. CW 7083 :
Department Direct Direct Direct Machine

Materials Wages Labour hours hours
(` )
Machining 1,200 240 60 180
Assembly 600 360 120 30
Packing 300 60 40 −
The factory adds 30% on the factory cost to cover administration and selling
overheads and profit.
Required:
(i) COMPUTE the overhead absorption rate as per the current policy of the
company and determine the selling price of the Job No. CW 7083.
(ii) Suggest any suitable alternative method(s) of absorption of the factory
overheads and CALCULATE the overhead recovery rates based on the
method(s) so recommended by you.
(iii) DETERMINE the selling price of Job CW 7083 based on the overhead
application rates calculated in (ii) above.
(iv) CALCULATE the department-wise and total under or over recovery of
overheads based on the company’s current policy and the method(s)
recommended by you.
10. A light engineering factory fabricates machine parts for customers. The factory
commenced fabrication of 12 nos. machine parts as per customers’
specifications, the expenditure incurred on the job for the week ending 21st
August is as tabulated below:
(` ) (` )
Direct materials (all items) 780.00
Direct labour (manual) 20 hours @` 15 per 300.00

hour

Machine facilities :
Machine No. I : 4 hours @ ` 45 180.00
Machine No. II : 6 hours @ ` 65 390.00 570.00
Total 1,650.00
Overheads @ ` 8 per hour on 20 manual hours 160.00
Total cost 1,810.00
The overhead rate of ` 8 per hour is based on 3,000 man hours per week;
similarly, the machine hour rates are based on the normal working of
Machine Nos. I and II for 40 hours out of 45 hours per week.
After the close of each week, the factory levies a supplementary rate for the
recovery of full overhead expenses on the basis of actual hours worked during
the week. During the week ending 21st August, the total labour hours worked
was 2,400 and Machine Nos. I and II had worked for 30 hours and 32.5 hours
respectively.
PREPARE a Cost Sheet for the job for the fabrication of 12 nos. machine parts
duly levying the supplementary rates.
11. ABC Ltd. manufactures a single product and absorbs the production overheads at
a pre-determined rate of ` 10 per machine hour.
At the end of current financial year, it has been found that actual production
overheads incurred were ` 6,00,000. It included ` 45,000 on account of ‘written
off’ obsolete stores and ` 30,000 being the wages paid for the strike period under
an award.
The production and sales data for the current year is as under:
Production :
Finished goods 20,000 units
Work-in-progress 8,000 units
(50% complete in all respects)

Sales :
Finished goods 18,000 units

The actual machine hours worked during the period were 48,000. It has been
found that one-third of the under-absorption of production overheads was due to
lack of production planning and the rest was attributable to normal increase in
costs.
(i) CALCULATE the amount of under-absorption of production overheads
during the current year; and
(ii) SHOW the accounting treatment of under-absorption of production overheads.

12. A Ltd., manufactures two products A and B. The manufacturing division consists
of two production departments P1 and P2 and two service departments S1 and S2.
Budgeted overhead rates are used in the production departments to absorb
factory overheads to the products. The rate of Department P1 is based on direct
machine hours, while the rate of Department P2 is based on direct labour hours.
In applying overheads, the pre-determined rates are multiplied by actual hours.
For allocating the service department costs to production departments, the
basis adopted is as follows:
(i) Cost of Department S1 to Department P1 and P2 equally, and
(ii) Cost of Department S2 to Department P1 and P2 in the ratio of 2 : 1
respectively.
The following budgeted and actual data are available:
Annual profit plan data:
Factory overheads budgeted for the year:
Production Departments Service Departments
P1 P2 S1 S2
` 25,50,000 ` 21,75,000 ` 6,00,000 ` 4,50,000
Budgeted output in units:
Product A 50,000; B 30,000.

Budgeted raw-material cost per unit:
Product A ` 120; Product B ` 150.

Budgeted time required for production per unit:

Department P1 : Product A : 1.5 machine hours
Product B : 1.0 machine hour
Department P2 : Product A : 2 Direct labour hours
Product B : 2.5 Direct labour hours
Average wage rates budgeted in Department P2 are:
Product A - ` 72 per hour and Product B – ` 75 per hour.

All materials are used in Department P1 only.
Actual data: (for the month of July, 2022)
Units actually produced: Product A: 4,000 units

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

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

Costs actually incurred: Product A Product B
Raw materials ` 4,89,000 ` 4,56,000
Wages ` 5,91,900 ` 5,52,000
Overheads: Department P1 ` 2,31,000 S1 ` 60,000
P2 ` 2,04,000 S2 ` 48,000
(i) COMPUTE the pre-determined overhead rate for each production
department.
(ii) PREPARE a performance report for July, 2022 that will reflect the budgeted
costs and actual costs.

ANSWERS
Answers to the MCQs
1. (a) 2. (c) 3. (c) 4. (b) 5. (b) 6. (c)
7. (c) 8. (c) 9. (d) 10 (d)


1. (a) Overhead Distribution Statement
Particulars Production Service Department

Department
Machine Packing General Stores &

Plant Maint.
Allocated Expenses:
Indirect labour 4,000 3,000 2,000 5,650
Maintenance material 1,800 700 1,020 1,500
Superintendent’s salary - - 4,000 -
Misc. supplies 400 1,000 150 200

Cost & payroll salaries - - 10,000 -
Total Allocated 6,200 4,700 17,170 7,350

Overheads
Apportioned expenses 77,720 25,800 2,830 22,650
(as per schedule below)
Total overheads 83,920 30,500 20,000 30,000
Schedule of Apportioned Expenses
Item Basis Total Production Depts. Service Depts.

Amount
Machine Packing Gen. Store
shop Plant &
Maint.
(`) (`) (`) (`) (`)
Power (7:1:-:2) HP hours 8,000 5,600 800 - 1,600
Rent (5:2:1:4) Floor Space 12,000 5,000 2,000 1,000 4,000
Fuel and heat Radiator 6,000 1,200 2,400 800 1,600

Secs.
(3:6:2:4)
Insurance Investment 1,000 640 200 10 150
(64:20:1:15)
Trade license Investment 2,000 1,280 400 20 300

fees
(64:20:1:15)
Depreciation Investment 1,00,000 64,000 20,000 1,000 15,000
(64:20:1:15)
Total 1,29,000 77,720 25,800 2,830 22,650

(b) Distribution of Service Department Expenses
Production Depts. Service Depts.
Machine Packing Gen. Store &

shop Plant Maint.
(`) (`) (`) (`)
Total Expense [as per (a)] 83,920 30,500 20,000 30,000

Dist. of Store & Maint. 15,000 6,000 9,000 -30,000
(5:2:3)
Dist. of General plant (4:2:1) 16,571 8,286 -29,000 4,143
Dist. of Store & Maint. 2,072 829 1,242 -4,143
(5:2:3)
Dist. of General plant (4:2:1) 710 355 -1,242 177
Dist. of Store & Maint. 89 35 53 -177
(5:2:3)
Dist. of General plant (4:2:1) 35 18 -53 0
Total 1,18,397 46,023
2. Statement Showing Distribution of Overheads of Modern Manufactures

Ltd.
Production Service
Total Departments Departments
Particulars Basis
P1 P2 P3 S1 S2
(`) (`) (`) (`) (`) (`)
Direct wages Actual 1,695 - - - 1,500 195
Rent & rates Area 5,000 1,000 1,250 1,500 1,000 250
General Light 600 100 150 200 100 50

lighting points
Indirect wages Direct 1,939 600 400 600 300 39

wages

Power H.P. 1,500 600 300 500 100 −
Depreciation of Value of 10,000 2,400 3,200 4,000 200 200

machines machines
Sundries Direct 9,695 3,000 2,000 3,000 1,500 195

wages
30,429 7,700 7,300 9,800 4,700 929
Redistribution of Service Department’s Expenses over Production

Departments
P1 (`) P2(`) P3(`) S1(`) S2(`)
Total overhead 7,700 7,300 9,800 4,700 929

distributed as above
Dept. S1 Overheads 940 1,410 1,880 -4,700 470
apportioned
(20:30:40:—:10)
Dept. S2 overheads 559.6 279.8 419.7 139.9 -1,399
apportioned
(40:20:30:10:—)
Dept. S1 Overheads 28 42 56 -139.9 13.9
apportioned
(20:30:40:—:10)
Dept. S2 overheads 6.2 3.1 4.6 - -13.9

apportioned
(40:20:30:10:—)
9,233.8 9,034.9 12,160.3
Working hours 3070 4475 2419
Rate per hour 3.00 2.02 5.03

Determination of total cost of Product ‘X’
(`)
Direct material cost 50.00

Direct labour cost 30.00
Overhead cost (See working note) 37.19
117.19
Working Note:
Overhead cost:
(` 3 × 4 hrs.) + (` 2.02 × 5 hrs.) + (` 5.03 × 3 hrs.)
= ` 12 + ` 10.10 + ` 15.09 = ` 37.19
3. (a) Deccan Manufacturing Limited
Schedule Showing the Distribution of Overhead Costs among
Departments
Production Service
X (`) Y (`) Z (`) P (`) Q (`) R (`) S (`)
Overhead cost 1,93,000 64,000 83,000 45,000 75,000 1,05,000 30,000

Distribution of 10,000 12,500 8,500 -45,000 5,000 4,000 5,000
Dept.P
(100:125:85:-
:50:40:50)
Distribution of 16,000 12,000 16,000 - -80,000 24,000 12,000

Dept.Q
(4:3:4:-:-:6:3)
Distribution of 57,000 28,500 28,500 - - -1,33,000 19,000

Dept.R
(6:3:3:-:-:-:-:2)
Distribution of 24,000 18,000 24,000 - - - -66,000

Dept.S
(4:3:4:-:-:-:-)
Total 3,00,000 1,35,000 1,60,000

(b) Calculation of overhead recovery rate
Dept-X Dept-Y Dept-Z
Total apportioned overheads `3,00,000 `1,35,000 `1,60,000
Direct labour hours 4,000 3,000 4,000
Overhead recovery rate per labour `75 `45 `40

hour
4. Working notes:
(i) Total machine hours used 3,500
(600 + 900 + 400 + 600 + 1,000)
(ii) Total machine hours without the use of computers 1,500
(600 + 900)
(iii) Total machine hours with the use of computer 2,000
(400 + 600 + 1,000)
(iv) Total overheads of the machine per month
Rent (` 17,500 ÷ 3 months) ` 5,833.33
Depreciation (` 2,00,000 ÷ 12 months) ` 16,666.67
Indirect Charges (` 1,50,000 ÷ 12 months) ` 12,500.00
Total ` 35,000.00
(v) Computer hire charges for a month = ` 35,000

(` 4,20,000 ÷ 12 months)
(vi) Overheads for using machines without computer
` 35,000
= × 1,500 hrs. = ` 15,000
3,500 hrs.
(vii) Overheads for using machines with computer

` 35,000
= ×2,000 hrs. + ` 35,000 = ` 55,000
3,500 hrs.

(a) Computation of Machine hour rate for the firm as a whole for a
month.
` 55,000
(1) When the Computer was used: = ` 27.50 per hour
2,000 hours
` 15,000
(2) When the computer was not used: = ` 10 per hour
1,500 hrs.
(b) Computation of Machine hour rate for the individual job
Rate Job
per
A B C
hour
(`) Hrs. (`) Hrs. (`) Hrs. (`)
Overheads
Without 10.0 600 6,000 900 9,000 - -

Computer
With computer 27.5 400 11,000 600 16,500 1,000 27,500
Total 1,000 17,000 1,500 25,500 1,000 27,500
Machine hour 17 17 27.5

rate
5. Computation of comprehensive machine hour rate of machine shop
Particulars (`)
Operator’s wages (Refer to working note 2) 7,38,000
Production bonus (15% on wages) 1,10,700
Power consumed 80,500
Supervision and indirect labour 33,000
Lighting and electricity 12,000
Repairs and maintenance (3%× ` 8 lakh×½) 12,000
Insurance (` 40,000 × ½) 20,000

Depreciation (10%×` 8 lakh×½) 40,000
Sundry works expenses (`12,000 × ½) 6,000
General management expenses (`54,530 × ½) 27,265
10,79,465
Total overheads of machine shop

Machine hour rate =
Hours of machines operation
` 10,79, 465
= (Refer to working note 1) = `149.93
7,200 hours
Working notes
1. Computation of hours, for which 6 operators are available for 6 months.
For 6 months and

6 operators
Normal available hours 7,488

(208 x 6 months x 6 operators)
Less: Absenteeism hours (18 x 6 operators) (108)
Paid hours 7,380
Less: Leave hours (20 x 6 operators) (120)
Less: Idle time hours (10 x 6 operators) (60)
Effective working hours 7,200
As machines cannot be worked without an operator wholly engaged on

them therefore, hours for which 6 operators are available for 6 months
are the hours for which machines can be used. Hence 7,200 hours
represent effective working hours.
2. Computation of operator’s wages
`800
Average rate of wages: = `100 per hour
8hours

Total wages paid to 6 operators for 6 months = 7,380 hours × ` 100

= ` 7,38,000
6. Computation for works costs for job No. 198
(`) (`)
Materials 6,000
Direct labour 4,000
10,000
Factory overheads:
Machine No. 215 : 40 hours @ `35 1,400
Machine No. 160 : 30 hours @ `40 1,200
*240 hours of welders @ ` 20 per hr. 4,800
**General expenses 10% of wages 400 7,800
Work cost 17,800
* 6 welders × 5 days × 8 hours = 240 hours

** Un- apportioned expenses ` 20,000 which works out at 10% of direct wages.
7. Computation of Over/Under-absorbed overhead expenses during the

month of August
(`) (`)
Total expenses incurred in the month of August: 80,000
Less: The amount paid according to labour court 15,000

award (Assumed to be non-recurring)
Expenses of previous year 5000 (20,000)
Net overhead expenses incurred for the month 60,000
Overhead recovered for 10,000 hours @ ` 5 per hour (50,000)
Under-absorbed overheads 10,000

60% of under-absorbed overhead was due to defective planning, it will be

charged to costing profit & loss account.
40% of under-absorbed overhead i.e. `4,000 may be distributed over
Finished Goods and Cost of Sales using supplementary overhead rate:
Under - absorbed OH
Supplementary rate =
Units produced
` 4,000
= = `0.10
40,000 units
Amount of under-absorbed overheads charged to finished goods

= 10,000 units × `0.10 = `1,000
Amount of under-absorbed overheads charged to cost of sales
= 30,000 units × `0.10 = `3,000
8. Computation of unabsorbed overheads
Man-days worked 1,50,000

(`)
Overhead actually incurred 41,50,000
Less: Overhead absorbed @ ` 25 per man-day 37,50,000
(` 25 × 1,50,000) ________
Unabsorbed overheads 4,00,000
Unabsorbed overheads due to defective
planning (i.e. 60% of ` 4,00,000) 2,40,000
Balance of unabsorbed overhead 1,60,000
Treatment of unabsorbed overheads in Cost Accounts

(i) The unabsorbed overheads of ` 2,40,000 due to defective planning to be
treated as abnormal and therefore be charged to Costing Profit and Loss
Account.

(ii) The balance unabsorbed overheads of `1,60,000 be charged to

production i.e., 40,000 units at the supplementary overhead absorption
rate i.e., ` 4 per unit (Refer to Working Note)
(`)
Charge to Costing Profit and Loss Account as part of
the cost of unit sold 1,20,000
(30,000 units @ ` 4 p.u.)

Add: To closing stock of finished goods 40,000
(10,000 units @ ` 4 p.u.) _________
Total 1,60,000
Working Note:
` 1,60,000
Supplementary overhead absorption rate = = ` 4 p.u.
40,000 units
9. (i) Computation of overhead absorption rate
(as per the current policy of the company)
Department Budgeted factory Budgeted direct

Overheads wages
(`) (`)
Machinery 3,60,000 80,000
Assembly 1,40,000 3,50,000
Packing 1,25,000 70,000
Total 6,25,000 5,00,000
Budgeted factory overheads

Overhead absorption rate = × 100
Budgeted direct wages
` 6,25,000
= × 100 = 125% of Direct wages
` 5,00,000

Selling Price of the Job No. CW-7083

(`)
Direct materials (` 1,200 + ` 600 + ` 300) 2,100.00
Direct wages (` 240 + ` 360 + ` 60) 660.00

Overheads (125% × ` 660) 825.00
Total factory cost 3,585.00
Add: Mark-up (30% × ` 3,585) 1,075.50
Selling price 4,660.50
(ii) Methods available for absorbing factory overheads and their
overhead recovery rates in different departments
1. Machining Department
In the machining department, the use of machine time is the
predominant factor of production. Hence machine hour rate
should be used to recover overheads in this department. The
overhead recovery rate based on machine hours has been
calculated as under:
Machine hour rate =
Budgeted machine hours
` 3,60,000
= = ` 4.50 per hour
80,000 hours
2. Assembly Department
In this department direct labour hours is the main factor of
production. Hence direct labour hour rate method should be
used to recover overheads in this department. The overheads
recovery rate in this case is:
Direct labour hour rate =
Budgeted direct labour hours
` 1, 40,000
= = ` 1.40 per hour
1,00,000 hours

3. Packing Department
Labour is the most important factor of production in this depart-
ment. Hence direct labour hour rate method should be used to
recover overheads in this department.
The overhead recovery rate in this case comes to:
Budgeted factory overhead
Direct labour hour rate =
Direct labour hours
` 1,25,000
= 50,000 hours = ` 2.50 per hour
(iii) Selling Price of Job CW-7083 [based on the overhead application
rates calculated in (ii) above]
(`)
Direct materials 2,100.00
Direct wages 660.00
Overheads (Refer to Working note) 1,078.00
Factory cost 3,838.00

Add: Mark up (30% of ` 3,838) 1,151.40
Selling price 4,989.40
Working note:
Overhead Summary Statement
Dept. Basis Hours Rate Overheads
(`) (`)
Machining Machine hour 180 4.50 810
Assembly Direct labour hour 120 1.40 168
Packing Direct labour hour 40 2.50 100
Total 1,078

(iv) Department-wise statement of total under or over recovery of

overheads
(a) Under current policy
Departments
Machining Assembly Packing Total
(`) (`) (`) (`)
Direct wages (Actual) 96,000 2,70,000 90,000
Overheads recovered @
125% of Direct wages: (A) 1,20,000 3,37,500 1,12,500 5,70,000
Actual overheads: (B) 3,90,000 84,000 1,35,000 6,09,000
(Under)/Over recovery of
overheads : (A–B) (2,70,000) 2,53,500 (22,500) (39,000)
(b) As per methods suggested
Basis of overhead recovery
Machine Direct Direct Total

hours labour labour (`)
hours hours
(Assembly) (Packing)
Hours worked 96,000 90,000 60,000
Rate/hour (`) 4.50 1.40 2.50
Overhead recovered (`): (A) 4,32,000 1,26,000 1,50,000 7,08,000
Actual overheads (`): (B) 3,90,000 84,000 1,35,000 6,09,000
(Under)/Over recovery: (A−B) 42,000 42,000 15,000 99,000

10. Fabrication of 12 nos. machine parts (job No......)

Date of commencement: 16th August
Date of Completion:
Cost sheet for the week ending, August 21st:
(`) (`)
Direct materials (all items) 780.00
Direct labour (manual) 20 hours @` 15 per hour 300.00
Machine facilities:
Machine No. I : 4 hours @ ` 45 180.00
Machine No. II : 6 hours @ ` 65 390.00 570.00
Total 1,650.00
Overheads @ ` 8 per hour on 20 manual hours 160.00
Total cost 1,810.00
Supplementary Rates
Overheads 20 hours @ ` 2 per hour (Refer WN-1) 40.00
Machine facilities: (Refer WN-2)
Machine No. I - 4 hours @ ` 15 60.00
Machine No. II - 6 hours @ ` 15 90.00 190.00
Cost 2,000.00
Working notes (WN):

1. Overheads budgeted: 3,000 man-hours × `8 =`24,000
Actual hours: 2,400 man-hours
Actual rate per hour `24,000 ÷ 2,400 hours = `10

Supplementary charge ` 2 (`10 – ` 8) per hour

2. Machine facilities:
Machine No. I Machine No. II
Budgeted `1,800 `2,600

(40 × `45) (40 × `65)
Actual number of hours 30 32.5
Actual rate per hour `60.00 `80.00
Supplementary rate per ` 15.00 ` 15.00

hour
(`60.00 – `45.00) (`80.00 – `65.00)
11. (i) Amount of under-absorption of production overheads during the

current year
(`)
Total production overheads actually incurred 6,00,000
during the current year
Less : ‘Written off’ obsolete stores ` 45,000
Wages paid for strike period ` 30,000 75,000
Net production overheads actually incurred : (A) 5,25,000
Production overheads absorbed by 48,000 machine
hours @ ` 10 per hour : (B) 4,80,000

Amount of under – absorption of production overheads :
[(A) – (B)] 45,000
(ii) Accounting treatment of under absorption of production overheads

It is given in the statement of the question that 20,000 units were
completely finished and 8,000 units were 50% complete, one third of
the under-absorbed overheads were due to lack of production
planning and the rest were attributable to normal increase in costs.

