Management Accounting PDF

MANAGEMENT ACCOUNTING
(FOR PRIVATE CIRCULATION ONLY)

2019
PROGRAMME COORDINATOR
Dr. Padmpriya Irabatti
COURSE DESIGN AND REVIEW COMMITTEE

Prof. Dr. Ravi Chitnis Prof. Dr. Shrish Limaye
Prof. Umesh Kulkarni Dr. Satish Inamdar
Prof. Prashant Ubarhande
COURSE WRITER
Dr. Satish Inamdar
EDITOR
Miss Neha Mule
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

2001 (Revision 04, 2018)
Copyright © 2019 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
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Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
Failure of majority of the industrial undertakings is mainly attributable to the lack of awareness about
the wrong financial decisions affecting the business, particularly accounting and costing decisions.
The crux of wrong financial decisions is that the implications of the wrong financial decisions are
not realised immediately and by the time they are realised, it is too late. As such, it is most important
to make proper financial decisions at proper point of time. For this, clear understanding of basic
financial and costing principles is a must for everybody.
My objective of writing this SLM is to introduce the basic concept of financial and cost accounting in
the simplest possible language to the students. I have attempted to explain the basic concepts with the
help of examples and illustrations. Good number of problems has been incorporated for self-study.
I am thankful to Symbiosis Centre for Distance Learning for providing me this opportunity to reach
out to a very wide spectrum of readership.
All the efforts have been done to make the text free of errors. Still, I don’t rule out the possibility
of some omissions. I will be obliged if such omissions can be pointed out and intimated so that
necessary modifications can be made in the subsequent editions.
Satish Inamdar
iii
ABOUT THE AUTHOR
Satish Inamdar holds a Master’s Degree in Commerce and Bachelor’s Degree in Law. He is fellow
Member of the Institute of Chartered Accountants of India, Graduate Member of The Institute of
Cost & Works Accountants of India and Associate Member of The Institute of Company Secretaries
of India. He is associated with the industry for the last two decades in various senior capacities. For
the past fifteen years, he is associated with Symbiosis Institute of Business Management as a Faculty
of Finance. He has conducted Management Development Programmes and Executive Development
Programmes for various private sector and public sector organisations. He has authored three books
on various subjects such as Cost & Management Accounting and Financial Management. He is a
Charter Member of Rotary Club of Pune, Kothrud.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introduction to Accounting 1-14
1.1 Introduction
1.2 Streams of Accounting
1.3 Financial Accounting vs. Cost Accounting
1.4 Financial Accounting vs. Management Accounting
1.5 Cost Accounting vs. Management Accounting
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Basics of Financial Accounting 15-38
2.1 Introduction
2.2 Accounting Concepts and Conventions
2.3 Principles and Methods (Basis) of Accounting
2.4 Types of Accounts
2.5 List of Common Terms used in Financial Accounting
2.6 Types of Expenditure
2.7 Double Entry Bookkeeping
2.8 Depreciation Accounting
Summary
Key Words
Suggested Reading
3 Process of Accounting 39-68
3.1 Introduction
3.2 Journal and Journalizing
3.3 Compound Journal Entry
3.4 Subsidiary Books
3.5 Ledger and Ledger Postings
3.6 Control Ledgers
3.7 Balancing of Ledger Accounts
3.8 Trial Balance
3.9 Preparation of Final Accounts from Trial Balance
3.10 Adjustments
Summary
Key Words
Illustrative Problems
Suggested Reading
v
4 Cost Accountancy (Basic Concepts and Principles) 69-74
4.1 Introduction
4.2 Concept of Cost Center
4.3 Different Types of Costs
Summary
Key Words
Suggested Reading
5 Elements of Cost 75-86
5.1 Introduction
5.2 Elements of Costs
5.2.1 Overheads
5.3 Cost Sheet/Cost Statement
Summary
Key Words
Suggested Reading
6 Material Costs 87-128
6.1 Introduction
6.2 Stages in the Movement of Material
6.3 Proper Conduct of Storage Function
6.4 Valuation of Material Movements
6.5 Inventory Control
Summary
Key Words
Suggested Reading
vi
7 Labour Costs 129-154
7.1 Introduction
7.2 Departments involved with Labour Costs for Cost Accounting
7.3 Methods to ascertain Labour Cost
7.3.1 Time-keeping
7.3.2 Time booking
7.4 Methods of Remunerating the Workers
7.4.1 Time rate system
7.4.2 Payments by results
7.4.3 Incentive/Bonus payment
7.4.4 Indirect monetary remuneration
7.4.5 Non-monetary incentives
7.5 Principles of a Good Wage Payment System
7.6 Important Terms in Case of Labour Cost
7.6.1 Labour turnover
7.6.2 Idle time
7.6.3 Internal control problems in labour cost
Summary
Key Words
Suggested Reading
8 Overhead Costs 155-180
8.1 Introduction
8.2 Overhead Classification
8.3 Procedure for Charging Overheads
8.4 Actual v/s Predetermined Overhead Absorption Rates
8.5 Under and Over Absorption of Overheads
8.6 Treatment of Under/Over Absorbed Overheads
8.7 Control Over Overheads
Summary
Key Words
Suggested Reading
vii
9 Marginal Costing 181-214
9.1 Introduction
9.2 Classification of Cost
9.3 Concept of Marginal Costing
9.4 Forms of Operating Statement
9.5 Basic Concepts of Marginal Costing
9.6 Graphical Presentation of Cost-Volume-Profit Relationships
9.7 Practical Applications of Marginal Costing
9.8 Problem of the Key Factor
9.9 Multiplicity of the Key Factor
9.10 Limitations of Marginal Costing
Summary
Key Words
Suggested Reading
10 Budgetary Control 215-236
10.1 Introduction
10.2 Advantages of Budgetary Control
10.3 Pre-requisites for the Implementation of Budgetary Control
10.4 Types of Budgets
10.5 Fixed and Flexible Budget
Summary
Key Words
Suggested Reading
viii
11 Standard Costing 237-272
11.1 Introduction
11.2 Concept of Standard Cost and Standard Costing
11.2.1 Advantages of Standard Costing
11.2.2 Limitations of Standard Costing
11.2.3 Comparison of Standard Costing and Budgetary Control
11.2.4 Preliminaries for Establishing Standard Costing System
11.3 Types of Standards
11.3.1 Current Standards
11.3.2 Standards with Various Elements of Costs
11.4 Analysis of Variances
11.4.1 Material Cost Variance
11.4.2 Labour Cost Variances
11.4.3 Overhead Cost Variances
Summary
Key Words
Suggested Reading
Annexure 273-278
ix
x
Introduction to Accounting
UNIT
1
Structure:
1.1 Introduction
1.2 Streams of Accounting
1.3 Financial Accounting vs. Cost Accounting
1.4 Financial Accounting vs. Management Accounting
1.5 Cost Accounting vs. Management Accounting
Summary
Key Words
Suggested Reading
Introduction to Accounting 1
Notes
Objectives
----------------------
---------------------- After going through this unit, you will be able to:
Recognize the need for the conceptual framework of business
•
----------------------
accounting
---------------------- • Judge the emergence, objects and scope of management accounting
---------------------- • Explain the different streams of accounting and their comparison
---------------------- • Analyse the advantages and limitations of management accounting

• Compare different streams of accounting
----------------------
----------------------
1.1 INTRODUCTION
----------------------
Business is a commercial activity carried out with the intention of earning
----------------------
profits. Any businessperson is interested in knowing two things:
---------------------- (a) What is the result of the operations of the business activity? In other words,
has the business has resulted in profit or loss?
----------------------
(b) Where does the business stand in financial terms at any given point of
---------------------- time?
---------------------- Providing the answers to the above questions is not possible unless the
transactions relating to the business are recorded in a systematic manner. The
---------------------- process of accounting comes into picture at this point.
---------------------- According to American Institute of Certified Public Accountants,
“Accounting is on art of recording, classifying and summarizing in a significant
----------------------
manner and in terms of money, transactions and events which are of a financial
---------------------- character and interpreting the results thereof.” The process of recording the
business transactions in a defined set of records, which in technical words are
---------------------- called as Books of Accounts, is referred to as bookkeeping. Accounting refers
to the process of analysing and interpreting the information already recorded in
----------------------
the books of accounts with the ultimate intention of answering the above stated
---------------------- questions. Financial statements fulfill this requirement.
The financial statements of any organization are of two types:
----------------------
(a) Profit & Loss Statement to understand the result of operations of the
---------------------- business activity, amount of profit earned or the amount of loss suffered.
---------------------- (b) Balance Sheet answers the second question, i.e. where the business stands
in financial terms at any given point of time. Thus, balance sheet indicates
---------------------- the financial status of the business at any time in terms of its assets and
---------------------- liabilities.
The nature of these financial statements is discussed in detail in the later
---------------------- units.
2 Management Accounting
The process of bookkeeping is more procedural and clerical in nature Notes
while the process of accounting is more managerial in nature. As such, the
job of bookkeeping is entrusted to junior level employees, whereas the job of ----------------------
accounting needs enhanced professional expertise.
----------------------
1.2 STREAMS OF ACCOUNTING ----------------------
1. Financial Accounting ----------------------
Financial Accounting is the process of systematic recording of the business ----------------------
transactions in various books of accounts maintained by the organization with
the ultimate intention of preparing the financial statements therefrom. These ----------------------
financial statements are basically in two forms. One, Profitability Statement that
indicates the result of operations carried out by the organization during a given ----------------------
period of time and two, Balance Sheet that indicates the state of affairs of the ----------------------
organization at any given point of time in terms of its assets and liabilities. This
nature of Financial Accounting indicates following characteristic features of the ----------------------
same:
----------------------
Financial Accounting considers those transactions, which can be expressed
in terms of money. All the transactions which cannot be expressed in terms of ----------------------
money, howsoever important they may be from business point of view, find no
----------------------
place in financial accounting and hence in financial statements. For example,
assume that the business of an organization is such that it is likely to be injurious ----------------------
to the health of local community. As such, there is a strong opposition from the
local community for the company’s carrying on the business at that location. ----------------------
This opposition cannot be expressed in terms of money and hence finds no
----------------------
place in financial accounting and thus in financial statements, even though it
greatly affects the business operations of the organization. ----------------------
Financial Accounting is referred to as the historical form of accounting. In
----------------------
other words, financial accounting is concerned with the recording of transactions
that have already taken place. ----------------------
No futuristic transactions and events, howsoever important and significant
----------------------
they may be from the business point of view, find any place in financial
accounting and hence in financial statements. ----------------------
In practical circumstances, financial accounting is more or less a legal ----------------------
requirement. In case of certain organizations such as the company form of
organization, banks, insurance companies etc., not only is it necessary to ----------------------
maintain the financial accounting records and prepare the financial statements
therefrom, but it is also obligatory to get these financial statements audited by ----------------------
an independent Chartered Accountant. ----------------------
In some cases, there may not be direct legal requirement to prepare
the financial statements, but indirectly it is necessary to prepare the financial ----------------------
statements. For example, if a partnership firm wants to file its Income Tax ----------------------
Return as per the provisions of Income Tax Act, 1961, preparation of financial
statements is a must to ascertain the profits. ----------------------
Notes Financial Accounting is meant for those people who are external to the
organization and those who are not a part of decision-making process. This
---------------------- class of people may consist of investors, customers, suppliers, banks, financial
institutions etc.
----------------------
Financial Accounting discloses the financial performance and financial
---------------------- status of the business as a whole. It does not indicate the details of the individual
department or job or process inside the organization, which information is more
----------------------
significant from the decision-making point of view. In this sense, financial
---------------------- accounting has a limitation.
Financial statements are essentially interim reports and cannot be the final
----------------------
ones. For example, in order to understand the correct profitability and correct
---------------------- position of the assets and liabilities of an organization, it will be necessary to
stop the business operations, dispose of all the assets of the organization and
---------------------- liquidate all the liabilities. Obviously, it is not feasible and practicable.
---------------------- In order to prepare the financial statements for a specific period, it may be
necessary to cut off various transactions involving costs and incomes at the date
---------------------- of closing the accounts. This may involve personal judgments. Various policies
and principles are required to be formulated and followed consistently for such
----------------------
cutting off of incomes and costs.
---------------------- Since the various assets and liabilities are shown at the historical prices,
---------------------- it may not necessarily represent the current market prices or the liquidation
prices.
---------------------- The process of Financial Accounting gets largely affected due to the
---------------------- various accounting policies followed by the accountants. Even though attempts
are being made to bring in the uniformity in the various accounting policies,
---------------------- those may differ from organization to organization mainly in two fields:
Valuation of Inventory and Calculation of Depreciation.
----------------------
The effect of these different accounting policies is discussed in the later
---------------------- units
---------------------- 2. Cost Accounting
Cost accounting is the process of classifying and recording of the
----------------------
expenditure in a systematic manner, with the intention to control the cost.
---------------------- The Institute of Cost and Management Accountants, London, has defined
---------------------- Cost Accounting 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 as well as the presentation of information for the
purpose of managerial decision-making.”
----------------------
The above description of Cost Accounting reveals the following
---------------------- characteristic features of Cost Accounting:
---------------------- a) Cost Accounting views the organization from the angle of individual
components of the organization such as a department, a job, a process
----------------------
etc. Cost Accounting is interested in ascertaining the profitability of these Notes
individual components of the organization.
----------------------
b) Cost Accounting is operated with basically three objectives:
i. Ascertainment of cost and profitability with the help of various ----------------------
principles, methods and techniques.
----------------------
ii. Cost Control, which indicates the process of controlling the costs of
operating the business. ----------------------
iii. Presentation of information to enable the managerial decision- ----------------------
making.
----------------------
c) Cost Accounting is meant for those people who are internal to the
organization. In other words, Cost Accounting is meant for those people ----------------------
who are the part of the decision-making process of the organization. The
people who are external to the organization do not have any access to the ----------------------
cost accounting records. Basic objective of cost accounting is to facilitate ----------------------
professional decision-making process on the part of managers.
----------------------
d) Maintenance of cost accounting records is not mandatory. However, the
maintenance of cost accounting records may be a legal requirement in ----------------------
some exceptional cases. According to Section 209 (1) (d) of the Companies
Act, 1956, it is mandatory for companies falling under certain class of ----------------------
industries to maintain cost accounting records and also get them audited
----------------------
from an independent cost accountant (which is technically referred to as
the “Cost Audit”). ----------------------
e) Cost Accounting does not necessarily restrict itself to the historical
----------------------
transactions or historical events. Future transactions or events may find
the place in cost accounting. In fact, each and every transaction, whether ----------------------
past or future, which is likely to have an impact on the business, is of
concern to the cost accounting. ----------------------
f) As Cost Accounting is supposed to facilitate professional decision- ----------------------
making on the part of the manager, immediate availability of data is the
prerequisite of cost accounting. As such, hundred percent accuracy is not ----------------------
insisted upon by cost accounting.
----------------------
3. Management Accounting
----------------------
Management Accounting is the process of analysis and interpretation of
financial data collected with the help of financial accounting and cost accounting, ----------------------
with the ultimate intention to draw certain conclusions therefrom, in order to
assist the management in the process of decision-making. ----------------------
The Institute of Chartered Accountants of England and Wales has defined ----------------------
management accounting as “any form of accounting which enables a business
to be conducted more efficiently”. ----------------------
The management accounting team of the Anglo-American Council ----------------------

on Productivity has described the term Management Accounting as “the
----------------------
Notes presentation of accounting information in such a way so as to assist management
in the creation of policy and the day-to-day operation of an undertaking.”
----------------------
American Accounting Association has defined the term Management
---------------------- Accounting as “the application of appropriate techniques and concepts in
processing historical and projected economic data of an entity to assist
---------------------- management in establishing plans for reasonable economic objectives and in
the making of rational decisions with a view towards these objectives.”
----------------------
Various definitions of the term ‘Management Accounting’ reveal the
---------------------- following characteristic features of the same.
---------------------- a) Management Accounting is a service function, which is concerned with
providing various types of information to the management to facilitate
---------------------- decision-making and to review the implementation of those decisions.
---------------------- b) Management Accounting not only uses the historical data but may also use
the data based on projections and forecasts for the purpose of evaluation
---------------------- of various possible alternatives.
---------------------- c) Management Accounting assists the management in establishing plans to
attain the economic objectives and in taking the proper decisions required
---------------------- for the attainment of these objectives.
---------------------- d) Management Accounting involves the application of various special
techniques and concepts for the attainment of its objects. The techniques
---------------------- used in the process of management accounting are discussed in the
---------------------- following chapters.
Techniques of Management Accounting
----------------------
There may be various techniques with the help of which the basic functions
---------------------- of management accounting can be discharged. We will discuss the following
techniques in details in the coming units:
----------------------
●● Marginal Costing (Break Even Analysis)
----------------------
●● Budgetary Control
---------------------- ●● Standard Costing
---------------------- ●● Uniform Costing
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
Check your Progress 1
----------------------
State True or False ----------------------
1. Financial statements are essentially final reports.
----------------------
2. Financial Accounting is referred to as the historical form of accounting.
----------------------
3. Accounting is on art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events, ----------------------
which are of a financial and non-financial character.
----------------------
4. Business is a non-commercial activity carried out with the intention
of earning profits. ----------------------
----------------------
Activity 1 ----------------------
Examine a financial statement and try to understand the difference ----------------------

between financial accounting and Management accounting. Write down
----------------------
at least two differentiating factors with examples from the samples you
study. ----------------------
----------------------
1.3 FINANCIAL ACCOUNTING VS. COST ACCOUNTING ----------------------
It is essential to first understand the important characteristics and features ----------------------
of financial accounting and cost accounting, so that we understand the exact
purpose they serve in the management accounting. ----------------------
a) Financial Accounting is concerned with the calculation of profitability and ----------------------
the state of affairs of the organization as a whole with the help of preparation
of the financial statements. Financial Accounting takes into consideration ----------------------
only the historical data, which may not be of any use from the cost control
----------------------
point of view. Cost Accounting may deal with the ascertainment of cost
and calculation of profitability of the individual products, departments, ----------------------
branches and so on. Cost Accounting involves a much-detailed study of
costs and profitability, which takes into consideration not only historical ----------------------
data but also the future events and possibilities. As such, cost accounting
----------------------
proves to be a better proposition from the cost control point of view.
b) Maintenance of financial accounting records and preparation of financial ----------------------
statements is a legal requirement as per the provisions of Section 209 (1)
----------------------
(d) of the Companies Act, 1956. However, maintenance of cost accounting
records is not a legal requirement except in case of certain company form ----------------------
of organizations.
----------------------
c) Financial Accounting primarily protects the interests of the outsiders
dealing with the organization in various capacities, e.g. investors, ----------------------
Notes suppliers, customers, banks, financial institutions, government authority
etc. Cost Accounting is primarily meant for the management to enable
---------------------- the same in discharging various functions such as planning, execution,
co-ordination and decision-making in a proper manner.
----------------------
This relationship between Cost Accounting and Financial Accounting can
---------------------- be better explained with the help of the following illustration, which states the
presentation of the profitability statement under both the sets of accounting.
----------------------
---------------------- Activity 2
----------------------
Change the figures and calculate the gross profit and net profit from the
---------------------- illustration below.
---------------------- Profit and Loss Account for the year ended on 31st march 2017
To Material Cost 1,50,000 By Sales By 5,00,000
---------------------- To Labour Cost 1,00,000
---------------------- To Factory Expenses 50,000
To Gross Profit c/fd (40% of 2,00,000
---------------------- sales)
---------------------- 5,00,000 5,00,000
To, Administration 90,000 Gross Profit 2,00,000
---------------------- Expenses B/fd
To, Selling Expenses 50,000
---------------------- To, Net Profit (12% of sales) 60,000
2,00,000 2,00,000
----------------------
----------------------
1.4 FINANCIAL ACCOUNTING VS. MANAGEMENT
---------------------- ACCOUNTING
----------------------
In the olden days, when the size of business operations was small and
---------------------- the complexities involved were limited, financial accounting was considered
sufficient. Financial accounting ultimately aims at preparing financial
---------------------- statements, which are basically of two types.
---------------------- ●● Profit and Loss statement, which is a period statement and relates to a
certain period, usually one year. This tells about the result of operations,
---------------------- either profit or loss, arising out of the conduct of business operations
during that period.
----------------------
●● Balance Sheet, which is a position statement and relates to a particular
---------------------- point of time. This tells about the various properties held by the business
(termed as ‘assets’) and obligations accepted by the business (termed as
----------------------
‘liabilities’) as on a particular date.
---------------------- The preparation of these financial statements was considered sufficient
to serve the requirements of all the interested parties, both outsiders as well as
----------------------
insiders.
PROFIT AND LOSS ACCOUNT for the year ended 31st march, 2017 (Rs. in lacs) Notes
Schedule 2017 2016
INCOME ----------------------
Grass Revenue from Operations K(13) 39808.10 30643.97
Less : Excise Duty 3745.27 36062.83 2400.26 28243.71 ----------------------
Other Income K(9) 23744 417.98
36300.27 28661.69 ----------------------
EXPENDITURE
Materials H 27330.12 21029.11 ----------------------
Operating & Administrative 1 2661.90 2257.77
Expenses ----------------------
Finance Charges (Net) J (573.26) (579.90)
Depreciation D 446.17 29864.93 433.54 23190.52 ----------------------
Profit before Tax 6435.34 5471.17
Provision for Tax
----------------------
- Current Tax 2120.00 1854.00
----------------------
- Deferred Tax (75.85) 2044.15 (118.30) 1735.70
Profit after Tax 4391.19 3735.47 ----------------------
Fig. 1.1: Sample Profit & Loss Account ----------------------
However, due to the increasing size and complexities of the business
operations and specifically due to the segregation of ownership and management, ----------------------
it was realised that financial accounting was insufficient due to certain limitations ----------------------
of financial accounting. The limitations are as follows:
a) Financial accounting considers only those transactions, which may be ----------------------
expressed in financial terms, either fully or at least partially. However, it ----------------------
ignores the fact that there may be other types of non-financial transactions,
which may have a bearing on business operations, for example, the ----------------------
prestige of business, credit standing of business, efficiency and loyalty of
employees, efficiency and intensity of management etc. ----------------------
b) Financial accounting deals with the recording of past events and as such, ----------------------
it is the post-mortem record of business transactions. For taking correct
----------------------
decisions regarding the business, the management may need, not only the
past details but also the future events and future events are not the subject ----------------------
matter of financial accounting.
----------------------
As such, financial accounting and preparation of financial statements
therefrom is no longer considered sufficient for a successful and smooth running ----------------------
of business. The analysis and interpretation of data available from financial
accounting is also considered necessary, which may not be directly available ----------------------
from financial accounting itself. This is where Management Accounting comes
----------------------
into picture.
Management accounting deals with the analysis and interpretation of ----------------------
financial data with the ultimate intention to draw certain conclusions therefrom, ----------------------
in order to assist the management in the process of decision-making. To
conclude, it may be said that the role of management accounting has emerged ----------------------
due to the shortcomings of financial accounting.
----------------------
Notes The above discussions reveal that the management accountant is an
invaluable aid to the management for discharging the basic functions of
---------------------- planning, execution and control. This is done by:
---------------------- 1. Making available accounting and other data to enable the management to
plan effectively.
----------------------
2. Measuring the actual performance and reporting the same to the various
---------------------- levels of management to indicate the effectiveness of the organisational
methods used.
----------------------
3. Computing the deviation of actual performance from the plans and
---------------------- standards set.
---------------------- 4. Presenting to the management the operating and financial statements at

reasonable intervals and interpreting the same to enable the management
---------------------- to take action/decisions regarding future policy and operations.
---------------------- Thus, we can say that:

1. For extracting the data required for managerial decision-making,
---------------------- Management Accounting may use the information appearing in the
---------------------- financial statements. This information may be used as it is or it can
be rearranged or regrouped if required. As such, financial accounting
---------------------- becomes a source of information for management accounting.
---------------------- 2. Financial Accounting considers only the historical financial transactions
and does not consider the non-financial transactions. Management
---------------------- Accounting however helps to take the decisions about the future. It may
consider future data and financial as well as non-financial factors.
----------------------
3. Maintenance of financial accounting records is a legal requirement.
---------------------- Various formats in which different financial statements are required to be
prepared are standardized.
----------------------
4. Financial accounting primarily protects the interests of the outsiders
---------------------- dealing with organization in various capacities, e.g. investors, suppliers,
---------------------- customers, banks, financial institutions, government authorities etc.
5. Financial statements, which are generated as a result of financial
---------------------- accounting, are a report of the financial performance of the organization
---------------------- as a whole. It may deal with the various parts of the organization such
as individual department or individual product. In case of management
---------------------- accounting, however, more emphasis is on making the data available to
the management as quickly as possible to facilitate effective decision-
---------------------- making. If up-to-date information is not made available to the management
---------------------- for decision-making, management accounting will lose its utility.
----------------------
----------------------
----------------------
Notes
Activity 3
----------------------
Change the figures and calculate % of profit on sales from the illustration ----------------------
below.
----------------------
Products
Total A B C ----------------------
Material Cost 1,50,000 20,000 50,000 80,000
Labour Cost 1,00,000 15,000 30,000 55,000 ----------------------
Prime Cost 2,50,000 35,000 80,000 1,35,000
----------------------
Factory Expenses 50,000 20,000 10,000 20,000
Factory Cost 3,00,000 55,000 90,000 1,55,000 ----------------------
Administration 90,000 40,000 20,000 30,000
Expenses ----------------------
Selling Expenses Total 50,000 15,000 20,000 15,000
Cost 4,40,000 1,10,000 1,30,000 2,00,000 ----------------------
Profit 60,000 (-) 10,000 20,000 50,000 ----------------------
Sales 5,00,000 1,00,000 1,50,000 2,50,000
Profit % on sales 12% _ 13.33% 20% ----------------------
----------------------
1.5 COST ACCOUNTING VS. MANAGEMENT
----------------------
ACCOUNTING
----------------------
Cost Accounting and Management Accounting are similar to each other
in many respects. Both the streams of accounting primarily aim at the effective ----------------------
decision-making on the part of management. Various techniques used by
management accounting, viz. Marginal Costing, Budgetary Control, Standard ----------------------
Costing, Uniform Costing etc. are regarded as the advanced methods of Cost ----------------------
Accounting.
As such, Cost Accounting may be considered a part of Management ----------------------
Accounting. Management accounting covers virtually every area of business ----------------------
operations in the following manner.
1. Accounting: Management accounting deals with the recording, ----------------------
summarising and analysing of various business transactions. The process ----------------------
of accounting may basically take two forms:
----------------------
• Financial Accounting: It deals with the recording of business
transactions, which are financial in nature. It aims at the preparation ----------------------
of financial statements, which may be in two forms, as seen earlier.
----------------------
• Cost Accounting: It deals with the recording of income and
expenditure, ascertainment of cost and profitability and the ----------------------
presentation of information derived therefrom for the purpose
of managerial decision-making. Cost accounting assists the ----------------------
management to make decisions.
----------------------
Notes 2. Cost Control Procedures: Management accounting deals with various
steps involved in the process of controlling the cost. Thus, it may in turn
---------------------- deal with the:
---------------------- • Establishment of plans or budgets for the future.
• Comparison of actual performance with the planned or budgeted
---------------------- performance.
---------------------- • Computation of variations between the planned and actual performance.
---------------------- 3. Reporting: Management accounting deals with the presentation of cost
data, statistical data or any other information to the various levels of
---------------------- managementt. It may be required for the purpose of decision-making or
for the purpose of fulfillment of various legal obligations.
----------------------
4. Taxation: Management accounting deals with the computation of income
---------------------- as per the law, filing tax returns and making the tax payments.
---------------------- 5. Audit: Management accounting deals with devising the internal control
systems and internal audit system to cover the various operational areas
---------------------- of business. In many cases, it may also deal with the management audit,
which is the evaluation of the managerial performance.
----------------------
6. Methods and Services: Management accounting deals with providing
---------------------- management services and the management information systems. It also
---------------------- deals with various methods of reducing the cost and improving the
efficiency of accounting and other office operations and preparing and
---------------------- issuing the accounting and other operational manuals.
---------------------- Thus, Management Accounting is an extension of managerial aspects of

cost accounting with the ultimate intention to protect the interests of the business.
----------------------
Summary
----------------------
---------------------- ●● Business is a commercial activity carried out with the intention of earning
profits. It requires timely analysis and interpretation of the information
---------------------- to know the standing of business. Financial Statements fulfill this
requirement.
----------------------
●● Accounting refers to the process of analysing and interpreting the
---------------------- information already recorded in the books of accounts with the ultimate
intention of answering the above stated questions.
----------------------
●● According to American Institute of Certified Public Accountants,
---------------------- “Accounting is on art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events which
---------------------- are of a financial character and interpreting the results thereof.”
---------------------- ●● Financial Accounting is the process of systematic recording of the
business transactions in the various books of accounts maintained by
---------------------- the organization with the ultimate intention of preparing the financial
statements therefrom.
----------------------
●● Cost Accounting deals with the recording of income and expenditure, Notes
ascertainment of cost and profitability and the presentation of information
derived therefrom for the purpose of managerial decision-making. Cost ----------------------
accounting assists the management to make decisions.
----------------------
●● Management Accounting is the process of analysis and interpretation of
financial data collected with the help of financial accounting and cost ----------------------
accounting, with the ultimate intention to draw certain conclusions
therefrom, in order to assist the management in the process of decision- ----------------------
making. ----------------------
●● Management Accounting is an extension of managerial aspects of cost
accounting with the ultimate intention to protect the interests of the ----------------------
business. It is an invaluable aid to the management for discharging the ----------------------
basic functions of planning, execution and control.
----------------------
Keywords ----------------------
●● Cost Accounting: Cost accounting is the process of classifying and ----------------------
recording of expenditure in a systematic manner, with the intention of
ascertaining the cost of a cost center for the controlling of the cost. ----------------------
●● Financial Accounting: Financial Accounting is the process of the ----------------------
systematic recording of the business transactions in the various books
of accounts maintained by the organization, based on generally accepted ----------------------
accounting principles.
----------------------
●● Financial Statements: This includes a profitability statement showing
the result of operations of the business activity and the balance sheet ----------------------
indicating the financial status of the statement at a given point of time in
terms of its assets and liabilities. ----------------------
●● Management Accounting: Management Accounting is the process of ----------------------
analysis and interpretation of financial data collected with the help of
financial accounting and cost accounting with the ultimate intention of ----------------------
drawing certain conclusions thereof in order to assist the management in
----------------------
the process of decision-making.
----------------------
Self-Assessment Questions ----------------------
1. Explain the nature and characteristic features of Financial Accounting ----------------------
and Cost Accounting with special reference to their interrelationship.
----------------------
2. What do you understand by Management Accounting? State the advantages
and limitations of Management Accounting. How is Management ----------------------
Accounting related to the other streams of accounting?
----------------------
3. Discuss the emergence of Management Accounting in brief.
4. Critically compare Management Accounting and Financial Accounting. ----------------------
----------------------
Notes Answers to Check your Progress
---------------------- Check your Progress 1
---------------------- 1. False
2. True
----------------------
3. False
----------------------
4. False
----------------------
---------------------- Suggested Reading

---------------------- 1. Donatila Agtarap-San Juan, Fundamentals of Accounting
---------------------- 2. http://www.myicwai.com/
3. http://www.icwai.org/icwainew/index.asp
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Basics of Financial Accounting
UNIT
2
Structure:
2.1 Introduction
2.2 Accounting Concepts and Conventions
2.3 Principles and Methods (Basis) of Accounting
2.4 Types of Accounts
2.5 List of Common Terms used in Financial Accounting
2.6 Types of Expenditure
2.7 Double Entry Bookkeeping
2.8 Depreciation Accounting
Summary
Key Words
Suggested Reading
Basics of Financial Accounting 15

Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define the accounting principles, concepts and conventions
----------------------
• Underline the methods of accounting and conceptual framework of
---------------------- accounting
• Use the general terms used in financial accounting
----------------------
• Analyze the need and importance of depreciation accounting and its
---------------------- various methods
---------------------- • Evaluate the practical considerations relating to depreciation
----------------------
2.1 INTRODUCTION
----------------------
You have learnt in previous unit that financial accounting is the process
---------------------- of recording the financial transactions of the past and calculating the net result
of these transactions, with the intention of communicating the same to various
----------------------
persons dealing with the business.
---------------------- Financial accountancy is applied to report financial health of an organization
by preparing accountancy data for people outside the organization or for those
----------------------
who are not involved in the day to day administration of the company. The
---------------------- central need for financial accounting is to reduce the various principal-agent
problems, by measuring and monitoring the agents’ performance and thereafter
---------------------- reporting the results to interested users.
---------------------- There are various accounting principles associated with financial
accounting. Proper understanding of these principles would help to distinguish
---------------------- technicalities of financial accounting and thus prepare financial statements
---------------------- Let us consider accounting principles associated with financial accounting.
----------------------
2.2 ACCOUNTING CONCEPTS AND CONVENTIONS
----------------------
In order to bring uniformity to the recording of business transactions,
---------------------- the accountants follow certain basic procedures universally which are called
Accounting Concepts and Accounting Conventions
----------------------
a. Accounting Concepts - These indicate those basic assumptions upon
---------------------- which the basic process of accounting is based. The following are the
important Accounting Concepts:
----------------------
i. Business Entity Concept
---------------------- ii. Dual Aspect Concept
---------------------- iii. Going Concern Concept
---------------------- iv. Accounting Period Concept
v. Cost Concept Notes
vi. Money Measurement Concept
----------------------
vii. Matching Concept
----------------------
b. Accounting Conventions - These indicate those customs and traditions
that are followed by the accountants while preparing the financial ----------------------
statements. The following are the important Accounting Conventions:
----------------------
i. Convention of Conservation
ii. Convention of Materiality ----------------------
iii. Convention of Consistency ----------------------

Accounting Concepts ----------------------
i. Business Entity Concept: This accounting concept proposes that the
----------------------
business is assumed to be a distinct entity than the person who owns the
business. The accounting process is carried out for the business and not ----------------------
for the person who owns the business.
----------------------
If there is a partnership concern carrying on the business in the name of
M/s. XYZ & Co., where Mr. A and Mr. B are equal partners, M/s. XYZ & Co. is ----------------------
supposed to be a separate entity from Mr. A and Mr. B. The financial statements
prepared on the basis of accounting records are of M/s. XYZ & Co. and not ----------------------
of Mr. A or Mr. B individually. It should be noted in this connection that the ----------------------
business entity concept has nothing to do with the legal entity of the business.
It applies to both corporate organizations (which by themselves are a separate ----------------------
legal entity from the owners) as well as non-corporate organizations (which are
not a legal entity separate from the owners). ----------------------
ii. Dual Aspect Concept: This concept proposes that every business ----------------------
transaction has two effects. However, the basic relationship between assets
and liabilities, which means that the assets are equal to the liabilities, ----------------------
remains the same. ----------------------
For example, if Mr. A starts the business by introducing the capital of Rs.
50,000, the assets and liabilities structure will be as below: ----------------------
Liabilities Assets ----------------------

Capital 50,000 Cash 50,000 ----------------------
Now, if Mr. A uses the cash to purchase material worth Rs. 40,000, the
----------------------
assets and liabilities structure will change as below:
Liabilities Assets ----------------------
Capital 50,000 Cash 10,000 ----------------------

Stock-in-Trade 40,000 ----------------------
50,000 50,000
----------------------
----------------------

Notes If A sells the above material worth Rs. 40,000 for Rs. 45,000 on credit
basis, the assets and liabilities structure will change as below:
----------------------
Liabilities Assets
---------------------- Capital 55,000 Cash 10,000
---------------------- Receivables 45,000
---------------------- 55,000 55,000

iii. Going Concern Concept: This concept proposes that the business
---------------------- organization is going to be in existence for an indefinitely longer period
---------------------- of time and is not likely to close down the business in the shorter period
of time. This affects the valuation of assets and liabilities. As such, the
---------------------- assets are disclosed in the Balance Sheet at cost less depreciation and not
at the current market price. If the assets are to be disclosed in the Balance
---------------------- Sheet at the correct value, the current market price will be most suitable.
---------------------- However, as the business is likely to exist for an indefinitely longer period
of time and as the assets are not likely to be sold off in the market in the
---------------------- near future, the market price becomes immaterial.
---------------------- iv. Accounting Period Concept: Even if the Going Concern Concept
proposes that the business is going to be in existence for an indefinitely
---------------------- longer period of time, in order to facilitate the preparation of financial
statements on periodical basis, the indefinitely longer life span on the
---------------------- business is divided into shorter time segments, each one being in the
---------------------- form of Accounting Period. Profitability is computed for this accounting
period (by preparing the profitability statement) and the financial position
---------------------- is assessed at the end of this accounting period (by preparing the balance
sheet). It should be noted that the selection of accounting period may
---------------------- depend upon various factors such as characteristics of the business
---------------------- organization, tax considerations, statutory requirements etc.
v. Cost Concept: This concept proposes that the assets acquired by the
----------------------
organization are recorded at their cost of acquisition and this cost is
---------------------- considered for all the subsequent accounting purposes, say charging of
depreciation. This concept does not take into consideration current market
---------------------- prices of the various assets.
---------------------- vi. Money Measurement Concept: This concept proposes that only those
transactions and facts find the place in accounting, which can be expressed
---------------------- in terms of money. As such, all those transactions and facts, which can not
be expressed in terms of money (for example, the morale and motivation
----------------------
of the workers, credibility of the business organization in the market etc.),
---------------------- do not find any place in accounting and thus also in financial statements,
though they may have a direct or indirect bearing on the business. This
---------------------- concept imposes severe restrictions on the kind of information available
from the financial statements. In fact, this is one of the major drawbacks
----------------------
of financial accounting and financial statements.
----------------------
vii. Matching Concept: This concept proposes that while calculating the Notes
profit for the accounting period in a correct manner, the expenses and costs
incurred during the period, whether paid or not, should be matched with ----------------------
the revenues generated during the period. For example, if the accounting
period ends on 31st March, the salaries for the month of March should be ----------------------
considered as the cost for the year ending on 31st March, even if they are ----------------------
actually paid for in the month of April. Otherwise, the calculation of the
profits for the year ending on 31st March will go wrong as the income will ----------------------
be for 12 months, while the expenses will be for 11 months only.
----------------------
b. Accounting Conventions
----------------------
Accounting Conventions indicate those customs and traditions that
are followed by the accountants while preparing the financial statements. ----------------------
The following are the important Accounting Conventions:
----------------------
i. Convention of Conservation
This convention is usually expressed as to “anticipate all the ----------------------
future losses and expenses, without considering the future incomes ----------------------
and profits unless they are actually realised.” This convention
generally applies to the valuation of current assets and as such, the ----------------------
current assets are valued at cost or market price, whichever is lower.
The valuation of non-current assets is done at cost (as per the cost ----------------------
concept). ----------------------
ii. Convention of Materiality
----------------------
This convention proposes that while accounting for the
various transactions, only those transactions will be considered, ----------------------
which have material impact on profitability or financial status of the
----------------------
organization and other insignificant transactions will be ignored,
for example, if the organization purchases some postal stamps, ----------------------
some of which remain unused at the end of the accounting period.
According to matching concept, the cost of such non-used postal ----------------------
stamps should not be considered as the item of cost. However as
----------------------
its impact on the overall profitability is likely to be negligible, the
cost of non-used postal stamps may be ignored, treating the cost of ----------------------
purchases as the expenditure. Which transactions should be treated
as material ones is subjective and depends upon the judgment and ----------------------
knowledge of the accountant.
----------------------
iii. Convention of Consistency
----------------------
This convention proposes that the accounting policies and
procedures should be followed consistently on a period-to-period ----------------------
basis so as to facilitate the comparison of financial statements on
a period-to-period basis. If there is any change in the accounting ----------------------
policies and procedures, this fact, coupled with its effect on
----------------------
profitability, should be disclosed explicitly while preparing the
financial statements. ----------------------

Notes
----------------------
---------------------- Fill in the blanks.

1. _______________ concept proposes that the business is assumed to
---------------------- be a distinct entity than the person who owns the business.
---------------------- 2. ______________ concept proposes that every business transaction
has two effects.
---------------------- 3. _________________ concept proposes that the business organization
---------------------- is going to be in existence for an indefinitely longer period of time
and is not likely to close down the business in the shorter period of
---------------------- time.
4. __________________ convention is usually expressed as to
----------------------
“anticipate all the future losses and expenses.
---------------------- 5. ________________ convention proposes that while accounting for
the various transactions, only those transactions will be considered,
---------------------- which have material impact on profitability or financial status of the
---------------------- organization.
6. _______________ convention proposes that the accounting policies
---------------------- and procedures should be followed consistently on a period-to-period
---------------------- basis.
----------------------
---------------------- Activity 1
----------------------
Explain with suitable examples any two accounting concepts, which you
---------------------- have come across in day-to-day business transactions of your organization.
----------------------
2.3 PRINCIPLES AND METHODS (BASIS) OF ACCOUNTING
----------------------
Now you are aware that accountancy, or the accounting, is the production
----------------------
of information about an enterprise and the transmission of that information
---------------------- from those who have it to those who need it.
---------------------- The communication is generally in the form of financial statements that

show in money terms the economic resources under the control of management;
---------------------- the art lies in selecting the information that is relevant to the user and is
representationally faithful.
----------------------
The principles of accountancy are applied to business entities in three
---------------------- divisions of practical art, named accounting, bookkeeping and auditing.
---------------------- The body of rules that governs financial accounting in a given jurisdiction
is called Generally Accepted Accounting Principles, or GAAP. The rules
---------------------- include International Financial Reporting Standards or IFRS or US GAAP.
(IFRS is explained in detail in separate unit of this SLM) Notes
Recognising revenue implies the act that would make the organisation
----------------------
consider that they have earned the revenue involved in the transaction. Based
on when the revenue is recognised, there are two methods (basis) of accounting ----------------------
systems:
----------------------
(a) Cash method (basis) of Accounting
(b) Accrual or Mercantile method (basis) of Accounting ----------------------
It is important for you to understand the basics of the two principal ----------------------
methods of keeping track of a business’s income and expenses: cash method
and accrual method (sometimes called cash basis and accrual basis). ----------------------
In a nutshell, these methods differ only in the timing of when sales and ----------------------
purchases are credited or debited to your accounts. If you use the cash method,
income is counted when cash (or a check) is actually received, and expenses ----------------------
are counted when actually paid. But under the more common accrual method, ----------------------
transactions are counted when they happen, regardless of when the money is
actually received or paid ----------------------
a. Cash basis of Accounting ----------------------
In this system of accounting, expenses are considered to be expenses only
----------------------
when they are paid for and the incomes are considered to be incomes only
when they are actually received. This system of accounting is mainly used ----------------------
by the organizations established not for earning the profits. This system of
accounting is considered to be defective in nature, as it may not represent ----------------------
the true picture of profitability as well as of the state of affairs.
----------------------
b. Mercantile or Accrual basis of Accounting
----------------------
In this system of accounting, expenses are considered as expenses during
the period to which they pertain. Similarly, incomes are considered to ----------------------
be incomes during the period to which they pertain. When the expenses
are actually paid for or when the incomes are actually received is not ----------------------
significant in case of Mercantile or Accrual System of Accounting. This ----------------------
system of accounting is considered to be more ideal and is generally
preferred by the accountants. However, as the time of physical receipt of ----------------------
cash is immaterial in this system of accounting, the Accrual System of
Accounting may result into the unrealised profits being reflected in the ----------------------
books of accounts on which the organization may be required to pay the ----------------------
taxes too.
Note: It will not be out of place to mention here that, as per the provisions of ----------------------
Section 209 of the Companies Act, 1956, all the company form of organizations ----------------------
are legally required to follow Mercantile or Accrual method of Accounting.
Other organizations have a choice to select either of the method of accounting. ----------------------
----------------------
----------------------

Notes
----------------------
---------------------- State True or False.