(`)
1. (33 – 1/3% of ` 45,000) i.e., ` 15,000 of under-absorbed
overheads were due to lack of production planning.
This being abnormal, should be debited to the Costing
Profit and Loss A/c. 15,000
2. Balance (66–2/3% of ` 45,000) i.e., ` 30,000
of under-absorbed overheads should be distributed
over work-in-progress, finished goods and cost of
sales by using supplementary rate. 30,000
Total under-absorbed overheads 45,000
Apportionment of unabsorbed overheads of ` 30,000 over, work-in
progress, finished goods and cost of sales
Equivalent (`)
Completed Units
Work-in-Progress
(4,000 units × ` 1.25) 4,000 5,000
Finished goods
(2,000 units × ` 1.25) 2,000 2,500
Cost of sales
(18,000 units × ` 1.25) 18,000 22,500
24,000 30,000
Working Note
` 30,000
Supplementary rate per unit = = ` 1.25
24,000

12. (i) Computation of predetermined overhead rate for each

production departments from budgeted data
Production Service Department

Department
P1 P2 S1 S2
Budgeted factory overheads for 25,50,000 21,75,000 6,00,000 4,50,000

the year in (`)
Allocation of service department 3,00,000 3,00,000 (6,00,000) —

S1’s costs to production
departments P1 and P2 equally in
(`)
Allocation of service department 3,00,000 1,50,000 — (4,50,000)

S2’s costs to production
departments P1 and P2 in the
ratio of 2:1 in (`)
Total 31,50,000 26,25,000 — —
Budgeted machine hours in 1,05,000 —

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

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

rate (`)

(ii) Performance report for July, 2022

(When 4,000 and 3,000 units of products A and B respectively were actually
produced)
Budgeted Actual
(`) (`)
Raw materials used in Dept. P1:
A : 4,000 units × ` 120 4,80,000 4,89,000
B : 3,000 units × ` 150 4,50,000 4,56,000
Direct labour cost

(on the basis of labour hours worked in department P2)
A : 4,000 units × 2 hrs. × ` 72 5,76,000 5,91,900
B : 3,000 units × 2.5 hrs. × ` 75 5,62,500 5,52,000
Overhead absorbed on machine hour basis in Dept.

P 1:
A : 4,000 units × 1.5 hrs. × `30 1,80,000 1,74,400*
B : 3,000 units × 1 hr. × `30 90,000 1,18,649*
Overhead absorbed on labour hour basis in Dept. P2:
A : 4,000 units × 2 hrs. × ` 15 1,20,000 1,31,364**
B : 3,000 units × 2.5 hrs. × ` 15 1,12,500

1,18,548**
25,71,000 26,31,861
* (Refer to working note 4) **(Refer to working note 5)

Working notes:
1.
Product A Product B Total
Budgeted output (in units) 50,000 30,000
Budgeted machine hours in Dept. P1 75,000 30,000 1,05,000
(50,000×1.5 hrs.) (30,000×1 hr.)
Budgeted labour hours in Dept. P2 1,00,000 75,000 1,75,000
(50,000×2 hrs.) (30,000×2.5 hrs.)
2.
Product A Product B Total
Actual output (in units) 4,000 3,000
Actual machine hours utilized in Dept. P1 6,100 4,150 10,250
Actual labour hours utilised in Dept. P2 8,200 7,400 15,600
3. Computation of actual overhead rates for each production department

from actual data
Production Department Service Department
P1 P2 S1 S2
Actual factory overheads for the 2,31,000 2,04,000 60,000 48,000

month of July, 2022 in (`)
Allocation of service Dept. S1’s costs 30,000 30,000 (60,000) −

to production Dept. P1 and P2
equally in (`)
Allocation of service Dept. S2’s costs 32,000 16,000 − (48,000)

to production Dept. P1 and P2 in the
ratio of 2:1 in (`)
Total 2,93,000 2,50,000 -- --

Actual machine hours in Dept. P1 10,250 --

(working note 2)
Actual labour hours in Dept. P2 -- 15,600

(working note 2)
Actual machine/ labour hour rate 28.59 16.02

(`)
4. Actual overheads absorbed (based on machine hours)

A : 6,100 hrs × ` 28.59 = ` 1,74,400
B : 4,150 hrs × ` 28.59 = ` 1,18,649
5. Actual overheads absorbed (based on labour hours)
A : 8,200 hrs × ` 16.02 = ` 1,31,364
B : 7,400 hrs × ` 16.02 = ` 1,18,548

CHAPTER a
5
ACTIVITY BASED
COSTING
LEARNING OUTCOMES
 Discuss problem of Traditional Costing System.
 Discuss usefulness of Activity Based Costing (ABC).
 Discuss Cost Allocation under ABC.
 Discuss Different level of activities under ABC.
 Understand stages, advantages, and limitations of ABC.
 Discuss various requirements in ABC implementation.
 Explain the concept of Activity Based Management (ABM).
 Explain the concept of Activity Based Budgeting (ABB).
CHAPTER OVERVIEW
Activity Based Costing
Cost
Concept Usefulness Steps
Hierarchy

a 5.2 COST AND MANAGEMENT ACCOUNTING
1. INTRODUCTION
As discussed in chapter 4 i.e. Overhead, in Traditional Costing System, overhead
costs are grouped together under cost center and then absorbed into product
costs on either of the basis such as direct labour hours, machine hours, volume
etc. In certain cases, this traditional costing system gives inaccurate cost
information. Though, it should not be assumed that all traditional absorption
costing systems are not accurate enough to give adequate information for pricing
purposes or other long-run management decision purposes. Some traditional
systems treat overheads in a detailed way and relate them to service cost centres
as well as production cost centres. The service centre overheads are then spread
over the production cost centres before absorption rates are calculated. The main
cause of inaccuracy is in the calculation of the overhead rate itself, which is usually
based on direct labour hours or machine hours. These rates assume that products
that take longer to make, generate more overheads and so on.
Organisations, who do not wish to know how much it costs to make a product
with precise accuracy, may be happy with traditional costing system. Others,
however, fix their price on cost basis and need to determine it with reasonable
accuracy. The latter organisations have been greatly benefitted from the
development of activity-based costing (ABC), which is considered as a modern
absorption costing method, and was evolved to give more accurate product costs.
1.1 Factors prompting the development of ABC

Various factors lead to the development of ABC include:
1. Growing overhead costs because of increasingly automated production
2. Increasing market competition, which necessitated more accurate product

costs.
3. Increasing product diversity to secure economies of scope & increased
market share.
4. Decreasing costs of information processing because of continual
improvements and increasing application of information technology.

ACTIVITY BASED COSTING 5.35.3 a
1.2 Usefulness/Suitability of ABC

ABC is particularly needed by organisations for product costing in the following
situations:
1. High amount of overhead: When production overheads are high and form
significant costs, ABC is more useful than traditional costing system.
2. Wide range of products: ABC is most suitable, when, there is diversity in

the product range or there are multiple products.
3. Presence of non-volume related activities: When non-volume related

activities e.g. material handling, inspection set-up, are present significantly
and traditional system cannot be applied, ABC is a superior and better
option. ABC will identify non-value-adding activities in the production process
that might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and

there is an urgent requirement to compute cost accurately and to fix the
selling price according to the market situation, ABC is very useful. ABC can
also facilitate in reducing cost by identifying non-value-adding activities in the
production process that might be a suitable focus for attention or elimination.
2. MEANING AND DEFINITION

Activity Based Costing is an accounting methodology that assigns costs to
activities rather than products or services. This enables resources & overhead
costs to be more accurately assigned to products & services that consume them.
ABC is a technique which involves identification of cost with each cost
driving activity and making it as the basis for apportionment of costs over
different cost objects/ jobs/ products/customers or services.
ABC assigns cost to activities based on their use of resources. It then assigns cost
to cost objects, such as products or customers, based on their use of activities.
ABC can track the flow of activities in organization by creating a link between the
activity (resource consumption) and the cost object.

CIMA defines ‘Activity Based Costing’ as “An approach to the costing and
monitoring of activities which involves tracing resource consumption and costing
final outputs. Resources are assigned to activities, and activities to cost objects
based on consumption estimates. The latter utilise cost drivers to attach activity
costs to outputs.”
3. MEANING OF TERMS USED IN ABC

(i) Activity: Activity, here, refers to an event that incurs cost.
(ii) Cost Object: It is an item for which cost measurement is required e.g. a
product or a customer.
(iii) Cost Driver: It is a factor that causes a change in the cost of an activity.
There are two categories of cost driver.
• Resource Cost Driver: It is a measure of the quantity of resources
consumed by an activity. It is used to assign the cost of a resource to an
activity or cost pool.
• Activity Cost Driver: It is a measure of the frequency and intensity of
demand, placed on activities by cost objects. It is used to assign activity
costs to cost objects.
(iv) Cost Pool: It represents a group of various individual cost items. It consists
of costs that have same cause and effect relationship. Example machine
set-up.
Examples of Cost Drivers:
Business Functions Cost Driver
Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services • Number of products in design

and procedures
• Number of parts per product
• Number of engineering hours
Customer Service • Number of service calls

• Number of products serviced

• Hours spent on servicing products
Marketing • Number of advertisements

• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers
4. COST ALLOCATION UNDER ABC

Under activity based cost allocation overheads are attributed to products on the
activity base. Traditionally, overhead costs are grouped together under cost
centre and then absorbed into product costs on some basis such as direct labour
hours. Activity based costing identifies the activities which cause cost to be
incurred and searches for fundamental cost drivers of these activities. Once the
activities and there cost drivers have been identified this information can be used
to assign overheads to cost objects (e.g. products) which have actually caused
cost to be incurred.

5. TRADITIONAL ABSORPTION COSTING VS

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

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

Difference between Activity Based Costing and Traditional Absorption

Costing
Activity Based Costing Traditional Absorption Costing
1. Overheads are related to 1. Overheads are related to cost

activities and grouped into centers/departments.
activity cost pools.
2. Costs are related to activities 2 Costs are related to cost centers

and hence are more realistic. and hence not realistic of cost
behaviour.
3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be

determined. the only cost driver governing
costs in all departments.
4. Activity–wise recovery rates are 4. Either multiple overhead recovery

determined and there is no rates (for each department) or a
concept of a single overhead single overhead recovery rate may
recovery rate. be determined for absorbing
overheads.
5. Cost are assigned to cost 5. Costs are assigned to Cost Units

objects, e.g. customers, i.e. to products, or jobs or hours.
products, services, departments,
etc.
6. Essential activities can be 6. Cost Centers/ departments cannot

simplified and unnecessary be eliminated. Hence, not suitable
activities can be eliminated. for cost control.
Thus, the corresponding costs
are also reduced/ minimized.
Hence ABC aids cost control.

6. LEVEL OF ACTIVITIES UNDER ABC METHO-

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

Activities
1. Unit level These are those activities • The use of indirect
activities for which the materials/consumables tends to
consumption of resources increase in proportion to the
can be identified with the number of units produced.
number of units • The inspection or testing of every
produced. item produced, if this was deemed
necessary or, perhaps more likely,
every 100th item produced.
2. Batch The activities such as • Material ordering–where an order
level setting up of a machine is placed for every batch of
activities or processing a purchase production
order are performed each • Machine set-up costs–where
time a batch of goods is machines need resetting between
produced. The cost of each different batch of production.
batch related activities • Inspection of products where the
varies with number of first item in every batch is
batches made, but is inspected rather than every 100th
common (or fixed) for all item quoted above.
units within the batch.
3. Product These are the activities • Designing the product,
level which are performed to • Producing parts specifications
activities support different • Keeping technical drawings of
products in product line products up to date.

4. Facilities These are the activities • Maintenance of buildings

level which cannot be directly • Plant security
activities attributed to individual
products. These activities
are necessary to sustain
the manufacturing
process and are common
and joint to all products
manufactured
7. STAGES IN ACTIVITY BASED COSTING (ABC)

The different stages in ABC calculations are listed below:
(1) Identify the different activities within the organisation: Usually the
number of cost centres that a traditional overhead system uses is quite
small, say up to fifteen. In ABC, the number of activities will be much more,
say 200; the exact number will depend on how the management subdivides
the organisation’s activities. It is possible to break the organisation down into
many very small activities. But if ABC is to be acceptable as practical system
it is necessary to use larger groupings, say, 40 activities may be used in
practice. The additional number of activities over cost centres means that
ABC should be more accurate than the traditional method regardless of
anything else. Some activities may be listed as follows:-
• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
• Maintenance

(2) Relate the overheads to the activities, both support and primary, that
caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done
using resource cost drivers that reflect causality.
(3) Support activities are then spread across the primary activities on some
suitable base, which reflects the use of the support activity. The base is the
cost driver that is the measure of how the support activities are used.
(4) Determine the activity cost drivers that will be used to relate the
overheads collected in the cost pools to the cost objects/products. This is
based on the factor that drives the consumption of the activity. The
question to ask is – what causes the activity to incur costs? In production
scheduling, for example, the driver will probably be the number of batches
ordered.
(5) Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.
Activity cost driver rate = Total cost of activity

Activity driver
The activity driver rate can be used not only to identify cost of products, as
in traditional absorption costing, but it can also be used for costing other
cost objects such as customers/customer segments and distribution
channels. The possibility of costing objects other than products is part of
the benefit of ABC. The activity cost driver rates will be multiplied by the
different amounts of each activity that each product/other cost object
consumes.
Cost allocation under ABC

ACTIVITY BASED COSTING 5.11
5.11
a
Let us take a small example to understand the steps stated above:

Assume that a company makes widgets and the management decides to install an
ABC system. The management decides that all overhead costs will have only three
cost drivers viz. direct labour hours, machine hours and number of purchase
orders. The general ledger of the company shows the following overhead costs –
General Ledger (`)

Perquisite taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Employees’ group insurance 1,500
Total 11,250
So, which overheads do you think are driven by direct labour hours?
The answer is
Perquisite taxes ` 1,000

Fringe benefits ` 2,000
Employees’ group insurance ` 1,500
Total ` 4,500
Similarly, overheads driven by machine hours include Machine maintenance,

depreciation and electricity, totaling ` 2,500 and finally overheads driven by
number of purchase orders include purchasing department labour and purchasing
department supplies, totaling ` 4,250.
Now, overhead rate is calculated by the formula
Total cost in the activity pool ÷ Base,
base being the total number of labour hours, machine hours and total number of
purchase orders in the given case.

Assume that the total number of labour hours be 1,000 hours, machine hours be
250 hours and total purchase orders be 100 orders.
So, Cost driver rate would be
Cost Driver Rate (`)
` 4,500/ 1,000 ` 4.50 per labour hour
` 2,500/ 250 ` 10 per machine hour
` 4,250/ 100 ` 42.50 per purchase order
Now, let’s allocate the overheads between two widgets A and B the details of
which are given below:
Particulars Widget A Widget B
Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50
So, total overhead costs applied to widget A = (400 × ` 4.50) + (100 × ` 10) + (50
× ` 42.50) = ` 4,925
And total overheads applied to widget B = (600 × ` 4.50) + (150 × ` 10) + (50 ×
` 42.50) = ` 6,325
So total overheads = ` 4,925 + ` 6,325 = ` 11,250.
Generally, in the traditional costing method, overheads are applied on the basis
of direct labour hours (total 1,000 labour hours in the given case). So, in that case
the overhead absorption rate would be – ` 11,250/1000 = ` 11.25 per hour and
the total overheads applied to Widget A would have been = 400 × 11.25 =
` 4,500 and to Widget B = 600 × ` 11.25 = ` 6,750.
Hence Widget A would have been under-valued and Widget B over-valued by
` 425.

5.13
a
Examples of Cost Drivers

Some of the examples of cost drivers for different activity pools in a production
department are stated below:
Activity Cost Pools Related Cost Drivers

Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours
The process of calculating cost driver rate is illustrated in diagrammatic

presentation as below:

ILLUSTRATION 1
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The
budgeted costs and production for the year ending 31st March are as follows:
A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
- Direct Materials (Kg.) 4 6 3
- Direct Labour (Minutes) 30 45 60

The budgeted direct labour rate was ` 10 per hour, and the budgeted material cost
was ` 2 per kg. Production overheads were budgeted at ` 99,450 and were
absorbed to products using the direct labour hour rate. ABC Ltd. followed the
Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The
following additional information is made available for this purpose.
1. Budgeted overheads were analysed into the following:
(`)
Material handling 29,100
Storage costs 31,200
Electricity 39,150
2. The cost drivers identified were as follows:
Material handling Weight of material handled
Storage costs Number of batches of material
Electricity Number of Machine operations

5.15
a
3. Data on Cost Drivers was as follows:
A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operations 6 3 2

You are requested to:
1. PREPARE a statement for management showing the unit costs and total costs
of each product using the absorption costing method.
2. PREPARE a statement for management showing the product costs of each
product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two
approaches?
SOLUTION
1. Traditional Absorption Costing
A B C Total
(a) Quantity (units) 4,000 3,000 1,600 8,600
(b) Direct labour (minutes) 30 45 60 -
(c) Direct labour hours (a × b)/60 minutes 2,000 2,250 1,600 5,850
Overhead rate per direct labour hour:
= Budgeted overheads Budgeted labour hours
= ` 99,450  5,850 hours
= ` 17 per direct labour hour

Unit Costs:
A (`) B (`) C (`)
Direct Costs:
- Direct Labour 5.00 7.50 10.00

- Direct Material 8.00 12.00 6.00
Production Overhead: 8.50 12.75 17.00

 ` 17×30   ` 17×45   ` 17×60 
     
 60   60   60 
Total unit costs 21.50 32.25 33.00
Number of units 4,000 3,000 1,600
Total costs 86,000 96,750 52,800
2. Activity Based Costing
A B C Total
Quantity (units) 4,000 3,000 1,600 -
Material Weight per unit (Kg.) 4 6 3 -
Total material weight 16,000 18,000 4,800 38,800
Machine operations per unit 6 3 2 -
Total operations 24,000 9,000 3,200 36,200
Total batches of Material 10 5 15 30
Material handling rate per kg. = ` 29,100  38,800 kg.

= ` 0.75 per kg.
Electricity rate per machine operations = ` 39,150  36,200

= ` 1.081 per machine operations
Storage rate per batch = ` 31,200  30 batches
= ` 1,040 per batch

5.17
a
Unit Costs:
A (`) B (`) C (`)
Direct Costs:
Direct Labour 5.00 7.50 10.00
Direct material 8.00 12.00 6.00
Production Overheads:
Material Handling 3.00 4.50 2.25

(`0.75  4) (`0.75  6) (`0.75  3)
Electricity 6.49 3.24 2.16

(`1.081  6) (`1.081  3) (`1.081  2)
Storage 2.60 1.73 9.75

 ` 1,040   `1,040   `1,040 
 `10    `5×   `15× 
 4,000   3,000   1,600 
Total unit costs 25.09 28.97 30.16
Number of units 4,000 3,000 1,600
Total costs ` 1,00,360 ` 86,910 ` 48,256
3. Comments: The difference in the total costs under the two systems is due
to the differences in the overheads borne by each of the products. The
Activity Based Costs appear to be more precise.
8. ADVANTAGES OF ACTIVITY BASED COSTING

The main advantages of using Activity Based Costing are:
(i) More accurate costing of products/services.
(ii) Overhead allocation is done on logical basis.
(iii) It enables better pricing policies by supplying accurate cost information.

(iv) Utilizes unit cost rather than just total cost

(v) Help to identify non-value added activities which facilitates cost reduction.
(vi) It is helpful to the organizations with multiple products.
(vii) It highlights problem areas which require attention of the management.
9. LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive, particularly in comparison with traditional costing
system.
(ii) It is not helpful to the small organizations.
(iii) It may not be applied to organizations with limited products.
(iv) Selection of the most suitable cost driver may not be easy/ may be difficult
or complicated.
10. REQUIREMENTS IN ABC IMPLEMENTATION

A number of distinct practical stages are required in the ABC implementation
which are given as below:
(1) Staff Training: The co-operation of the workforce is critical to the
successful implementation of ABC. Staff training should be done to create
an awareness on the purpose of ABC.
(2) Process Specification: Informal, but structured interviews with key members
of personnel will identify the different stages of the production process, the
commitment of resources to each, processing times and bottlenecks.
(3) Activity Definition: The activities must be defined clearly in the early stage in
order to manage the problems, if any, effectively. There might be overloading
of information from the new data, but the same is needed in codification.
(4) Activity Driver Selection: Cost driver for each activity shall be selected.
(5) Assigning Cost: A single representative activity driver can be used to assign
costs from the activity pools to the cost objects.

5.19
a
11. PRACTICAL APPLICATIONS OF ACTIVITY

BASED COSTING
11.1 As a Decision-Making Tool
ABC can act as a decision making tool in the following ways:
(i) ABC along with some other cost management technique can be utilized to
improve performance and profitability of an organization.
(ii) Wholesale distributors can gain significant advantage in the decision-
making process through implementation of ABC concepts by correlating
costs to various activities. Introduction of new product or vendor can be
better decided through ABC.
(iii) ABC can assist in decisions related to facility and resource expansion. Often
the basis for relocation or opening of a new distribution center is based on
cost associations. Reduction in freight or other logistic costs can offset the
expense of the new facility, staff or equipment. The ABC model can identify
the specific cost elements being targeted, providing a much clearer picture
which aids in management actions.
(iv) ABC augments decision support for human resources. Since the activity
(and therefore costs) can be associated to an individual, new levels of
financial performance can be determined. This might be evident in the case
of branch management or sales.
(v) Companies who wish to determine price based on cost plus markup basis
find ABC method of costing very relevant and are able to determine
competitive prices for their products.
11.2 As Activity Based Management

Meaning of Activity Based Management
The term Activity Based Management (ABM) is used to describe the cost
management application of ABC. The use of ABC as a costing tool to manage
costs at activity level is known as Activity Based Management (ABM). ABM is
a discipline that focuses on the efficient and effective management of activities as
the route to continuously improving the value received by customers. ABM
utilizes cost information gathered through ABC.