1. In Mercantile or Accrual basis of Accounting, expenses are considered
----------------------
to be expenses only when they are paid for and the incomes are
---------------------- considered to be incomes only when they are actually received.
2. In Cash basis of Accounting, expenses are considered as expenses
----------------------
during the period to which they pertain.
----------------------
---------------------- Activity 2
----------------------
Meet with the accountant in your organization and observe which basis
---------------------- of accounting is used.
----------------------
2.4 TYPES OF ACCOUNTS
----------------------
For the purpose of financial accounting various accounts are classified
---------------------- under the following categories:
---------------------- A. Personal Accounts: These are the accounts of persons with whom the
organization deals in various capacities. In practical circumstances,
----------------------
personal accounts may consist of the following types of accounts:
---------------------- 1. Accounts of the suppliers
---------------------- 2. Accounts of the customers
---------------------- 3. Bank / Financial Institutions

4. Capital Account
----------------------
B. Real Accounts: These are the accounts of assets and liabilities. In
---------------------- practical circumstances, real accounts may consist of the following types
of accounts:
----------------------
1. Land Account
----------------------
2. Building Account
---------------------- 3. Machinery Account
---------------------- 4. Furniture Account
---------------------- 5. Vehicles Account

Real Accounts may also consist of the accounts of some intangible assets,
----------------------
which cannot be experienced in physical form
---------------------- 1. Goodwill Account
---------------------- 2. Patents and Trade Marks Account
C. Nominal Accounts: These are the accounts of incomes or expenses. In Notes
practical circumstances, nominal accounts may consist of the following
types of accounts: ----------------------
1. Salary Account ----------------------
2. Wages Account
----------------------
3. Printing and Stationery Account
----------------------
4. Insurance Account
5. Telephone Expenses Account ----------------------
6. Interest paid or Received Account ----------------------

7. Commission paid or Received Account ----------------------
2.5 LIST OF COMMON TERMS USED IN FINANCIAL ----------------------

ACCOUNTING ----------------------
Followings are the terms those are frequently used in Financial Accounting ----------------------
1. Assets: All the properties owned by the business are collectively referred ----------------------
to as the assets of the business.
2. Account: It is the record of all the transactions pertaining to a person, ----------------------
asset, liability, income or expenditure, which have taken place during a ----------------------
specified period and shows the final net effect of all these transactions.
----------------------
3. Balance Sheet: It is the summarized statement of what the business owns,
i.e. assets and what the business owes, i.e. liabilities at any given point of ----------------------
time.
----------------------
4. Bills Payable: It indicates the amount payable to the suppliers for which
the negotiable instrument in the form of Bill of Exchange is given to the ----------------------
suppliers.
----------------------
5. Bills Receivable: It indicates the amount receivable from the customers
for which the negotiable instrument in the form of bill of exchange is ----------------------
received from the customer.
----------------------
6. Brought Forward (b/f): When the balances in the ledger account or cash/
bank book of the previous year or previous period are entered in the current ----------------------
year’s books of accounts, the balances are said to be Brought Forward.
----------------------
7. Capital: It indicates the amount of funds invested by the owner of the
business in the business. ----------------------
8. Carried Forward (c/f): When the balances in the ledger account or cash/ ----------------------
bank book of the current year or current period are to be transferred to the
next year’s books of accounts, the balances are said to be Carried Forward. ----------------------
9. Cash Discount: It is the discount received from the suppliers or allowed to ----------------------
customers for making early payment of dues. Cash discount is accounted
for in the books of accounts. Cash discount received from the suppliers ----------------------

Notes is revenue income and cash discount allowed to the customers is revenue
expenditure.
----------------------
10. Casting: It refers to the totaling of the books of accounts.
---------------------- 11. Credit Note: It is an intimation sent to a person dealing with the business
that his account is being credited for the purpose indicated therein.
----------------------
12. Creditor: A creditor is a supplier to whom the business owes money for
---------------------- the goods or services bought from him on credit basis.
---------------------- 13. Credit Side: Credit side of the account is the right hand side of the account.
---------------------- 14. Debit Side: Debit side of the account is the left hand side of the account.
15. To credit: To credit an account means to make the entry on credit side of
---------------------- the account.
---------------------- 16. To debit: To debit an account means to make the entry on the debit side of
the account.
----------------------
17. Debit Note: It is an intimation sent to a person dealing with the business
---------------------- that his account is being debited for the purpose indicated therein.
---------------------- 18. Debtor: A debtor is a customer who owes money to the business for the
goods or services supplied to him on credit basis.
----------------------
19. Depreciation: It applies to fixed assets such as Land, Buildings, Machinery,
---------------------- Furniture, Vehicles etc. The term indicates reduction in the value of fixed
assets, which can arise either due to time factor or use factor or both. A
---------------------- detailed note on Depreciation Accounting is given in this unit..
---------------------- 20. Drawings: It indicates the amount of funds or goods withdrawn by the
owner of the business for his personal use.
----------------------
21. Entry: It means the record of a financial transaction in the books of
---------------------- accounts.
---------------------- 22. Folio: It refers to the page number of the book of original entry or the
ledger.
----------------------
23. Journal: It is the Book of Original Entry or the Book of Prime Entry
---------------------- where the financial transactions are recorded in the chronological order
as and when they take place.
----------------------
24. Ledger: It is the book where the transactions of the similar nature are
---------------------- pooled together under one Ledger Account. Ledger or General Ledger, as
it is referred to in practical circumstances, maintains all types of accounts,
---------------------- i.e. personal, real and nominal. Whichever transactions are recorded
---------------------- in the Journal or Subsidiary Books in a chronological order, the same
transactions are posted in the Ledger, account wise.
---------------------- 25. Liabilities: All the amounts owed by the business to various providers of
---------------------- funds or services are collectively referred to as liabilities.
26. Narration: It is the summarized explanation or description of the financial
---------------------- transactions recorded in the books of accounts.
27. Posting: It refers to the process of transferring the transaction entered into Notes
the book or original entry or subsidiary book to the ledger account.
----------------------
28. Trade Discount: It is the discount received on purchases or the discount
allowed on sales, which is an adjustment with the basic purchase or ----------------------
sales price. Trade discount is not accounted for in the books of accounts.
Purchase value or sales value is accounted for net of trade discount. ----------------------
29. Voucher: It is any documentary evidence to justify that a particular ----------------------
transaction has taken place. The voucher can be internal or external.
----------------------
Check your Progress 3 ----------------------
----------------------
Fill in the blanks.
1. _________ means the record of a financial transaction in the books of ----------------------
accounts. ----------------------
2. ___________ side of the account is the right hand side of the account.
----------------------
3. _____________ side of the account is the left hand side of the account.
----------------------
4. When the balances in the ledger account or cash/bank book of the current
year or current period are to be transferred to the next year’s books of ----------------------
accounts, the balances are said to be _____________________.
----------------------
----------------------
Activity 3
----------------------
From the above three types of accounts Personal, Real, Nominal Account,
----------------------
categorize and list any ten items applicable in your organization.
----------------------
2.6 TYPES OF EXPENDITURE ----------------------
For the purpose of accounting, the expenses or the money paid for goods/ ----------------------
services is classified in three ways:
----------------------
1. Capital Expenditure
----------------------
2. Revenue Expenditure
3. Deferred Revenue Expenditure ----------------------
1. Capital Expenditure ----------------------
Capital Expenditure indicates the amount of funds paid for acquiring the ----------------------
infrastructural properties required for doing business, technically referred
to as Fixed Assets. Fixed Assets do not give returns during the same period ----------------------
during which they are paid for. As such, benefits available from capital
expenditure are long-term benefits. Hence, it will be wrong to consider the ----------------------
capital expenditure as expenses while calculating the profitability during ----------------------
a certain period. In technical words, capital expenditure never affects the

Notes Profitability Statement, except in case of Depreciation, which, in simple
words, indicates that part of the capital expenditure, returns equivalent to
---------------------- which are received during the corresponding period.
---------------------- 2. Revenue Expenditure
Revenue Expenditure indicates the amount of funds paid during a certain
----------------------
period with the intention to receive the return during the same period. As
---------------------- such, the benefits available from revenue expenditure are received during
the same period during which they are paid for. The entire amount of
---------------------- revenue expenditure affects the Profitability Statement.
---------------------- 3. Deferred Revenue Expenditure
---------------------- Deferred Revenue Expenditure indicates the amount of funds paid, which
does not result into the acquisition of any fixed asset. However, at the
---------------------- same time benefits from this expenditure are not received during the same
period during which they are paid for.
----------------------
The examples of Deferred Revenue Expenditure are:
---------------------- 1. Initial Advertisement Expenditure
---------------------- 2. Research and Development Expenditure
---------------------- 3. In case of company form of organization, Preliminary Expenses or
Company Formation Expenses
----------------------
Principally, deferred revenue expenditure is not transferred to the
---------------------- profitability statement in the period during which it is paid for. As such,
deferred revenue expenditure does not affect the profitability of the period
---------------------- during which it is paid for. It is transferred to the profitability statement (in
---------------------- technical words “written off to the Profitability Statement”) over the period over
which benefits are received, by passing the adjustment entry. As such, deferred
---------------------- revenue expenditure affects the profitability only when they are written off to
Profitability Statement. Till they are written off to the Profitability Statement,
---------------------- they are shown on the asset side of the Balance Sheet.
----------------------
2.7 DOUBLE ENTRY BOOKKEEPING
----------------------
The basic presumption made by the Double Entry System of Accounting
---------------------- is that every business transaction has two elements, which are expressed as:
‘when the business receives something, it has to pay something’. For example,
----------------------
if the business pays the telephone bill in cash, it gets the benefit of using the
---------------------- telephone, but at the same time the cash goes out. Similarly, if goods are
sold to the customer for cash, goods of the business go out, but it receives
---------------------- the corresponding amount of cash. Accordingly, if Double Entry System of
Accounting is followed, every business transaction affects two accounts. One
----------------------
account is debited, while another account is credited by the similar amount.
---------------------- Thus, the Double Entry System of accounting follows the principle of “every
debit has a corresponding credit” and hence, total of all debits has to be equal to
---------------------- the total of all credits.
Advantages of Double Entry Bookkeeping Notes
Double Entry System of Accounting proves to be advantageous due to
----------------------
certain reasons.
a. It takes into consideration both the aspects of each business transaction. ----------------------
b. Arithmetical accuracy of the accounting records can be verified by ----------------------
preparing the trial balance.
----------------------
c. The correct result of operations can be ascertained by preparing the final
accounts periodically. ----------------------
d. Correct valuation of assets and liabilities is possible at any given point of ----------------------
time by preparing the Balance Sheet.
Basic Rules for Double-Entry Bookkeeping ----------------------
While entering into various financial transactions in the records maintained ----------------------
by the organization, the following basic rules for accounting are followed:
----------------------
a. In case of personal accounts – debit the receiver, credit the giver
----------------------
b. In case of real accounts – debit what comes in, credit what goes out
c. In case of nominal accounts – debit all the expenses, credit all the incomes ----------------------
----------------------
Activity 4
----------------------
Visit the accounts department of your organization and observe double ----------------------
entry bookkeeping followed by them.
----------------------
----------------------
2.8 DEPRECIATION ACCOUNTING
----------------------
Depreciation can be defined as a permanent, continuous and gradual
reduction in the book value of a fixed asset. Normally, all the fixed assets except ----------------------
land depreciate in value, rendering the asset useless after the end of a certain
period. ----------------------
Let us study Depreciation accouting in detail: ----------------------

1. Main causes of depreciation ----------------------
The following may be stated as the main causes of depreciation.
----------------------
a. Use factor: The fixed assets depreciate because they are used for
the purpose they are meant for. It is applicable in case of tangible ----------------------
assets like machinery, furniture, office equipment etc. ----------------------
b. Time factor: The fixed assets depreciate due to the passage of time.
----------------------
c. Obsolescence: It is the reduction in the value of fixed assets. It may
take place due to new inventions, modifications or improvements. ----------------------
----------------------

Notes 2. Need for Depreciation Accounting
According to the nature of fixed assets, these are the assets, which may be
----------------------
used for the business purposes over a certain number of future accounting
---------------------- periods and the benefit received from them is spread over the said number
of future accounting periods. According to the matching principle of
---------------------- accounting, the costs incurred during an accounting period are required
to be matched with the benefits or revenues earned during that period.
----------------------
To distribute the cost of a fixed asset
----------------------
It is necessary to distribute the cost of a fixed asset, less the scrap or
---------------------- salvage or realizable value, after the useful life of the fixed asset is over, in such
a way so as to allocate it as equitably as possible to the periods during which
---------------------- the benefits are received from the use of fixed assets. This system or procedure
---------------------- is called depreciation accounting.
Thus, the depreciation accounting is necessary for two main purposes.
----------------------
a) To ascertain due profits by correctly matching the various costs and
---------------------- expenses incurred with various incomes and revenues earned during
various accounting periods.
----------------------
b) To represent the value of a fixed asset on the balance sheet at its unexpired
---------------------- cost, i.e. at book value less depreciation. If the depreciation is not provided,
the asset may appear in the balance sheet at an overstated amount.
----------------------
Depreciation forms a part of cost
----------------------
It may also be noted in this connection that the depreciation forms a part
---------------------- of cost for arriving at the profits, which can be distributed to the owners of the
business in the form of dividend. By providing the depreciation, the amount
---------------------- of distributable profits is reduced and retained in the business, which can be
---------------------- utilized for the replacement of the asset at the end of its economic life.
3. Methods for Calculating Depreciation
----------------------
There may be various methods available for calculating the amount
---------------------- of depreciation to be charged to Profit & Loss Account. Amount of
depreciation is a function of various factors, viz time, usage, time and
---------------------- usage, time and cost of maintaining the fixed assets and provision of
---------------------- funds for replacing the assets.
As such, the various methods available for charging the depreciation can
----------------------
be described as below.
---------------------- a. Straight Line Method
---------------------- b. Written Down Value (Reducing Balance) Method
---------------------- c. Production Unit Method

d. Joint Factor Rate Method
----------------------
e. Revaluation Method
----------------------
f. Renewal Method
a. Straight Line Method Notes
According to this method, the amount of yearly depreciation is calculated
----------------------
as below:
Cost of asset Estimated scrap value ----------------------
Estimated life in years ----------------------
E.G. C = Cost of Asset Rs. 1,10,000 ----------------------
Estimated scrap value
----------------------
(At the end of life of the asset) Rs. 10,000
----------------------
∴ Yearly depreciation = Rs. 1,10,000 - Rs. 10,000
10 ----------------------
= Rs. 10,000 ----------------------
The benefit of this method is that an equal amount of depreciation is ----------------------
charged every year throughout the life of the asset, making the calculation
of depreciation and of the cost comparison easy. The main drawback of this ----------------------
method is that the amount of depreciation in later years is high when the utility
of the asset is reduced. ----------------------
b. Written Down Value (Reducing Balance) Method ----------------------

According to this method, the depreciation is provided at a predetermined ----------------------
percentage, on the balance of cost of asset after deducting the depreciation
previously charged (usually termed as written down value). ----------------------
E.g. Cost of asset Rs. 1,10,000 ----------------------
Estimated scrap value Rs. 10,000
----------------------
Cost of asset subjected to depreciation Rs. 1,00,000
----------------------
Rate of depreciation 10%
The amount of depreciation is calculated as shown below. ----------------------
Year Balance Cost Depreciation Written Down ----------------------

of Assets Value - WDV ----------------------
Rs. Rs. Rs.
1 1,00,000 10,000 90,000 ----------------------
2 90,000 9,000 81,000
----------------------
3 81,000 8,100 72,900
4 72,900 7,290 65,610 ----------------------
5 65,610 6,651 59,049 ----------------------
The rate of depreciation to be charged is calculated according to the
following formula. ----------------------
D = ----------------------
----------------------

Notes where n = number of years
R = Residual / Scrap Value
----------------------
C = Cost of the asset
---------------------- The main benefit of this method is that it recognizes the fact that in the
initial years of life of the asset, the repairs and maintenance cost is less, which
----------------------
goes on increasing gradually with the progressing life of asset. According
---------------------- to this method, the higher amount of depreciation in the initial years and a
gradual decrease therein is counterbalanced by the lower amount of repairs and
---------------------- maintenance cost in the initial years and a gradual increase therein. It should be
noted here that the written down value can never become zero.
----------------------
c. Production Unit Method
----------------------
According to this method, depreciation is provided at a predetermined
---------------------- rate per unit, which in turn is calculated on the basis of total number of units lo
be produced during the life of the asset.
----------------------
E.g. Cost of the machine Rs. 1,10,000
---------------------- Estimated scrap value Rs. 10,000
Estimated number of units to be produced 50,000
----------------------
Rs. 1,10,000 - Rs. 10,000
---------------------- ∴ Rate of depreciation per unit =
50,000
---------------------- = Rs. 2 per unit
---------------------- If in a particular year, 7,000 units are produced, the depreciation to be
charged will be:
----------------------
7,000 units x Rs. 2 per unit = Rs. 14,000.
---------------------- This method gives more stress on usage factor rather than time factor.
Higher the number of units produced, higher is the amount of depreciation and
----------------------
vice versa.
---------------------- d. Production Hour Method:
---------------------- This method is similar to the production unit method except that instead
of number of units to be produced during the life of asset, number of hours for
---------------------- which the asset is expected to work is taken into consideration.
---------------------- E.g. Cost of the machine Rs. 1,10,000
Estimated scrap value Rs. 10,000
---------------------- Estimated number of hours 25,000
---------------------- Rs. 1,10,000 - Rs. 10,000
∴ Rate of depreciation per unit =
---------------------- 25,000
= Rs. 4 per hour
----------------------
If in a particular year, the machine works for 2,500 hours, the depreciation
---------------------- to be charged will be:
---------------------- 2,500 hours x Rs. 4 per hour = Rs. 10,000
e. Joint Factor Rate Method Notes
According to this method, the depreciation is provided partly at a fixed
----------------------
rate on time basis and partly at a variable rate on usage basis.
E.g. Cost of the machine Rs. 1,00,000 ----------------------
To be depreciated on time basis over life of the ----------------------
machine i.e. 10 year Rs. 50,000
----------------------
Estimated number of units to be produced 50,000
Depreciation ----------------------
(a) On time basis - Rs. 50,000 ----------------------

= Rs. 5,000 per year
10 years ----------------------
(b) On time basis - Rs. 50,000 ----------------------
= Re. 1 per unit
50,000 units ----------------------
If in a particular year, the machine produces 6,000 units, the depreciation
to be charged will be: ----------------------
Time basis Rs. 5,000 ----------------------

Usage basis 6,000 units x Re. 1 Rs. 6,000 ----------------------
Rs. 11,000
----------------------
f. Revaluation Method
----------------------
According to this method, the asset is revalued periodically. The amount
of depreciation for that period is the difference between the cost of the asset ----------------------
at the beginning of the period and the amount of revaluation at the end of the
period. ----------------------
This method of charging the depreciation is extensively used for the assets ----------------------
such as livestock, patterns etc.
----------------------
g. Renewal Method
According to this method, the full cost of the asset is charged as ----------------------
depreciation during the period in which the asset is renewed. No depreciation is ----------------------
charged in between the period. This method of charging can be used if the asset
is of small value and is renewed frequently. ----------------------
4. Practical Aspect of Depreciation
----------------------
In spite of the fact that there are various methods available for calculating
depreciation, the final choice of the method depends upon the individual ----------------------
organization. It should be noted that Income Tax Act, 1961, which is a very ----------------------
important piece of legislation applicable to all types of business organizations,
recognizes only one method for calculating the depreciation i.e. Written Down ----------------------
Value method. The rates at which the depreciation is to be calculated is also
specified in the Income Tax Act, 1961. If the organization wants to calculate the ----------------------
depreciation on some different basis or at some different rates, it can do so for ----------------------
financial accounting purposes.

Notes However, for calculating the tax liability, the depreciation has to be
calculated on Written Down Value basis and that too at the specified rates.
----------------------
Salient features of Schedule XIV of the Companies Act, 1956
---------------------- The company form of organization to whom the provision of Companies
Act, 1956 apply, are required to calculate the depreciation as per the provisions
----------------------
of Schedule XIV of the Companies Act, 1956. The salient features of Schedule
---------------------- XIV of the Companies Act, 1956 can be stated as below:
a. Schedule XIV of the Companies Act, 1956 provides that the company can
----------------------
calculate the depreciation by using either Written Down Value method
---------------------- or Straight Line method. The companies are given the choice to select
between these two methods. The actual choice of the method may depend
---------------------- upon the effect on the profitability of the company. If the company wants
to change the method of calculating the depreciation, this amounts to a
----------------------
change in the accounting policy. Any change in the method of calculating
---------------------- the depreciation has to be effected with retrospective effect from the date
of incorporation of the company. The company is required to disclose
---------------------- the fact of change in the method of calculating the depreciation while
preparing its financial statements along with the effect of change in the
----------------------
method of calculating the depreciation.
---------------------- b. The rates at which the companies are required to calculate the depreciation
---------------------- are specified in Schedule XIV. For this purpose, the fixed assets are
classified in various categories. The broad categorization of the fixed
---------------------- assets is as below:
---------------------- 1. Buildings - Factory buildings as well as administration buildings

2. Plant and Machinery
---------------------- 3. Furniture
---------------------- 4. Vehicles
5. Computer Installations
----------------------
c. If during the financial year, any addition has been made to any asset or any
---------------------- asset has been sold, the depreciation on such an asset will be calculated on
a pro rata basis from the date of such addition or up to the date on which
----------------------
such an asset has been sold.
---------------------- The rates for calculation of depreciation are as below:
---------------------- Nature of the Fixed Asset WDV SLM
---------------------- Buildings - Factory 10% 3.63%
---------------------- Buildings - Administrative 5% 1.63%

Plant and Machinery 15% 4.75%
----------------------
Furniture 10% 6.33%
---------------------- Vehicles 20% 9.5%
---------------------- Computer Installations 40% 16.21%
Following questions are normally raised in respect of the nature of Notes
depreciation.
----------------------
(1) Is depreciation a cost?
Yes, depreciation is a cost because of the obvious reasons that it reduces ----------------------
the profitability and it is a charge against the profit. At the same time,
----------------------
it should also be noted that it is a non-cash cost, as it is never paid or
incurred in cash. ----------------------
(2) Does depreciation generate funds for replacement of assets?
----------------------
If the depreciation is provided under the Sinking Fund Method or
Endowment Policy Method, sufficient funds may be available at the end ----------------------
of life of the asset, equivalent to the original cost of the asset. As such, it ----------------------
can be said that these two methods make available the funds equivalent
to the original cost of the asset at the end of the life of the asset. However ----------------------
these funds may not be sufficient to replace the asset due to the increased
price of the same. Other methods of charging the depreciation do not ----------------------
directly generate the funds required for replacing the assets. The fact ----------------------
that the assets are depreciated to the extent of almost the entire of the
original cost of the same does not indicate that the funds are available for ----------------------
replacement purpose. However, depreciation may be viewed from one
more angle. It is a charge to profits, which reduces the profits that can be ----------------------
distributed among the shareholders by way of dividends, thus conserving ----------------------
the business funds in the business itself. This may be considered a very
indirect way of interpretation that depreciation involves a source of funds. ----------------------
----------------------
----------------------
State True or False.
----------------------
1. According to Production Unit Method of Depreciation , the full cost
of the asset is charged as depreciation during the period in which the ----------------------
asset is renewed
----------------------
2. According to Renewal Method of Depreciation, the depreciation is
provided at a predetermined rate per unit ----------------------
3. According to Revaluation Method of Depreciation, the depreciation ----------------------
is provided at a predetermined percentage, on the balance of cost of
asset after deducting the depreciation previously charged (usually ----------------------
termed as written down value). ----------------------
----------------------
Activity 5
----------------------
Observe which method of depreciation is followed in your organization ----------------------
and why?
----------------------

Notes Summary
---------------------- ●● Accounting as a field of study in its developmental process, has evolved
a theoretical framework consisting of principles over a period of time.
----------------------
These principles enjoy a wide measure of support of the accounting
---------------------- profession; that is why they are known as Generally Accepted Accounting
Principles (GAAP).
----------------------
●● This unit covers the process of recording the business transactions on the
---------------------- basis of Accounting Principles, classified in two categories, Accounting
Concepts and Accounting Conventions.
----------------------
●● Accounting concepts indicates basic assumptions and accounting
---------------------- conventions indicate the customs and traditions to be followed by the
accountants while preparing the Financial Statements.
---------------------- ●● There are two systems of accounting followed in the process of maintaining
---------------------- the books of accounts, called Cash System of Accounting and Mercantile
or Accrual System of Accounting.
---------------------- ●● For the purpose of accounting, the amount paid as expenditure in the
---------------------- business is classified as Capital Expenditure, Revenue Expenditure and
Deferred Revenue Expenditure.
---------------------- ●● The basic presumption made by the Double Entry System of Accounting
---------------------- is that every business transaction has two elements. If the Double Entry
System of Accounting is followed, every business transaction affects two
---------------------- accounts. One account is debited while another account is credited.
---------------------- ●● While entering the various financial transactions in the records maintained
by the organisation, the rules of personal, real and nominal accounts are
---------------------- followed.
---------------------- ●● For the purpose of correct valuation of assets, depreciation is charged on

the cost of acquisition of assets and shown in the Financial Statements.
---------------------- Depreciation is a permanent, continuous and gradual reduction in the
book value of fixed assets. Depreciation accounting is necessary so as not
---------------------- to show the assets at an overstated amount.
---------------------- ●● There are various methods available for calculating the amount of
depreciation to be charged to Profit & Loss account, based on time, usage,
---------------------- and provision of funds for replacing the assets. Finally, depreciation is
charged for the purpose of tax liability.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Keywords Notes
----------------------
●● Accounting Principles: Comprise accounting concepts and conventions.
Concepts imply basic assumptions and conventions indicate customs and ----------------------
traditions followed by accountants.
●● Depreciation: A permanent, continuous and gradual reduction in the ----------------------
book value of fixed asset. ----------------------
●● Double Entry Bookkeeping System: Follows the principle of “every
debit has a corresponding credit” and hence, total of all debits has to be ----------------------
equal to the total of all credits. ----------------------
●● Methods of Depreciation: Various methods are available for calculating
the amount of depreciation to be charged to Profit & Loss Account. Amount ----------------------
of Depreciation is a function of time, usage, and cost of maintaining the ----------------------
fixed assets and provision of funds for replacing the assets.
●● Systems of Accounting: Cash System of Accounting and Mercantile or ----------------------
Accrual System of Accounting. ----------------------
●● Types of Expenditure: For the purpose of accounting, the amount of
money that is paid in the business is classified into three types. Capital ----------------------
Expenditure indicates the amount of funds paid for acquiring the
----------------------
infrastructure properties required for doing the business that are technically
referred to as Fixed Assets. Revenue Expenditure indicates the amount ----------------------
of funds paid during a certain period with the intention to receive the
return during the same period. Deferred Revenue Expenditure indicates ----------------------
the amount of funds paid, which does not result into the acquisition of any
----------------------
fixed asset.
●● Types of Accounts: Various accounts for the purpose of Financial ----------------------
Accounting are classified into, Personal Accounts- accounts of persons
----------------------
with whom the organisation deals in various capacities, Real Accounts-
accounts of assets and liabilities and Nominal Accounts- the accounts of ----------------------
incomes or expenses.
----------------------
1. What are the various accounting principles? ----------------------
2. Explain the various accounting concepts and conventions used in financial ----------------------
accounting.
----------------------
3. Distinguish between the following pairs of terms:
a) Cash Basis of Accounting and Accrual Basis of Accounting ----------------------
b) Revenue Expenditure and Capital Expenditure ----------------------
c) Written Down Value Method and Straight Line Method of ----------------------
Depreciation
d) Depreciation as per Companies Act and Income Tax Act ----------------------