Various analysis in Activity Based Management

The various types of analysis involved in ABM are as follows:
(1) Cost Driver Analysis: The factors that cause activities to be performed need
to be identified in order to manage activity costs. Cost driver analysis
identifies the causal factors.
(2) Activity Analysis.
(a) Value-Added Activities (VA): The value-added activities are those

activities which are indispensable in order to complete the process.
The customers are usually willing to pay (in some way) for these
services. For example, polishing furniture by a manufacturer dealing in
furniture is a value added activity.
(b) Non-Value-Added Activities (NVA): The NVA activity represents work
that is not valued by the external or internal customer. NVA
activities do not improve the quality or function of a product or
service, but they can adversely affect costs and prices. Moving
materials and machine set up for a production run are examples of
NVA activities.
(3) Performance Analysis: Performance analysis involves the identification of
appropriate measures to report the performance of activity centres or
other organisational units, consistent with each unit’s goals and objectives.
Activity Based Management in Business
Activity Based Management can be used in the following ways
(i) Cost Reduction: ABM helps the organisation to identify costs against
activities and to find opportunities to streamline or reduce the costs or
eliminate the entire activity, especially if there is no value added.
(ii) Business Process Re-engineering: Business process re-engineering

involves examining business processes and making substantial changes
to how organisation currently operates. ABM is a powerful tool for
measuring business performance, determining the cost of business output
and is used as a means of identifying opportunities to improve process
efficiency and effectiveness.

5.21
a
(iii) Benchmarking: Benchmarking is a process of comparing of ABC-derived

activity costs of one segment of company with those of other
segments. It requires uniformity in the definition of activities and
measurement of their costs.
(iv) Performance Measurement: Many organisations are now focusing on
activity performance as a means of facing competitors and managing costs
by monitoring the efficiency and effectiveness of activities.
Area Measure
Quality of purchased component Zero defects
Quality of output % yield
Customer awareness Orders; number of complaints
11.3 Facilitate Activity Based Budgeting

Meaning of Activity Based Budgeting (ABB)
Activity based budgeting analyse the resource input or cost for each activity. It
provides a framework for estimating the amount of resources required in
accordance with the budgeted level of activity. Actual results can be compared
with budgeted results to highlight both, in financial and non-financial terms,
those activities with major discrepancies from budget for potential reduction in
supply of resources. It is a planning and control system which seeks to support
the objectives of continuous improvement. It means planning and controlling the
expected activities of the organization to derive a cost-effective budget that meet
forecast workload and agreed strategic goals. ABB is the reversing of the ABC
process to produce financial plans and budgets.
Key Elements of ABB

The three key elements of activity based budgeting are as follows:-
 Type of work to be done
 Quantity of work to be done

 Cost of work to be done

Benefits of ABB
Few benefits of activity based budgeting are as follows:-
(i) Activity Based Budgeting (ABB) can enhance accuracy of financial forecasts
and increasing management understanding.
(ii) When automated, ABB can rapidly and accurately produce financial plans
and models based on varying levels of volume assumptions.
(iii) ABB eliminates much of the needless rework created by traditional
budgeting techniques.
ILLUSTRATION 2
MST Limited has collected the following data for its two activities. It calculates
activity cost rates based on cost driver capacity.
Activity Cost Driver Capacity Cost
Power Kilowatt hours 50,000 kilowatt hours ` 2,00,000
Quality Inspections Number of Inspections 10,000 Inspections ` 3,00,000

The company makes three products M, S and T. For the year ended March 31st, the
following consumption of cost drivers was reported:
Product Kilowatt hours Quality Inspections
M 10,000 3,500
S 20,000 2,500
T 15,000 3,000
Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level
to compute the budgeted fixed overhead cost rate.

5.23
a
SOLUTION
(i) Statement of cost allocation to each product from each activity
Product
M (`) S (`) T (`) Total
(`)
Power (Refer 40,000 80,000 60,000 1,80,000
to working (10,000 kWh (20,000 kWh (15,000 kWh
note) × `4) ×`4) ×`4)
Quality 1,05,000 75,000 90,000 2,70,000
Inspections (3,500 (2,500 (3,000
(Refer to inspections inspections × inspections ×
working note) × `30) ` 30) ` 30)
Working note
Rate per unit of cost driver:
Power (` 2,00,000 / 50,000 kWh) ` 4/kWh

Quality Inspection (` 3,00,000 / 10,000 inspections) ` 30 per inspection
(ii) Computation of cost of unused capacity for each activity:
(`)
Power (` 2,00,000 – ` 1,80,000) or 5,000 x 4 20,000
Quality Inspections (` 3,00,000 – ` 2,70,000) or 1,000 x 30 30,000
Total cost of unused capacity 50,000
(iii) Factors management consider in choosing a capacity level to compute

the budgeted fixed overhead cost rate:
• Effect on product costing & capacity management
• Effect on pricing decisions.

• Effect on performance evaluation
• Effect on financial statements
• Regulatory requirements.
• Difficulties in forecasting.

ILLUSTRATION 3
ABC Ltd. Manufactures two types of machinery equipment Y and Z and
applies/absorbs overheads on the basis of direct-labour hours. The budgeted
overheads and direct-labour hours for the month of December are
` 12,42,500 and 20,000 hours respectively. The information about Company’s
products is as follows:
Equipment Equipment
Y Z
Budgeted Production volume 2,500 units 3,125 units
Direct material cost ` 300 per unit ` 450 per unit
Direct labour cost
Y : 3 hours @ ` 150 per hour
Z : 4 hours @ ` 150 per hour ` 450 ` 600
ABC Ltd.’s overheads of ` 12,42,500 can be identified with three major activities:
Order Processing (` 2,10,000), machine processing ( ` 8,75,000), and product
inspection (` 1,57,500). These activities are driven by number of orders processed,
machine hours worked, and inspection hours, respectively. The data relevant to
these activities is as follows:
Orders processed Machine hours Inspection hours

worked
Y 350 23,000 4,000
Z 250 27,000 11,000
Total 600 50,000 15,000
Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production,

COMPUTE the unit manufacturing cost of the equipment Y and Z, if the
budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs
of the equipment Y and Z, if the budgeted manufacturing volume is achieved.

5.25
a
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct -labour
hours as an application base, CALCULATE the amount of cost distortion
(under-costed or over-costed) for each equipment.
SOLUTION
(i) Overheads application base: Direct labour hours
Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Overheads* 186.38 248.50
936.38 1,298.50
Budgeted overheads ` 12, 42,500

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

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

Orders processed
Machine 8,75,000 50,000 17.50

processing
Machine hours
Inspection 1,57,500 15,000 10.50

Inspection hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Prime Cost 750 1,050
Overhead Cost
Order processing 350 : 250 or Rs 350 per 1,22,500 87,500
order
Machine processing 23,000 : 27,000 or ` 4,02,500 4,72,500

17.5 per hour
Inspection 4,000 : 11,000 42,000 1,15,500
Total overhead cost 5,67,000 6,75,500
Per unit cost Y (`) Z (`)
5,67,000 /2,500 226.80 ` 216.16
6,75,500/ 3,125
Unit manufacturing cost (Prime Cost + ` 976.80 ` 1,266.16

Overhead per unit)
(iii)
Equipment Equipment
Y (`) Z (`)
Unit manufacturing cost–using direct
labour hours as an application base 936.38 1,298.50
Unit manufacturing cost-using activity 976.80 1,266.16
based costing
Cost distortion (-)40.42 + 32.34
Low volume product Y is under-costed and high volume product Z is over
costed using direct labour hours for overhead absorption.

5.27
a
ILLUSTRATION 4
‘Humara - Apna’ bank offers three products, viz., deposits, Loans and Credit Cards.
The bank has selected 4 activities for a detailed budgeting exercise, following
activity based costing methods.
The bank wants to know the product wise total cost per unit for the selected
activities, so that prices may be fixed accordingly.
The following information is made available to formulate the budget:
Activity Present Estimation for the budget

Cost (`) period
ATM Services:
(a) Machine Maintenance 4,00,000 All fixed, no change.
(b) Rents 2,00,000 Fully fixed, no change.
(c) Currency Replenishment 1,00,000 Expected to double during
Cost budget period.
7,00,000 (This activity is driven by no. of
ATM transactions)
Computer Processing 5,00,000 Half this amount is fixed and no
change is expected.
The variable portion is expected
to increase to three times the
current level.
(This activity is driven by the
number of computer
transactions)
Issuing Statements 18,00,000 Presently, 3 lakh statements are
made. In the budget period, 5
lakh statements are expected.
For every increase of one lakh
statement, one lakh rupees is the
budgeted increase.
(This activity is driven by the
number of statements)

Computer Inquiries 2,00,000 Estimated to increase by 80%

during the budget period.
(This activity is driven by
telephone minutes)
The activity drivers and their budgeted quantifies are given below:
Activity Drivers Deposits Loans Credit

Cards
No. of ATM Transactions 1,50,000 --- 50,000

No. of Computer Processing 15,00,000 2,00,000 3,00,000
Transactions
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000
The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and
14,000 Credit Card Accounts.
Required:
(i) CALCULATE the budgeted rate for each activity.

(ii) PREPARE the budgeted cost statement activity wise.
(iii) COMPUTE the budgeted product cost per account for each product using (i)
and (ii) above.
SOLUTION
Statement Showing “Budgeted Cost per unit of the Product”
Activity Activity Activity No. of Activity Deposits Loans Credit

Cost Driver Units of Rate Cards
(Budgeted) Activity (`) (`) (`) (`)
(` ) Driver
(Budget)
ATM 8,00,000 No. of ATM 2,00,000 4.00 6,00,000 --- 2,00,000

Services Transaction

5.29
a
Computer 10,00,000 No. of 20,00,000 0.50 7,50,000 1,00,000 1,50,000

Processing Computer
processing
Transaction
Issuing 20,00,000 No. of 5,00,000 4.00 14,00,000 2,00,000 4,00,000

Statements Statements
Customer 3,60,000 Telephone 7,20,000 0.50 1,80,000 90,000 90,000

Inquiries Minutes
Budgeted 41,60,000 29,30,000 3,90,000 8,40,000

Cost
Units of Product (as estimated in the budget period) 58,600 13,000 14,000
Budgeted Cost per unit of the product (`) 50 (`) 30 (`) 60
Working Note
Activity Budgeted Remark

Cost (` )
ATM Services:
(a) Machine 4,00,000 − All fixed, no change.
Maintenance −
(b) Rents 2,00,000 − Fully fixed, no change.
(c) Currency
Replenishment
2,00,000 − Doubled during budget period.
Cost
Total 8,00,000
Computer Processing 2,50,000 − ` 2,50,000 (half of ` 5,00,000) is

fixed and no change is
expected.
− ` 2,50,000 (variable portion) is
expected to increase to three
7,50,000
times the current level.
Total 10,00,000

Issuing Statements 18,00,000 − Existing.

2,00,000 − 2 lakh statements are expected
to be increased in budgeted
period. For every increase of
one lakh statement, one lakh
rupees is the budgeted
Total 20,00,000 increase.
Computer Inquiries 3,60,000 − Estimated to increase by 80%

during the budget period.
Total 3,60,000 (` 2,00,000 x 180%)
SUMMARY
 Activity based costing is an accounting methodology that assigns costs to
activities rather than products or services. This enables resources &
overhead costs to be more accurately assigned to products & services that
consume them.
 Unit level activities, batch level activities, product level activities and facility
level activities are the categories of activities that help to determine the
type of activity cost driver required.
 ABC is very much useful to the organization with multiple products.
 The limitations of ABC are that, it is very costly and cannot be applied to all
companies.
 The use of ABC as a costing tool to manage costs at activity level is known
as Activity Based Cost Management (ABM). ABM is a discipline that focuses
on the efficient and effective management of activities as the route to
continuously improving the value received by customers. ABM utilizes cost
information gathered through ABC.
 The value-added activities are those activities which are indispensable in
order to complete the process.

5.31
a
 NVA activity represents work that is not valued by the external or internal
customer. NVA activities do not improve the quality or function of a product
or service, but they can adversely affect costs and prices.
 Activity-based budgeting is a process of planning and controlling the
expected activities for the organisation to derive a cost-effective budget
that meets forecast workload and agreed strategic goals.
 Key elements of ABB are type of work/activity to be performed, quantity of
work/activity to be performed and cost of work/activity to be performed.
TEST YOUR KNOWLEDGE

1. A cost driver is:
(a) An item of production overheads
(b) A common cost which is shared over cost centres
(c) Any cost relating to transport
(d) An activity which generates costs

2. In activity based costing, costs are accumulated by activity using:
(a) Cost drivers
(b) Cost objects

(c) Cost pools
(d) Cost benefit analysis
3. A cost driver:
(a) Is a force behind the overhead cost
(b) Is an allocation base
(c) Is a transaction that is a significant determinant of cost

4. Which of the following is not a correct match:
Activity Cost Driver

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

appropriate cost drivers. Find the one which is not appropriate:
(a) The number of purchase, supplies and customers’ orders drives the cost
associated with new material inventory, work-in-progress and finished
goods inventory
(b) The number of production runs undertaken drives production
scheduling, inspection and material handling
(c) The quality of raw material issued drives the cost of receiving
department costs
(d) The number of packing orders drives the packing costs

6. Steps in ABC include:
(a) Identification of activities and their respective costs
(b) Identification of cost driver of each activity and computation of an

allocation rate per activity
(c) Allocation of overhead cost to products/ services based on the activities
involved
7. Which of the following is not a benefit of ABC?
(a) Accurate cost allocation
(b) Improved decision making
(c) Better control on activity and costs
(d) Reduction of prime cost

5.33
a
8. The steps involved for installation of ABC in a manufacturing company

include the following except:
(a) Borrowing fund

(b) Feasibility study
(c) Building up necessary IT infrastructure and training of line employees
(d) Strategy and value chain analysis
9. Which of the following statements are true: (1) Activity based Management
involves activity analysis and performance measurement. (2) Activity based
costing serves as a major source of information in ABM.
(a) (1) True; (2) False
(b) (1) True; (2) True
(c) (1) False; (2) True
(d) (1) False; (2) False
10. The key elements of activity based budgeting are:
(a) Type of activity to be performed
(b) Quantity of activity to be performed
(c) Cost of activity to be performed
1. DEFINE the following terms:
(i) Cost driver
(ii) Activity cost pool
2. EXPLAIN in brief the problems of traditional costing where overhead costs are
allocated based on volume.
3. STATE what is Activity based costing. How are product costs determined in
ABC?

4. A manufacturing company in India wants to replace its traditional costing

system by ABC. It produces a number of products, each having complex
production process of different degree. SUGGEST various requirements for
installing activity based costing.
5. DESCRIBE various levels of activities under ABC.
6. STATE what are the benefits of ABC.
7. STATE what are the limitations of ABC.
8. STATE what are the practical applications of ABC.
9. STATE what is Activity based Management. How does ABC help ABM?
10. DEFINE Activity based Budgeting. STATE what are its key elements.
Practical Problems
1. Woolmark Ltd. manufactures three types of products namely P, Q and R. The
data relating to a period are as under:
Particulars P Q R
Machine hours per unit 10 18 14
Direct Labour hours per unit 4 12 8
Direct Material per unit ( `) 90 80 120
Production (units) 3,000 5,000 20,000

Currently the company uses traditional costing method and absorbs all
production overheads on the basis of machine hours. The machine hour rate
of overheads is ` 6 per hour. Direct labour hour rate is ` 20 per hour.
The company proposes to use activity based costing system and the activity
analysis is as under:
Particulars P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per batch 3 10 8
Number of inspections per batch 5 4 3

5.35
a
The total production overheads are analysed as under:
Machine set up costs……………………………………… 20%
Machine operation costs……………………………………. 30%
Inspection costs……………………………………………… 40%
Material procurement related costs……………………….. 10%

Required
(i) CALCULATE the cost per unit of each product using traditional method
of absorbing all production overheads on the basis of machine hours.
(ii) CALCULATE the cost per unit of each product using activity based
costing principles.
2. RST Limited specializes in the distribution of pharmaceutical products. It buys
from the pharmaceutical companies and resells to each of the three different
markets.
(i) General Supermarket Chains
(ii) Drugstore Chains

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

Supermarket Chains Shops
Chains
(` ) (` ) (` )
Average revenue per delivery 84,975 28,875 5,445
Average cost of goods sold per 82,500 27,500 4,950

delivery
Number of deliveries 330 825 2,750

In the past, RST Limited has used gross margin percentage to evaluate the
relative profitability of its distribution channels.

The company plans to use activity–based costing for analysing the

profitability of its distribution channels.
The Activity analysis of RST Limited is as under:
Activity Area Cost Driver
Customer purchase order processing Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store per

delivery
Shelf-stocking at customer store Hours of shelf-stocking

The April month’s operating costs (other than cost of goods sold) of RST
Limited are ` 8,27,970. These operating costs are assigned to five activity
areas. The cost in each area and the quantity of the cost allocation basis u sed
in that area for the month of April are as follows:
Activity Area Total costs (`) Total Units of Cost

Allocation Base
Customer purchase order 2,20,000 5,500 orders

processing
Line-item ordering 1,75,560 58,520 line items
Store delivery 1,95,250 3,905 store deliveries
Cartons dispatched to 2,09,000 2,09,000 cartons

store
Shelf-stocking at customer 28,160 1,760 hours

store

5.37
a
Other data for the month of April include the following:

Supermarket Chains Shops
Chains
Total number of orders 385 990 4,125
Average number of line items 14 12 10
per order
Total number of store deliveries 330 825 2,750
Average number of cartons 300 80 16
shipped per store delivery
Average number of hours of 3 0.6 0.1
shelf-stocking per store delivery
Required:
(i) COMPUTE gross-margin percentage for each of its three distribution
channels and compute RST Limited’s operating income.
(ii) COMPUTE the rate per unit of the cost-allocation base for each of the
five activity areas.
(iii) COMPUTE the operating income of each distribution channel using the
activity-based costing information. Comment on the results. What new
insights are available with the activity-based cost information?
(iv) DESCRIBE four challenges one would face in assigning the total
operating costs of ` 8,27,970 to five activity areas.
3. Family Store wants information about the profitability of individual product
lines: Soft drinks, Fresh produce and Packaged food. Family store provides the
following data for the current year for each product line:
Soft drinks Fresh Packaged

produce food
Revenues ` 39,67,500 ` 1,05,03,000 ` 60,49,500
Cost of goods sold ` 30,00,000 ` 75,00,000 ` 45,00,000
Cost of bottles returned ` 60,000 `0 `0

Number of purchase orders 360 840 360

placed
Number of deliveries received 300 2,190 660
Hours of shelf-stocking time 540 5,400 2,700
Items sold 1,26,000 11,04,000 3,06,000
Family store also provides the following information for the current year:
Activity Description of activity Total Cost Cost-allocation

base
Bottles Returning of empty ` 60,000 Direct tracing to

returns bottles soft drink line
Ordering Placing of orders for ` 7,80,000 1,560 purchase

purchases orders
Delivery Physical delivery and ` 12,60,000 3,150 deliveries

receipt of goods
Shelf Stocking of goods on ` 8,64,000 8,640 hours of

stocking store shelves and on- shelf-stocking time
going restocking
Customer Assistance provided to ` 15,36,000 15,36,000 items

Support customers including sold
check-out
Required:
(i) Family store currently allocates support cost (all cost other than cost of
goods sold) to product lines on the basis of cost of goods sold of each
product line. CALCULATE the operating income and operating income
as a % of revenues for each product line.
(ii) If Family Store allocates support costs (all costs other than cost of goods
sold) to product lines using and activity-based costing system,
CALCULATE the operating income and operating income as a % of
revenues for each product line.

5.39
a
4. Alpha Limited has decided to analyse the profitability of its five new
customers. It buys bottled water at ` 90 per case and sells to retail customers
at a list price of ` 108 per case. The data pertaining to five customers are:
Customers
A B C D E
Cases sold 4,680 19,688 1,36,800 71,550 8,775
Listed Selling Price ` 108 ` 108 ` 108 ` 108 ` 108

Actual Selling Price ` 108 ` 106.20 ` 99 ` 104.40 ` 97.20
Number of 15 25 30 25 30
Purchase orders
Number of 2 3 6 2 3
Customer visits
Number of 10 30 60 40 20
deliveries
Kilometers 20 6 5 10 30
travelled per
delivery
Number of 0 0 0 0 1
expedited deliveries
Its five activities and their cost drivers are:
Activity Cost Driver Rate
Order taking ` 750 per purchase order
Customer visits ` 600 per customer visit
Deliveries ` 5.75 per delivery Km travelled
Product handling ` 3.75 per case sold
Expedited deliveries ` 2,250 per expedited delivery

Required:
(i) COMPUTE the customer-level operating income of each of five retail
customers now being examined (A, B, C, D and E). Comment on the results.
(ii) STATE what insights are gained by reporting both the list selling price
and the actual selling price for each customer.
5. BABYSOFT is a global brand created by Bio-organic Ltd. The company

manufactures three ranges of beauty soaps i.e. BABYSOFT- Gold, BABYSOFT-
Pearl, and BABYSOFT- Diamond. The budgeted costs and production for the
month of December are as follows:
BABYSOFT- Gold BABYSOFT- Pearl BABYSOFT- Diamond
Production 4,000 3,000 2,000

of soaps
(Units)
Resources Qty Rate Qty Rate Qty Rate

per Unit:
Essential 60 ml ` 200 / 100 ml 55 ml ` 300 / 100 ml 65 ml ` 300 / 100 ml

Oils
Cocoa 20 g ` 200 / 100 g 20 g ` 200 / 100 g 20 g ` 200 / 100 g

Butter
Filtered 30 ml ` 15 / 100 ml 30 ml ` 15 / 100 ml 30 ml ` 15 / 100 ml

Water
Chemicals 10 g ` 30 / 100 g 12 g ` 50 / 100 g 15 g ` 60 / 100 g
Direct 30 ` 10 / hour 40 ` 10 / hour 60 ` 10 / hour

Labour minutes minutes minutes
Bio-organic Ltd. followed an Absorption Costing System and absorbed its

production overheads, to its products using direct labour hour rate, which
were budgeted at ` 1,98,000.
Now, Bio-organic Ltd. is considering adopting an Activity Based Costing
system. For this, additional information regarding budgeted overheads and
their cost drivers is provided below:

5.41
a
Particulars (` ) Cost drivers

Forklifting cost 58,000 Weight of material lifted
Supervising cost 60,000 Direct labour hours
Utilities 80,000 Number of Machine operations
The number of machine operations per unit of production are 5, 5, and 6 for
BABYSOFT- Gold, BABYSOFT- Pearl, and BABYSOFT- Diamond respectively.
(Consider (i) Mass of 1 litre of Essential Oils and Filtered Water equivalent to
0.8 kg and 1 kg respectively (ii) Mass of output produced is equivalent to the
mass of input materials taken together.)
You are requested to:
(i) PREPARE a statement showing the unit costs and total costs of each
product using the absorption costing method.
(ii) PREPARE a statement showing the product costs of each product using
the ABC approach.
(iii) STATE what are the reasons for the different product costs under the
two approaches.
ANSWERS
Answers to the MCQs
1. (d) 2. (c) 3. (d) 4. (d) 5. (c) 6. (d)
7. (d) 8. (a) 9. (b) 10. (d)

3. Please refer paragraph 2, 5 and 7



1. (i) Statement Showing “Cost per unit - Traditional Method”
Particulars of Costs P Q R
(`) (`) (`)
Direct Materials 90 80 120

Direct Labour [(4, 12, 8 hours)  ` 20] 80 240 160
Production Overheads [(10, 18, 14 hours)  ` 6] 60 108 84
Cost per unit 230 428 364
(ii) Statement Showing “Cost per unit - Activity Based Costing”
Products P Q R
Production (units) 3,000 5,000 20,000
(`) (`) (`)
Direct Materials (90, 80, 120) 2,70,000 4,00,000 24,00,000
Direct Labour (80, 240, 160) 2,40,000 12,00,000 32,00,000
Machine Related Costs @ ` 1.80 per

hour 54,000 1,62,000 5,04,000
(30,000, 90,000, 2,80,000)
Setup Costs @ ` 9,600 per setup

(20, 10, 20) 1,92,000 96,000 1,92,000
Inspection Costs @ ` 4,800 per

inspection 4,80,000 1,92,000 2,88,000

5.43
a
Products P Q R
(100, 40, 60)
Purchase Related Costs @ ` 750 per

purchase (60, 100, 160) 45,000 75,000 1,20,000
Total Costs 12,81,000 21,25,000 67,04,000
Cost per unit (Total Cost  Units) 427.00 425.00 335.20
Workings
Number of Batches, Purchase Orders, and Inspections-
Particulars P Q R Total
A. Production (units) 3,000 5,000 20,000

B. Batch Size (units) 150 500 1,000
C. Number of Batches (A÷B) 20 10 20 50
D. Number of Purchase Order per
batch 3 10 8
E. Total Purchase Orders [C  D] 60 100 160 320
F. Number of Inspections per 5 4 3
batch
G. Total Inspections [C  F] 100 40 60 200
Total Machine Hours-
Particulars P Q R
A. Machine Hours per unit 10 18 14

B. Production (units) 3,000 5,000 20,000
C. Total Machine Hours [A  B] 30,000 90,000 2,80,000
Total Machine Hours = 4,00,000
Total Production Overheads-
= 4,00,000 hrs.  ` 6 = ` 24,00,000

Cost Driver Rates-
Cost Pool % Overheads Cost Driver Cost Cost Driver

Basis Driver Rate
(`) (Units) (`)
Setup 20% 4,80,000 Number of 50 9,600 per

batches Setup
Inspection 40% 9,60,000 Number of 200 4,800 per

inspections Inspection
Purchases 10% 2,40,000 Number of 320 750 per

purchases Purchase
Machine 30% 7,20,000 Machine 4,00,000 1.80 per

Operation Hours Machine Hour
2. (i) RST Limited’s

Statement of operating income and gross margin percentage
for each of its three distribution channel
Particulars General Super Drugstore Chemist Shops Total

Market Chains
Chains
Revenues: (`) 2,80,41,750 2,38,21,875 1,49,73,750 6,68,37,375
(330 × ` 84,975) (825 × ` 28,875) (2,750 × ` 5,445)
Less: Cost of 2,72,25,000 2,26,87,500 1,36,12,500 635,25,000

goods sold: (330 × ` 82,500) (825 × ` 27,500) (2,750 × ` 4,950)
(`)
Gross Margin: 8,16,750 11,34,375 13,61,250 33,12,375

(`)
Less: Other
operating 8,27,970
costs: (`)

5.45
a
Operating 24,84,405
income: (`)
Gross Margin 2.91% 4.76 % 9.09% 4.96%
Operating 3.72
income %
(ii) Computation of rate per unit of the cost allocation base for
each of the five activity areas for the month of April
(`)
Customer purchase order processing 40 per order

(` 2,20,000/ 5,500 orders)
Line item ordering 3 per line item order
(` 1,75,560/ 58,520 line items)
Store delivery 50 per delivery
(` 1,95,250/ 3,905 store deliveries)
Cartons dispatched 1 per dispatch
(` 2,09,000/ 2,09,000 dispatches)
Shelf-stocking at customer store ( ` ) 16 Per hour
(` 28,160/ 1,760 hours)
(iii) Operating Income Statement of each distribution channel

in April (Using the Activity based Costing information)

Super Chains Shops
Market
Chains
Gross margin (`) : (A) 8,16,750 11,34,375 13,61,250
(Refer to (i) part of the answer)
Operating cost (`): (B) 1,62,910 1,90,410 4,74,650

Operating income (`): (A–B) 6,53,840 9,43,965 8,86,600
Operating income (in %) 2.33 3.96 5.92

(Operating income/ Revenue)
× 100
Comments and new insights: The activity-based cost information

highlights, how the ‘Chemist Shops’ uses a larger amount of RST Ltd.’s
resources per revenue than do the other two distribution channels.
Ratio of operating costs to revenues, across these markets is:
General supermarket chains 0.58%

(` 1,62,910/ ` 2,80,41,750) × 100
Drug store chains 0.80%
(` 1,90,410/ ` 2,38,21,875) × 100
Chemist shops 3.17%
(` 4,74,650/ ` 1,49,73,750) ×100
Working note:
Computation of operating cost of each distribution channel:

Super Chains Shops
Market
(`) (`)
Chains (`)
Customer 15,400 39,600 1,65,000

purchase order (` 40 × 385 (` 40 × 990 (` 40 ×4125
processing orders) orders) orders)
Line item 16,170 35,640 1,23,750
ordering (` 3 × 14 x (` 3 × 12 x (` 3 × 10 ×
385) 990) 4125)
Store delivery 16,500 41,250 1,37,500
(` 50 × 330 (` 50 × 825 (` 50 × 2750
deliveries) deliveries) deliveries)

5.47
a
Cartons 99,000 66,000 44,000

dispatched ( ` 1× 300 ( ` 1 × 80 ( ` 1 × 16
cartons × 300 cartons × cartons ×
deliveries) 825 2,750
deliveries) deliveries)
Shelf stocking 15,840 7,920 4,400
(` 16 × 330 (` 16 × 825 (` 16 × 2,750
deliveries × 3 deliveries × deliveries ×
Av. hrs.) 0.6 Av. hrs) 0.1 Av. hrs)
Operating cost 1,62,910 1,90,410 4,74,650
(iv) Challenges faced in assigning total operating cost of ` 8,27,970:

• Choosing an appropriate cost driver for activity area.
• Developing a reliable data base for the chosen cost driver.
• Deciding, how to handle costs that may be common across
several activities.
• Choice of the time period to compute cost rates per cost driver.
• Behavioural factors
3. Working notes:
1. Total support cost:
(`)
Bottles returns 60,000
Ordering 7,80,000
Delivery 12,60,000
Shelf stocking 8,64,000
Customer support 15,36,000
Total support cost 45,00,000

2. Percentage of support cost to cost of goods sold (COGS):

Total support cost
= ×100
Total cost of goods sold
` 45,00,000
= ×100 = 30%
` 1,50,00,000
3. Cost for each activity cost driver:
Activity Total cost Cost Cost driver rate

(1) (`) allocation (4)=[(2)÷(3)]
(2) base
(3)
Ordering 7,80,000 1,560 purchase ` 500 per
orders purchase order
Delivery 12,60,000 3,150 ` 400 per delivery
deliveries
Shelf-stocking 8,64,000 8,640 hours ` 100 per stocking
hour
Customer 15,36,000 15,36,000 ` 1 per item sold
support items sold
(i) Statement of Operating income and Operating income as a
percentage of revenues for each product line
(When support costs are allocated to product lines on the basis of cost of
goods sold of each product)
Soft Fresh Packaged Total (`)

Drinks (`) Produce Foods (`)
(`)
Revenues: (A) 39,67,500 1,05,03,000 60,49,500 2,05,20,000
Cost of Goods sold 30,00,000 75,00,000 45,00,000 1,50,00,000

(COGS): (B)

5.49
a
Support cost (30% of 9,00,000 22,50,000 13,50,000 45,00,000

COGS): (C)
(Refer working notes)
Total cost: (D) = {(B) + 39,00,000 97,50,000 58,50,000 1,95,00,000

(C)}
Operating income: E= 67,500 7,53,000 1,99,500 10,20,000

{(A)-(D)}
Operating income as a 1.70% 7.17% 3.30% 4.97%

percentage of revenues:
(E/A) × 100)
(ii) Statement of Operating income and Operating income as a

percentage of revenues for each product line
(When support costs are allocated to product lines using an activity-
based costing system)
Soft Fresh Packaged Total

drinks Produce Food (`)
(`) (`) (`)
Revenues: (A) 39,67,500 1,05,03,000 60,49,500 2,05,20,000
Cost & Goods sold 30,00,000 75,00,000 45,00,000 1,50,00,000
Bottle return costs 60,000 0 0 60,000
Ordering cost* 1,80,000 4,20,000 1,80,000 7,80,000

(360:840:360)
Delivery cost* 1,20,000 8,76,000 2,64,000 12,60,000

(300:2190:660)
Shelf stocking cost* 54,000 5,40,000 2,70,000 8,64,000

(540:5400:2700)

Customer Support cost* 1,26,000 11,04,000 3,06,000 15,36,000

(1,26,000:11,04,000:
3,06,000)
Total cost: (B) 35,40,000 1,04,40,000 55,20,000 1,95,00,000
Operating income C:{(A)- 4,27,500 63,000 5,29,500 10,20,000
(B)}
Operating income as a % 10.78% 0.60% 8.75% 4.97%
of revenues
* Refer to working note 3
4. Working note:
Computation of revenues (at listed price), discount, cost of goods sold
and customer level operating activities costs:
Customers
A B C D E
Cases sold: 4,680 19,688 1,36,800 71,550 8,775

(a)
Revenues 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
(at listed
price) (`):
(b)
{(a) × `
108)}
Discount - 35,438 12,31,200 2,57,580 94,770
( ` ): (c)
(19,688 (1,36,800 (71,550 (8,775
{(a) ×
cases × cases × cases × cases ×
Discount
` 1.80) ` 9) ` 3.60) ` 10.80)
per case}
Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(`) : (d)
{(a) × ` 90}

5.51
a
Customer level operating activities costs

Order 11,250 18,750 22,500 18,750 22,500
taking costs
(`):
(No. of
purchase ×
`750)
Customer 1,200 1,800 3,600 1,200 1,800
visits costs
(`)
(No. of
customer
visits ×
` 600)
Delivery 1,150 1,035 1,725 2,300 3,450

vehicles (5.75 x
(5.75 x 30 x (5.75 x 60x 5) (5.75 x 40 x (5.75 x 20
travel costs 10x20)
6) 10) x 30)
(`)
(` 5.75 per
km)
(Kms
travelled by
delivery
vehicles ×
` 5.75 per
km.)
Product 17,550 73,830 5,13,000 2,68,313 32,906

handling
costs (`)
{(a) ×` 3.75}

Cost of - - - - 2,250
expediting
deliveries (`)
{No. of
expedited
deliveries ×
` 2,250}
Total cost of 31,150 95,415 5,40,825 2,90,563 62,906

customer
level
operating
activities (`)
(i) Computation of Customer level operating income
Customers
A (`) B (`) C (`) D (`) E (`)
Revenues 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
(At list price)
(Refer to
working note)
Less: Discount - 35,438 12,31,200 2,57,580 94,770
(Refer to
working note)
Revenue 5,05,440 20,90,866 1,35,43,200 74,69,820 8,52,930
(At actual
price)
Less: Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(Refer to
working note)
Gross margin 84,240 3,18,946 12,31,200 10,30,320 63,180

5.53
a
Less: 31,150 95,415 5,40,825 2,90,563 62,906

Customer
level
operating
activities costs
(Refer to
working note)
Customer 53,090 2,23,531 6,90,375 7,39,757 274

level
operating
income
Comment on the results:
Customer D is the most profitable customer. D’s profits are even

higher than C (whose revenue is the highest) despite having only
52.30% of the unit volume of customer C. The main reason is that C
receives a discount of ` 9 per case while customer D receives only a
` 3.60 discount per case.
Customer E is the least profitable. The profits of E is even less than A

(whose revenue is least) Customer E received a discount of ` 10.80 per
case, makes more frequent orders, requires more customer visits and
requires more delivery kms. in comparison with customer A.
(ii) Insight gained by reporting both the list selling price and the
actual selling price for each customer:
Separate reporting of both-the listed and actual selling prices enables

Alpha Ltd. to examine which customer has received what discount per
case, whether the discount received has any relationship with the sales
volume. The data given below provides us with the following
information;

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

Gold Pearl Diamond
(a) Production of soaps 4,000 3,000 2,000 9,000

(Units)
(b) Direct labour 30 40 60 -

(minutes)
(c) Direct labour hours 2,000 2,000 2,000 6,000

(a × b)/60 minutes
Overhead rate per direct labour hour:
= Budgeted overheads  Budgeted labour hours
= ` 1,98,000  6,000 hours
= ` 33 per direct labour hour

5.55
a
Unit Costs:
BABYSOFT- BABYSOFT- BABYSOFT-

Gold (`) Pearl (`) Diamond (`)
Direct Costs:
- Direct Labour 5.00 6.67 10.00

 10×30   10×40   10×60 
     
 60   60   60 
- Direct Material 167.50 215.50 248.50

(Refer working
note1)
Production Overhead 16.50 22.00 33.00

 33×30   33×40   33×60 
     
 60   60   60 
Total unit costs 189.00 244.17 291.50
Number of units 4,000 3,000 2,000
Total costs 7,56,000 7,32,510 5,83,000
Working note-1
Calculation of Direct material cost

120.00 165.00 195.00

Essential oils  200×60   300×55   300×65 
     
 100   100   100 
40.00 40.00 40.00

Cocoa Butter  200×20   200×20   200×20 
     
 100   100   100 

Filtered 4.50 4.50 4.50

water  15×30   15×30   15×30 
     
 100   100   100 
Chemicals 3.00 6.00 9.00

 30×10   50×12   60×15 
     
 100   100   100 
Total costs 167.50 215.50 248.50
(ii) Activity Based Costing
BABYSOFT- BABYSOFT- BABYSOFT- Total

Gold Pearl Diamond
Quantity (units) 4,000 3,000 2,000 -
Weight per unit 108 106 117 -

(grams) {(60×0.8)+20+ {(55×0.8)+20 {(65×0.8)+20+
30+10} +30+12} 30+15}
Total weight 4,32,000 3,18,000 2,34,000 9,84,000

(grams)
Direct labour 30 40 60 -
(minutes)
Direct labour 2,000 2,000 2,000 6,000

hours  4,000×30   3,000×40   2,000×60 
     
 60   60   60 
Machine 5 5 6 -
operations per
unit
Total 20,000 15,000 12,000 47,000

operations
Forklifting rate per gram = ` 58,000  9,84,000 grams
= ` 0.06 per gram

5.57
a
Supervising rate per direct = ` 60,000  6,000 hours

labour hour = ` 10 per labour hour
Utilities rate per machine

operations = ` 80,000  47,000 machine operations
= ` 1.70 per machine operations
Unit Costs under ABC:

Direct Costs:
- Direct Labour 5.00 6.67 10.00
- Direct material 167.50 215.50 248.50
Production Overheads:
- Forklifting cost 6.48 6.36 7.02
(0.06  108) (0.06  106) (0.06  117)
- Supervising cost 5.00 6.67 10.00

 10×30   10×40   10×60 
     
 60   60   60 
Utilities 8.50 8.50 10.20
(1.70  5) (1.70  5) (1.70  6)
Total unit costs 192.48 243.70 285.72
Number of units 4,000 3,000 2,000
Total costs 7,69,920 7,31,100 5,71,440
(iii) Comments: The difference in the total costs under the two systems is
due to the differences in the overheads borne by each of the products.
The Activity Based Costs appear to be more accurate

CHAPTER a
6
COST SHEET
LEARNING OUTCOMES
 Classify and ascertain Cost on the basis of function.
 Prepare Cost Sheet/statement for production of goods and
providing of services.
CHAPTER OVERVIEW
Cost Sheet
Functional Head of Costs in Format of Cost Advantages of

Classification Cost Sheet Sheet Cost Sheet
1. INTRODUCTION
One of the objectives of cost accounting system is ascertainment of cost for a
cost object. The cost objects may be a product, service or any cost centre.
Ascertainment of cost includes elementwise collection of costs, accumulation
of the costs so collected for a certain volume or period and then arrange all
these accumulated costs into a sheet to calculate total cost for the cost
object. In this chapter, a product or a service will be the cost object for cost
calculation and cost ascertainment.
A Cost Sheet or Cost Statement is “a document which provides a detailed

cost information. In a typical cost sheet, cost information are presented on the
basis of functional classification. However, other classification may also be
adopted as per the requirements of users of the information.
2. FUNCTIONAL CLASSIFICATION OF ELEMENTS

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

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

COST SHEET 6.3 a
3.1 Prime Cost

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

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

Add: Additions/ Purchases xxx
Less: Closing stock of Material (xxx)
Direct materials consumed xxxx
The valuation of materials purchased and issued for production shall be

done as per methods discussed in the ‘Chapter- 2 Material Cost’.
Few examples of items to be added in the cost of raw material :
(a) Freight inwards;
(b) Insurance and other expenditure directly attributable to
procurement;
(c) Trade discounts or rebates (to be deducted);
(d) Duties & Taxes (if input tax credit is not available/ availed) etc.
(ii) Direct Employee (Labour) Cost: It is the total of payment made to

the employees who are engaged in the production of goods and provision
of services. Employee cost is also known as labour cost; it includes the
following:
(a) Wages and salary;
(b) Allowances and incentives;
(c) Payment for overtimes;

(d) Bonus/ ex-gratia;
(e) Employer’s contribution to welfare funds such as Provident fund and
other similar funds;
(f) Other benefits (medical, leave with pay, free or subsidised food,
leave travel concession and provisions for retirement benefits) etc.
(iii) Direct Expenses: Expenses other than direct material cost and direct
employee cost, which are incurred to manufacture a product or for
provision of service and can be directly traced in an economically feasible
manner to a cost object. The following costs are examples for direct
expenses:
(a) Cost of utilities such as power & fuel, steam etc.;
(b) Royalty paid/ payable for production or provision of service;
(c) Hire charges paid for hiring specific equipment;
(d) Fee for technical assistance and know-how;
(e) Amortised cost of moulds, patterns, patents etc.;
(f) Cost for product/ service specific design or drawing;
(g) Cost of product/ service specific software;
(h) Other expenses which are directly related with the production of
goods or provision of service.
3.2 Cost of Production

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

Add : Factory Overheads xxx
Gross Works Costs xxxx
Add: Opening stock of Work-in-process xxx
Less: Closing stock of Work-in-process (xxx)
COST SHEET 6.5 a
Factory or Works Costs xxxx

Add: Quality Control Cost xxx
Add: Research & Development cost (Process related) xxx
Add: Administrative Overheads related with production xxx
Less: Credit for recoveries (miscellaneous income) (xxx)
Add: Packing Cost (Primary packing) xxx
Cost of Production xxxx
(i) Factory Overheads: It is also known as works/production/ manufacturing

overheads. It includes the following indirect costs:
(a) Consumable stores and spares;
(b) Depreciation of plant and machinery, factory building etc.
(c) Lease rent of production assets;
(d) Repair and maintenance of plant and machinery, factory building etc.
(e) Indirect employees cost related with production activities;
(f) Drawing and Designing department cost;
(g) Insurance of plant and machinery, factory building, stock of raw
material & WIP etc.
(h) Amortized cost of jigs, fixtures, tooling etc.
(i) Service department cost such as Tool Room, Engineering &
Maintenance, Pollution Control etc.
(ii) Stock of Work-in-process: The cost of opening and closing stock of work-
in-process (WIP) is adjusted to arrive at factory/ works cost. The WIP stock is
valued on the basis of percentage of completion in respect of each element
of cost. Students may refer the ‘Chapter- Process & Operation Costing’ to
know the WIP valuation methods.
(iii) Quality Control Cost: This is the cost of resources consumed towards
quality control procedures.
(iv) Research & Development Cost: It includes only those research and
development related cost which is incurred for the improvement of process,
system, product or services.
(v) Administrative Overheads: It includes only those administration overheads

which are related to production. The general administration overhead is
not included in production cost.
(vi) Credit for Recoveries: The realised or realisable value of scrap or waste is
deducted as it reduces the cost of production.
(vii) Packing Cost (primary): Packing material which is essential to hold and
preserve the product for its use by the customer.
(viii) Joint Products and By-Products: Joint costs are allocated between/among
the products on a rational and consistent basis. In case of by-products, the
net realisable value of by-products is deducted from the cost of production.
3.3 Cost of Goods Sold

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

It is the total cost of a product incurred to make the product available to the
customer or consumer. It includes Cost of goods sold, administration and
marketing expenses. It is calculated as below:
COST SHEET 6.7 a
Cost of Goods Sold xxx
Add: Administrative Overheads (General) xxx
Add: Selling Overheads xxx
Add: Packing Cost (secondary) xxx
Add: Distribution Overheads xxx
Cost of Sales xxxx
(i) Administrative Overheads: It is the cost related with general

administration of the entity. It includes the followings:
(a) Depreciation and maintenance of, building, furniture etc. of corporate
or general management.
(b) Salary of administrative employees, accountants, directors, secretaries
etc.
(c) Rent, rates & taxes, insurance, lighting, office expenses etc.
(d) Indirect materials- printing and stationery, office supplies etc.
(e) Legal charges, audit fees, corporate office expenses like directors’
sitting fees, remuneration and commission, meeting expenses etc.
(ii) Selling Overheads: It is the cost related with sale of products or services.
It includes the following costs:
(a) Salary and wages related with sales department and employees
directly related with selling of goods.
(b) Rent, depreciation, maintenance and other cost related with sales
department.
(c) Cost of advertisement, maintenance of website for online sales,

market research etc.
(iii) Packing Cost (secondary): Packing material that enables to store,
transport, inform the customer, promote and otherwise make the product
marketable.
(iv) Distribution Overheads: It includes the cost related with making the
goods available to the customers. The costs are :
(a) Salary and wages of employees engaged in distribution of goods.