Notes 4. What do you mean by depreciation? What are the objectives for calculating
it?
----------------------
5. Explain various methods for calculating depreciation.
---------------------- 6. Write an essay on “Depreciation”.
----------------------
---------------------- Answers to Check your Progress

Fill in the blanks.
----------------------
1. Business Entity accounting concept proposes that the business is assumed
---------------------- to be a distinct entity than the person who owns the business
---------------------- 2. Dual Aspect concept proposes that every business transaction has two
effects.
----------------------
3. Going Concern concept proposes that the business organization is going
---------------------- to be in existence for an indefinitely longer period of time and is not likely
to close down the business in the shorter period of time.
----------------------
4. Convention of Conservation convention is usually expressed as to
---------------------- “anticipate all the future losses and expenses
---------------------- 5. Convention of Materiality convention proposes that while accounting for
the various transactions, only those transactions will be considered, which
---------------------- have material impact on profitability or financial status of the organization
---------------------- 6. Convention of Consistency convention proposes that the accounting
policies and procedures should be followed consistently on a period-to-
---------------------- period basis
---------------------- State True or False

1. False
----------------------
2. False
----------------------
----------------------
Fill in the blanks.
----------------------
1. Entry means the record of a financial transaction in the books of accounts.
---------------------- 2. Credit side of the account is the right hand side of the account.
---------------------- 3. Debit side of the account is the left hand side of the account.
---------------------- 4. When the balances in the ledger account or cash/bank book of the current
year or current period are to be transferred to the next year’s books of
---------------------- accounts, the balances are said to be Carried Forward.
----------------------
Check your Progress 4 Notes
State True or False
----------------------
1. False
----------------------
2. False
3. False ----------------------
----------------------
Suggested Reading ----------------------
1. Michael P. Griffin, MBA Fundamentals Accounting and Finance ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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----------------------
Process of Accounting
UNIT
3
Structure:
3.1 Introduction
3.2 Journal and Journalizing
3.3 Compound Journal Entry
3.4 Subsidiary Books
3.5 Ledger and Ledger Postings
3.6 Control Ledgers
3.7 Balancing of Ledger Accounts
3.8 Trial Balance
3.9 Preparation of Final Accounts from Trial Balance
3.10 Adjustments
Summary
Key Words
Suggested Reading
Process of Accounting 39
Notes
Objectives
----------------------
• Explain the process of journalizing and ledger postings
----------------------
• Discuss the concept of control ledgers and balancing of ledger
---------------------- accounts
---------------------- • Construct the trial balance and final accounts
---------------------- • Justify the preparation of the trial balance and final accounts
----------------------
3.1 INTRODUCTION
----------------------
We have learnt the double entry bookkeeping in the previous unit, now
---------------------- this unit would let you learn the process of recording the past financial business
transactions. We would learn not only the Journal entry, Ledger posting and
----------------------
preparation of Trial balance, but finally, we would also be able to construct
---------------------- Final Accounts from Trial Balance.
The objective of preparing the books such as Journal, Ledger is to
----------------------
communicate the net results to various parties dealing with the business.
----------------------
3.2 JOURNAL AND JOURNALIZING
----------------------
Various transactions are entered in the journal in the chronological order,
----------------------
as and when the transactions take place. Thus, the Journal or Subsidiary Books
---------------------- are the books that record the transactions in the chronological order; Journal is
also referred to as the Book of Original Entry or the Book of Prime Entry.
----------------------
Journalizing refers to the process of recording the business transaction in
---------------------- the Journal. The Journal may look as stated below and it may be subdivided in
the following five columns:
---------------------- Journal
---------------------- Date Particulars L.F. Debit - Rs. Credit- Rs.
a b c d e
----------------------
Account (To be Debited)- Dr. To.
---------------------- Account (To be Credited) Narration
---------------------- a. Date — It refers to the date on which a particular transaction has taken
place.
----------------------
b. Particulars — It refers to titles of the account to be debited or credited.
---------------------- Title of the account to be debited starts from the extreme left and the
abbreviation “Dr.” is written to the extreme right of the same column on
---------------------- the same line. Title of the account to be credited is entered on the next line
preceded by the words “To” leaving some space from the extreme left. In
----------------------
the same column on the next line, brief description of the transaction is
written which is referred to as “Narration”. The narration conventionally Notes
starts with the wording “Being”.
----------------------
c. L.F. —Thus is the abbreviation of Ledger Folio. This column refers to
the page number of the ledger. The nature of Ledger is discussed in the ----------------------
following paragraphs.
----------------------
d. Amount Debited — The amount to be debited is stated in this column.
e. Amount Credited — The amount to be credited is stated in this column. ----------------------
Illustration ----------------------
Journalize the following transactions in the books of Mr. Amit Sen – ----------------------
a. Mr. Sen commenced business with cash Rs. 10,000, Machinery Rs. 10,000,
----------------------
Buildings Rs. 30,000 and Furniture Rs. 15,000.
b. Installed and paid for Neon Sign Board at a cost ofRs. 1,000 ----------------------
c. Mr. Sen borrowed Rs. 25,000 from his wife and the same were deposited ----------------------
by him in bank to open an account.
----------------------
d. Mr. Sen purchased goods for Rs. 7,000 for cash.
e. Mr. Sen purchased goods worth Rs. 10,000 from Mr. Rao on cash @2% ----------------------
Cash Discount. ----------------------
f. Sold goods to Ramdas worth Rs. 15,000 against cash after allowing 5%
Trade Discount. ----------------------
g. Paid Rs. 1,995 to Mr. Rajesh for purchases of goods after allowing 5% ----------------------
Cash Discount on the invoice.
----------------------
h. Sent a cheque of Rs. 1,000 to Chief Minister’s Fund as Mr. Sen’s personal
contribution. ----------------------
i. Placed an order for goods worth Rs. 2,000 with Ms Arch an a Traders. ----------------------
j. A personal table fan worth Rs. 450 brought in the office for office use. ----------------------
Solution
----------------------
In the Books of Mr. Amit Sen
----------------------
Date Particulars L.F. Debit – Rs. Credit – Rs.
Cash A/c Dr. 10,000 ----------------------
Machinery A/c Dr. 10,000
Building A/c Dr. 30,000 ----------------------
Furniture A/c Dr. 15,000 65,000
----------------------
To, Capital A/c
(Business started with cash, ----------------------
machinery, building and furniture)
Advertisement A/c Dr. 1,000 ----------------------
To, Cash A/c
1,000 ----------------------
(Being paid for neon sign board
installed) ----------------------
Notes Date Particulars L.F. Debit – Rs. Credit – Rs.
Bank A/c Dr. 25,000
----------------------
To, Loan from Mrs. Sen A/c 25,000
---------------------- (Being the amount borrowed from
Mrs. Sen to open account with the
---------------------- bank)
Purchases A/c Dr. To, Cash A/c 7,000
---------------------- 7,000
(Being paid for cash purchases)
---------------------- Purchases A/c Dr. 10,000
To, Cash A/c 9,800
---------------------- To, Discount Received 200
(Being purchases worth Rs.
----------------------
10,000 after getting 2% cash
---------------------- discount)
Cash A/c Dr. 14,250
---------------------- To, Sales
(Sold goods worth Rs. 15,000 14,250
----------------------
after allowing trade discount of
---------------------- 5%)
Purchases A/c Dr. 2,100
---------------------- To, Cash A/c 1,995
To, Discount Received 105
---------------------- (Paid Rs. 1,995 for goods
---------------------- purchased after getting 5% cash
discount)
---------------------- Drawings A/c Dr. 1,000
To, Bank A/c 1,000
---------------------- (Being donation paid to Chief
---------------------- Minister’s Fund as Mr. Sen’s
personal contribution)
---------------------- No Journal Entry will be passed,
as the transaction (placing order)
---------------------- is not a financial transaction (not
---------------------- monetary).
Furniture A/c Dr. 450
---------------------- To, Capital A/c 450
(Being the personal table fan
---------------------- brought for office use)
----------------------
----------------------
Activity 1
---------------------- Visit a proprietary business and observe the rules of accounting while
journalizing transactions.
----------------------
----------------------
3.3 COMPOUND JOURNAL ENTRY Notes
Suppose similar transactions take place on the same day and the same ----------------------
account is either debited or credited. Instead of passing different journal
entries, it can be accounted for by passing a compound journal entry. It avoids ----------------------
duplication and makes the journal less bulky. ----------------------
Illustration
----------------------
Mr. Anirudh commenced the business on 1st April 2011 with cash Rs.
10,000, machinery worth Rs. 25,000 and computer/s worth Rs. 50,000. The ----------------------
transaction will be journalized as below –
----------------------
Date Particulars L.F. Debit – Rs. Credit – Rs.
1.4.2011 10,000 ----------------------
Cash A/c Dr.
25,000 ----------------------
Machinery A/c Dr.
50,000
Computer A/c Dr. 85,000 ----------------------
To, Capital A/c (Commenced
business with cash, machinery ----------------------
and computer)
----------------------
----------------------
Fill in the blanks.
----------------------
1. Journal is also referred to as the Book of ___________________
2. Journalizing refers to the process of ___________ the business ----------------------
transaction in the Journal. ----------------------
3.4 SUBSIDIARY BOOKS ----------------------
----------------------
If the volume of transactions is very large, recording all the transactions
in the Journal may prove to be a voluminous job. Hence, the transactions of the ----------------------
similar nature may be entered into a separate Subsidiary Book and the net effect
of the similar transactions may be transferred into the main records. ----------------------
In the practical circumstances, following subsidiary books are used very ----------------------
frequently:
----------------------
a. Cash Book: This records all the cash transactions, i.e. Cash Receipts and
Cash Payments. In some cases, Cash and Bank Book may be maintained, ----------------------
which records Cash as well as Bank Receipts and Cash as well as Bank
Payments. ----------------------
The Cash and Bank Book looks as follows: ----------------------

Date Particulars L.F. Cash Bank Date Particulars L.F. Cash Bank ----------------------
----------------------
Notes Note: “L.F.” stands for Ledger Folio Number, which indicates the Page Number
in the Ledger
----------------------
b. Purchases Register or Purchases Day Book: This records all the credit
---------------------- purchases transactions and looks like this:
---------------------- Date Name of the Supplier L.F. Invoice No. Amount
---------------------- c. Sales Register or Sales Day Book: This records all the credit sales
transactions. The Sales Register looks as stated below:
----------------------
Date Name of the Customer L.F. Invoice No. Amount
----------------------
d. Purchases Returns Register: This records the transactions of return of
---------------------- goods to the suppliers from whom purchases were made on credit basis.
The Purchases Return Register looks as below:
----------------------
Date Name of the Supplier L.F. Debit Note Amount
----------------------
No.
---------------------- The Debit Note is an intimation sent to the supplier at the time of returning
---------------------- the goods, which informs the supplier that his account is being debited on
account of goods returned to him.
----------------------
e. Sales Returns Register: This records all the transactions of return of
---------------------- goods by the customers to whom sales were made on credit basis.
The Sales Return Register looks like this:
----------------------
Date Name of the Customer L.F. Credit Note Amount
----------------------
No.
---------------------- The Credit Note is an intimation sent to the customer at the time of
---------------------- accepting the returned goods, which informs the customer that his account is
being credited on account of goods returned by him.
---------------------- f. Journal Proper: This records all the residual transaction, which cannot
---------------------- be entered into any other subsidiary book.
The transactions, which can be entered in the Journal proper, are:
----------------------
1. Opening Entries
----------------------
2. Closing Entries
---------------------- 3. Rectification Entries
---------------------- 4. Adjustment Entries
----------------------
----------------------
----------------------
----------------------
Notes
Activity 2
----------------------
Visit the same proprietary business, observe any four subsidiary books ----------------------
separately and try to differentiate between the transactions to be entered
in each of them. ----------------------
----------------------
3.5 LEDGER AND LEDGER POSTINGS
----------------------
The Ledger is the book where transactions of a similar nature are pooled ----------------------
together under one Ledger Account. Ledger or General Ledger as it is referred
to in practical circumstances, maintains all types of accounts, i.e. personal, real ----------------------
and nominal.
----------------------
Whichever transactions are recorded in the Journal or Subsidiary Books
in chronological order, the same transactions are posted account-wise in the ----------------------
Ledger.
----------------------
Thus, a ledger account can be defined as the record of all the transactions
pertaining to a person, asset, liability, income or expenditure, which have taken ----------------------
place during a specified period, and show the net effect of all these transactions ----------------------
at the end.
----------------------
As such, the transactions are first entered into the Journal or Subsidiary
Book when they take place and from there, they are transferred to Ledger. This ----------------------
process is called Ledger Posting.
----------------------
The Ledger Account may be maintained in two ways –
----------------------
Type I
Dr. Cr. ----------------------
Date Particulars Folio Rs. Date Particulars Folio Rs. ----------------------
----------------------
Type II ----------------------
Date Particulars Folio Debit Credit Rs. Balance Rs. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------

1. The Ledger is the book where transactions of a similar nature are
----------------------
_______ together under ___________ Ledger Account.
---------------------- 2. _____________ records all the residual transaction, which cannot be
entered into any other subsidiary book.
----------------------
---------------------- 3.6 CONTROL LEDGERS

----------------------
In practical circumstances, if the transactions of purchases and sales are
---------------------- very large, it may not be feasible to carry the accounts of all the suppliers and
customers in the Main or General Ledger. In such cases, apart from the Main
---------------------- Ledger or General Ledger, the Control Ledgers can be maintained.
---------------------- Control Ledgers carry the individual accounts whereas the Main Ledger
or General Ledger records the consolidated effect of the individual transactions.
---------------------- As such, the balance shown by the consolidated account in the Main Ledger or
General Ledger has to tally with the balances in the individual ledger accounts
----------------------
maintained in the control ledger.
---------------------- In practical circumstances, control ledgers may be maintained for the
---------------------- following purposes:
a. Sundry debtors
----------------------
b. Sundry creditors
----------------------
c. Advances to staff
----------------------
3.7 BALANCING OF LEDGER ACCOUNTS
----------------------
To ascertain the net effect of all the transactions recorded in the Ledger
---------------------- Account, the account is required to be “balanced”. Balancing of Ledger Account
---------------------- involves the following steps:
a. Take the total of both sides of the Ledger Account.
----------------------
b. Calculate the difference between totals of both the sides.
----------------------
• If the total of debit side is heavier, place the difference on the
---------------------- amount column of credit side by writing “By Balance c/fd”.
---------------------- • If the total of credit side is heavier, place the difference on the
amount column of debit side by writing the “To Balance c/fd”.
---------------------- • If the balance appears on the credit side, the account will be
---------------------- considered to have Debit Balance.
• If the balance appears on the debit side, the account will be
----------------------
considered to have Credit Balance.
c. After balance is placed on the appropriate side, ensure that totals of both Notes
the sides match with each other.
----------------------
Illustration
Machinery Account ----------------------

01.04.14 Balance b/ 25,000 31.03.15 Depreciation 10,000 ----------------------
10.04.14 fd Bank 70,000 31.03.15 Balance c/fd 85,000
(Balancing ----------------------
figure)
----------------------
95,000 95,000
Steps explained: ----------------------
a. Before considering the Balancing Figure, the total of debit side is Rs. ----------------------
95,000 and the total of credit side is Rs. 10,000. As such, the debit side is
heavy. ----------------------
b. Difference between both the sides is Rs. 85,000. ----------------------

c. As the debit side is heavy, the difference of Rs. 85,000 is put on the credit ----------------------
side.
----------------------
Activity 3 ----------------------
With the help above example, balance the account based on the given ----------------------
information. ----------------------
Machinery Account ----------------------

01.04.14 Balance b/ 75,000 31.03.15 Depreciation 25,000 ----------------------
10.04.14 fd Bank 31.03.15 Balance c/fd
(Balancing ----------------------
figure)
----------------------
----------------------
3.8 TRIAL BALANCE
----------------------
Trial Balance is the summary of all the balances in all the accounts
listed in the General Ledger and Cash / Bank Book of an organization at any ----------------------
given date. Tallying of the Trial Balance is the evidence of the fact that all the ----------------------
transactions have been properly posted in the General Ledger. As such, tallying
of Trial Balance generally ensures the arithmetical accuracy of the process of ----------------------
Ledger Posting.
----------------------
----------------------
Notes Format of Trial Balance
Trial Balance as on 31st March 2015
----------------------
Name of the Account Debit Credit
----------------------
---------------------- For the preparation of Trial Balance, all the accounts in the General
Ledger need to be balanced to ascertain the closing balance.
----------------------
Similarly, the cashbook / bankbook is also required to be balanced to
---------------------- ascertain the closing balance. Accounts having debit balance are shown on the
debit side whereas the accounts having credit balance are shown on the credit
---------------------- side.
---------------------- Generally, accounts of the assets will have debit balance and hence will
be shown on the debit side. Generally, accounts of all liabilities will have a
---------------------- credit balance and hence will be shown on the credit side. Generally, accounts
---------------------- of all the expenses will have a debit balance and hence will be shown on the
debit side. Generally, accounts of all the incomes will have credit balance and
---------------------- hence will be shown on credit side.
----------------------
----------------------
Fill in the blanks.
----------------------
1. __________ is the summary of all the balances in all the accounts
---------------------- listed in the General Ledger and Cash / Bank Book of an organization
at any given date
----------------------
2. Tallying of Trial Balance generally ensures the _____________
---------------------- accuracy of the process of Ledger Posting.
----------------------
---------------------- 3.9 PREPARATION OF FINAL ACCOUNTS FROM

TRIAL BALANCE
----------------------
Preparation of financial statements is the basic objective of financial
---------------------- accounting. These financial statements are basically in two forms:
---------------------- 1. Profitability Statement: This financial statement is referred to as “Profit
and Loss Account” in more technical language. The purpose of this
---------------------- financial statement is to disclose the result of operations of the business
---------------------- transactions during a given period of time. As such, by nature, profit &
loss account is a period statement that relates to a specific duration of
---------------------- time. Hence, profit and loss account is always referred to as “Profit and
Loss Account for the year ended on 31st March 2015.”
----------------------
2. Balance Sheet: The purpose of this financial statement is to disclose the
---------------------- financial status of the organization in terms of its assets and liabilities
at any given point of time. Thus, in simple language, Balance Sheet
---------------------- is a listing of the assets and liabilities of an organization at any given
point of time. Whichever sources are used by an organization for raising Notes
the required amount of funds create an obligation or liability for the
organization and whichever ways the funds are used or applied by an ----------------------
organization create the properties or assets for the organization. Hence,
in practical circumstances, the liabilities are referred to as “Sources of ----------------------
Funds” and the assets are referred to as “Application of Funds”. As such, ----------------------
by nature, the Balance Sheet is a positive statement in the sense that it
relates to a specific point of time or date. Hence, the Balance Sheet is ----------------------
always referred to as “Balance Sheet as on 31st March.”
----------------------
3. Profit & Loss Account
----------------------
As stated earlier, Profit & Loss Account is prepared to disclose the result
of operation of the business transactions during certain duration of time. ----------------------
In technical language, profit and loss account may have the following
four components: ----------------------
a. Manufacturing Account: This part of Profit & Loss Account discloses ----------------------
the result of manufacturing operations carried out by the organization.
The final result disclosed by the Manufacturing Account is the Cost of ----------------------
Production incurred by the organization. Following is the specimen of
----------------------
Manufacturing Account.
Manufacturing Account for the year ended on 31st March ----------------------
Particulars Amount Particulars Amount ----------------------

Opening Stock Closing Stock ----------------------
Raw Material Raw Material
Work in Progress Work in Progress ----------------------
----------------------
Purchases of Raw Material Cost of Production
----------------------
(Transferred to Trading
Carriage Inward
Account) ----------------------
Wages Paid
----------------------
Power and Fuel
Consumable Stores ----------------------
Manufacturing Expenses
----------------------
Depreciation on
Production Assets ----------------------
----------------------
Total Total
----------------------
b. Trading Account: This part of Profit & Loss Account discloses the
result of trading operations carried out by the organization. The final ----------------------
result disclosed by the Trading Account is the Gross Profit earned by the
organization. Following is the specimen of Trading Account. ----------------------
----------------------
Notes Trading Account for the year ended on 31st March
---------------------- Particulars Amount Particulars Amount

Opening Stock Sales (Net of Sales
---------------------- Returns)
---------------------- Finished Goods
---------------------- Closing Stock

---------------------- Cost of Production Finished Goods
(Brought from
---------------------- Manufacturing A/c)
----------------------
Gross Profit
----------------------
----------------------
Total Total
----------------------
c. Profit & Loss Account: This part discloses the final result of business
---------------------- transactions of the organization. The final result disclosed by the Profit
---------------------- & Loss Account is the Profit After Tax (PAT) earned by the organization.
Following is the specimen of Profit & Loss Account.
---------------------- Profit & Loss Account for the year ended on 31st March
---------------------- Particulars Amount Particulars Amount
---------------------- Administrative Expenses Gross Profit b/fd
Office Salaries
---------------------- Postage & Telephone Other Income
Traveling & Conveyance Discount Received
----------------------
Legal Charges Commission Received
---------------------- Office Rent
Depreciation Non-Trading Income
----------------------
Audit Fees Interest Received
---------------------- Insurance Rent Received
Repairs & Renewals
----------------------
---------------------- Abnormal Income