(b) Transportation and insurance costs related with distribution.
(c) Depreciation, hire charges, maintenance and other operating costs
related with distribution vehicles etc.
4. COST SHEET/STATEMENT
4.1 Presentation of Cost Information
The cost items in the cost statement shall be presented on ‘basis of relevant
classification’.
Specimen Format of Cost Sheet for a Manufacturing entity
Particulars Total Cost per

Cost (`) unit (`)
1. Direct materials consumed:
Opening Stock of Raw Material xxx
Add: Additions/ Purchases xxx
Less: Closing stock of Raw Material xxx
xxx
2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx
5. Add: Works/ Factory Overheads xxx
6. Gross Works Cost (4+5) xxx
7. Add: Opening Work in Process xxx
8. Less: Closing Work in Process (xxx)
9. Works/ Factory Cost (6+7-8) xxx
10. Add: Quality Control Cost xxx
11. Add: Research and Development Cost xxx
COST SHEET 6.9 a
12. Add: Administrative Overheads (relating to xxx

production activity)
13. Less: Credit for Recoveries/Scrap/By-Products/ (xxx)
misc. income
14. Add: Packing cost (primary) xxx
15. Cost of Production (9+10+11+12-13+14) xxx
16. Add: Opening stock of finished goods xxx
17. Less: Closing stock of finished goods (xxx)
18. Cost of Goods Sold (15+16-17) xxx
19. Add: Administrative Overheads (General) xxx
20. Add: Marketing Overheads :
Selling Overheads xxx
Distribution Overheads xxx
21. Cost of Sales (18+19+20) xxx
Cost sheet/statement for services is also prepared but the format and
presentation may differ as per the information requirement. Format and
presentation has been discussed in “Service Costing” chapter.
4.2 Treatment of various items of Cost in Cost

Sheet/Statement
(i) Abnormal costs: Any abnormal cost, where it is material and quantifiable,
shall not form part of cost of production or acquisition or supply of goods
or provision of service. Examples of abnormal costs are:
(a) Cost pertaining to or arising out of a pandemic e.g. COVID-19
(b) Cost associated with employees due to sudden lockdown.
(ii) Subsidy/Grant/Incentives: Any such type of payment received/ receivable

are reduced from the cost objects to which such amount pertains.
(iii) Penalty, fine, damages, and demurrage: These types of expenses are not
form part of cost.
(iv) Interest and other finance costs: Interest, including any payment in the
nature of interest for use of non-equity funds and incidental cost that an
entity incurs in arranging those funds. Interest and finance charges are not
included in cost of production. Interest and Financing Charges shall be
presented in the cost statement as a separate item of cost of sales.
4.3 Advantages of Cost Sheet or Cost Statements

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

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

Administration overheads (general) ` 35,000
Selling overheads (per unit) `5
Units produced 4,000
Units sold 3,600
Selling price per unit ` 125

COST SHEET 6.11 a
You are required to PREPARE a cost sheet in respect of the above showing:
(i) Cost per unit
(ii) Profit for the month
SOLUTION
(i) Cost Sheet Output: 4,000 units
Particulars Total Cost per

Cost (`) (unit) (`)
Raw materials 1,80,000 45.00
Direct wages 90,000 22.50
Prime cost 2,70,000 67.50
Add: Factory overheads (10,000 hrs × ` 8 per hour) 80,000 20.00
Cost of Production 3,50,000 87.50
Less: Closing Stock of finished goods (4,000 – (35,000) --

3,600 units)
Cost of Goods Sold 3,15,000 87.50
Add: Administration overheads (general) 35,000 9.72
Add: Selling Overheads (3,600 units × ` 5 unit) 18,000 5.00
Cost of sales (total Cost) 3,68,000 102.22

(ii) Statement of Profit
Particulars Total Cost (`)
Sales revenue (3,600 units @ ` 125) 4,50,000
Less: Cost of sales 3,68,000
Profit 82,000
ILLUSTRATION 2
The following information has been obtained from the records of ABC
Corporation for the period from June 1 to June 30.
On June 1 On June 30
(`) (`)
Cost of raw materials 60,000 50,000
Cost of work-in-process 12,000 15,000
Cost of stock of finished goods 90,000 1,10,000
Purchase of raw materials during June 2020 4,80,000
Wages paid 2,40,000
Factory overheads 1,00,000
Administration overheads (related to 50,000

production)
Selling & distribution overheads 25,000
Sales 10,00,000
PREPARE a statement giving the following information:

(a) Raw materials consumed;
(b) Prime cost;
(c) Factory cost;
(d) Cost of goods sold; and
(e) Net profit.
COST SHEET 6.13 a
SOLUTION
Statement of Cost & Profit
(for the month of June)
(`)
Opening stock of raw materials 60,000
Add: Purchase of raw materials during the month of June 4,80,000
Less: Closing stock of raw materials (50,000)
(a) Raw materials consumed 4,90,000
Add: Direct wages 2,40,000
(b) Prime cost 7,30,000
Add: Factory overheads 1,00,000
Works cost 8,30,000
Add: Opening work-in-process 12,000
Less: Closing work-in-process (15,000)
(c) Factory cost 8,27,000
Add: Administration overheads 50,000
Cost of production 8,77,000
Add: Opening stock of finished goods 90,000
Less: Closing stock of finished goods (1,10,000)
(d) Cost of goods sold 8,57,000
Add: Selling & distribution overheads 25,000
Cost of sales 8,82,000
(e) Net Profit 1,18,000
Sales 10,00,000
ILLUSTRATION 3
Arnav Inspat Udyog Ltd. has the following expenditures for the year ended 31st
March 2023:
Sl. (` ) (` )
No.
(i) Raw materials purchased 10,00,00,000
(ii) GST paid on the above purchases @18% 1,80,00,000

(eligible for input tax credit)
(iii) Freight inwards 11,20,600
(iv) Wages paid to factory workers 29,20,000
(v) Contribution made towards employees’

PF & ESIS 3,60,000
(vi) Production bonus paid to factory workers 2,90,000
(vii) Royalty paid for production 1,72,600
(viii) Amount paid for power & fuel 4,62,000
(ix) Amount paid for purchase of moulds and

patterns (life is equivalent to two years
production) 8,96,000
(x) Job charges paid to job workers 8,12,000
(xi) Stores and spares consumed 1,12,000
(xii) Depreciation on:
Factory building 84,000
Office building 56,000
Plant & Machinery 1,26,000
Delivery vehicles 86,000 3,52,000

COST SHEET 6.15 a
(xiii) Salary paid to supervisors 1,26,000
(xiv) Repairs & Maintenance paid for:

Plant & Machinery 48,000
Sales office building 18,000
Vehicles used by directors 19,600 85,600
(xv) Insurance premium paid for:
Plant & Machinery 31,200
Factory building 18,100
Stock of raw materials & WIP 36,000 85,300
(xvi) Expenses paid for quality control check

activities 19,600
(xvii) Salary paid to quality control staffs 96,200
(xviii) Research & development cost paid for

improvement in production process 18,200
(xix) Expenses paid for pollution control and

engineering & maintenance 26,600
(xx) Expenses paid for administration of

factory work 1,18,600
(xxi) Salary paid to functional mangers:
Production control 9,60,000
Finance & Accounts 9,18,000
Sales & Marketing 10,12,000 28,90,000
(xxii) Salary paid to General Manager 12,56,000
(xxiii) Packing cost paid for:
Primary packing necessary to maintain

quality 96,000
For re-distribution of finished goods 1,12,000 2,08,000

(xxiv) Interest and finance charges paid (for

usage of non- equity fund) 7,20,000
(xxv) Fee paid to auditors 1,80,000
(xxvi) Fee paid to legal advisors 1,20,000
(xxvii) Fee paid to independent directors 2,20,000
(xxviii) Performance bonus paid to sales staffs 1,80,000
(xxix) Value of stock as on 1st April, 2022:
Raw materials 18,00,000
Work-in-process 9,20,000
Finished goods 11,00,000 38,20,000
(xxx) Value of stock as on 31st March, 2023:
Raw materials 9,60,000
Work-in-process 8,70,000
Finished goods 18,00,000 36,30,000
Amount realized by selling of scrap and waste generated during manufacturing

process – ` 86,000/-
From the above data you are required to PREPARE Statement of cost for Arnav Ispat
Udyog Ltd. for the year ended 31st March, 2023, showing (i) Prime cost, (ii) Factory
cost, (iii) Cost of Production, (iv) Cost of goods sold and (v) Cost of sales.
SOLUTION
Statement of Cost of Arnav Ispat Udyog Ltd. for the year ended 31st March,
2023:
Sl. Particulars (`) (`)

No.
(i) Material Consumed:
Raw materials purchased 10,00,00,000
Freight inwards 11,20,600
Add: Opening stock of raw materials 18,00,000
Less: Closing stock of raw materials (9,60,000) 10,19,60,600
COST SHEET 6.17 a
(ii) Direct employee (labour) cost:

Wages paid to factory workers 29,20,000
Contribution made towards employees’ PF
& ESIS 3,60,000
Production bonus paid to factory workers 2,90,000 35,70,000
(iii) Direct expenses:
Royalty paid for production 1,72,600
Amount paid for power & fuel 4,62,000
Amortised cost of moulds and patterns 4,48,000
Job charges paid to job workers 8,12,000 18,94,600
Prime Cost 10,74,25,200
(iv) Works/ Factory overheads:
Stores and spares consumed 1,12,000
Depreciation on factory building 84,000
Depreciation on plant & machinery 1,26,000
Repairs & Maintenance paid for plant &
machinery 48,000
Insurance premium paid for plant &
machinery 31,200
Insurance premium paid for factory
building 18,100
Insurance premium paid for stock of raw
materials & WIP 36,000
Salary paid to supervisors 1,26,000
Expenses paid for pollution control and
engineering & maintenance 26,600 6,07,900
Gross factory cost 10,80,33,100
Add: Opening value of W-I-P 9,20,000
Less: Closing value of W-I-P (8,70,000)
Factory Cost 10,80,83,100
(v) Quality control cost:

Expenses paid for quality control check
activities 19,600
Salary paid to quality control staffs 96,200 1,15,800
(vi) Research & development cost paid for
improvement in production process 18,200
(vii) Administration cost related with
production:
-Expenses paid for administration of
factory work 1,18,600
-Salary paid to Production control manager 9,60,000 10,78,600
(viii) Less: Realisable value on sale of scrap and
waste (86,000)
(ix) Add: Primary packing cost 96,000
Cost of Production 10,93,05,700
Add: Opening stock of finished goods 11,00,000
Less: Closing stock of finished goods (18,00,000)
Cost of Goods Sold 10,86,05,700
(x) Administrative overheads:
Depreciation on office building 56,000
Repairs & Maintenance paid for vehicles
used by directors 19,600
Salary paid to Manager- Finance &
Accounts 9,18,000
Salary paid to General Manager 12,56,000
Fee paid to auditors 1,80,000
Fee paid to legal advisors 1,20,000
Fee paid to independent directors 2,20,000 27,69,600
COST SHEET 6.19 a
(xi) Selling overheads:

Repairs & Maintenance paid for sales office
building 18,000
Salary paid to Manager- Sales & Marketing 10,12,000
Performance bonus paid to sales staffs 1,80,000 12,10,000
(xii) Distribution overheads:
Depreciation on delivery vehicles 86,000
(xiii) Packing cost paid for re-distribution of
finished goods 1,12,000 1,98,000
(xiv) Interest and finance charges paid 7,20,000
Cost of Sales 11,35,03,300
Note:
GST paid on purchase of raw materials would not be part of cost of materials as it
is eligible for input tax credit.
SUMMARY
 Cost Sheet: A Cost Sheet or Cost Statement is “a document which provides a
detailed cost information. In a typical cost sheet, cost information are
presented on the basis of functional classification. However, other classification
may also be adopted as per the requirements of users of the information.
 Direct Expenses: Expenses other than direct material cost and direct
employee cost, which are incurred to manufacture a product or for
provision of service and can be directly traced in an economically feasible
manner to a cost object.
 Prime Cost: Prime cost represents the total of direct materials costs, direct
employee (labour) costs and direct expenses.
 Cost of Production: Cost of production consists of cost of materials
consumed, direct employee (labour) costs, direct expenses, production
overheads, quality control costs, primary packing cost, R&D and
administration cost relating to production.
 Primary Packing Cost: Cost incurred on packing materials which are

essential to hold and preserve the product for further processing or its use
by consumer.
 Secondary Packing Cost: Cost incurred on packing materials which is used
to store, transport, and promote the product.
 Cost of Goods Sold: Cost of production adjusted with opening and closing
inventories of finished goods.
 Administrative overheads: Cost incurred of all activities relating to general
management and administration of an entity.
 Marketing overheads: Marketing overheads comprise of selling overheads
and distribution overheads.
 Selling Overheads: Expenses related to sale of products or services.
 Distribution overheads: Costs incurred in handling a product or service
from the time it is ready to dispatch or delivery until it reaches the ultimate
consumer.
 Cost of Sales: It is the total cost of a product incurred to make the product
available to the customer or consumer. It is the aggregate of cost of goods
sold, administrative costs, marketing costs and other separate line items of
cost which could not form part of cost of production.
TEST YOUR KNOWLEDGE

1. Generally, for the purpose of cost sheet preparation, costs are classified on the
basis of:
(a) Functions
(b) Variability
(c) Relevance
(d) Nature
COST SHEET 6.21 a
2. Which of the following does not form part of prime cost:

(a) Cost of packing
(b) Cost of transportation paid to bring materials to factory
(c) GST paid on raw materials (input credit cannot be claimed)
(d) Overtime premium paid to workers.
3. A Ltd. received an order, for which it purchased a special frame for
manufacturing, it is a part of:
(a) Direct Materials
(b) Direct expenses

(c) Factory Overheads
(d) Administration Overheads
4. Salary paid to plant supervisor is a part of
(a) Direct expenses
(b) Factory overheads
(c) Quality control cost
(d) Administration cost
5. Depreciation of director’s laptop is treated as a part of:
(a) Administration Overheads
(b) Factory Overheads
(c) Direct Expenses
(d) Research & Development cost.

6. A manufacture has set-up a lab for testing of products for compliance with
standards, salary of this lab staffs are part of:
(a) Works overheads

(b) Quality Control Cost
(c) Direct Expenses
(d) Research & Development Cost.

7. Audit fees paid to auditors is part of:

(a) Administration Cost
(b) Production cost
(c) Selling & Distribution cost
(d) Not shown in cost sheet.
8. Salary paid to factory store staff is part of:
(a) Factory overheads
(b) Production Cost
(c) Direct Employee cost

(d) Direct Material Cost.
9. Canteen expenses for factory workers are part of:
(a) Factory overhead
(b) Administration Cost
(c) Marketing cost
(d) None of the above.
10. A company pays royalty to State Government on the basis of production, it is
treated as:
(a) Direct Material Cost
(b) Factory Overheads
(c) Direct Expenses
(d) Administration cost.
1. DESCRIBE how costs are classified on the basis of function.
2. EXPLAIN the treatment of administration overheads.
3. STATE the advantages of a cost sheet.
COST SHEET 6.23 a
Practical Problems
1. The books of Adarsh Manufacturing Company present the following data for
the month of April:
Direct labour cost ` 17,500 being 175% of works overheads.
Cost of goods sold excluding administrative expenses ` 56,000.
Inventory accounts showed the following opening and closing balances:
April 1 (`) April 30 (`)

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

(i) FIND out the value of materials purchased.
(ii) PREPARE a cost statement showing the various elements of cost and
also the profit earned.
2. From the following particulars, you are required to PREPARE monthly cost
sheet of Aditya Industries:
(` )
Opening Inventories:
- Raw materials 12,00,000
- Work-in-process 18,00,000
- Finished goods (10,000 units) 9,60,000
Closing Inventories:
- Raw materials 14,00,000
- Work-in-process 16,04,000
- Finished goods ?
GST paid on raw materials purchased (ITC 7,20,000
available)
Wages paid to production workers 36,64,000
Expenses paid for utilities 1,45,600
Office and administration expenses paid 26,52,000
Travelling allowance paid to office staffs 1,21,000
Selling expenses 6,46,000
Machine hours worked- 21,600 hours

Machine hour rate- ` 8.00 per hour
Units sold- 1,60,000
Units produced- 1,94,000
Desired profit- 15% on sales

3. A Ltd. Co. has capacity to produce 1,00,000 units of a product every month. Its
works cost at varying levels of production is as under:
Level Works cost per unit ( `)

10% 400
20% 390
30% 380
40% 370
50% 360
60% 350
70% 340
80% 330
90% 320
100% 310
COST SHEET 6.25 a
Its fixed administration expenses amount to `1,50,000 and fixed marketing

expenses amount to `2,50,000 per month respectively. The variable
distribution cost amounts to ` 30 per unit.
It can sell 100% of its output at `500 per unit provided it incurs the following
further expenditure:
(a) it gives gift items costing ` 30 per unit of sale;

(b) it has lucky draws every month giving the first prize of ` 50,000; 2nd
prize of ` 25,000, 3rd prize of ` 10,000 and three consolation prizes of `
5,000 each to customers buying the product.
(c) it spends `1,00,000 on refreshments served every month to its
customers;
(d) it sponsors a television programme every week at a cost of ` 20,00,000
per month.
It can market 30% of its output at `550 per unit without incurring any of the
expenses referred to in (a) to (d) above.
PREPARE a cost sheet for the month showing total cost and profit at 30% and
100% capacity level.
4. The following figures are extracted from the Trial Balance of G.K Co. on 31 st
March:
Dr. Cr.
(`) (`)
Inventories:
Finished Stock 80,000
Raw Materials 1,40,000
Work-in-Process 2,00,000
Office Appliances 17,400
Plant & Machinery 4,60,500
Building 2,00,000
Sales 7,68,000
Sales Return and Rebates 14,000
Materials Purchased 3,20,000
Freight incurred on Materials 16,000
Purchase Returns 4,800
Direct employee cost 1,60,000
Indirect employee cost 18,000
Factory Supervision 10,000
Repairs and factory up-keeping expenses 14,000
Heat, Light and Power 65,000
Rates and Taxes 6,300
Miscellaneous Factory Expenses 18,700
Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Office Salaries and Expenses 8,600
Interest on Borrowed Funds 2,000
Further details are available as follows:
(i) Closing Inventories:

Finished Goods 1,15,000
Raw Materials 1,80,000
(ii) Outstanding expenses on:
Direct employee cost 8,000
Indirect employee cost 1,200
Interest on Borrowed Funds 2,000
COST SHEET 6.27 a
(iii) Depreciation to be provided on:

Office Appliances 5%
Plant and Machinery 10%
Buildings 4%
(iv) Distribution of the following costs:
Heat, Light and Power to Factory, Office and Distribution in the ratio
8 : 1 : 1.
Rates and Taxes two-thirds to Factory and one-third to Office.
Depreciation on Buildings to Factory, Office and Selling in the ratio

8 : 1 : 1.
With the help of the above information, you are required to PREPARE a
condensed Profit and Loss Statement of G.K Co. for the year ended 31 st March
along with supporting schedules of:
(i) Cost of Sales.
(ii) Selling and Distribution Expenses.
(iii) Administration Expenses
ANSWERS
Answers to the MCQs
1. (a) 2. (a) 3. (b) 4. (b) 5. (a) 6. (b)
7. (a) 8. (a) 9. (a) 10. (c)


1. (i) Computation of the value of materials purchased
To find out the value of materials purchased, reverse calculations from
the given data can be presented as below:
Particulars (`)
Cost of goods sold 56,000
Add: Closing stock of finished goods 19,000
Less: Opening stock of finished goods (17,600)
Cost of production 57,400
Add: Closing stock of work-in-progress 14,500
Less: Opening stock of work-in-progress (10,500)
Works cost 61,400
 `17,500 100  (10,000)

Less: Factory overheads:  
 175 
Prime cost 51,400
Less: Direct labour (17,500)
Raw material consumed 33,900
Add: Closing stock of raw materials 10,600
Raw materials available 44,500
Less: Opening stock of raw materials ( 8,000)
Value of materials purchased 36,500