Selling & Distribution Profit on the sale of
---------------------- Expenses assets
---------------------- Advertisement
Carriage Outward
---------------------- Free Samples
---------------------- Bad Debts
Sales Commission
----------------------
Particulars Amount Particulars Amount Notes
Financial Expenses
----------------------
Interest & Bank Charges
----------------------
Other Expenses
----------------------
Loss on the sale of assets
Salary to Working Partners ----------------------
Interest on Capital
----------------------
Provision for Taxation
----------------------
Net Profit after Taxes ----------------------
(Transferred to Capital
Account) ----------------------
----------------------
Total Total
d. Profit & Loss Appropriation Account – This part of Profit & Loss ----------------------
Account, which is mainly applicable to the company form of organization, ----------------------
discloses the manner in which the PAT earned by the organization
is appropriated. The amount of profit not appropriated or retained is ----------------------
transferred to Reserves and Surplus in the Balance Sheet. Following is
the specimen of Profit & Loss Appropriation Account. ----------------------
Profit & Loss Appropriation Account for the year ended on 31st March ----------------------
Particulars Amount Particulars Amount ----------------------

Dividend Paid Profit After Tax b/fd
----------------------
Amount withdrawn ----------------------

Transferred to Reserves
from Reserves
----------------------
Balance transferred to ----------------------

Balance Sheet
----------------------
Total Total ----------------------
Balance Sheet ----------------------

As stated earlier, the purpose of preparing the Balance Sheet is to disclose ----------------------
the financial status of the organization in terms of its assets and liabilities at any
given point of time. As such, the Balance Sheet has two sides: ----------------------
----------------------
----------------------
----------------------
Notes A. Liabilities:
Credit balances in all the Personal and Real Accounts appear on Liabilities
----------------------
side. Following items may appear on the liabilities side –
---------------------- a. Capital
---------------------- Capital indicates the amount of funds contributed by the owners of the
business to the requirement of funds of the business. As the owner of the
---------------------- business is considered an entity separate from the business, any amount
contributed by the owner is a liability for the business. Similarly, any
----------------------
amount of profit earned in the past, which is not distributed to the owner,
---------------------- also belongs to the owner and becomes a part of the capital.
---------------------- b. Long Term Liabilities

This indicates the liabilities, which are to be paid off over a longer span
---------------------- of time, say 5 to 10 years. In practical circumstances, it may consist of
---------------------- long-term loan borrowed from banks or financial institutions.
c. Current Liabilities
----------------------
This indicates the liabilities, which are supposed to be paid off within a
---------------------- very short span of time, say one year. In practical circumstances, it may
consist of the following items:
----------------------
1. Sundry Creditors: Amounts payable to the suppliers of goods and/
---------------------- or services.
---------------------- 2. Advances received from customers: This amount may not be paid
back to the customers. It gets adjusted with the final selling price.
---------------------- Till it is adjusted with the selling price, it appears as a current
---------------------- liability.
3. Outstanding Expenses: This amount indicates the expenses already
---------------------- incurred during the relevant period but not paid for.
---------------------- 4. Income Received in Advance.
---------------------- 5. Liability for taxes.
B. Assets:
----------------------
Debit balances in all the Personal and Real Accounts appear on the Asset
---------------------- side. Following items may appear on the assets side:
---------------------- a. Fixed Assets
---------------------- As stated earlier, fixed assets indicate the value of infrastructural properties
acquired by the business where the benefits are likely to be received
---------------------- over a longer duration of time. Fixed assets are the assets, which are not
supposed to be sold, but they are supposed to be used to do the business
---------------------- to earn profits. Some of the fixed assets found in practical circumstances
---------------------- are Land, Building, Machinery, Furniture, Vehicles, Computers etc.
----------------------
b. Investments Notes
This indicates the amount of funds invested by the organization outside
----------------------
the business.
c. Current Assets ----------------------
Current Assets are the assets that are likely to be converted in the form of ----------------------
cash or likely to be consumed during the normal operating cycle of the
business within a very short span of time, say one year. The purpose of ----------------------
holding the current assets is to sell the current assets or use them during
----------------------
the normal course of operations. Current assets change their form very
frequently while doing the business. Some of the current assets, which ----------------------
can be found in practical circumstances, are Stock, Sundry Debtors, Cash
& Bank Balances, Prepaid Expenses etc. ----------------------
Following is the specimen of Balance Sheet. ----------------------
Specimen of Balance Sheet as per old SCHEDULE VI ----------------------
Balance Sheet as on 31st March
----------------------
Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets ----------------------
Land ----------------------
Long Term Liabilities Building
Loan from Bank Machinery ----------------------
Furniture ----------------------
Current Liabilities Vehicles
Sundry Creditors Computers ----------------------
Advance from Customers ----------------------
Outstanding Expenses Investments
Income Received in Advance ----------------------
Current Assets
----------------------
Stock
Sundry Debtors ----------------------
Cash Balance
----------------------
Bank Balance
Prepaid Expenses ----------------------
----------------------
Total Total
----------------------
----------------------
----------------------
----------------------
----------------------
Notes Specimen of Balance Sheet as per Revised SCHEDULE VI
Name of the Company
----------------------
Balance Sheet at 31 March
----------------------
Particulars As at 31 As at 31
---------------------- March March
---------------------- A EQUITY AND LIABILITIES

----------------------
1 Shareholders’ funds
---------------------- (a) Share capital
(b) Reserves and surplus
---------------------- (c) Money received against share warrants

---------------------- 2 Share application money pending
---------------------- allotment

---------------------- 3 Non-current liabilities
(a) Long-term borrowings
---------------------- (b) Deferred tax liabilities (net)
(c) Other long-term liabilities
----------------------
(d) Long-term provisions
----------------------
4 Current liabilities
---------------------- (a) Short-term borrowings
(b) Trade payables
---------------------- (c) Other current liabilities
---------------------- (d) Short-term provisions
TOTAL
----------------------
B ASSETS
----------------------
1 Non-current assets
----------------------
(a) Fixed assets
---------------------- (i) Tangible assets
(ii) Intangible assets
---------------------- (iii) Capital work in progress
(iv) Intangible assets under development
---------------------- (v) Fixed assets held for sale
----------------------
(b) Non-current investments
---------------------- (c) Deferred tax assets (net)
(d) Long-term loans and advances
---------------------- (e) Other non-current assets

----------------------
2 Current assets
---------------------- (a) Current investments
(b) Inventories
(c) Trade receivables Notes
(d) Cash and cash equivalents
(e) Short-term loans and advances ----------------------
(f) Other current assets
----------------------
TOTAL
----------------------
----------------------
Fill in the blanks. ----------------------
1. Profit & Loss Account discloses the ________ result of business ----------------------
transactions of the organization
2. The final result disclosed by the Trading Account is the __________ ----------------------
earned by the organization ----------------------
3. The final result disclosed by the Profit & Loss Account is the
----------------------
____________ earned by the organization.
4. The final result disclosed by the Manufacturing Account is the ______ ----------------------
incurred by the organization.
----------------------
----------------------
3.10 ADJUSTMENTS
----------------------
While preparing the final accounts from the Trial Balance, it should be
remembered that the Trial Balance might not reflect all the transactions, which ----------------------
have an impact on profitability for the relevant period or the state of affairs
of the organization on a particular date. As such, before preparing the final ----------------------
accounts, the effect of such transactions needs to be considered. The same is
----------------------
done by passing the Adjustment Entries. Thus, the effect of Adjustment Entries
is yet to be reflected in the Trial Balance. As such, according to the Double ----------------------
Entry principles, the Adjustment Entries always have two effects. Following are
some of the main adjustment entries made while preparing the final accounts ----------------------
from the Trial Balance.
----------------------
a. Closing Stock
----------------------
This indicates the amount of stock in hand on the date of Balance Sheet.
The basic principle on which the closing stock is valued is at cost or ----------------------
market price, whichever is less. Accordingly, the first effect of the closing
stock is that it is shown on the credit side of Manufacturing and/or Trading ----------------------
Account and the second effect is that it is shown on Balance Sheet Asset ----------------------
side. The Journal Entry passed for this is:
----------------------
Closing Stock A/c Dr.
To, Trading Account ----------------------
b. Depreciation ----------------------
This indicates the reduction in the value of fixed assets due to wear and ----------------------
Notes tear. As the basic cost of the fixed assets is not transferred to the profit and
loss account, this adjustment is necessary to reflect the cost for the use of
---------------------- fixed asset during the year. Accordingly, the first effect of the adjustment
for depreciation is that the amount is debited to profit and loss account,
---------------------- reducing the profit or increasing the loss and the second effect is that
---------------------- the corresponding amount is reduced from the value of fixed asset in the
balance sheet. In other words, the value of fixed assets in the Balance
---------------------- Sheet is the net of depreciation. The Journal Entry passed for this is:
---------------------- Depreciation A/c Dr.
To, Fixed Asset A/c
----------------------
c. Outstanding Expenses
----------------------
This indicates the amount of expenses pertaining to the relevant period,
---------------------- which are not paid during the said period. According to the Matching
Principle of Accounting, income for a certain period needs to be compared
---------------------- with the expenses for the same period, whether it is paid for or not.
---------------------- Accordingly, the first effect of this adjustment is that the corresponding
amount of expenses is increased reducing the profit or increasing the
---------------------- loss and the second effect is that the corresponding amount is shown as
Current Liability on the Balance Sheet liabilities side. The Journal Entry
---------------------- passed for this is:
---------------------- Expenses A/c Dr.
To, Outstanding Expenses A/c
----------------------
d. Prepaid Expenses
----------------------
This indicates the amount of expenses pertaining to the next period,
---------------------- which are paid in advance during the relevant period. According to the
Matching Principle of Accounting, income for a certain period needs to
---------------------- be compared with the expenses for the same period. Accordingly, the first
effect of this adjustment is that the corresponding amount of expenses are
----------------------
reduced, thus increasing the profit or reducing the loss. The second effect
---------------------- is that the corresponding amount is shown as current asset on the asset
side of the balance sheet. The Journal Entry passed for this is:
----------------------
Prepaid Expenses A/c Dr.
---------------------- To, Expenses A/c
---------------------- e. Accrued Income
---------------------- This indicates the amount of income for the current period, which is not
received during it. According to the Matching Principle of Accounting,
---------------------- income for a certain period needs to be compared with the expenses for
the same period. Accordingly, the first effect of this adjustment is that the
---------------------- corresponding amount of income is increased, thus increasing the profit or
---------------------- reducing the loss and the second effect is that the corresponding amount
is shown as Current Asset on the Balance Sheet Asset side. The Journal
---------------------- Entry passed for this is –
Accrued Income A/c Dr. Notes
To, Income A/c
----------------------
f. Income Received in Advance
This indicates the amount of income for the next period, which is ----------------------
received during the current period. According to the matching principle ----------------------
of accounting, the income for a certain period needs to be compared with
the expenses for the same period. Accordingly, the first effect of this ----------------------
adjustment is that the corresponding amount of income is reduced, thus
reducing the profit or increasing the loss and the second effect is that the ----------------------
corresponding amount is shown as Current Liability on the Balance Sheet ----------------------
Liabilities side. The Journal Entry passed for this is:
----------------------
Income A/c Dr.
To, Income received in advance A/c ----------------------
g. Bad Debts
----------------------
This indicates the unrecoverable amount from the customers on account of
credit sales made to them. If the customer is not likely to pay the amount ----------------------
due from him, the same is written off as Bad Debts. Accordingly, the first
----------------------
effect of this adjustment is that the amount of bad debts is debited to the
profit and loss account, thus reducing the profits or increasing the losses ----------------------
and the second effect is that the amount of Sundry Debtors is reduced.
The Journal Entry passed for this is: ----------------------
Bad Debts A/c Dr. ----------------------
To, Sundry Debtors
----------------------
h. Provision for Doubtful Debts
Provision for doubtful debts is necessary due to the possibility that all the ----------------------
customers to whom the credit sales have been made may not pay the entire ----------------------
amount. Accordingly, the first effect of this adjustment is that the amount
equivalent to the provision for doubtful debts is written off to profit and ----------------------
loss Account and the second effect is that the corresponding amount is
reduced from the Sundry Debtors in the balance sheet. It should be noted ----------------------
that if the provision for bad and doubtful debts is to be maintained at a ----------------------
certain percentage of Sundry Debtors and if the provision to some extent
has already been made in the books of account, the differential amount ----------------------
only needs to be debited to profit and loss account. The Journal Entry
passed for this is: ----------------------
Provision for Doubtful Debts A/c Dr. ----------------------

To, Sundry Debtors A/c ----------------------
i. Provision for Discount on Debtors ----------------------
In some cases, it is necessary to allow a cash discount to the customers for
making an early payment. As the amount of debtors who are likely to avail ----------------------
of the cash discount is not known in advance, a provision is made in the ----------------------
Notes books of accounts for the discount to be allowed to debtors. Accordingly,
the first effect of this adjustment is that the amount equivalent to the
---------------------- provision for discount on debtors is written off to Profit and Loss Account
and the second effect is that the corresponding amount is reduced from
---------------------- the Sundry Debtors in the Balance Sheet. The Journal Entry passed for
---------------------- this is:
---------------------- Provision for Discount for Debtors A/c Dr.

To, Sundry Debtors A/c
----------------------
j. Interest on Capital
---------------------- In order to calculate the profit earned by the organization properly, in
---------------------- some cases, interest may be provided on the amount of capital introduced
by the proprietor or partner in the business. It should be mentioned here
---------------------- that in the case of partnership firms, interest on capital is considered to
be an allowable expenditure for calculating the tax liability as per the
---------------------- provisions of Income Tax Act, 1961, if it is payable to the Working
---------------------- Partners at the rate not exceeding 12% p.a. Accordingly, the first effect
of this adjustment is that the amount of Interest on Capital is debited to
---------------------- Profit and Loss Account, thus reducing the profits or increasing the losses
and the second effect is that the corresponding amount is credited to the
---------------------- Capital Account of proprietor or partner.The Journal Entry passed for this
---------------------- is:
Interest on Capital A/c Dr.
----------------------
To, Capital A/c
----------------------
k. Drawings
---------------------- This represents the amount of cash or value of goods withdrawn by the
proprietor or partner for personal use. If the amount is withdrawn in cash,
----------------------
the same may be entered in the books of accounts regularly and thus will
---------------------- be reflected in the trial balance. However, the value of goods withdrawn
by the proprietor or partner may be required to be considered by way
---------------------- of adjustment. Accordingly, the first effect of this adjustment is that the
amount of sales will be increased, thus increasing the profits or reducing
----------------------
the loss and the second effect is that the corresponding amount will be
---------------------- debited to the capital account of the proprietor or partner. The Journal
Entry passed for this is:
----------------------
Drawing / Capital A/c Dr.
---------------------- To, Sales A/c
---------------------- l. Deferred Revenue Expenditure Written Off

This represents that part of the Deferred Revenue Expenditure, returns
---------------------- equivalent to which are received during the current period. Accordingly,
---------------------- the first effect of this adjustment is that the deferred revenue expenditure
written off will be debited to Profit & Loss Account, thus reducing the
---------------------- profit or increasing the loss and the second effect is that the corresponding
amount will be reduced from the Asset side of the Balance Sheet. The Notes
Journal Entry passed for this is:
----------------------
Deferred Revenue Expenditure Written Off A/c Dr.
To, Deferred Revenue Expenditure A/c ----------------------
It should be noted that Deferred Revenue Expenditure Written Off
----------------------
Account is a Nominal Account whereas Deferred Revenue Expenditure
Account is a Real Account. ----------------------
m. Abnormal Loss due to fire etc.
----------------------
In some cases, the organization incurs the loss of stock due to some
abnormal events like fire, earthquake etc. Accordingly, the first effect of ----------------------
this adjustment is that the Trading Account is credited with the cost of ----------------------
goods lost due to fire, earthquake etc. and the corresponding amount is
debited to Profit & Loss Account as Loss due to Fire Account. The Journal ----------------------
Entry passed for this is:
----------------------
Loss due to Fire Account Dr.
To, Stock Destroyed Account ----------------------
In some cases, the stock held by the organization is insured with the ----------------------
Insurance Company. After the abnormal event such as fire or earthquake
takes places, the insurance company settles the claim, either in full or ----------------------
in part. The actual loss incurred by the organization is to the extent of
difference between the cost of goods destroyed and the amount of claim ----------------------
settled by the insurance company. In such event, the amount of claim ----------------------
settled by the insurance company is debited to the Insurance Company’s
Account and only the net amount of loss is debited to Profit and Loss ----------------------
Account. The Journal Entry passed for this is:
----------------------
Insurance Company A/c Dr.Loss due to Fire A/c Dr.
To, Stock Destroyed A/c ----------------------
n. Goods Distributed as Free Samples ----------------------
This represents the value of goods distributed as free samples as a part ----------------------
of the sales promotion effort of the organization. This is in the form of
advertisement. Accordingly, the first effect of this adjustment is that the ----------------------
amount of goods distributed as free samples is debited to Profit & Loss
Account, thus reducing the profits or increasing the losses and the second ----------------------
effect is that the amount of Sales is increased, thus increasing the profit or ----------------------
reducing the loss. The Journal Entry passed for this is:
----------------------
Advertisement A/c Dr.
To, Sales A/c ----------------------
o. Goods sent on approval basis ----------------------
Goods sent to the customers on approval basis should not be treated as
----------------------
the sales till the goods are finally approved by the customers or the period
as agreed upon by both the parties is over. This is due to the fact that the ----------------------
Notes property in the goods is not transferred until the said period is over. If the
amount of such goods sent on approval basis is treated as the sales, the
---------------------- effect of this entry needs to be reversed. At the same time, the closing
stock needs to be increased by the cost of such goods sent on approval
----------------------
basis.
---------------------- p. Commission payable to the manager
---------------------- In some cases, commission is payable to the manager as a percentage of
profit earned by the business. The calculation of this commission may be
---------------------- made in two ways:
---------------------- 1. As a percentage of profit before charging such commission to Profit
& Loss Account.
---------------------- 2. As a percentage of profit after charging such commission to Profit
---------------------- & Loss Account.
In both cases, the amount of profit is calculated before the commission
---------------------- and then the amount of commission is calculated based upon the methods to be
used for calculating the same. The journal Entry passed for this is:
----------------------
Commission A/c Dr.
---------------------- To, Commission Payable A/c
----------------------
Activity 5
----------------------
---------------------- While preparing the final accounts, why do we need to make adjustments
in the books of accounts at the end of a financial accounting year? Ask a
---------------------- practising accountant and write your views.
----------------------
----------------------
Summary
---------------------- ●● This unit discusses various books maintained by a business.

●● Journalizing refers to the process of recording the business transaction in
---------------------- the journal that is referred to as the Book of Original Entry or the Book
---------------------- of Prime Entry.
●● The various transactions are entered in the journal in chronological order,
---------------------- as and when the transactions take place.
---------------------- ●● Subsidiary books are the additional books, which assist the business
entries made in the journal. Among these, the Cash Book is considered as
---------------------- both journal and ledger together.
---------------------- ●● The ledger accounts and classifies various business transactions with the
help of the control ledgers to facilitate the business and the people dealing
---------------------- with it.
---------------------- ●● Trial Balance is a statement prepared in order to know the arithmetical
accuracy of the books maintained, through which errors can be detected
----------------------
and rectified. With the help of trial balance, financial statements, consisting Notes
of the income statement and the balance sheet, are prepared.
●● These financial statements depict the status of assets and liabilities, ----------------------
affecting the financial soundness of the business. ----------------------
Keywords ----------------------
●● Adjustments: While preparing the final accounts from the Trial Balance, ----------------------
it should be remembered that the Trial Balance might not reflect all the ----------------------
transactions, which have the impact on profitability for the relevant period
or the state of affairs of the organization on a particular date. As such, ----------------------
before preparing the final accounts, the effect of such transactions needs
to be considered. Passing the Adjustment Entries does the same. Thus, the ----------------------
effect of Adjustment Entries is yet to be reflected in the Trial Balance. As ----------------------
such, according to the Double Entry principles, the Adjustment Entries
always have two effects. ----------------------
●● Financial Statements: Consist of Profit & Loss Account and Balance ----------------------
Sheet. Profit & Loss Account discloses the final result of business
transactions of the organization. The final result disclosed by the Profit ----------------------
& Loss Account is the Profit After Tax (PAT) earned by the organization.
Balance sheet shows the assets owned and liabilities incurred by a ----------------------
business. The purpose of preparing the Balance Sheet is to disclose the ----------------------
financial status of the organization in terms of its assets and liabilities at
any given point of time. ----------------------
●● Journalizing: Refers to the process of recording the business transactions
----------------------
in the Journal that is referred to as the Book of Original Entry or the Book
of Prime Entry. ----------------------
●● Subsidiary Books: Are the additional books that assist the Journal. The
books are Cash Book, Purchases Day Book, Sales Day Book, Purchases ----------------------
Returns Book, Sales Returns Book, Bills Receivable Book, Bills Payable ----------------------
Book and Journal Proper.
●● Trial Balance: Is the summary of all the balances in all the accounts ----------------------
listed in the General Ledger and Cash / Bank Book of an organization at ----------------------
any given date. Tallying of the Trial Balance is the evidence of the fact
that all the transactions have been properly posted in the General Ledger. ----------------------
As such, tallying of Trial Balance generally ensures the arithmetical
accuracy of the process of Ledger Posting. ----------------------
----------------------
----------------------
Problem 1
From the following particulars in respect of M/s Pam Industries, Journalize the ----------------------
following transactions, post them to the ledger, prepare the trial balance and ----------------------
final accounts.
----------------------
Notes Date Particulars
March 2015
----------------------
1 Started business with the capital of Rs. 50,000
---------------------- 2 Opened a Bank Account by paying Rs. 35,000
---------------------- 3 Purchased goods from Ajay on credit Rs. 20,000
5 Sold the goods to Vijay on credit Rs. 14,000
----------------------
7 Paid Ajay by cheque Rs. 19,500 in full settlement
---------------------- 9 Received Rs. 13,000 from Vijay in full settlement by cheque
15 Purchased furniture of Rs. 10,000 and paid the amount by cheque
----------------------
18 Paid for traveling expenses in cash Rs. 3,000
---------------------- 21 Sold the goods to Vinod for cash Rs. 10,000
25 Goods purchased from Ashok against cash Rs. 8,000
----------------------
27 Cash deposited in bank Rs. 5,000
---------------------- 28 Amount withdrawn by cheque for personal purpose Rs. 3,000
---------------------- 30 Paid salary in cash Rs. 2,000
---------------------- Adjustments:
a. Value of goods unsold on 31st March 2015, valued at cost, Rs. 17,000
----------------------
b. Depreciate furniture @2%
----------------------
c. Telephone bill for the month of March 2015 not yet paid Rs. 1500
---------------------- Solution
---------------------- In the books of M/s Pam Industries
---------------------- Date March Particulars L.F. Debit – Credit –