COST SHEET 6.29 a
(ii) Cost statement
(`)
Raw material consumed [Refer to statement (i) above] 33,900
Add: Direct labour cost 17,500
Prime cost 51,400
Add: Factory overheads 10,000
Works cost 61,400
Add: Opening work-in-progress 10,500
Less: Closing work-in-progress (14,500)
Cost of production 57,400
Add: Opening stock of finished goods 17,600
Less: Closing stock of finished goods (19,000)
Cost of goods sold 56,000
Add: General and administration expenses 2,500
Add: Selling expenses 3,500
Cost of sales 62,000
Profit (Balance figure ` 75,000 – ` 62,000) 13,000
Sales 75,000
2. Cost sheet of Aditya Industries for month of……

Units produced- 1,94,000
Units sold- 1,60,000
Particulars (`) Cost per unit (`)

Add: Opening value of raw materials 12,00,000
Less: Closing value of raw materials (14,00,000)
Materials consumed 1,42,00,000 73.19
Wages paid to production workers 36,64,000 18.89

Expenses paid for utilities 1,45,600 0.75
Prime Cost 1,80,09,600 92.83
Factory overheads (` 8 × 21,600 hours) 1,72,800
Add: Opening value of W-I-P 18,00,000
Less: Closing value of W-I-P (16,04,000)
Cost of Production 1,83,78,400 94.73
Add: Value of opening finished stock 9,60,000
Less: Value of closing finished stock (` (41,68,120)
94.73 × 44,000)
Cost of Goods Sold 1,51,70,280 94.81
Office and administration expenses 26,52,000 16.58
paid
Travelling allowance paid to office 1,21,000 0.75
staffs
Selling expenses 6,46,000 4.04
Cost of Sales 1,85,89,280 116.18
Add: Profit 32,80,461 20.50
2,18,69,741 136.68
3. Cost Sheet (For the month)
Level of Capacity 30% 100%

30,000 units 1,00,000 units
Per Total Per Total
unit (`) unit (`)
(`) (`)
Works Cost 380.00 1,14,00,000 310.00 3,10,00,000
Add: Fixed 5.00 1,50,000 1.50 1,50,000
administration
expenses
COST SHEET 6.31 a
Add: Fixed marketing 8.33 2,50,000 2.50 2,50,000

expenses
Add: Variable 30.00 9,00,000 30.00 30,00,000
distribution
cost
Add: Special Costs:
- Gift items costs — — 30.00 30,00,000
- Customers’ prizes* — — 1.00 1,00,000
- Refreshments — — 1.00 1,00,000
- Television
programme — — 20.00 20,00,000
sponsorship cost
Cost of sales 423.33 1,27,00,000 396.00 3,96,00,000
Profit (Balancing figure) 126.67 38,00,000 104.00 1,04,00,000
Sales revenue 550.00 1,65,00,000 500.00 5,00,00,000
*Customers’ prize cost:
Amount (`)
1 Prize
st
50,000
2nd Prize 25,000
3 Prize
rd
10,000
Consolation Prizes (3 × `5,000) 15,000
Total 1,00,000
4. Profit and Loss Statement of G.K Co.

for the year ended 31st March
(`) (`)
Gross Sales 7,68,000
Less: Returns and rebates (14,000) 7,54,000
Less: Cost of Sales (excluding interest on (7,14,020)
borrowed funds) [Refer to Schedule (i)]
Net Operating Profit 39,980
Less: Interest on borrowed funds (4,000)
(2,000+2,000)
Net Profit 35,980
(i) Schedule of Cost of Sales
(`) (`)
Raw Material (Inventory opening balance) 1,40,000
Add: Material Purchased 3,20,000
Add: Freight on Material 16,000
Less: Purchase Returns (4,800) 3,31,200
4,71,200
Less: Closing Raw Material Inventory (1,80,000)
Materials consumed in Production 2,91,200
Direct employee cost (`1,60,000 + `8,000) 1,68,000
Prime Cost 4,59,200
Factory Overheads:
Indirect employee cost (`18,000 + `1,200) 19,200
Factory Supervision 10,000
Repairs and factory up-keeping expenses 14,000
Heat, Light and Power (`65,000 × 8/10) 52,000
Rates and Taxes (`6,300 × 2/3 rd) 4,200
Miscellaneous Factory Expenses 18,700
Depreciation of Plant (10% of `4,60,500) 46,050
Depreciation of Buildings (4% of `2,00,000 × 6,400 1,70,550

8/10)
Gross Works Cost 6,29,750
Add: Opening Work-in-Process inventory 2,00,000
Less: Closing Work-in-Process inventory (1,92,000)
Cost of production 6,37,750

COST SHEET 6.33 a
Add: Opening Finished Goods inventory 80,000

Less: Closing Finished Goods inventory (1,15,000)
Cost of Goods Sold 6,02,750
Add: Administration Expenses [See 18,870
Schedule (iii)]
Add: Selling and Distribution Expenses 92,400
[See Schedule (ii)]
Cost of Sales (excluding interest on 7,14,020
borrowed funds)
Alternatively, Interest on borrowed funds of ` 4,000 (` 2,000 + ` 2,000)

may be added to arrive at cost of sales.
(ii) Schedule of Selling and Distribution Expenses
(`)
Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Depreciation of Buildings 800
92,400
(iii) Schedule of Administration Expenses
(`)
Office Salaries and Expenses 8,600
Depreciation of Office Appliances 870
Depreciation of Buildings 800
Rates and Taxes 2,100
18,870
CHAPTER a
7
COST ACCOUNTING
SYSTEMS
LEARNING OUTCOMES
 Discuss the Cost Accounting System.
 Differentiate between Integral and Non-Integral System of
Accounting.
 Identify the ledgers maintained under Integral and Non-
Integral Accounting System.
 Analyse the reasons for differences in profit under Financial
and Cost Accounting Systems.
 Prepare reconciliation statement for profit under Financial
and Cost Accounting Systems.
 Discuss the Accounting for Management Information and
Cost Control.

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

It is a system of accounting under which separate ledgers are maintained for both
cost and financial accounts. This system is also known as cost ledger accounting
system. Under this system the cost accounts restrict itself to recording only those
transactions which relate to the product or service being supplied. Items of
expenses which are related to sales, production or other matters of factory
management are the ones dealt with in such accounts. This leads to the exclusion
of certain expenses like interest, bad debts and revenue/income from ‘other than

COST ACCOUNTING SYSTEMS 7.3 a
the sale of product or service’.
Non-Integrated accounting systems contain fewer accounts as compared to

financial accounting system due to the exclusion of purchases, expenses and also
Balance Sheet items like fixed assets, debtors and creditors. Items of accounts
which are excluded are represented by an account known as Cost ledger
control account.
The important ledgers to be maintained under non-integrated accounting
system in the Cost Accounting are the followings:
(a) Cost Ledger - This is the principle ledger of the cost department in which
impersonal accounts are recorded. This ledger is made self-balancing by
maintaining therein a Control Account for each subsidiary ledger.
(b) Stores Ledger - It contains an account for each item of stores. The entries in
each account maintained in this ledger are made from the invoice, goods
received note, material requisitions, material received note etc. Accounts in
respect of each item of stores show receipt, issue and balance in physical as well
as in monetary terms.
(c) Work-in-Process Ledger - This ledger is also known as job ledger, it
contains accounts of unfinished jobs and processes. All material costs,
wages and overheads for each job in process are posted to the respective
job accounts in this ledger. The balance in a job account represents total
balance of job/work-in-process, as shown by the job account.
(d) Finished Goods Ledger - It contains an account for each item of finished
product manufactured or the completed job. If the finished product is
transferred to stock, a credit entry is made in the work-in-process ledger
and a corresponding debit entry is made in this ledger.
2.1 Principal Accounts

The main accounts which are usually prepared when a separate Cost Ledger is
maintained are as follows:
(1) Cost Ledger Control Account - This account is also known as General
Ledger Adjustment Account. This account is made to complete double
entry. All items of expenditure are credited to this account. Sales are
debited to this account and net profit/loss from Costing Profit & Loss

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

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

The difference between administrative overheads incurred and recovered is

transferred to Overhead Adjustment Account.
(7) Finished Goods Control Accounts - This account is debited with the value
of goods transferred from Work-in-process Control Account and
administration costs recovered (if relates to production activities). This
account is credited with Cost of Sales Account. The balance of this account
represents the value of goods unsold at the end of the period.
(8) Selling and Distribution Overhead Control Account - This account is debited
with selling and distribution overheads incurred and credited with the selling and
distribution overheads recovered. The difference between overheads incurred and
recovered is transferred usually to Overhead Adjustment Account.
(9) Cost of Sales Account - This account is debited with the cost of finished
goods transferred from Finished Goods Control Account for sale,
General Administrative overhead recovered, Selling and distribution
overhead recovered. The balance of this account is ultimately transferred to
Sales Account or Costing Profit & Loss Account.
(10) Costing Profit & Loss Account – This account is debited with cost of sales,
under-absorbed overheads and abnormal losses and is credited with sales
value, over-absorbed overhead and abnormal gains. The net profit or loss in
this account is transferred to Cost Ledger Control Account.
(11) Overhead Adjustment Account - This account is to be debited for under-
recovery of overhead and credited with over-recovery of overhead
amount. The net balance in this account is transferred to Costing Profit &
Loss Account.
Note: Sometimes, Overhead Adjustment Account is dispensed with and

under/over absorbed overheads is directly transferred to Costing Profit & Loss
Account from the respective overhead accounts.
2.2 Scheme of Accounting Entries

The manner in which the Cost Ledger, when maintained on a double entry basis,
would operate is illustrated by the following statements of various journal entries
as would appear in the cost books.

Material: (`) (`)

(a) Purchase–` 5,000 (credit or cash)
(i) Material Control A/c …………………………….. Dr. 5,000
To Cost Ledger Control A/c 5,000
(ii) Stores Ledger Control A/c ……………………… Dr. 5,000
To Material Control A/c 5,000
Note: Sometimes Material Control Account is dispensed with and entries are
directly made into Stores Ledger Control A/c, giving a credit to Cost Ledger
Control A/c.
(b) Purchases worth ` 500 for special job
Work-in-Process Ledger Control A/c…………………. Dr. 500
To Cost Ledger Control A/c 500
(c) Material returned to vendor—` 500
Cost Ledger Control A/c …………………………………. Dr. 500
To Store Ledger Control A/c 500
(d) (i) Material (Direct) issued to production—` 1,000
Work-in-Process Control A/c……………………. Dr. 1,000
To Store Ledger Control A/c 1,000
(ii) Material (Indirect) issued to production—` 200
Production Overhead Control A/c…………………. Dr. 200
To Store Ledger Control A/c 200
(e) (i) Material worth ` 200 returned from shop to
stores
Stores Ledger Control A/c…………………. Dr. 200
To Work-in-Process Control A/c 200
(ii) Material worth ` 100 is transferred from Job-1 to Job- 2
Job- 2 A/c………………………………………… Dr. 100
To Job- 1 A/c 100

(f) Material worth ` 100 is issued from stores for re-

pairs
Production Overhead Control A/c………………………. Dr. 100
To Stores Ledger Control A/c 100
Labour:
(g) Direct wages paid to workers— ` 1,000
Wages Control A/c………………………………………… Dr. 1,000
(h) Indirect wages paid to workers in the production— ` 700
(i) Wages Control A/c……………………………………… Dr. 700
(ii) Production Overhead Control A/c…………………… Dr. 700
To Wages Control A/c 700
(i) Indirect wages paid to workers in administration— ` 500
(ii) Administration Overhead A/c………………………… Dr. 500
(j) Indirect wages paid to workers in Selling & Dist. department— ` 300
(ii) Selling & Dist. Overhead A/c…………………………. Dr. 300
Direct Expenses:
(k) Direct expenses incurred ` 500 for Job No. 12
Job No. 12 A/c (WIP Control A/c)………………………. Dr. 500

Overheads:
(l) Overhead expenses incurred ` 500 (Production
`150; Administrative `150; Selling and Distribution
`200)
Production Overhead Control A/c……………………….. Dr. 150
Administrative Overhead Control A/c…………………… Dr. 150
Selling & Dist. Overhead Control A/c…………………… Dr. 200
(m) Carriage Inward (Direct to Factory) —` 100
Production Overhead Control A/c……………………….. Dr. 100
(n) Production overhead recovered—` 1,000
Work-in-Process Ledger Control A/c…………………... Dr. 1,000
To Production Overhead Control A/c 1,000
(o) Administrative Overhead recovered ` 500 from finished goods
Cost of Sales A/c………………………………………….. Dr. 500
To Administrative Overhead Control A/c 500
(p) Selling and Distribution Overhead ` 100 recovered from sales
Cost of Sales A/c………………………………………….. Dr. 100
To Selling & Dist. Overhead Control A/c 100
(q) Under recovery of overheads
Costing Profit & Loss A/c…………………………………. Dr. xxx
To Administrative Overhead Control A/c xxx
(r) Over recovery of overheads
Production Overheads Control A/c…………………….. Dr. xxx
To Costing Profit & Loss A/c xxx

Sales:
(s) Cost Ledger Control A/c………………………………….. Dr. xxx
Profit/ Loss:
(t) In case of Profit
(i) Costing Profit & Loss A/c…………………………… Dr. xxx
To Cost Ledger Control A/c xxx
(u) In case of Loss
(ii) Cost Ledger Control A/c…………………………… Dr. xxx
Non-Integrated Accounting System-flowchart
*In the diagram administrative overhead is assumed to be related with production

activity. In case of general administration expenses, it is treated as a part of Cost of
Sales.

ILLUSTRATION 1
As on 31st March, the following balances existed in a firm’s Cost Ledger:
Dr. Cr.
(` ) (` )
Stores Ledger Control A/c 3,01,435
Work-in-Process Control A/c 1,22,365
Finished Stock Ledger Control A/c 2,51,945
Manufacturing Overhead Control A/c 10,525
Cost Ledger Control A/c 6,65,220
6,75,745 6,75,745
During the next three months the following items arose:
(` )
Finished product (at cost) 2,10,835
Manufacturing Overhead incurred 91,510
Raw Materials purchased 1,23,000
Factory Wages 50,530
Indirect Labour 21,665
Cost of Sales 1,85,890
Material issued to production 1,27,315
Sales returned at Cost 5,380
Material returned to suppliers 2,900
Manufacturing Overhead charged to production 77,200
You are required to PASS the Journal Entries; write up the accounts and schedule
the balances, stating what each balance represents.

SOLUTION
Journal entries are as follows:
Dr. Cr.
(`) (`)
1. Finished stock ledger Control A/c Dr. 2,10,835
To Work-in-Process Control A/c 2,10,835
2. Manufacturing Overhead Control A/c Dr. 91,510
3. Stores Ledger Control A/c Dr. 1,23,000
To Cost Ledger Control A/c 1,23,000
4. (i) Wage Control A/c Dr. 72,195
(ii) Work-in-Process Control A/c Dr. 50,530
To Wages Control A/c 50,530
(iii) Manufacturing Overhead Control A/c Dr. 21,665

5. Cost of Sales A/c Dr. 1,85,890
To Finished Stock Ledger A/c 1,85,890
6. Work-in-Process Control A/c Dr. 1,27,315
To Stores Ledger Control A/c 1,27,315
7. Finished Stock Ledger Control A/c Dr. 5,380
To Cost of Sales A/c 5,380
8. Cost Ledger Control A/c Dr. 2,900
To Stores Ledger Control A/c 2,900
9. Work-in-Process Control A/c Dr. 77,200
To Manufacturing Overhead Control A/c 77,200

COST LEDGERS
Cost Ledger Control Account
Particulars (`) Particulars (`)
To Stores Ledger Control By Balance b/d 6,65,220

A/c (return) 2,900
” Balance c/d 9,49,025 ” Manufacturing OH

Control A/c 91,510
” Stores Ledger Control

A/c 1,23,000
” Wages Control A/c 72,195
9,51,925 9,51,925
Stores Ledger Control Account
To Balance b/d 3,01,435 By Work in Process Control 1,27,315

A/c
” Cost Ledger Control A/c 1,23,000 ” Cost Ledger Control A/c 2,900
” Balance c/d 2,94,220
4,24,435 4,24,435
Wages Control Account
To Cost Ledger Control A/c 72,195 By Work in Process Control A/c 50,530
” Manufacturing OH Control 21,665

A/c
72,195 72,195

Manufacturing Overhead Control Account
To Cost Ledger Control A/c 91,510 By Balance b/d 10,525
” Wages Control A/c 21,665 ” Work in Process Control 77,200

A/c
” Balance c/d 25,450
1,13,175 1,13,175
Work-in-Process Control Account
To Balance b/d 1,22,365 By Finished Stock Ledger 2,10,835

Control A/c
” Wages Control A/c 50,530 ” Balance c/d 1,66,575
” Stores Ledger Control

A/c 1,27,315
” Manufacturing OH
Control A/c 77,200
3,77,410 3,77,410
Finished Stock Ledger Control Account
To Balance b/d 2,51,945 By Cost of Sales Control A/c 1,85,890
” Work in Process ” Balance c/d 2,82,270

Control A/c 2,10,835
” Cost of Sales Control

A/c (Return at cost) 5,380
4,68,160 4,68,160

Cost of Sales Account

To Finished Stock Ledger By Finished Stock Ledger
Control 1,85,890 Control (Return) 5,380
” Balance c/d 1,80,510
1,85,890 1,85,890
Trial Balance
Particulars Dr. Cr.

(`) (`)
Stores Ledger Control A/c 2,94,220
Work-in-Process Control A/c 1,66,575
Finished Stock Ledger Control A/c 2,82,270
Manufacturing Overhead Control A/c 25,450
Cost of Sales A/c 1,80,510
9,49,025 9,49,025
ILLUSTRATION 2
Acme Manufacturing Co. Ltd. opens the costing records, with the balances as on 1st
July as follows:
(`) (`)
Material Control A/c 1,24,000
Work-in-Process Control A/c 62,500
Finished Goods Control A/c 1,24,000
Production Overhead Control A/c 8,400
Administrative Overhead Control A/c 12,000
Selling & Distribution Overhead Control A/c 6,250
3,25,150 3,25,150

The following are the transactions for the quarter ended 30th September :
(`)
Materials purchased 4,80,100
Materials issued to jobs 4,77,400
Materials to works maintenance 41,200
Materials to administrative office 3,400
Materials to sales department 7,200
Wages Direct 1,49,300
Wages Indirect 65,000
Transportation for Indirect Materials 8,400
Production Overheads incurred 2,42,250
Absorbed Production Overheads 3,59,100
Administrative Overheads incurred 74,000
Administrative Overheads allocated to production 52,900
Administrative Overheads allocated to sales department 14,800
Selling & Distribution overheads incurred 64,200
Selling & Distribution overheads absorbed 82,000
Finished goods produced 9,58,400
Finished goods sold 9,77,300
Sales 14,43,000
Make up the various accounts as you envisage in the Cost Ledger and PREPARE a
Trial Balance as at 30th September.

SOLUTION
Cost Ledgers
Material Control A/c*

To Balance b/d 1,24,000 By Work-in-process Control 4,77,400
A/c
” Cost Ledger Control 4,80,100 ” Production OH Control 41,200
A/c (purchase) A/c
” Admn. OH Control A/c 3,400
” S&D OH Control A/c 7,200
6,04,100 6,04,100
*Material Control A/c may also be written as Stores Ledger Control A/c
Wages Control A/c

To Cost Ledger Control 2,14,300 By Work-in-process Control 1,49,300
A/c A/c
” Production OH Control 65,000
A/c
2,14,300 2,14,300
Production Overhead Control A/c

To Balance b/d 8,400 By Work-in-process 3,59,100
Control A/c
” Cost Ledger Control
A/c:
- Transportation 8,400
- Production OH 2,42,250
” Material Control A/c 41,200 ” Balance c/d 6,150
3,65,250 3,65,250

Administrative Overhead Control A/c

To Cost Ledger Control 74,000 By Balance b/d 12,000
A/c
” Material Control A/c: 3,400 ” Finished Goods 52,900
Control A/c
” Balance c/d 2,300 ” Cost of sales A/c 14,800
79,700 79,700
Work-in-Process Control A/c

To Balance b/d 62,500 By Finished goods Control 9,58,400
A/c
” Material Control A/c 4,77,400
” Wages Control A/c 1,49,300
” Production OH 3,59,100
Control A/c
10,48,300 10,48,300
Finished Goods Control A/c

To Balance b/d 1,24,000 By Cost of Sales A/c 9,77,300
” Administrative 52,900
Overhead Control A/c
” Work-in-process 9,58,400 ” Balance c/d 1,58,000

Control A/c
11,35,300 11,35,300

Selling and Distribution Overhead Control A/c

To Balance b/d 6,250 By Cost of Sales A/c 82,000
” Cost Ledger Control 64,200
A/c:
” Material Control A/c 7,200
82,000 82,000
Cost of Sales A/c

To Finished Goods 9,77,300 By Costing P&L A/c 10,74,100
Control A/c
” Admn. OH Control 14,800
A/c
10,74,100 10,74,100
Cost Ledger Control A/c

To Costing P&L A/c (Sales) 14,43,000 By Balance b/d 3,13,150
” Material Control A/c 4,80,100
” Wages Control A/c 2,14,300
(`1,49,300+`65,000)
” Production OH Control A/c 2,50,650
(`8,400+`2,42,250)
” Administrative OH A/c 74,000
” Balance c/d 3,22,300 ” Costing P&L A/c 3,68,900
17,65,300 17,65,300

Costing Profit & Loss A/c

To Cost of sales A/c 10,74,100 By Cost Ledger Control 14,43,000
A/c (sales)
” Cost Ledger Control 3,68,900
A/c (profit) (balancing
figure)
14,43,000 14,43,000
Trial Balance as at 30th September
Dr. (`) Cr. (`)

Material Control A/c 74,900
Production OH Control A/c 6,150
Administrative OH Control A/c 2,300
Selling & Distribution OH Control A/c 4,350
Work-in-process Control A/c 89,900
Finished Goods Control A/c 1,58,000
3,28,950 3,28,950
3. INTEGRATED (OR INTEGRAL) ACCOUNTING

SYSTEM
Integrated Accounts is the name given to a system of accounting, whereby cost
and financial accounts are kept in the same set of books. Obviously, then
there will be no separate sets of books for Costing and Financial records.
Integrated accounts provide or meet out fully the information requirement for
Costing as well as for Financial Accounts. For Costing it provides information
useful for ascertaining the cost of each product, job, process and operation of any
other identifiable activity and for carrying necessary analysis. Integrated
accounts provide relevant information which is necessary for preparing
profit and loss account and the balance sheet as per the requirement of law
and also helps in exercising effective control over the liabilities and assets of its
business.