2015 Rs. Rs.
---------------------- 1 Cash A/c Dr. To, Capital A/c 50,000 50,000
(Capital introduced in the business)
---------------------- 2 Bank A/c Dr. To, Cash A/c (Opened 35,000 35,000
---------------------- Bank Account)
3 Purchases A/c Dr. To, Ajay A/c 20,000 20,000
---------------------- (Goods purchased on credit)
5 Vijay A/c Dr. To, Sales A/c (Sold 14,000 14,000
---------------------- goods on credit)
7 Ajay A/c Dr. To, Bank A/c To, 20,000 19,500500
----------------------
Discount A/c (Paid Ajay in full
---------------------- settlement)
----------------------
----------------------
----------------------
----------------------
Date March Particulars L.F. Debit – Credit – Notes
2015 Rs. Rs.
9 Bank A/c Dr. Discount A/c Dr. To, 13,000 14,000 ----------------------
Vijay A/c (Received from Vijay in 1,000
----------------------
full settlement)
15 Furniture A/c Dr. To, Bank A/c 10,000 10,000 ----------------------
(Furniture purchased against
cheque) ----------------------
18 Traveling Expenses A/c Dr. To, 3,000 3,000
----------------------
Cash A/c (Paid for traveling
expenses) ----------------------
21 Cash A/c Dr. To, Sales A/c (Sold 10,000 10,000
goods for cash) ----------------------
25 Purchases A/c Dr. To, Cash A/c 8,000 8,000
----------------------
(Goods purchased for cash)
27 Bank A/c Dr. To, Cash A/c(Cash 5,000 5,000 ----------------------
deposited in bank)
28 Drawings A/c Dr. To, Bank A/c 3,000 3,000 ----------------------
(Withdrawn for personal purpose)
30 Salary A/c Dr. To, Cash A/c (Paid 2,000 2,000 ----------------------
salary in cash) ----------------------
General Ledger of M/s Pam Industries for March 2015 Cash Account
----------------------
Date Particulars Folio Rs. Date Particulars Folio Rs.
1 To Capital 50,000 2 By Bank 35,000 ----------------------
21 A/c To Sales 10,000 18 By Travelling 3,000 ----------------------
25 Exp. By 8,000
27 Purchases 5,000 ----------------------
By Bank
30 By Salary By 2,000 ----------------------
31 Balance c/fd 7,000 ----------------------
60,000 60,000
----------------------
Bank Account
----------------------
1 To Cash A/c 35,000 7 By Ajay 19,500 ----------------------
9 To Vijay 13,000 15 By Furniture 10,000
27 To Cash 5,000 27 By Drawings 3,000 ----------------------
31 By Balance c/fd 20,500 ----------------------
53,000 53,000
----------------------
Purchases Account
3 To Ajay 20,000 31 By Trading A/c 28,000 ----------------------
25 To Cash 8,000
28,000 28,000 ----------------------
Notes Sales Account
----------------------
31 To Trading 24,000 By Vijay By 14,000
---------------------- A/c Cash 10,000
24,000 24,000
----------------------
Travelling Expenses Account
---------------------- Date Particulars Folio Rs. Date Particulars Folio Rs.
18 To Cash 3,000 31 By Profit & 3,000
----------------------
Loss A/c
---------------------- 3,000 3,000
Salary Account
----------------------
---------------------- 30 To Cash 2,000 31 By Profit & 2,000
---------------------- Loss A/c
2,000 2,000
---------------------- Telephone Expenses Account
31 To 1,500 31 By Profit & 1,500
---------------------- Outstanding Loss A/c
---------------------- Exp.
1,500 1,500
---------------------- Discount Account
9 To Vijay 1,000 7 By Ajay By 500
---------------------- Profit & Loss A/c 500
1,000 1,000
----------------------
Depreciation Account
31 To Furniture 200 31 By Profit & 200
----------------------
Loss A/c
---------------------- 200 200
Ajay Account
---------------------- 7 To Bank 19,500 3 By Purchases 20,000
7 To Discount 500
---------------------- 20,000 20,000
Vijay Account
----------------------
---------------------- 5 To Sales 14,000 9 By Bank 13,000
9 By Discount 1,000
---------------------- 14,000 14,000
----------------------
Capital Account Notes
28 To Bank 3,000 1 By Cash 50,000 ----------------------
31 To Balance 47,000
----------------------
c/fd
50,000 50,000 ----------------------
Outstanding Expenses Account
31 To Balance c/ 1,500 31 By Telephone 1,500 ----------------------
fd Exp.
1,500 1,500 ----------------------
Furniture Account
----------------------
15 To Bank 10,000 31 By Depreciation 200 ----------------------
31 By Balance c/fd 9,800
10,000 10,000 ----------------------
Trial Balance as on 31st March 2015 ----------------------
Name of the Account Debit Credit
----------------------
Cash 7,000
Bank 20,500 ----------------------
Purchases 28,000
Sales 24,000 ----------------------
Traveling Expenses 3,000
Salary 2,000 ----------------------
Telephone Expenses 1,500 ----------------------
Depreciation 200
Discount 500 ----------------------
Capital 47,000
Furniture 9,800 ----------------------
Outstanding Expenses 1,500
----------------------
Total 72,500 72,500 ----------------------
Trading Account for the year ended on 31st March 2015
----------------------
Particulars Amount Particulars Amount
----------------------
Opening Stock Nil Sales 24,000
----------------------
Purchases 28,000 Closing Stock 17,000
----------------------
Gross Profit c/fd 13,000
----------------------
Total 41,000 Total 41,000
----------------------
----------------------
----------------------
Notes Profit & Loss Account for the year ended on 31st March 2015
Particulars Amount Particulars Amount
----------------------
---------------------- Traveling Expenses 3,000 Gross Profit b/fd 13,000

Salary 2,000
---------------------- Telephone Expenses 1,500
Discount 500
---------------------- Depreciation 200
----------------------
Profit carried to Capital
5,800
---------------------- Account
---------------------- Total 13,000 Total 13,000

---------------------- Balance Sheet as on 31st March 2015
---------------------- Capital & Liabilities Amount Assets & Properties Amount

Capital Fixed Assets
---------------------- Balance 47,000 Furniture 10,000
Add: Profit for year 5,800 Less: Depreciation 200
----------------------
52,800 9,800
----------------------
Current Assets
---------------------- Current Liabilities Stock 17,000
Outstanding Expenses 1,500 Cash 7,000
---------------------- Bank 20,500
---------------------- Total 54,300 Total 54,300
----------------------
----------------------
1. If the Trial Balance does not match, what steps will you take to ensure
----------------------
that it tallies?
---------------------- 2. What do you mean by Final Accounts? Explain in brief the structure of
Profitability Statement and Balance Sheet.
----------------------
3. What are the various components of the Profit & Loss Account? Explain
---------------------- the purpose of each component.
---------------------- 4. While preparing the final accounts, how would you deal with:
---------------------- a. Goods lost by fire

b. Goods distributed as free samples
----------------------
c. Goods sent on approval basis
----------------------
d. Bad Debts and Provision for Bad Debts
---------------------- e. Interest on Capital
---------------------- f. Prepaid Expenses and Outstanding Expenses
Answers to Check your Progress Notes
1. Journal is also referred to as the Book of Original Entry or the Book of
Prime Entry. ----------------------
2. Journalizing refers to the process of recording the business transaction in ----------------------

the Journal.
----------------------
----------------------
Fill in the blanks.
1. The Ledger is the book where transactions of a similar nature are pooled ----------------------
together under one Ledger Account. ----------------------
2. Journal Proper records all the residual transaction, which cannot be
entered into any other subsidiary book. ----------------------

1. Trial Balance is the summary of all the balances in all the accounts listed
----------------------
in the General Ledger and Cash / Bank Book of an organization at any
given date ----------------------
2. Tallying of Trial Balance generally ensures the arithmetical accuracy of
----------------------
the process of Ledger Posting.

1. Profit & Loss Account discloses the final result of business transactions of ----------------------
the organization
----------------------
2. The final result disclosed by the Profit & Loss Account is the Profit After
Tax (PAT) earned by the organization. ----------------------
3. The final result disclosed by the Trading Account is the Gross Profit
----------------------
earned by the organization
4. The final result disclosed by the Manufacturing Account is the Cost of ----------------------
Production incurred by the organization. ----------------------
----------------------
1. Erlinda C. Pefianco, Rosario D. Mercadp; The Accounting Process
2. http://www.myicwai.com/ ----------------------
3. http://www.icwai.org/icwainew/index.asp ----------------------
----------------------
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Cost Accountancy (Basic Concepts and Principles)
UNIT
4
Structure:
4.1 Introduction
4.2 Concept of Cost Center
4.3 Different Types of Costs
Summary
Key Words
Suggested Reading
Cost Accountancy (Basic Concepts and Principles) 69

Notes
Objectives
----------------------
• Define the objects of cost accountancy
----------------------
• Explain the concept of cost centers and various types of costs
----------------------
• Analyse the principles of different types of costs
----------------------
---------------------- 4.1 INTRODUCTION

----------------------
To understand the basic concepts and principles of Cost Accounting, we
---------------------- need to first understand what cost accounting means and includes. For this, we
need to know how Cost Accounting is defined.
---------------------- The Institute of Cost and Management Accountants, London has defined
---------------------- Cost Accountancy 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 as well as the presentation of information for the
purpose of managerial decision making.” The analysis of the above definition
---------------------- reveals the following facts:
---------------------- 1. Cost Accountancy is a science, art and practice of a Cost Accountant.
Science indicates the possession and the application of relevant systematic
---------------------- knowledge. Art indicates the skill and ability of the cost accountant.
---------------------- Practice indicates continuous effort on the part of the cost accountant.
2. The terms costing and cost accounting should not be confused with each
---------------------- other. Costing indicates the process of ascertaining the costs, which can
also be done arithmetically. Cost accounting indicates the process of
----------------------
recording the costs in a formal and systematic manner, with the intention
---------------------- of preparing statistical data therefrom to ascertain the cost.
3. The objects of Cost Accountancy can be threefold.
----------------------
i. Ascertainment of cost and profitability with the help of various
---------------------- principles, methods and techniques.
ii. Cost control, which indicates the process of controlling the costs of
---------------------- operating the business. This process, in turn, involves the following
---------------------- stages- plan the operations (which can be done by the establishment
of budgets and standards), execute the plans, measure the actual
---------------------- performance, compare planned and actual performance, compute
the variations between planned and actual performance and take the
---------------------- decisions to maintain favorable variations or to remove unfavourable
---------------------- variations.
iii. Presentation of information to enable managerial decision making.
---------------------- Unless and until the results of any study or action are presented
correctly to the person who takes the decision in respect of the
----------------------
same, the study has no meaning.
4.2 CONCEPT OF COST CENTER Notes
Cost Center is defined as a location, person, or item of equipment (or a ----------------------
group of these) in or connected with an undertaking, in relation to which costs
may be ascertained and used for the purpose of cost control. ----------------------
Correct identification of a cost center is a pre-requisite for the successful ----------------------
implementation of the cost accounting process as the costs are ascertained and
controlled with respect to the cost centers. Similarly, correct identification of ----------------------
cost center facilitates the fixation of responsibility in a correct manner. ----------------------
For example, a person in charge of a cost center may be held responsible
for the proper functioning and cost control in relation to that cost center. As ----------------------
cost centers facilitate this control function, in many cases, they are termed as ----------------------
‘Responsibility Centers’.
----------------------
There may not be any fixed principle for deciding the number and size
of cost centers. It depends upon the nature and size of the organisation, the ----------------------
expenditure involved, requirements of management from the cost control point
of view and so on. However, the following pattern of classification may be ----------------------
followed to decide the type of the cost centers.
----------------------
(1) Impersonal and Personal Cost Centers:
----------------------
An impersonal cost center consists of location or item of equipment
(or group of these). For example, a region of sales, a branch, a department, a ----------------------
grinding machine and so on.
----------------------
A personal cost center consists of a person or a group of persons. For
example, finance manager, sales manager, works manager and so on. ----------------------
(2) Production and Service Cost Centers: ----------------------
A production cost center is the one where the production activity is carried
on. For example, a machine shop, a paint shop, an assembly shop and so on. ----------------------
A service cost center is the one which assists the production activity. For ----------------------
example, the store department, the internal transport department, the labour
----------------------
office, the maintenance department, the accounts/costing department and so on.
----------------------
----------------------
State True or False ----------------------
1. Cost Accountancy is a science, art and practice of a Cost Accountant.
2. The terms costing and cost accounting are different in their meanings. ----------------------
----------------------
4.3 DIFFERENT TYPES OF COST ----------------------
The term ‘cost’ indicates the amount of expenditure (actual or notional) incurred ----------------------
on or attributable to, a given thing. The term cost can be viewed from various
angles. ----------------------

Notes (1) Direct and Indirect Cost:
---------------------- • Direct Cost indicates that cost that can be identified with the
individual cost center. It consists of direct material cost, direct
---------------------- labour cost and direct expenses. It is also termed as Prime Cost.
---------------------- • Indirect Cost indicates that cost that cannot be identified with the
individual cost center. It consists of indirect material cost, indirect
---------------------- labour cost and indirect expenses. It is also termed as overheads. As
it is not possible to identify these costs with individual cost centers,
---------------------- such identification is done in an indirect way by following the
---------------------- process of allocation, apportionment and absorption. (It is discussed
in detail in the following units).
----------------------
(2) Fixed, Variable and Semi-Variable / Semi-Fixed Cost:
---------------------- • Fixed cost indicates that portion of total cost, which remains
constant at all the levels of production, irrespective of any change
----------------------
in the later. As the volume of production increases, per unit fixed
---------------------- cost may reduce, but not the total fixed cost.
• Variable cost indicates that portion of the total cost, which varies
----------------------
directly with the level of production. The higher the volume of
---------------------- production, the higher the variable cost and vice versa, though per
unit variable cost remains constant at all the levels of production.
----------------------
• Semi-variable or semi-fixed cost indicates that portion of the total
---------------------- cost, which is partly fixed and partly variable in relation to the
volume of production.
----------------------
(3) Controllable Cost and Uncontrollable Cost:
---------------------- • Controllable cost indicates that cost, which can be controlled by
---------------------- a specific number of person(s) in the organisation. For example, a
person in charge of a responsibility center may be in the position to
---------------------- control the costs in relation to that responsibility center.
---------------------- • Uncontrollable cost indicates that cost, which cannot be controlled
by a specific number of person(s) in the organisation. For example,
---------------------- the costs relating to one responsibility center cannot be controlled
by a person who is in-charge of another responsibility center.
----------------------
Note: It should be noted here that a clear-cut distinction between controllable
---------------------- and uncontrollable costs may not be possible. The cost which is controllable for
one person may not be controllable by another one. In fact, no cost is completely
----------------------
uncontrollable. The degree of controllability varies in relation to a particular
---------------------- individual and a level of management. In a very broad sense, it can be said that
the variable costs are controllable at the lower level of management while fixed
---------------------- costs are controllable at the top level of management.
---------------------- (4) Normal Cost and Abnormal Cost:
---------------------- • Normal Cost indicates that cost, which is normally incurred at a

certain level of output under normal circumstances.
• Abnormal cost indicates that cost, which is normally not incurred at Notes
a certain level of output under normal circumstances.
----------------------
----------------------
State True or False
1. Indirect Cost indicates that cost, which can be identified with the ----------------------
individual cost center.
----------------------
2. Fixed cost indicates that portion of total cost, which remains constant at
all levels of production, irrespective of any change in the latter. ----------------------
----------------------
Activity 1 ----------------------
Direct Cost, Indirect Cost,, Fixed, Variable and Semi-Variable cost are the ----------------------
various types of costs. Write two examples of each type of the cost, based ----------------------
on your experience.
----------------------
Summary ----------------------
●● Cost Accountancy is 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 as well as the presentation of
information for the purpose of managerial decision-making. ----------------------
●● Costing indicates the process of ascertaining the costs, which can also be
----------------------
done arithmetically.
●● Cost accounting indicates the process of recording the costs in a formal ----------------------
and systematic manner with the intention of preparing statistical data
----------------------
therefrom to ascertain the cost.
●● The objects of Cost Accountancy are to ascertain the cost and profitability ----------------------
with the help of various principles, methods and techniques.
----------------------
●● Cost control indicates the process of controlling the costs of operating the
business. ----------------------
●● Cost Center is defined as a location, person or item of equipment (or a ----------------------
group of these) in or connected with an undertaking, in relation to which
costs may be ascertained and used for the purpose of cost control. ----------------------
●● There are different types of costs such as direct and indirect; fixed and ----------------------
variable; normal and abnormal etc. and special costs such as opportunity
cost, differential cost, sunk cost, which are helpful in decision-making. ----------------------
----------------------
----------------------

Notes Keywords
----------------------
●● Opportunity cost: It is the cost of any activity measured in terms of the
---------------------- value of the next best alternative forgone (that is not chosen). It is the
sacrifice related to the second best choice available to someone, or group,
---------------------- who has picked among several mutually exclusive choices.
---------------------- ●● Differential cost: It is the difference between the cost of two alternative
decisions, or of a change in output level.
---------------------- ●● Sunk costs: These are retrospective (past) costs that have already been
incurred and cannot be recovered
----------------------
●● Cost Control: This indicates the process of controlling the costs of
---------------------- operating the business.
●● Cost Center: Cost Center is defined as a location, person or item of
----------------------
equipment (or a group of these) in or connected with an undertaking, in
---------------------- relation to which costs may be ascertained and used for the purpose of
cost control.
----------------------
●● Cost: Indicates the amount of expenditure (actual or notional) incurred
---------------------- on or attributable to a given thing.
----------------------
----------------------
1. Explain the nature of Cost Accounting.
---------------------- 2. Write short notes on:
---------------------- a. Cost Center
---------------------- b. Direct and Indirect Cost
c. Opportunity Cost
----------------------
d. Fixed and Variable Cost
----------------------
----------------------
----------------------
1. True
---------------------- 2. True
1. False
----------------------
2. True
----------------------
----------------------
Suggested Reading
---------------------- 1. Jain, P. K. Cost Accounting

2. http://www.myicwai.com/
---------------------- 3. http://www.icwai.org/icwainew/index.asp
Elements of Costs
UNIT
5
Structure:
5.1 Introduction
5.2 Elements of Costs
5.2.1 Overheads
5.3 Cost Sheet/Cost Statement
Summary
Keywords
Suggested Reading
Elements of Costs 75
Notes
Objectives
----------------------
• Define the elements of costs
----------------------
• Classify direct and indirect costs
---------------------- • Explain the term overheads
• Prepare cost statements
----------------------
• Calculate Net Profit
----------------------
---------------------- 5.1 INTRODUCTION

---------------------- In case of a typical manufacturing type of operation, the activity may consist of
---------------------- conversion of raw material into finished goods with the help of labour and other
services and selling the finished goods in the market to earn the profits. In order
---------------------- to interpret the term ‘cost’ correctly and to ascertain the cost with respect to the
centres, the cost attached with the manufacturing process may be subdivided
---------------------- into what is known as Elements of Cost.
----------------------
5.2 ELEMENTS OF COSTS
----------------------
Broadly there can be three elements of costs:
----------------------
(A) Material
---------------------- This is the cost of commodities and materials used by the organization. It
---------------------- can be direct or indirect.
• Direct Material indicates that material, which can be identified
---------------------- with the individual cost center and which becomes an integral part
---------------------- of the finished goods. It basically consists of all raw materials,
either purchased from outside or manufactured in-house.
---------------------- • Indirect Material indicates that material, which cannot be
---------------------- identified with the individual cost center. This material assists the
manufacturing process and does not become an integral part of
---------------------- finished goods. The examples of this type of material are consumable
stores, cotton waste, oils and lubricants, stationery material etc.
----------------------
(B) Labour
---------------------- This is the cost of remuneration paid to the employees of the organisation.
---------------------- It can also be direct or indirect.
• Direct Labour Cost indicates that labour cost, which can be
---------------------- identified with the individual cost center and is incurred for those
---------------------- employees who are engaged in the manufacturing process.
• Indirect Labour Cost indicates that labour cost, which cannot be
---------------------- identified with the individual cost center and is incurred for those
employees who are not engaged in the manufacturing process but Notes
only assist in the same. The examples of this type of cost are wages
paid to foreman/storekeeper and salaries of works manager and ----------------------
Accounts/Personnel department etc.
----------------------
(C) Expenses
----------------------
This is the cost of services provided to the organisation (and the notional
cost of assets owned). It can also be direct or indirect. ----------------------
• Direct Expenses are those expenses, which can be identified with
----------------------
the individual cost centers. Examples of these expenses are hiring
charges for machinery / equipment required for a particular job, ----------------------
cost of defective work for a particular job etc.
----------------------
• Indirect Expenses are those expenses, which cannot be identified
with the individual cost centers. The examples of these expenses ----------------------
are rent, telephone expenses, insurance, lighting etc.
----------------------
The above elements of cost can be shown as below:
----------------------
Elements of Cost
----------------------
----------------------
Material Labour Expenses ----------------------
----------------------
----------------------
Direct Indirect Direct Indirect Direct Indirect
----------------------
The aggregate of Direct Material Cost, Direct Labour Cost and Direct Expenses
----------------------
is termed as ‘Prime Cost’.
The aggregate of Indirect Material Cost, Indirect Labour Cost and Indirect ----------------------
Expenses is termed as ‘Overheads’.
----------------------
5.2.1 Overheads
----------------------
As discussed above, the aggregate of Indirect Material Cost, Indirect Labour Cost
and Indirect Expenses is termed as ‘Overheads’. For the proper interpretation ----------------------
and presentation of cost, the term overheads may be further classified as
(a) Factory Overheads (Also termed as production/works/manufacturing ----------------------
overheads.), (b) Office and Administration Overheads and (c) Selling and ----------------------
Distribution Overheads.
(A) Factory Overheads: These overheads consist of all overhead costs ----------------------
incurred from the stage of procurement of material till the stage of ----------------------
production of finished goods. They include:
• Indirect Material such as consumable stores, cotton waste, oil and ----------------------
lubricants etc. ----------------------
Notes • Indirect Labour Cost such as wages paid to the foreman/storekeeper,
works manager’s salary etc.
----------------------
• Indirect Expenses such as carriage inward cost, cost of factory
---------------------- lighting/power expenses, rent/insurance/repairs for factory building/
machinery, depreciation on factory building or machinery etc.
----------------------
(B) Office and Administration Overheads: These overheads consist of all
---------------------- overhead costs incurred for the overall administration of the organization.
They include:
----------------------
• Indirect Material such as stationery items, office supplies etc.
---------------------- • Indirect Labour cost such as salaries paid to Accounts and
---------------------- Administration staff, Directors’ remuneration etc.
• Indirect Expenses such as postage/telephone, rent/insurance/
----------------------
repairs/depreciation on office building, general lighting, legal/audit
---------------------- charges, bank charges etc.
(C) Selling and Distribution Overheads: These overheads consist of all
----------------------
overhead costs insured from the stage of final manufacturing of finished
---------------------- goods till the stage of sale of goods in the market and collection of dues
from the customers. They include:
----------------------
• Indirect Material such as packing material, samples etc.
---------------------- • Indirect Labour such as salaries paid to sales personnel, commission
---------------------- paid to sales manager etc.
• Indirect Expenses such as carriage outwards, warehouse charges,
---------------------- advertisement, bad debts, repairs and running of distribution van,
---------------------- discount offered to customers etc.
The above classification of overheads can be shown as follows:
----------------------
Overheads
----------------------
---------------------- Factory Overheads Office/Admin Selling & Distribution

Overheads Overheads
----------------------
Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect
---------------------- Material Labour Labour Material Labour Labour Material Labour Labour
----------------------
----------------------
---------------------- Multiple Choice Multiple Response.

1. Broadly, there are three elements of cost, viz.
----------------------
i. Material
---------------------- ii. Labour
iii. Expenses
----------------------
iv. Overheads
Multiple Choice Single Response. Notes
1. _______________ overheads consist of all overhead costs incurred ----------------------
from the stage of procurement of material till the stage of production of
finished goods. ----------------------
i. Factory Overheads ----------------------
ii. Office/Administration Overheads
iii. Selling Overheads ----------------------
iv. Distribution Overheads ----------------------
----------------------
Activity 1
----------------------
After understanding various elements of cost, identify a manufacturing/
----------------------
trading organization and list the various cost involved in the process.
----------------------
5.3 COST SHEET/COST STATEMENT ----------------------
Various elements/components of the cost as discussed above can be presented ----------------------

in the form of a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’.
The cost sheet may be prepared separately for each cost center and may have ----------------------
the columns such as cost per unit or cost of previous period etc. ----------------------
A detailed Proforma cost sheet is shown below:
----------------------
M/s. _____________________
----------------------
Cost Sheet for the period________________________
Quantity Manufactured: ______________ Total Cost per ----------------------
Quantity Sold: _____________ Cost unit ----------------------
DIRECT COST: ----------------------
Raw Material Consumed
----------------------
Opening stock of Raw Material
(Add) Purchases of Raw Materials ----------------------
(Add) Carriage Inwards ----------------------
(Less) Closing Stock of Raw Material
----------------------
Direct Wages
Direct Expenses ----------------------
Prime Cost ----------------------
INDIRECT COST:
----------------------
Factory Overheads
Power Consumption ----------------------
Fuel Expenditure ----------------------
Notes Factory Rent
(Less) Sale of Scrap
----------------------
Gross Factory Cost
---------------------- (Add) Opening Stock of Work-in-progress
---------------------- (Less) Closing Stock of Work-in-progress
Net Work Cost/Net Factory Cost/Factory Cost/
----------------------
Work Cost
---------------------- Office and Administration Overheads
---------------------- Salaries
Printing Expenses
----------------------
Stationery
---------------------- Cost of production of goods produced
---------------------- (Add) Opening stock of Finished Goods
(Less) Closing stock of Finished Good
----------------------
Cost of production of goods produced
---------------------- Selling and Distribution overheads
---------------------- Advertisement Expenses
Door Delivery
----------------------
Cost of Sales/Total Cost
---------------------- Profit/Loss
---------------------- SALES
---------------------- The above relationship among the various elements of costs can be explained in
a better way with the help of the following diagram.
----------------------
PROFIT
----------------------
SELLING & DISTRIBUTION
---------------------- OVERHEADS
---------------------- ADMINISTRATION
OVERHEADS
----------------------
FACTORY
---------------------- OVERHEADS
---------------------- DIRECT
COST OF SALES
FACTORY COST
EXPENSES
----------------------
TOTAL COST
PRIME COST
DIRECT
---------------------- LABOUR
SALES
---------------------- DIRECT
MATERIAL
----------------------
Note: Notes
The difference between sales and factory/works cost is termed as ‘Gross Profit’
----------------------
and the difference between sales and cost of sales is termed as ‘Net Profit’ or
‘Operating Profit’. ----------------------
This Net Profit of cost statement may be different from the Net Profit as disclosed
----------------------
by the financial statement in the form of Profit & Loss Account. This is due to
the fact that the Profit and Loss Account considers the various non-operating ----------------------
incomes/expenses or incomes/expenses of purely financial nature (as discussed
below), while they may be ignored by the cost statement. ----------------------
(A) Non-operating/Financial Incomes: These represent incomes, which do ----------------------
not arise as a part of regular operations of the organisation, for example,
profit on the sale of assets/investment, dividend received, windfall income ----------------------
etc. Due to these, the operating profit as per cost statement may be less
----------------------
than profit as per Profit & Loss Account.
(B) Non-operating/Financial Expenses: These represent expenses, which do ----------------------
not arise as a part of regular operations of the organisation. Such expenses ----------------------
may be in the form of those incurred as a result of policy, for example loss
on the sale of assets/investment, goodwill/ preliminary expenses written ----------------------
off, provision for income tax, interest paid, the dividend paid etc. Due to
these, the operating profit as per the cost statement may be more than the ----------------------
profit as per Profit & Loss Account. ----------------------
As such Net Profit (as per Profit & Loss Account) may also be presented as
below ----------------------
----------------------
Sales ----------------------
Less: Factory/Works Cost
----------------------
Gross Profit
Less: Office and Administration Overheads ----------------------
Selling and Distribution Overheads ----------------------

Operating Profit ----------------------
Less: Non-Operating/Financial Expenses ----------------------
Add: Non-Operating/Financial Income
----------------------
Net Profit (As per Profit & Loss Account)
----------------------
Summary
----------------------
●● Material Cost is the cost of commodities and materials used by the ----------------------
organization. It can be direct or indirect.
●● Labour Cost is the cost of remuneration paid to the employees of the ----------------------
organisation. It can also be direct or indirect.
----------------------
Notes ●● Expenses are the cost of services provided to the organisation (and the
notional cost of assets owned). It can also be direct or indirect.
---------------------- ●● The aggregate of Direct Material Cost, Direct Labour Cost and Direct
---------------------- Expenses is termed as ‘Prime Cost’.
●● The aggregate of Indirect Material Cost, Indirect Labour Cost and Indirect
---------------------- Expenses is termed as ‘Overheads’.
---------------------- ●● Various elements/components of the cost can be presented in the form of
a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’.
----------------------
●● Non-operating/Financial Incomes represent incomes, which do not arise
---------------------- as a part of regular operations of the organisation.
●● Non-operating/Financial Expenses represent expenses, which do not arise
----------------------
as a part of regular operations of the organisation.
----------------------
Keywords
----------------------
●● Non-operating Incomes: Incomes, which do not arise as a part of regular
----------------------
operations of the organisation.
---------------------- ●● Non-operating Expenses: Expenses, which do not arise as a part of
regular operations of the organisation.
----------------------
●● Material Cost: Cost of commodities and materials used by the
---------------------- organization. It can be direct or indirect.
---------------------- ●● Cost Sheet: Form of a statement in which various elements/components
of the cost can be presented.
----------------------
----------------------
---------------------- 1) From the following list of balances, prepare a statement showing Cost of
Sales, Gross Profit, Operating Expenses, Operating Profit and Net Profit.
----------------------
Rs.
---------------------- Sales 7,80,000
Purchases 4,83,375
----------------------
Sales Returns 30,000
---------------------- Salaries: Office 40,350
---------------------- Selling 22,950 63,300
Rent and Taxes : Office 2,700
---------------------- Selling 1,350 4,050
---------------------- Stationery and Postage 3,850
Depreciation 13,950
----------------------
Advertising 4,700
---------------------- Selling expenses 2,350
Travelling expenses 3,000
----------------------
Opening Stock 1,14,375 Notes
Sundry Expenses: Office 16,500
----------------------
Selling 8,250 24,750
Closing Stock 1,47,750 ----------------------
Dividend on shares, paid 13,500 ----------------------
Profit on sale of shares 4,500
Loss on sale of shares 6,000 ----------------------
Solution: ----------------------
COST STATEMENT ----------------------
(A) Sales Rs. Rs.
----------------------
Gross Sales 7,80,000
Less: Sales Returns 30,000 ----------------------
Net Sales 7,50,000 ----------------------
(B) Prime Cost (Material consumed) ----------------------
Opening Stock 1,14,375
----------------------
Add: Purchases 4,83,375
5,97,750 ----------------------
Less: Closing stock 1,47,750
----------------------
4,50,000
(C) Gross Profit (i.e. A-B) 3,00,000 ----------------------
(D) (a) Office and Administration ----------------------
Overheads:
- Salaries 40,350 ----------------------
- Rent and Taxes 2,700 ----------------------
- Stationery and Postage 3,850
- Depreciation 13,950 ----------------------
- Travelling Expenses 3,000 ----------------------
- Sundry Expenses 16,500
----------------------
80,350
(b) Selling and Distribution ----------------------
Overheads
----------------------
- Salaries 22,950
- Rent and Taxes 1,350 ----------------------
- Advertising 4,700
----------------------
- Selling Expenses 2,350
- Sundry Expenses 8,250 ----------------------
(E) Operating Profit (i.e. C-D) 39,600 1,19,950 ----------------------
1,80,050
----------------------
Notes (F) (a) Less : Non-operating
Expenses
----------------------
Dividend on shares 13,500
---------------------- Loss on sale of shares 6,000 19,500
1,60,550
----------------------
(b) Add: Non-operating Income
---------------------- Profit on sale of shares 4,500
---------------------- (G) Net Profit 1,65,050
----------------------
Notes:
---------------------- a) From the available details, it appears that the above activity is a trading
---------------------- activity. As such there will be no factory overheads and prime cost will
consist of only material cost.
---------------------- b) For want of sufficient information, depreciation and travelling expenses
---------------------- are treated as office and administration overheads.
c) Dividend on shares may indicate the non-operating income also. However,
----------------------
for want of sufficient information, it is treated as dividend paid by the
---------------------- company i.e. a part of non-operating expenses.
2. From the books of accounts of M/s. Aryan Enterprises, the following
----------------------
details have been extracted for the year ending March, 1994.
---------------------- Rs.
---------------------- Stock of Materials - Opening 1,88,000
- Closing 2,00,000
----------------------
Materials purchased during the year 8,32,000
---------------------- Direct Wages paid 2,38,400
Indirect Wages 16,000
----------------------
Salaries to administrative staff 40,000
---------------------- Freights - Inward 32,000
---------------------- - Outward 20,000
Cash Discounts allowed 14,000
---------------------- Bad Debts written off 18,800
---------------------- Repairs to Plant & Machinery 42,400
Rent, Rates and Taxes - Factory 12,000
----------------------
- Office 6,400
---------------------- Travelling Expenses 12,400
Salesmen’s Salaries and Commission 33,600
----------------------
Depreciation - Plant & Machinery 28,400
---------------------- - Furniture 2,400
---------------------- Directors’ Fees 24,000
Electricity Charges (Factory) 48,000 Notes
Fuel (for boiler) 64,000
----------------------
General Charges 24,800
Manager’s Salary 48,000 ----------------------
The manager’s time is shared between the factory and the office in the ----------------------
ratio of 20:80.
----------------------
From the above details, you are required to prepare the following:
a. Prime Cost ----------------------
b. Factory Overheads ----------------------

c. Factory Cost ----------------------
d. Administrative Overheads
----------------------
e. Selling Overheads
----------------------
f. Total Cost
----------------------
COSTSHEET
Direct Materials Cost Rs. Rs. ----------------------
Opening Stock 1,88,000 ----------------------
Add: Purchases 8,32,000 ----------------------
Less: Closing Stock 2,00,000
----------------------
8,20,000
----------------------
Add: Freight Inward 32,000
8,52,000 ----------------------
Direct Wages 2,38,400 ----------------------
PRIME COST 10,90,400 ----------------------
Factory Overheads
----------------------
Indirect wages 16,000
Repairs to Plant & Machinery 42,400 ----------------------
Rent, Rates and Taxes 12,000 ----------------------
Depreciation- Plant & Machinery 28,400
Electricity Charges 48,000 ----------------------
Fuel for boiler 64,000 ----------------------
Manager’s Salary 9,600
Factory Overheads 2,20,400 ----------------------
FACTORY COST 13,10,800 ----------------------
Administration Overheads
Salaries 40,000 ----------------------
Rent, Rates and Taxes 6,400 ----------------------
Notes Travelling Expenses 12,400
Depreciation - Furniture 2,400
----------------------
Directors’ Fees 24,000
---------------------- General Charges 24,800
Manager’s Salary 38,400
----------------------
Administration Overheads 1,48,400
---------------------- 14,59,200
Selling Overheads
----------------------
Freight Outward 20,000
---------------------- Cash Discount allowed 14,000
---------------------- Bad Debts written off 18,800
Salesmen’s Salary & Commission 33,600
---------------------- Selling Overheads 86,400
---------------------- TOTAL COST OF SALES 15,45,600
---------------------- Self-Assessment Questions

----------------------
1. What do you mean by Elements of Cost? Explain in detail.
---------------------- 2. How is cost classified into various elements for presenting the same in the
---------------------- form of a cost sheet?

---------------------- Multiple Choice Multiple Response.
---------------------- 1. Broadly, there are three elements of cost, viz.

i. Material
----------------------
ii. Labour
----------------------
iii. Expenses
---------------------- Multiple Choice Single Response.
---------------------- 1. _______________ consist of all overhead costs incurred from the stage
of procurement of material till the stage of production of finished goods.
----------------------
i. Factory Overheads
----------------------
---------------------- Suggested Reading

---------------------- 1. http://220.227.161.86/18528paper5_finalnew_sugg_nove09.pdf
---------------------- 2. http://www.myicwai.com/
3. http://www.icwai.org/icwainew/index.asp
----------------------
4. Jain, P. K. Cost Accounting
Material Costs
UNIT
6
Structure:
6.1 Introduction
6.2 Stages in the Movement of Material
6.3 Proper Conduct of Storage Function
6.4 Valuation of Material Movements
6.5 Inventory Control
Summary
Key Words
Suggested Reading
Material Costs 87
Notes
Objectives
----------------------
• Recognise how the material cost is identified with the individual
----------------------
cost centre
----------------------
• Examine the movement of material
---------------------- • Exercise control on the material cost
---------------------- • Evaluate the techniques of inventory control
----------------------
6.1 INTRODUCTION
----------------------
We have learnt that material cost is the first and probably the most
---------------------- important element of cost. In the case of specific types of industries, say cement,
---------------------- sugar, chemicals, iron and steel etc., the materials cost forms a very significant
portion of the overall cost of production.
----------------------
The term material refers to all commodities that are consumed in the
---------------------- production process. The materials, which can be consumed in the production
process, can be classified as:
----------------------
(i) Direct Materials
---------------------- (ii) Indirect Materials
---------------------- We have already discussed the meaning of both these terms in the
previous unit. The basic objective of cost accounting, i.e. ascertainment of cost
---------------------- and control of cost is equally applicable to material cost as well.
---------------------- The ascertainment of material cost is made basically from two documents:
---------------------- 1. The invoice of the supplier of material

2. The material requisition slip specifying material issued from stores
----------------------
department to production department.
---------------------- However, a whole lot of organisational procedures are also involved in
the process, which affects the material cost, either directly or indirectly. For
----------------------
example, purchases from improper sources of supply may be expensive and
---------------------- non-availability of material in time may result into hold ups. As such, a proper
study of the various procedures involved in case of the movement of materials
---------------------- and a proper control thereon enables an organisation to exercise control on a
sizeable manufacturing cost.
----------------------
---------------------- 6.2 STAGES IN THE MOVEMENT OF MATERIAL

---------------------- The movement of material may involve the following stages.
---------------------- A. Procurement of materials.
B. Storing the material till it is required for consumption. Notes
C. Issue of the material for consumption.
----------------------
There may be additional stages, too.
----------------------
D. Return of Material
----------------------
E. Transfer of Materials
The details of above stages are given below. ----------------------
A. Procurement of Materials: Though the practices may differ from ----------------------

organisation to organisation, normally the process of purchasing the
----------------------
materials involves the following stages.
1. Purchase Requisition: It is an indication given to the purchase ----------------------
department to purchase certain material. It is issued either by the
----------------------
storekeeper (in respect of material required for regular production
purposes) or by production department (in respect of special ----------------------
materials required).
----------------------
Following particulars must appear in purchase requisition.
a. Material to be purchased: It should be clearly specified. To make it ----------------------
more specific, in addition to the description of the material required, ----------------------
the code number should also be specified.
b. When it is required: Unless the material is required for regular ----------------------
production purposes (when the storekeeper himself will place the ----------------------
purchase requisition as soon as it reaches the ordering level), purchase
requisition should mention the last date by which the material is ----------------------
required. Ideally, the material should be purchased whenever the
market for the same is favourable. ----------------------
c. How much to be purchased: Purchase requisition should state the ----------------------
quantity of the material required. Before deciding the quantity of
material to be purchased, the principle to be kept in mind is that ----------------------
there should not be any overstocking or under stocking of materials,
----------------------
as both these situations involve costs.
Overstocking may have following consequences: ----------------------
a. Blocking of working capital. ----------------------
b. Risk of deterioration of quality and obsolescence. ----------------------
c. More storage facilities.
----------------------
d. Additional Insurance Cost.
----------------------
e. More material handling and upkeeping.
f. Risk of breakage/pilferage etc. ----------------------
Understocking may have following consequences: ----------------------
a. Production holdups, resulting into disturbed delivery schedules. ----------------------
Material Costs 89
Notes b. Frantic eleventh hour purchases, which may result into unfavourable
prices and quality.
----------------------
c. Payment for idle time to workers.
---------------------- Before deciding the quantity to be purchased, consideration will have to
be given to the following factors also:
----------------------
a. Quantity already ordered.
----------------------
b. Quantity reserved: It may happen that a particular quantity, though
---------------------- in hand, might have been reserved for a particular job and it may
not be available for other purposes. In such cases, this quantity is
---------------------- considered as if it is not in stock.
---------------------- c. Funds availability: Amounts kept aside for drawing up purchase
budget should be considered.
----------------------
The purchase requisition should be signed by Head of the Department drawing
---------------------- the same.
---------------------- A standard form of Purchase Requisition is as shown below:
---------------------- PURCHASE REQUISITION

To: Purchase Department From : Department
----------------------
---------------------- No.: Date:

Please purchase the material stated below.
----------------------
---------------------- Sr. Description Code Quantity Quantity on Remarks

No. Required hand
----------------------
----------------------
----------------------
----------------------
----------------------
Signed by; Storekeeper Approved by
----------------------
For the use of Purchase Department only
----------------------
Date P.O. No. Name of Supplier Delivery Remarks
---------------------- Date
----------------------
----------------------
----------------------
----------------------
Signed: Purchase Manager
2. Selection of Source of Supply: Notes
For this purpose, the purchase department may call for quotations from
the prospective suppliers of a certain type of material. In practice, following ----------------------
types of quotations may be called for: ----------------------
a. Single Tender: It is addressed to only one selected source when there is
only one source of supply available. ----------------------
b. Limited Tender: It is addressed to a limited number of suppliers known ----------------------

to be reliable sources on the basis of data maintained by the purchase
----------------------
department.
c. Open Tender: It is open to all who can supply specified quality and quantity ----------------------
of the required material. Tenders are called by giving advertisements in
----------------------
the newspapers, journals etc.
d. Global Tender: Anybody from any part of the world can respond to these ----------------------
tenders.
----------------------
To discourage unreliable and unwanted sources from quoting, some
tender deposit may be insisted upon. ----------------------
Comparative Statements: ----------------------
After receiving the tenders as stated above, a comparison has to be made
----------------------
among the various available sources so that the best possible source can be
selected. All the offers are tabulated in a comparative statement. The authority ----------------------
authorised to accept the tender should be specified.
----------------------
The criteria for selecting the final source of supply may depend upon
the terms of offer, which can be compared in respect of price offered, quality, ----------------------
other terms (like Sales Tax, Octroi, Freight etc.), terms of delivery, terms of
payment, guarantee offered by the supplier, goodwill of the supplier etc. Lowest ----------------------
quotation may not necessarily be the best quotation.
----------------------
3. Purchase Order
----------------------
The contractual obligation between the supplier and purchaser starts
from the purchase order. It is drawn in favour of the supplier by the purchase ----------------------
department. It may specify a number of facts.
----------------------
a) Material to be supplied (Description as well as code numbers and quality).
b) Quantity to be supplied. ----------------------
c) Price and other terms (for example, excise duty, sales tax, octroi, insurance, ----------------------
packing and transportation etc.).
----------------------
d) Cash and trade discount.
e) Instructions in respect of delivery. ----------------------
f) Guarantee clause. ----------------------
g) Liquidated damages clause. ----------------------
h) Escalation clause.
----------------------
Material Costs 91
Notes i) Inspection clause.
j) Method of settlement of disputes.
----------------------
k) Details in respect of letters of credit, import license etc.
----------------------
l) Details in respect of interest payable in the event of late payment of dues.
---------------------- Ideally, purchase orders should be serially numbered. Normally, four or
five copies of Purchase Orders are drawn, to be distributed as below:
----------------------
a) One to Supplier.
----------------------
b) One to User Department.
---------------------- c) One to Stores Department.
---------------------- d) One to Accounts/Costing Department.
---------------------- e) One with Purchase Department.
A standard form of Purchase Order is shown below.
----------------------
PURCHASE ORDER
----------------------
No.- Date-
----------------------
Date-Requisition No. - Date-
----------------------
Please supply the following material on such terms and conditions is
---------------------- stated therein.
---------------------- Description Code Quantity Rate Delivery Remarks
No. Rs. Date
----------------------
----------------------
----------------------
----------------------
Delivery: Goods to be delivered it -
----------------------
Extra is applicable -
---------------------- Excise Duty
---------------------- Sales Tax
---------------------- Picking Charges

Insurance
----------------------
Terms of payment
----------------------
For (Purchasing Company)
----------------------
Purchase Manager]
---------------------- 4. Receipt and Inspection: After material is received from the supplier, the
quantity received actually is compared with quantity ordered. Variations,
----------------------
if any, are taken up with the supplier again. Excess material received may
be dealt with in any of the following ways: Notes
a) Accept all the material received.
----------------------
b) Accept the material ordered and return the excess to the supplier.
Before accepting, material may be subjected to inspection. The extent of ----------------------
inspection may vary from material to material.
----------------------
5. Checking invoice and accounting for purchases: The supplier’s
invoice received for the supply of material is subjected to scrutiny before ----------------------
a voucher is passed for the same for making the entry in the books of
accounts. For this purpose, the supplier’s invoice may be compared with ----------------------
the following documents.
----------------------
(a) Purchase Order.
(b) Goods Received Note. ----------------------
(c) Inspection Report. ----------------------
If the quantity and/or rate as per purchase order and invoice match with
each other, the invoice of the supplier is passed for making the entry in the ----------------------
books of accounts. If the quantity and/or rate as per purchase order and invoice ----------------------
differ from each other, the difference is adjusted by raising a debit or credit note
in favour of the supplier. ----------------------
B. Storing and Issue of Material: After the material is received, inspected ----------------------
and approved, the process of storing comes into operation, which deals
with storing the material in good condition till it is required for use by ----------------------
production departments and issuing the same whenever required.
----------------------
As far as the movement of the material from the store’s point of view is
concerned, there can be basically four types of movements. ----------------------
1. Receipt of Material: Usually the receipt of material is accompanied by ----------------------
the delivery challan given by the supplier. On receipt of the material,
quantity received is checked with the quantity ordered by the Stores ----------------------
Department. The received material may be inspected, before acceptance
----------------------
either by separate inspection department or by Stores Department itself.
A document known as Goods Received Note or Goods Received Report ----------------------
(GRN or GRR) is prepared to record the details of the material received.
The usual form in which GRN or GRR is prepared is as below: ----------------------
GOODS RECEIVED NOTE ----------------------
No.: Date: ----------------------
Sr. Code Qty. Qty. Qty. ----------------------

Description Remarks
No. Recd. Accepted Rejected ----------------------
----------------------
----------------------
----------------------
Material Costs 93
Notes
---------------------- Prepare by Received by Inspected by Store Keeper
---------------------- GNR/GRR may be prepared in quadruplicate to be distributed as follows:

a) One copy to Purchases Department for comparing with purchases order
---------------------- and approving the invoice of the supplier.
---------------------- b) One copy to Accounts Department for making the payment of supplier’s
invoice.
----------------------
c) One copy to Costing Department for pricing and entering in stores record.
----------------------
d) One copy to be retained by Stores Department.
---------------------- Ideally, GRN/GRR should be serially numbered in order to locate the
---------------------- material that is physically received but for which invoice is not received.
Discrepancies in material receipts:
----------------------
The material physically received when compared with material ordered as
---------------------- per the purchase order may reveal certain discrepancies of any of the following
forms.
----------------------
a) Quantity received in excess.
----------------------
b) Quantity received in short.
---------------------- c) Quantity received of different quality.
---------------------- Excess quantity received may be retained and accepted, if required, with
the approval of the purchase department. Alternatively, if it is not accepted, it
---------------------- may be returned to the supplier with Goods Returned Note. The usual form in
---------------------- which Goods Returned Note is prepared is as below:
---------------------- GOODS RETURNED NOTE