3.1 Advantages
The main advantages of Integrated Accounts are as follows:
(a) No need for Reconciliation- The question of reconciling costing profit and
financial profit does not arise, as there is only one figure of profit.
(b) Less efforts- Due to use of one set of books, there is a significant saving in
efforts made.
(c) Less time consuming- No delay is caused in obtaining information as it is

provided from books of original entry.
(d) Economical process- It is economical also as it is based on the concept of
“Centralisation of Accounting function”.
3.2 Essential pre-requisites for Integrated Accounts

The essential pre-requisites for integrated accounts include the following steps:
1. The management’s decision about the extent of integration of the two sets
of books. Some concerns find it useful to integrate up to the stage of prime
cost or factory cost while other prefers full integration of the entire
accounting records.
2. A suitable coding system must be made available so as to serve the
accounting purposes of financial and cost accounts.
3. An agreed routine, with regard to the treatment of provision for accruals,
prepaid expenses, other adjustment necessary for preparation of interim
accounts.
4. Perfect coordination should exist between the staff responsible for the
financial and cost aspects of the accounts and an efficient processing of
accounting documents should be ensured.
Under this system there is no need for a separate cost ledger. Of course, there will
be a number of subsidiary ledgers; in addition to the useful Customers’ Ledger
and the Purchase Ledger, there will be: (a) Stores Ledger; (b) Stock Ledger and (c)
Job Ledger.

3.3 Features of Integrated Accounting System

Following are the main points of integrated accounting:
(a) Complete analysis of cost and sales are kept.
(b) Complete details of all payments in cash are kept
(c) Complete details of all assets and liabilities are kept and this system does
not use a notional account to represent all impersonal accounts
In non-integrated system, a cost ledger control account or general ledger
adjustment account is used in cost ledger. But in the integrated accounting
system, general ledger adjustment account is eliminated and detailed accounts
for assets and liabilities are maintained. In other words, following accounts are
used for “General Ledger Adjustment Account/ Cost Ledger Control Account” of
non-integrated system:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account etc.

In integrated system, all accounts necessary for showing classification of cost will
be used but the cost ledger control account of non-integrated accounting is
replaced by use of following accounts:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account
(e) Fixed assets account
(f) Share capital account
If the illustration given below is to be worked out on integrated account basis, the
journal entries would be as follows:

ILLUSTRATION 3
JOURNALISE the following transactions assuming that cost and financial
transactions are integrated:
(`)
Raw materials purchased 2,00,000
Direct materials issued to production 1,50,000
Wages paid (30% indirect) 1,20,000
Wages charged to production 84,000
Manufacturing expenses incurred 84,000
Manufacturing overhead charged to production 92,000
Selling and Distribution costs 20,000
Finished products (at cost) 2,00,000
Sales 2,90,000
Closing stock Nil
Receipts from debtors 69,000
Payments to creditors 1,10,000
SOLUTION
Journal entries are as follows:
DR. (`) CR. (`)

Stores Ledger Control A/c……………………………… Dr. 2,00,000
To Payables (Creditors)/ Bank A/c 2,00,000
(Materials purchased)
Work-in-Process Control A/c…………………………… Dr. 1,50,000
(Materials issued to production)
Wages Control A/c………………………………………. Dr. 1,20,000
To Bank A/c 1,20,000
(Wages paid)

Factory Overhead Control A/c…………………………. Dr. 36,000

(30% of wages paid being indirect charged to
overhead)
Work-in-Process Control A/c…………………………… Dr. 84,000
(Direct wages charged to production)
Factory Overhead Control A/c………………………… Dr. 84,000
To Bank A/c 84,000
(Manufacturing overhead incurred)
Work-in-Process Control A/c…………………………… Dr. 92,000
To Factory Overhead Control A/c 92,000
(Manufacturing overhead charged to production)
Selling & Distribution Overhead Control A/c………. Dr. 20,000
To Bank A/c 20,000
(Selling and Distribution costs incurred)
Finished Goods Control A/c……………………………. Dr. 2,00,000
(Cost of finished goods)
Cost of Sales A/c………………………………………… Dr. 2,20,000
To Finished Goods Control A/c 2,00,000
To Selling and Distribution Control A/c 20,000
(Costs of sales)
Receivables (Debtors)/ Bank A/c…………………………… Dr. 2,90,000
To Sales A/c 2,90,000
(Finished goods sold)
Bank A/c…………………………………………………... Dr. 69,000
To Receivables (Debtors) A/c 69,000
(Receipts from receivables)
Payables (Creditors) A/c………………………………... Dr. 1,10,000
(Payment made to payables)

ILLUSTRATION 4
In the absence of the Chief Accountant, you have been asked to prepare a month’s
cost accounts for a company which operates a batch costing system fully integrated
with the financial accounts. The following relevant information is provided to you:
(`) (`)
Balances at the beginning of the month:
Stores Ledger Control Account 25,000
Work-in-Process Control Account 20,000
Finished Goods Control Account 35,000
Prepaid Production Overheads brought forward from 3,000
previous month
Transactions during the month:
Materials Purchased 75,000
Materials Issued:
To production 30,000
To factory maintenance 4,000 34,000
Materials transferred between batches 5,000
Total wages paid:
To direct workers 25,000
To indirect workers 5,000 30,000
Direct wages charged to batches 20,000
Recorded non-productive time of direct workers 5,000
Selling and Distribution Overheads Incurred 6,000
Other Production Overheads Incurred 12,000
Sales 1,00,000
Cost of Finished Goods Sold 80,000
Cost of Goods completed and transferred into finished 65,000
goods during the month
Physical value of work-in-Process at the end of the month 40,000

The production overhead absorption rate is 150% of direct wages charged to work-
in-Process.
Required:
PREPARE the following accounts for the month:
(a) Stores Ledger Control Account.
(b) Work-in-Process Control Account.
(c) Finished Goods Control Account.
(d) Production Overhead Control Account.

(e) Costing Profit and Loss Account.
SOLUTION
(a) Stores Ledger Control Account
(`) (`)
To Balance b/d 25,000 By Work in Process Control A/c 30,000
” Creditors/ Bank A/c 75,000 ” Production OH Control A/c 4,000
1,00,000 1,00,000
(b) Wages Control Account
(`) (`)
To Bank A/c (Paid to 25,000 By Work in Process Control A/c 20,000
direct workers) (Charged to batches)
” Bank A/c (Paid to 5,000 ,, Production OH Control A/c 5,000
indirect workers)
” Production OH Control A/c 5,000
(Non-productive wages)
30,000 30,000

(c) Production Overhead Control Account
(`) (`)
To Balance b/d 3,000 By Work-in-Process 30,000
(Prepaid amount) Control A/c (150% of
direct wages)
” Stores Ledger 4,000
Control A/c
” Wages Control 10,000
A/c
(`5,000 + `5,000)
” Bank A/c 12,000
” Costing P&L A/c 1,000

(Over-absorption,
balancing figure)
30,000 30,000
(d) Work-in-Process Control Account
(`) (`)
To Balance b/d 20,000 By Finished Goods 65,000

Control A/c
” Store Ledger Control A/c 30,000 ” Balance c/d 40,000

(Physical value)
” Production OH Control A/c 30,000

(150% of direct wages)
” Costing P&L A/c 5,000

(Stock Gains)
1,05,000 1,05,000

(e) Finished Goods Control Account
(`) (`)
To Balance b/d 35,000 By Cost of Goods Sold* A/c 80,000
” Work-in-Process 65,000 ” Balance c/d 20,000

Control A/c
1,00,000 1,00,000
* Alternatively, Costing Profit & Loss Account
(f) Costing Profit & Loss Account
(`) (`)
To Finished Goods 80,000 By Sales A/c 1,00,000

Control A/c or Cost
of Goods Sold A/c
” Selling & Distribution 6,000 ” Production OH 1,000

OH A/c Control A/c
” Balance c/d 20,000 ” Work-in-Process 5,000

Control A/c
(Stock gain)
1,06,000 1,06,000
Notes:
(1) Materials transferred between batches will not affect the Control
Accounts.
(2) Non-production time of direct workers is a production overhead and
therefore will not be charged to work-in-Process Control A/c.
(3) Production overheads absorbed in work-in-Process Control A/c equals
to ` 30,000 (150% of ` 20,000).
(4) In the work-in-Process Control A/c the excess physical value of stock
is taken resulting in stock gain. Stock gain is transferred to Profit &
Loss A/c.

ILLUSTRATION 5
A fire destroyed some accounting records of a company. You have been able to
collect the following from the spoilt papers/records and as a result of consultation
with accounting staff for the month of January:
(i) Incomplete Ledger Entries:
Materials Control A/c
(`) (`)
To Balance b/d 32,000
(`) (`)
To Balance b/d 9,200 By Finished Goods 1,51,000
Control A/c
Payables (Creditors) A/c
(`) (`)
To Balance c/d 19,200 By Balance b/d 16,400
Manufacturing Overheads Control A/c
(`) (`)
To Bank A/c (Amount 29,600
spent)
(`) (`)
To Balance b/d 24,000 By Balance c/d 30,000

(ii) Additional Information:

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

Cost Ledger Control A/c 32,000 control A/c 53,000
“ Payables (Creditors) A/c “ Balance c/d 71,000

(Purchases) 92,000
1,24,000 1,24,000
Manufacturing Overheads A/c
(`) (`)
To Bank A/c (amount 29,600 By Work-in-process

spent) control A/c (`4 × 7,000
hours) 28,000
“ Costing P/L A/c

(Under-absorbed OH) 1,600
29,600 29,600

(`) (`)
To Balance b/d 9,200 By Finished Goods Control 1,51,000
A/c
“ Wages Control A/c 70,000 “ Balance c/d:
(`10 × 7,000 hours)
“ Overheads Control A/c 28,000 -Material 5,000

(`4 × 7,000 hours)
-Wages (`10 × 3,000

300 hours)
“ Materials Control A/c 53,000 - Overheads (`4

(Balancing figure) × 300 hours) 1,200 9,200
1,60,200 1,60,200
(`) (`)
To Balance b/d 24,000 By Cost of sales A/c (Bal.
fig.) 1,45,000
“ Work-in-process “ Balance c/d 30,000
Control A/c (as above) 1,51,000
1,75,000 1,75,000
Payables (Creditors) A/c
(`) (`)
To Bank A/c 89,200 By Balance b/d 16,400
“ Balance c/d 19,200 “ Material Control
A/c (Purchases)
(Balancing fig.) 92,000
1,08,400 1,08,400

4. RECONCILIATION OF COST AND FINANCIAL

ACCOUNTS
When the cost and financial accounts are kept separately, it is imperative that
these should be reconciled to make the cost accounts reliable. It is necessary for
reconciliation of the two sets of accounts that sufficient details are available to
locate the differences and the reasons for the same. It is, therefore, important that
in the financial accounts, the expenses should be analysed in the same way as in
the cost accounts.
The General Ledger Adjustment Account in the Cost Ledger may be studied to
know the items which are included here and how differently these are presented
in the financial accounts. The reconciliation of the balances of two sets of
accounts is possible by preparing a Memorandum Reconciliation Account. In
this account, the items charged in one set of accounts but not in the other or
those charged in excess as compared to the other are identified and collected.
These items of differences are either added or subtracted from the profit as
shown by one of the accounts. Finally the profits from two sets of accounts are
reconciled. The procedure is similar to those which are followed for reconciling
bank balance as per bank ledger with the balance as shown in bank statement.
It is important, however, to know the causes which, generally, give rise to
differences in the Cost and Financial Accounts. These are briefly summarised
below:
4.1 Causes of differences in Financial and Cost Accounts

1. Items included in Financial Accounts only-
(a) Purely Financial Expenses:
(i) Interest on loans or bank mortgages.
(ii) Expenses and discounts on issue of shares, debentures etc.
(iii) Other capital losses i.e., loss by fire not covered by insurance etc.
(iv) Losses on the sales of fixed assets and investments
(v) Income tax, donations, subscriptions
(vi) Expenses of the company’s share transfer office, if any.

(b) Purely Financial Income

(i) Interest received on bank deposits, loans and investments
(ii) Dividends received

(iii) Profits on the sale of fixed assets and investments
(iv) Transfer fee received.
(v) Rent receivables

2. Item included in Cost Accounts only (notional expenses):
(i) Charges in lieu of rent where premises are owned
(ii) Interest on capital at notional figure though not incurred
(iii) Salary for the proprietor at notional figure though not incurred
(iv) Notional Depreciation on the assets fully depreciated for which book
value is nil.
3. Items whose treatment is different in the two sets of accounts: The

objective of cost accounting is to provide information to management for
decision making and control purposes while financial accounting conforms
to external reporting requirements. Hence there are chances that certain
items are treated differently in the two sets of accounts. For example, LIFO
method for inventory valuation is not recommended by Accounting
Standards for Financial Reporting purpose but this method may be adopted
for cost accounting purpose if management feels it suitable for making any
decision. Similarly cost accounting may use a different method of
depreciation than what is allowed under financial accounting.
4. Varying basis of valuation: It is another factor which sometimes is

responsible for the difference. It is well known that in financial accounts
stock are valued either at cost or market price, whichever is lower. But in
Cost Accounts, stocks are only valued at cost.

4.2 Procedure for Reconciliation

There are 3 steps involved in the procedure for reconciliation.
1. Ascertainment of profit as per Financial Accounts
2. Ascertainment of profit as per Cost Accounts
3. Reconciliation of both the profits
Circumstances where reconciliation statement can be avoided: When the Cost and
Financial Accounts are integrated - there is no need to have a separate reconciliation
statement between the two sets of accounts. Integration means that the same set of
accounts fulfil the requirement of both i.e., Cost and Financial Accounts.
ILLUSTRATION 6
The following figures are available from the financial records of ABC Manufacturing
Co. Ltd. for the year ended 31 st March.
(`)
Sales (20,000 units) 25,00,000
Materials 10,00,000
Wages 5,00,000
Factory Overheads 4,50,000
Administrative Overhead (production related) 2,60,000
Selling and Distribution Overheads 1,80,000
Finished goods (1,230 units) 1,50,000

(`) (`)
Work-in-Process:
Materials 30,000
Labour 20,000
Factory overheads 20,000 70,000
Goodwill written off 2,00,000
Interest on loan taken 20,000
In the Costing records, factory overhead is charged at 100% of wages,

administrative overhead 10% of factory cost and selling and distribution overhead
at the rate of ` 10 per unit sold.
PREPARE a statement reconciling the profit as per cost records with the profit as per
financial records.
SOLUTION
Profit & Loss Account of ABC Manufacturing Co. Ltd.
(for the year ended 31 st March)
(`) (`)
To Opening Stock - By Sales (20,000 units) 25,00,000
“ Materials 10,00,000 “ Closing Stock:
“ Wages 5,00,000 Finished goods 1,50,000
(1,230 units)
“ Factory Overheads 4,50,000 Work-in-Process 70,000
“ Admn. Overheads 2,60,000
“ S&D Overheads 1,80,000
“ Goodwill written off 2,00,000
“ Interest on loan 20,000
“ Net Profit 1,10,000
27,20,000 27,20,000

Cost Sheet
(` )
Materials 10,00,000
Wages 5,00,000
Direct Expenses Nil
Prime Cost 15,00,000
Add: Factory Overhead @ 100% of wages 5,00,000
Gross Factory Cost 20,00,000
Less: Closing WIP (70,000)
Factory Cost of (20,000 + 1,230) units 19,30,000
Add: Admn. Overhead @ 10% of Factory cost 1,93,000
21,23,000
Less: Closing Stock of finished goods (1,230 units) (1,23,000)*
Cost of Goods sold (20,000 units) 20,00,000
Add: Selling & Dist. Overhead @ ` 10 per unit 2,00,000
Cost of sales (20,000 units) 22,00,000
Sales of 20,000 units 25,00,000
Profit 3,00,000
* (`21,23,000 × 1,230 units/ 21,230 units)
Reconciliation Statement
(`) (`)
Profit as per Cost Accounts 3,00,000
Add: Factory overheads over-absorbed 50,000
(` 5,00,000 – ` 4,50,000)
Selling & Dist. Overhead over-absorbed 20,000
(` 2,00,000 – ` 1,80,000)
Difference in the valuation of closing stock of 27,000 97,000
finished goods (` 1,50,000 – ` 1,23,000)
3,97,000

Less: Admn. overhead under-absorbed 67,000

(` 2,60,000 – ` 1,93,000)
Goodwill written off 2,00,000
Interest on loan 20,000 2,87,000
Profit as per financial accounts 1,10,000
ILLUSTRATION 7
Following are the figures extracted from the Cost Ledger of a manufacturing unit.
(` )
Stores:
Opening balance 15,000
Purchases 80,000
Transfer from WIP 40,000
Issue to WIP 80,000
Issue to repairs and maintenance 10,000
Sold as a special case at cost 5,000
Shortage in the year 3,000
Work-in-Process:
Opening inventory 30,000
Direct labour cost charged 30,000
Overhead cost charged 1,20,000
Closing Balance 20,000
Finished Products:
Entire output is sold at 10% profit on actual cost from Work-in-
Process.
Others:
Wages for the period 35,000
Overhead Expenses 1,25,000
ASCERTAIN the profit or loss as per financial account and cost accounts and
reconcile them.

SOLUTION
Stores Ledger Control A/c
(`) (`)
To Balance b/d 15,000 By Work-in-Process Control 80,000
A/c (Issued to WIP)
“ Cost Ledger Control 80,000 “ Overhead Control A/c 10,000
A/c (Purchases) (Issued for repairs)
“ Work-in-Process 40,000 “ Cost Ledger Control A/c 5,000
Control A/c (Sold at cost)
(Return from WIP)
“ Overheads Control A/c* 3,000
(Shortages)
“ Balance c/d 37,000
1,35,000 1,35,000
* Assumed normal
Wages Control A/c
(`) (`)
To Cost Ledger Control A/c 35,000 By Work-in-process Control 30,000
A/c
“ Overhead Control A/c 5,000
35,000 35,000
Overhead Control A/c

(`) (`)
To Stores Ledger Control A/c 10,000 By Work-in-Process 1,20,000
Control A/c
“ Stores Ledger Control A/c 3,000
“ Cost Ledger Control A/c 1,25,000
“ Wages Control A/c 5,000 “ Balance c/d 23,000
1,43,000 1,43,000

WIP Control A/c
(`) (`)
To Balance b/d 30,000 By Stores Ledger

Control A/c 40,000
“ Stores Ledger Control A/c 80,000 “ Finished Goods

Control A/c 2,00,000*
“ Wages Control A/c 30,000
“ Overheads Control A/c 1,20,000 “ Balance c/d 20,000
2,60,000 2,60,000
* Finished output at cost 2,00,000

Profit at 10% on actual cost from WIP Sales 20,000
2,20,000
Statement of Profit as per Costing Records
(`)
Direct Material Cost (`80,000 – `40,000) 40,000
Direct wages 30,000
Prime Cost 70,000
Production Overheads 1,20,000
Works Cost 1,90,000
Add: Opening WIP 30,000
2,20,000
Less: Closing WIP (20,000)
Cost of finished goods 2,00,000
Profit (10% of cost) 20,000
Sales 2,20,000

Profit & Loss A/c
(`) (`)
To Material (Op. bal. + By Sales A/c 2,20,000

Purchases - Sale) 90,000
“ Opening WIP 30,000 “ Closing WIP 20,000
“ Wages for the period 35,000 “ Closing stock of

Raw Material 37,000
“ Overheads expenses 1,25,000 “ Net loss 3,000
2,80,000 2,80,000
Reconciliation Statement
(` )
Profit (loss) as per Financial Accounts (3,000)
Add: Overheads over absorbed (refer Overhead control A/c) 23,000
Net Profit as per Cost Accounts 20,000
ILLUSTRATION 8
The following figures have been extracted from the Financial Accounts of a
manufacturing firm for the first year of its operation:
(`)
Direct Material Consumption 50,00,000
Direct Wages 30,00,000
Factory Overheads 16,00,000
General Administrative Overheads 7,00,000
Selling and Distribution Overheads 9,60,000
Bad Debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000

Dividends Received 1,00,000
Interest received on Deposits 20,000
Sales (1,20,000 units) 1,20,00,000
Closing Stock:
Finished Goods (4,000 units) 3,20,000
The cost accounts for the same period reveal that the direct material consumption
was ` 56,00,000. Factory overhead is recovered at 20% on prime cost.
Administration overhead is recovered at ` 6 per unit of goods sold. Selling and
Distribution overheads are recovered at ` 8 per unit sold.
PREPARE the Profit and Loss Accounts both as per financial records and as per cost
records. RECONCILE the profits as per the two records.
SOLUTION
Profit and Loss Account
(As per financial records)
(`) (`)
To Direct Material 50,00,000 By Sales (1,20,000 1,20,00,000

units)
“ Direct Wages 30,00,000 “ Closing Stock
“ Factory Overheads 16,00,000 Work-in-process 2,40,000
“ Gross Profit c/d 29,60,000 Finished Goods 3,20,000

(4,000 units)
1,25,60,000 1,25,60,000
“ General 7,00,000 “ Gross Profit b/d 29,60,000

Administrative
Overheads
“ Selling and Dist. 9,60,000 “ Dividend 1,00,000

OH received

“ Bad debts 80,000 “ Interest received 20,000
“ Preliminary 40,000
Expenses written
off
“ Legal Charges 10,000
“ Net Profit 12,90,000
30,80,000 30,80,000
Statement of Cost and Profit

(As per Cost Records)
(`)
Direct Material 56,00,000
Prime Cost 86,00,000
Factory Overhead (20% of `86,00,000) 17,20,000
1,03,20,000
Less: Closing Stock (WIP) (2,40,000)
Works Cost or Cost of production (1,24,000 units) 1,00,80,000
Less: Finished Goods (4,000 units @ `81.29) (3,25,160)
Cost of goods sold (1,20,000 units) 97,54,840
Administrative Overhead (1,20,000 units @ ` 6 p.u.) 7,20,000
Selling and Distribution Overhead (1,20,000 @ ` 8 p.u.) 9,60,000
Cost of Sales 1,14,34,840
Net profit (Balancing figure) 5,65,160
Sales Revenue 1,20,00,000

Statement of Reconciliation of profit as obtained under Cost and Financial

Accounts
(`) (`)
Profit as per Cost Records 5,65,160
Add: Excess of Material Consumption 6,00,000
Factory Overhead 1,20,000
Administrative Overhead 20,000
Dividend Received 1,00,000
Interest Received 20,000 8,60,000
14,25,160
Less: Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Over-valuation of stock in cost book

(` 3,25,160 – ` 3,20,000) 5,160 (1,35,160)
Profit as per Financial Records 12,90,000

SUMMARY
 Cost Control Accounts: These are accounts maintained for the purpose of
exercising control over the costing ledgers and also to complete the double
entry in cost accounts.
 Integral System of Accounting: A system of accounting where both costing
and financial transactions are recorded in the same set of books.
 Non-Integral System of Accounting: A system of accounting where two sets
of books are maintained-(i) for Costing transactions; and (ii) for Financial
transactions
 Reconciliation: In the Non-Integral System of Accounting, since the cost and
financial accounts are kept separately, it is imperative that those should be
reconciled; otherwise the cost accounts would not be reliable. The reason for
differences in the cost & financial accounts can be of purely financial nature
(Income and expenses) and notional nature.
TEST YOUR KNOWLEDGE

1. Under the Non-integrated accounting system
(a) Same ledger is maintained for cost and financial accounts by
accountants
(b) Separate ledgers are maintained for cost and financial accounts
(c) (a) and (b) both
2. Notional costs
(a) May be included in Integrated accounts
(b) May be included in Non- integrated accounts
(c) Cannot be included in Non-integrated accounts

3. Under Non-integrated accounting system, the account made to complete

double entry is
(a) Stores ledger control account
(b) Work in progress control account
(c) Finished goods control account
(d) General ledger adjustment account
4. Integrated systems of accounts are maintained
(a) In separate books of accounts for costing and financial accounting

purposes
(b) In same books of accounts
(c) Both (a) & (b)
5. Under Non-integrated system of accounting, purchase of raw material is

debited to which account
(a) Material control account / Stores ledger control account
(b) General ledger adjustment account
(c) Purchase account
6. Under Non-integrated accounts, if materials worth ` 1,500 are purchased for

a special job, then which account will be debited:
(a) Special job account / Work in Process account
(b) Material Control account
(c) Cost Control account

7. Which account is to be debited if materials worth ` 500 are returned to

vendor under Non-integrated accounts:
(a) Cost ledger control account
(b) Finished goods control account
(c) WIP control account

8. Which of the following items is included in cost accounts?
(a) Notional rent

(b) Donations
(c.) Transfer to general reserve
(d) Rent receivable
9. When costing loss is ` 5,600, administrative overhead under-absorbed being `
600, the loss as per financial accounts should be
(a) ` 5,600
(b) ` 6,200
(c) ` 5,000
10. Which of the following items should be added to costing profit to arrive at
financial profit?
(a) Over-absorption of works overhead

(b) Interest paid on debentures
(c) Income tax paid
1. EXPLAIN what are the essential pre-requisites of Integrated Accounting
System.
2. STATE what are the advantages of Integrated Accounting.

3. EXPLAIN why is it necessary to reconcile the Profits between the Cost

Accounts and Financial Accounts.
4. STATE what are the reasons for disagreement of profits as per Cost Accounts
and Financial Accounts. Discuss.
5. LIST the Financial expenses which are not included in Cost.

6. STATE when is the Reconciliation statement of Cost and Financial accounts
not required.
Practical Problems
1. The following incomplete accounts are furnished to you for the month ended
31st October, 2022.

1.10.2022 To Balance ` 54,000
Work in Process Control Account
1.10. 2022 To Balance ` 6,000
Finished Goods Control Account
1.10. 2022 To Balance ` 75,000
Factory Overheads Control Account
Total debits for October, 2022 ` 45,000
Factory Overheads Applied Account
Cost of Goods Sold Account
Creditors for Purchases Account
1.10. 2022 By Balance V` 30,000
Additional information:
(i) The factory overheads are applied by using a budgeted rate based on
direct labour hours. The budget for overheads for 2022 is ` 6,75,000 and
the budget of direct labour hours is 4,50,000.

(ii) The balance in the account of creditors for purchases on 31.10.2022 is `

15,000 and the payments made to creditors in October, 2022 amount to
` 1,05,000.
(iii) The finished goods inventory as on 31st October, 2022 is ` 66,000.
(iv) The cost of goods sold during the month was ` 1,95,000.
(v) On 31st October, 2022 there was only one unfinished job in the factory.
The cost records show that ` 3,000 (1,200 direct labour hours) of direct
labour cost and ` 6,000 of direct material cost had been charged.
(vi) A total of 28,200 direct labour hours were worked in October, 2022. All
factory workers earn same rate of pay.
(vii) All actual factory overheads incurred in October, 2022 have been
posted.
You are required to FIND:
(a) Materials purchased during October, 2022.
(b) Cost of goods completed in October, 2022.
(c) Overheads applied to production in October, 2022.
(d) Balance of Work-in-Process Control A/c on 31st October, 2022.
(e) Direct Materials consumed during October, 2022.
(f) Balance of Stores Ledger Control Account on 31st October, 2022.
(g) Over absorbed or under absorbed overheads for October, 2022.
2. A company operates on historic job cost accounting system, which is not
integrated with the financial accounts. At the beginning of a month, the
opening balances in cost ledger were:
(` in lakhs)
Stores Ledger Control Account 80
Work-in-Process Control Account 20
Finished Goods Control Account 430
Building Construction Account 10
Cost Ledger Control Account 540

During the month, the following transactions took place:
(` in lakh)
Materials Purchased 40
Issued to production 50
Issued to factory maintenance 6
Issued to building construction 4
Wages Gross wages paid 150
Indirect wages 40
For building construction 10
Works Overheads Actual amount incurred 160
(excluding items shown above)
Absorbed in building construction 20
Under absorbed 8
Royalty paid (related to production) 5
Selling, Distribution and Administration overheads 25
Sales 450
At the end of the month, the stock of raw material and work-in-Process was
` 55 lakhs and ` 25 lakhs respectively. The loss arising in the raw material
accounts is treated as factory overheads. The building under construction was
completed during the month. Company’s gross profit margin is 20% on sales.
PREPARE the relevant control accounts to record the above transactions in the
cost ledger of the company.
3. Dutta Enterprises operates an Integral system of accounting. You are required

to PASS the Journal Entries for the following transactions that took place for
the year ended 31st March.
(Narrations are not required.)

(`)
Raw Materials purchased (50% on Credit) 6,00,000
Materials issued to production 4,00,000
Wages paid (50% Direct) 2,00,000
Wages charged to production 1,00,000
Factory Overheads incurred 80,000
Factory Overheads charged to production 1,00,000
Selling and Distribution Overheads incurred 40,000
Finished Goods at cost 5,00,000
Sales (50% Credit) 7,50,000
Closing stock Nil
Receipts from debtors 2,00,000
Payments to creditors 2,00,000
4. The following information is available from the financial books of a company

having a normal production capacity of 60,000 units for the year ended 31st
March:
(i) Sales ` 10,00,000 (50,000 units).
(ii) There was no opening and closing stock of finished units.
(iii) Direct Material and Direct Wages cost were ` 5,00,000 and ` 2,50,000
respectively.
(iv) Actual factory expenses were ` 1,50,000 of which 60% are fixed.
(v) Actual Administrative expenses were ` 45,000 which are completely
fixed.
(vi) Actual Selling and Distribution expenses were ` 30,000 of which 40%
are fixed.
(vii) Interest and dividends received ` 15,000.
(a) FIND OUT profit as per financial books for the year ended 31st March;
(b) PREPARE the cost sheet and ascertain the profit as per cost accounts for
the year ended 31st March assuming that the indirect expenses are
absorbed on the basis of normal production capacity; and
(c) PREPARE a statement reconciling profits shown by financial and cost books.

5. M/s. H.K. Piano Company showed a net loss of ` 4,16,000 as per their
financial accounts for the year ended 31st March. The cost accounts, however,
disclosed a net loss of ` 3,28,000 for the same period. The following
information were revealed as a result of scrutiny of the figures of both the sets
of books:
(`)
(i) Factory Overheads under-recovered 6,000
(ii) Administration Overheads over-recovered 4,000
(iii) Depreciation charged in financial accounts 1,20,000
(iv) Depreciation recovered in costs 1,30,000
(v) Interest on investment not included in costs 20,000
(vi) Income-tax provided 1,20,000
(vii) Transfer fees (credit in financial books) 2,000
(viii) Stores adjustment (credit in financial books) 2,000

PREPARE a Memorandum reconciliation account.
ANSWERS
Answers to the MCQs
1. (b) 2. (b) 3. (d) 4. (b) 5. (a) 6. (a)
7. (a) 8. (a) 9. (b) 10. (a)



1. Working Notes:
(i) Overhead recovery rate per direct labour hour:
Budgeted Factory Overheads = ` 6,75,000
Budgeted Direct Labour hours = 4,50,000
Budgeted Factory Overheads
Overhead recovery rate =
Budgeted Direct Labour hours
` 6,75,000
=
4,50,000 hours
= ` 1.50 per direct labour
(ii) Direct Wage rate per hour:
Direct Labour cost of WIP = ` 3,000
(on 31st October 2022)
Direct labour hours of WIP = 1,200 hours
Direct labour cost on WIP
Direct wage rate per hour =
Direct labour hours on WIP
` 3,000
= = `2.50
1,200 hours
(iii) Total Direct Wages charged to production:

Total direct labour hours spent on production × Direct wage rate per
hour
= 28,200 hours × ` 2.50 = ` 70,500
(a) Material purchased during October, 2022
(`)
Payment made to creditors 1,05,000
Add: Closing balance in the account of creditors for 15,000
purchase
Less: Opening balance (30,000)
Material Purchased 90,000

(b) Cost of Finished Goods in October, 2022
(`)
Cost of goods sold during the month 1,95,000
Add: Closing finished goods inventory 66,000
Less: Opening finished goods inventory (75,000)
Cost of goods completed during the month 1,86,000
(c) Overhead applied to production in October, 2022

= 28,200 hours × ` 1.50 = ` 42,300
(d) Balance of Work-in-Process on 31st October, 2022
(`)
Direct material cost 6,000
Direct labour cost 3,000
Overheads (` 1.50 × 1,200 hours) 1,800
10,800
(e) Direct material consumed during October, 2022 = ` 78,000

(Refer to following Accounts)
Work in Process Control A/c
(`) (`)
To Balance b/d 6,000 By Finished goods 1,86,000
control A/c
[Refer (b)
above]
“ Wages Control 70,500 “ Balance c/d 10,800
A/c [Refer [Refer (d)
working note (iii)] above]

“ Factory OH 42,300
Control A/c
[Refer (c) above]
“ Material 78,000
consumed
(Balancing fig.)
1,96,800 1,96,800
(f) Balance of Stores Control Account on 31st October, 2022 = ` 66,000

(Refer to following Account)
(`) (`)
“ Balance b/d 54,000 By Work-in-process 78,000
Control A/c
[Refer (e) above]
“ Payables 90,000 “ Balance c/d 66,000
(Creditors) A/c (Balancing fig.)
[Refer (a) above}
1,44,000 1,44,000
(g) Over-absorbed or under-absorbed overheads for October, 2022:

Balance in Factory Overhead Account below showing that ` 2,700 is
under-absorbed.
Factory Overhead Account
(`) (`)
To Bank A/c 45,000 By Work-in-process 42,300
Control A/c
(Factory OH
applied)
“ Costing P/L A/c 2,700
(Under-
absorbed)
45,000 45,000

2. Cost Ledger Control A/c

Amount (` in lakhs)
(`) (`)
To Costing P&L A/c 450 By Balance b/d 540
“ Building Construction 44 “ Stores Ledger Control 40
A/c A/c
“ Balance c/d 483 “ Wages Control A/c 150
“ Works OH Control A/c 160
“ Royalty A/c 5
“ Admn. OH and S&D 25
OH A/c
“ Costing P&L A/c 57
977 977
Stores Ledger Control A/c

(`) (`)
To Balance b/d 80 By Work-in-Process A/c 50
“ Cost Ledger Control A/c 40 “ Works OH Control A/c 6
“ Building Const. A/c 4
(Bal. fig.) (loss)
“ Balance c/d 55
120 120
Wages Control A/c
(`) (`)
To Cost Ledger Control A/c 150 By Works OH Control A/c 40
“ Building Const. A/c 10
“ Work-in-process 100
Control A/c
(Balancing figure)
150 150

Works Overhead Control A/c
(`) (`)
To Stores Ledger Control 6 By Building Const. A/c 20
A/c
“ Wages Control A/c 40 “ Work-in-process 183
Control A/c
(Balancing figure)
“ Cost Ledger Control A/c 160 “ Costing P&L A/c (under- 8
absorption)
“ Store Ledger Control 5
A/c (loss)
211 211
Royalty A/c
(`) (`)
To Cost Ledger Control A/c 5 By Work-in-process 5
Control A/c
5 5
(`) (`)
To Balance b/d 20 By Finished Goods Control 333
A/c
(Balancing figure)
“ Stores Ledger Control 50

A/c
“ Wages Control A/c 100
“ Royalty A/c 5 “ Balance c/d 25
358 358

(`) (`)
To Balance b/d 430 By Cost of Goods Sold A/c 360
(80% of ` 450)
“ Work-in-process 333 “ Balance c/d 403
Control A/c
763 763
Cost of Goods Sold A/c
(`) (`)
To Finished Goods Control 360 By Cost of sales A/c 360
A/c
360 360
Selling, Distribution and Administration Overhead A/c
(`) (`)
To Cost Ledger Control A/c 25 By Cost of sales A/c 25
25 25
Cost of Sales A/c

(`) (`)
To Cost of Goods Sold 360 By Costing P&L A/c 385
“ Admn. OH and S&D OH 25

A/c
385 385

Costing P & L A/c
(`) (`)
To Cost of Sales A/c 385 By Cost Ledger 450
Control A/c (Sales)
“ Works Overhead Control 8
A/c
“ Cost Ledger Control A/c 57
(Profit) (Balancing figure)
450 450
Building Construction A/c
(`) (`)
To Balance b/d 10 By Cost Ledger 44

Control A/c
“ Stores Ledger Control 4

A/c
“ Wages Control A/c 10
44 44
Trial Balance (` in lakhs)
Dr. (`) Cr. (`)
Stores control A/c 55
Work-in-Process A/c 25
Finished Goods A/c 403
Cost Ledger Adjustment A/c 483
483 483

3. Journal entries are as follows:
Dr. (`) Cr. (`)

Stores Ledger Control A/c…………………………… Dr. 6,00,000
To Payables (Creditors) A/c 3,00,000
To Cash or Bank 3,00,000
Work-in-Process Control A/c…………………… Dr. 4,00,000
Wages Control A/c………………………………………. Dr. 2,00,000
Factory Overhead Control A/c…………………… Dr. 1,00,000
To Wages Control A/c 1,00,000
Work-in-Process Control A/c……………………… Dr. 1,00,000
To Wages Control A/c 1,00,000
Factory Overhead Control A/c………………… Dr. 80,000
To Bank A/c 80,000
Work-in-Process Control A/c…………………… Dr. 1,00,000
To Factory Overhead Control A/c 1,00,000
Selling and Dist. Overhead Control A/c Dr. 40,000
To Bank A/c 40,000
Finished Goods Control A/c…………………… Dr. 5,00,000
Cost of Sales A/c………………………………………… Dr. 5,40,000
To Finished Goods Control A/c 5,00,000
To Selling and Distribution Control A/c 40,000
Receivables (Debtors) A/c……………………………… Dr. 3,75,000
Bank or Cash A/c………………………………………… Dr. 3,75,000
To Sales A/c 7,50,000
Bank A/c…………………………………………………... Dr. 2,00,000
To Receivables (Debtors) A/c 2,00,000
Payables (Creditors) A/c………………………………... Dr. 2,00,000

4. (a) Profit & Loss Account

(for the year ended 31st March)
(`) (`)
To Direct Material 5,00,000 By Sales (50,000 10,00,000

units)
“ Direct Wages 2,50,000 “ Interest and 15,000

dividends
“ Factory 1,50,000
expenses
“ Administrative 45,000
expenses
“ Selling & Dist. 30,000

Expenses
“ Net Profit 40,000
10,15,000 10,15,000
(b) Cost Sheet

(for the year ended 31st March)
(`) (`)
Direct Material 5,00,000
Prime cost 7,50,000
Factory expenses:
Variable (40% of ` 1,50,000) 60,000
Fixed (` 90,000 × 50,000/60,000) 75,000 1,35,000
Works cost/ Cost of production 8,85,000

Administrative expenses: (` 45,000 × 37,500

50,000/60,000)
Selling & Distribution expenses:
Variable (60% of ` 30,000) 18,000
Fixed* (` 12,000 × 50,000/60,000) 10,000 28,000
Cost of Sales 9,50,500
Profit (Balancing figure) 49,500
Sales revenue 10,00,000
*It is assumed that the company sells what it generally produces i.e. normal
production.
(c) Statement of Reconciliation

(Reconciling profit shown by Financial and Cost Accounts)
(`) (`)
Profit as per Cost Account 49,500
Add : Income from interest and dividends 15,000
64,500
Less: Factory expenses under-charged in 15,000

Cost Accounts (` 1,50,000 – ` 1,35,000)
Administrative expenses under-charged in 7,500

Cost Accounts (` 45,000 – ` 37,500)
Selling & distribution expenses under—

charged in Cost Accounts (` 30,000 –
` 28,000) 2,000 (24,500)
Profit as per Financial Accounts 40,000

5. Memorandum Reconciliation Account
(`) (`)
To Net loss as per 3,28,000 By Administration 4,000

costing books Overhead- over-
recovered in costs
“ Factory 6,000 “ Depreciation 10,000

Overheads overcharged in
under-recovered costs
in costs
“ Income-tax not 1,20,000 “ Interest on invest- 20,000

provided in ments not
costs included in costs
“ Transfer fees in 2,000

financial books
“ Stores adjustment 2,000
“ Net loss as per

financial books 4,16,000
4,54,000 4,54,000


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© The Institute of Chartered Accountants of India

© THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

Basic draft of this publication was prepared by CA. Vandana D Nagpal

Edition : April, 2023

Committee/Department : Board of Studies (Academic)

Price : ` /- (For All Modules)

ISBN No. : 978-81-19472-04-8

Published by : The Publication & CDS Directorate on behalf of

© The Institute of Chartered Accountants of India

In contemporary business environment, existence of an entity depends on the

Chapter-2: Material Cost

© The Institute of Chartered Accountants of India

Chapter-3: Employee Cost and Direct Expenses

Chapter-8: Unit & Batch Costing

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Further the solutions/answers contained in the study material are based on

© The Institute of Chartered Accountants of India

SKILL SPECIFICATION ASSESSMENT GRID

Level-I: Understanding or List – Preparing a list of

Explain – Making the

and similar verbs

© The Institute of Chartered Accountants of India

Level-II: Applying and analyzing Application:

Compute - Arriving at some

Find/ Find out- Ascertain or

Solve – Find an answer or

Tabulate – Exhibiting the

© The Institute of Chartered Accountants of India

(Analysis: Applying, Analysis:

Compare - Examining the

Discuss - Writing about or

Analyse and apply and

© The Institute of Chartered Accountants of India

PAPER – 4: COST AND MANAGEMENT ACCOUNTING

(d) Installation of Costing System

(f) Cost terms and Concepts

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

(ii) Employee Cost

(iii) Direct Expenses

(vi) Integration of cost and financial data

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

(b) Determination of Cost of a product/ service under marginal

(d) Introduction to Principal/ Key budget factor, Zero Based

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

DETAILED CONTENTS: MODULE-1

CHAPTER-1 : INTRODUCTION TO COST AND MANAGEMENT

Learning Outcomes .............................................................................................................................. 1.1

1. Introduction ............................................................................................................................ 1.2

7. Essentials of a Good Cost Accounting System..........................................................1.14

9.1 Digital Costing System ........................................................................................1.18

© The Institute of Chartered Accountants of India

Theoretical Questions ......................................................................................................................1.45

CHAPTER-2 : MATERIAL COST .......................................................................2.1-2.96

Learning Outcomes .............................................................................................................................. 2.1

2. Material Control .................................................................................................................... 2.3

© The Institute of Chartered Accountants of India

3. Materials Procurement Procedure .................................................................................. 2.6

Difference between Bill of Materials and Material

5. Material Storage & Records ..................................................................................... …. 2.18