To.: No:
----------------------
Date:
----------------------
Following material supplied by you vide your D.C. No._______ and Invoice
---------------------- No.__________ against our purchase Order No._________is being returned
---------------------- to you for the reasons stated below:
---------------------- Description Quantity Reasons
----------------------
----------------------
----------------------
Signature
----------------------
----------------------
Usually, three copies of Goods Returned Note are prepared to be Notes
distributed as follows:
a) One copy to the Supplier. ----------------------
b) One copy to the Purchase Department. ----------------------
c) One copy to be retained by the Stores Department.
----------------------
Excess Quantity Accepted: If excess quantity is already billed in the
invoice, it will be approved and paid. If not, either the supplier may be asked ----------------------
to give a supplementary invoice or credit note may be issued to the supplier for
amending the amount. ----------------------
Excess Quantity Returned: If excess quantity is already billed in the ----------------------
invoice, a debit note may be issued to the supplier for amending the amount.
----------------------
Short quantity: In case the quantity received is short, purchase department
may take up the case with the supplier or carrier or insurer as per the terms of ----------------------
purchases. If quantity short supplied is billed in the invoice, invoice is suitably
amended and debit note is issued to the supplier. ----------------------
If quantity received is of different quality and is rejected in inspection, it ----------------------
can either be retained or returned. It may be retained by accepting some mutually
decided concessional price. The variation in prices may be adjusted by issuing ----------------------
either the credit note or debit note in favour of the supplier. If quantity rejected
is billed in the invoice, invoice is suitably amended and debit note is issued to ----------------------
the supplier. ----------------------
C. Issue of Material:
----------------------
Here, the issue of material refers to issue of material from stores department
to production department. The material should not be issued from the stores ----------------------
unless a proper authority in writing is produced before the stores department.
Usually, this authority is in the form of Material Requisition Note or Material ----------------------
Requisition Slip.
----------------------
The normal contents of this note/slip are:
1. Number and date (Ideally, they should be serially numbered). ----------------------
2. Department demanding the material. ----------------------
3. Description and code of material demanded.
----------------------
4. Quantity of material demanded.
5. Signature of authority approving the demand. ----------------------
6. Signature of the person receiving the material. ----------------------
Normally one note/slip is prepared for requisitioning a single item of material.
----------------------
Usually, it is prepared in three copies. One copy is for demanding
department and two copies to Stores Department, which in its turn passes one ----------------------
copy to Costing Department for pricing while second copy is retained by the
Stores Department. ----------------------
----------------------
----------------------
Material Costs 95
Notes The usual form in which material requisition note is prepared is as below:
---------------------- MATERIAL REQUISITION NOTE

Production/Job Order No. No:
----------------------
Bill of Materials No:
----------------------
Date: Dapartment:
----------------------
---------------------- Cost (for costing Dept. only)

Description Code Qty. Unit
Rate per unit Amount Rs.
----------------------
----------------------
----------------------
---------------------- Authorised Issued by Received by Entered and valued by
---------------------- D. Return of Material:

There can be some situations, when material once issued to production
----------------------
departments is returned back to the stores. It can happen in the following
---------------------- circumstances.
(a) Material issued in excess of requirement.
----------------------
(b) Scrap or defective work arising out of the production processes.
---------------------- Under these circumstances, a document in the form of Materials Returned
Note is prepared, which is to record return of unused materials.
----------------------
The usual form in which materials returned note is prepared is as below:
----------------------
MATERIALS RETURNED NOTE
----------------------
Production/Job Order No. No.
---------------------- Bill of Materials No.
---------------------- Date: Dapartment:
----------------------
---------------------- Cost (for costing Dept. only)
Description Code Qty. Unit
----------------------
----------------------
----------------------
Authorised by Received by Posted by
----------------------
As far as the valuation of the returned material is concerned, it may be
---------------------- treated as the fresh receipt of the material or alternatively, it may be treated as
---------------------- the negative (minus) issues.
E. Transfer of Materials: In some situations, considering the urgency Notes
for the requirement of the material, it may be necessary to transfer the material
from one production/job order to another. Such transfer of material is usually ----------------------
accompanied by preparing a document in the form of Material Transfer Note.
----------------------
The usual form in which material transfer note is prepared is as below:
----------------------
MATERIAL TRANSFER NOTE
No. Date: ----------------------
From............Dept. To..............Dept. ----------------------

Production/Job Order No. Production/Job Order No. ----------------------
Cost (for costing Dept. only) ----------------------
Description Code No. Qty.
----------------------
----------------------
----------------------
Authorised by Received by Entered by
----------------------
Transfer of materials does not result into any fresh issue of material.
However, material transfer notes should be valued and considered in order to ----------------------
compute the material cost as per the job orders and production orders. ----------------------
----------------------
Fill in the blanks.
----------------------
1. If excess quantity is already billed in the invoice and it is not approved,
then either of the following may be done: ________________ or ----------------------
__________________.
----------------------
2. The process of purchasing the materials involves the following stages:
----------------------
a. Purchase _____________
b. Selection ____________________ ----------------------
c. __________________Order ----------------------
d. Receipt and _______________ ----------------------
e. Checking ________ and ____________for purchases
----------------------
3. GNR/GRR may be prepared in quadruplicate to be distributed as
follows: ----------------------
One copy to ____________________ ----------------------
One copy to ____________________
----------------------
One copy to ____________________
----------------------
One copy to be ____________________
Material Costs 97
Notes
Activity 1
----------------------
---------------------- Visit a manufacturing organization and list any three of the various
documents involved in the movement of raw material of the organization.
----------------------
---------------------- 6.3 PROPER CONDUCT OF STORAGE FUNCTION

---------------------- As discussed earlier, the proper conduct of storage function requires that
material should be properly stored in a good condition till it is required for
---------------------- use by production departments and should be issued whenever required. This
proper conduct is ensured by what is known as “Perpetual Inventory System”.
---------------------- The aims of the perpetual inventory system are twofold.
---------------------- (1) Recording receipts and issues in such a way so as to know at any time,
the stock in hand, in quantity and/or value, without the need of physical
---------------------- counting. This aim is achieved by maintaining what is called as Bin Card
---------------------- and Stores Ledger.
(2) Continuous verification of physical stock at regular intervals.
----------------------
Bin Card
----------------------
It is only a quantitative record of receipts, issues and closing balance of
---------------------- an item of material. Separate bin card is maintained for each item of material.
The usual form in which a bin card is maintained is as below.
----------------------
BIN CARD
----------------------
Description Maximum level
----------------------
Code No. Minimum level
---------------------- Location/Unit Reorder level
----------------------
Date Document No. Receipt Issue Balance Remarks
----------------------
----------------------
----------------------
Entries in receipts column are made on the basis of Goods Received Note
---------------------- or Material Returned Note. Entries in issues column are made on the basis of
Material Requisition Note. After every entry of either receipts or issues, the
----------------------
balance quantity is calculated and recorded so that the balance can be known at
---------------------- any point of time. The levels indicated on bin card enable the stores department
to keep a watch on balance and replace the material as soon as it reaches the
---------------------- reorder level.
Ideally, the bin card should be placed along with the material. But it may
----------------------
not be possible in all the cases, so the bin cards are placed at a centrally located
---------------------- place, but within stores department only.
Stores Ledger Notes
Like the Bin Card, it is maintained for the recording of all receipts and
issue transactions of material, but with the exception that it records not only the ----------------------
quantities received or issued or in stock but also the financial expressions of the
same. ----------------------
The usual form in which the stores ledger is maintained is as follow: ----------------------
STORES LEDGER ----------------------
Maximum level ----------------------
Description Code No. Minimum level
----------------------
Location/Unit Reorder level
----------------------
Document Receipt Issue Balance Remarks
Date ----------------------
No. Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
----------------------
----------------------
----------------------
By summing up the amounts appearing in the ‘issues’ column of stores
----------------------
ledger, one can get the cost of material issued to Production Department, which
forms the ‘Material Cost’. ----------------------
As in case of bin card, separate store ledger sheets are maintained in case
----------------------
of each item of material. The stores ledger sheets are maintained either in loose
form or in bound book form. ----------------------
Bin Card Vs. Stores Ledger:
----------------------
If the stores ledger is having all the information mentioned in a bin card
and some additional information is also available, the next question that arises is ----------------------
why is it necessary to maintain both bin card and stores ledger simultaneously as ----------------------
it will be only duplication of work. In case of computerized inventory accounting
system, maintenance of bin card and stores ledger simultaneously can be avoided. ----------------------
However, in the case of manual inventory accounting system, it will be ideal to
maintain bin card and stores ledger simultaneously due to the following reasons. ----------------------
i. Bin card is maintained by stores department while stores ledger is ----------------------
maintained by costing department.
----------------------
ii. Bin card is not an accounting record but only a quantity record and
as such is not concerned with the financial implications of stores ----------------------
transactions.
----------------------
iii. Maintenance of stores ledger provides a second check on maintenance
of bin cards. ----------------------
Reconciliation of Bin Card and Stores Ledger: ----------------------
As the source documents for the entries in Bin Card and Stores Ledger
are the same, the closing balances disclosed by both of them should match with ----------------------
Material Costs 99
Notes each other. But in practice, they may not match due to the following reasons.
i. Arithmetical error in calculating balance.
----------------------
ii. Non-posting of a certain document in either of these documents.
----------------------
iii. Posting on wrong bin card or stores ledger sheet.
---------------------- iv. Treating receipts transaction as issue transaction or vice versa.
---------------------- If the closing balance as per bin card and stores ledger does not match,
the very purpose of maintaining these two documents simultaneously will be
---------------------- defeated. As such, it is necessary to reconcile both balances at regular intervals
---------------------- by keeping all the postings up to date. If the balances as on a particular day
are not matching, all the previous transactions should be checked to locate
---------------------- differences.
---------------------- 6.4 VALUATION OF MATERIAL MOVEMENTS
---------------------- As discussed above, the stores ledger considers not only the movement of
---------------------- material in terms of quantity but also in terms of its financial implications. As
such, it is necessary that all the possible movements of material are valued
---------------------- properly and are expressed in terms of money. We will consider this problem
under the following heads: Valuation of receipts, Valuation of issues, Valuation
---------------------- of returns from production department to stores department. These are discussed
---------------------- in detail below:
I. Valuation of receipts:
----------------------
Valuation of receipts is a relatively easy task, as the invoice or bill received
---------------------- from the supplier of the material is available as a starting point. Following
propositions should be considered for this purpose.
----------------------
(a) The price as billed by the supplier will be the valuation of the receipts.
---------------------- The trade discount is deducted from the basic price and all other amounts
as billed by the supplier are added, e.g. excise duty, sales tax, octroi duty,
----------------------
transport/insurance charges etc. There are different opinions in respect
---------------------- of the treatment of cash discount. One opinion says that cash discount
should be ignored, being purely of a financial nature, while valuing the
---------------------- receipts, while another opinion says that it should be considered while
valuing the receipt of the material.
----------------------
(b) In some cases, more than one item of material is included in one single bill
---------------------- and some costs are jointly incurred for all the items of material. Such joint
costs may be distributed on the basis of the basic price of the material.
----------------------
(c) In case of the imported material, the cost of the material consists of a basic
---------------------- price (which may be stated in foreign currency and should be converted in
Indian Rupees), customs duty, clearing charges, transport charges, octroi
----------------------
duty etc. In some cases, the point of receipt of imported material and
---------------------- the point of making the payment of invoice amount may be different. As
such, the rate of foreign currency may be different at the time of payment
---------------------- of the customs duty and at the time of payment of the invoice amount.

In such cases, the rate of exchange existing at the time of making the Notes
payment of invoice amount should be considered for valuing basic cost
of material imported. ----------------------
Illustration: ----------------------
The particulars relating to 1,200 kg. of a certain raw material purchased
----------------------
by a company during June 2012, were as below:
Lot prices quoted by suppliers and accepted by the company for supplies ----------------------
to factory are:
----------------------
Up to 1000 kg. @ Rs. 22 per kg.
----------------------
Between 1000 - 1500 kg. @ Rs. 20 per kg.
Between 1500 - 2000 kg @ Rs. 18 per kg. ----------------------
1. Trade Discount 20%. ----------------------

2. Additional charge for containers @ Rs. 10 per drum of 25 kg. ----------------------
3. Credit allowed on return of containers @ Rs. 8 per drum.
4. Sales Tax @ 10% on raw material and 5% on drums. ----------------------
5. Total freight paid by the purchaser Rs. 240. ----------------------
6. Insurance @ 2.5% (on net invoice value) paid by the purchaser.
----------------------
7. Stores Overheads applied @ 5% on total purchase cost of material.
The entire quantity was received and issued to production. The containers ----------------------
are returned in due course. Draw up a suitable statement to show: ----------------------
i. Total cost of material purchased.
----------------------
ii. Unit cost of material issued to production.
Solution: ----------------------
Statement showing cost of purchases ----------------------
Basic Cost Rs. Rs. ----------------------

1,200 kg x Rs. 20/kg. 24,000 ----------------------
Less: Trade Discount @ 20% 4,800
----------------------
19,200.00
----------------------
Container Cost:
48 Drums x Rs. 10 /Drum 480.00 ----------------------
19,680.00 ----------------------
Sales Tax: ----------------------
10% on Rs. 19,200 1,920.00
----------------------
5% on Rs. 480 24.00
----------------------
1,944.00
21,624.00 ----------------------
Material Costs 101

Notes Other charges
---------------------- Insurance 2.5% on Rs. 21,624.00 540.60
Freight 240.00
----------------------
22,404.60
----------------------
Less: Credit for drums returned
---------------------- Rs. 8 per Drum x 48 Drums 384.00
---------------------- TOTAL COST 22,020.60
---------------------- Add: Stores Overheads 5% 1,101.03
23,121,63
----------------------
Unit cost for valuation of issues
----------------------
Rs. 23,121.63. = Rs. 19.268/kg. 1,200 kg.
---------------------- II. Valuation of Issues:
---------------------- This is a more complex process than the valuation of the receipts. Because
of this reason, the material may be issued out of the various lots, which might
----------------------
have been purchased at various prices. As such, a problem may arise as to
---------------------- which of the receipt prices should be used to value the material requisition
notes. Various methods may be used for this purpose, main methods of which
---------------------- are discussed as below.
---------------------- (i) First In First Out (FIFO): Under this method, the price of the earliest
available lot is considered first and if that lot is exhausted, the price of the
---------------------- next available lot is considered. It should be remembered that the physical
issue of the material may not be made out of the said lots, though it is
----------------------
presumed that it is made out of these lots as stated above.
---------------------- The advantages of this method are as below:
---------------------- a. It is simple to operate.
---------------------- b. It considers the valuation of closing stock at the current market prices.
c. It can be conveniently applied if transactions are not too many and the
----------------------
prices of the material are fairly steady.
---------------------- The objections raised against this method are as follows:
---------------------- a. Calculations become complicated if the lots are received frequently and
at varying prices.
----------------------
b. Costs may be wrongly presented if the prices of different lots of material
---------------------- with different prices have been issued to various batches of production.
---------------------- c. In case of varying prices, the pricing of issues does not consider current
market prices.
---------------------- Illustration:
---------------------- Following transactions have taken place in respect of a material during

March 2012. Prepare the Stores Ledger assuming that the issues are valued on Notes
FIFO basis.
----------------------
Date Transactions
1 Opening Balance 500 units @ Rs. 6 per unit. ----------------------
5 Purchased 100 units @ Rs. 7 per unit ----------------------

7 Issued 400 units. ----------------------
9 Purchased 300 units @ Rs. 8 per unit
----------------------
19 Issued 250 units
----------------------
22 Issued 50 units
25 Purchased 300 units @ Rs. 7.50 per unit ----------------------
30 Issued 250 units ----------------------
Solution: ----------------------
Stores Ledger ----------------------
Description/Code No. Maximum level
----------------------
Unit Minimum level
Location Re-order level ----------------------
Date Particulars RECEIPTS ISSUES BALANCE
----------------------
Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
Rs. Rs. Rs. ----------------------
1 Op. Bal. 500 6 3,000 ----------------------
5 GRN No. 100 7 700 500 6
100 7 3,700 ----------------------
7 MRN NO. 400 6 2,400 100 6 ----------------------
100 7 1300
----------------------
9 GRN NO. 300 8 2,400 100 6
100 7 ----------------------
300 8 3700
----------------------
19 MRN NO. 100 6 ----------------------

100 7 ----------------------
50 8 1700 250 8 2,000
22 MRN NO. 50 8 400 200 8 1,600 ----------------------
25 GRN NO. 300 7.5 2,250 200 8 ----------------------
300 7.5 3850
----------------------
30 MRN NO. 200 8 1975 250 7.5 1,875 ----------------------

50 7.5
----------------------
Material Costs 103

Notes Value of closing stock is Rs. 1,875, which considers latest available
market price of the material.
----------------------
(ii) Last In First Out (LIFO):
---------------------- Under this method, the price of the latest available lot is considered first
and if that lot is exhausted, the price of the lot prior to that is considered.
----------------------
Here also, it should be remembered that the physical issue of the material
---------------------- may not be made out of the said lots, though it is presumed that it is made
out of the lots as stated above.
----------------------
The advantages of this method are as follows:
---------------------- a. It is simple to operate.
---------------------- b. The cost of materials issued considers fairly recent and current prices.
The prices quoted on this cost fairly represent the real cost.
----------------------
c. It can be conveniently applied if transactions are not too many and prices
---------------------- of the material are fairly steady.
---------------------- The objections raised against this method are as follows:
a. Calculations become complicated if the lots are received frequently and
----------------------
at varying prices.
---------------------- b. Costs may be wrongly presented if the price of different lots of material
is used for pricing issues to various batches of production.
----------------------
c. In case of falling prices in the market, this method may give wrong results.
----------------------
Illustration:
---------------------- Following transactions have taken place in respect of a material during
March 2015.
----------------------
Date Description
----------------------
1 Opening Balance 500 units @ Rs. 6 per unit.
---------------------- 5 Purchased 100 units @ Rs. 7 per unit.
7 Issued 400 units.
----------------------
9 Purchased 300 units @ Rs. 8 per unit.
---------------------- 19 Issued 250 units.
---------------------- 22 Issued 50 units.
25 Purchased 300 units @ Rs. 7.50 per unit.
---------------------- 30 Issued 250 units.
---------------------- Prepare the stores ledger assuming that the issues are valued on LIFO basis.
----------------------
----------------------
----------------------
----------------------

Solution: Notes
Stores Ledger
Description/Code No. Maximum level ----------------------
Unit Minimum level
----------------------
Location Re-order level
Date Particulars RECEIPTS ISSUES BALANCE ----------------------
----------------------
Rs. Rs. Rs.
1 Op. Bal. 500 6 3,000 ----------------------
5 GRN NO. 100 7 700 500 6
100 7 3,700 ----------------------
7 MRN NO. 100 7 ----------------------
300 6 2,500 200 6 1,200
9 GRN NO. 300 8 2,400 200 6 ----------------------
300 8 3,600 ----------------------
19 MRN NO. 250 8 2,000 200 6
50 8 1,600 ----------------------
22 MRN NO. 50 8 400 200 6 1,200 ----------------------
25 MRN NO. 300 7.5 2,250 200 6
300 7.5 3,450 ----------------------
30 MRN NO. 250 7.5 1,875 200 6 ----------------------
50 7.5 1,575
----------------------
Value of closing stock is Rs. 1,575, which consists of 200 units valued at
Rs. 6 per unit, which happens to be the earliest available price of the material, ----------------------
i.e. price of the opening balance available.
----------------------
(iii) Average Price Method:
Both the above methods, i.e. FIFO and LIFO, consider the exact or actual ----------------------
cost for valuing the issue of material. However, these methods may prove to ----------------------
be disadvantageous if the transactions are too many and are at varying prices.
In such cases, instead of considering the exact or actual cost, average cost ----------------------
may be considered to lessen the effect of variation in prices, either upward or
downward. ----------------------
Assume a situation as below: ----------------------
March 1, 2012 - Received -1500 units @ Rs. 10 -Rs. 15,000 ----------------------
March 15, 2012 -Received -1600 units @ Rs. 30 -Rs. 48,000
----------------------
On March 20, 1800 units were issued to production. If FIFO method is followed
to price the issues, the issues will be valued as below. ----------------------
1500 units @ Rs. 10 per unit Rs. 15,000 ----------------------

300 units @ Rs. 30 per unit Rs. 9,000
----------------------
Total Rs. 24,000
----------------------
Material Costs 105

Notes The issues will be considerably under-valued and closing stock will be
considerably over valued, as compared to the current market prices.
---------------------- If LIFO method is followed to price the issues, the issues will be valued as
---------------------- below.
---------------------- 1600 unit @ Rs. 30 per unit Rs. 48,000

200 units @ Rs. 10 per unit Rs. 2,000
---------------------- Total Rs. 50,000
---------------------- The closing stock will be considerably undervalued as compared to the
current prices.
----------------------
To lessen the effect of such drastic price variation, both on the valuation
---------------------- of issues as well as of closing stock, instead of considering the actual/exact
price of Rs. 10 per unit or Rs. 30 per unit, average price may be taken into
----------------------
consideration.
---------------------- Ways to consider Average Price:
---------------------- There are mainly two ways in which average prices may be considered.
---------------------- (1) Simple Average Method: Under this method, the simple average of the
prices of the lots available for making the issues is considered for pricing
---------------------- the issues. After the receipt of new lot, a new average price is worked out.
It should be remembered in this connection that for deciding the possible
---------------------- lots out of which the issues could have been made, the method of First In
---------------------- First Out is followed.
Illustration:
----------------------
Following transactions have taken place in respect of a material during March
---------------------- 2015.
---------------------- Date:
1 Opening Balance 500 units @ Rs. 6 per unit
----------------------
----------------------
7 Issued 400 units.9 Purchased 300 units @ Rs. 8 per unit.
---------------------- 19 Issued 250 units.
---------------------- 22 Issued 50 units.
---------------------- 25 Purchased 300 units @ Rs. 7.50 per unit.
30 Issued 250 units.
----------------------
Prepare the stores ledger assuming that the issues are valued on a Simple
---------------------- Average basis.
----------------------
----------------------
----------------------

Stores Ledger Notes
Description/Code No. Maximum level
Unit Minimum level ----------------------
Location Re-order level
Date Particulars Receipts Issues Balance ----------------------
Rs. Rs. Rs. ----------------------
1 Op.Bal. 500 6 3.000.00
5 GRNNo. 100 7 700 600 6.5 3.000.00 ----------------------
7 MRNNo. 400 6.5 2.600.00 200 6.5 1.300.00
0 GRNNo. 300 8 2.400 500 7.25 3.625.00 ----------------------
19 MRNNo. 250 7.25 1,812.50 250 725 1.812.50
22 MRNNo. 50 7.25 362.50 200 7.25 1450.00 ----------------------
25 GRNNo. 300 7.5 2250 500 7.375 3,687.50
30 MRNNo. 250 7.375 1.84375 250 7.375 1,843.75 ----------------------
This method is suitable if the material is received in uniform quantity. If the ----------------------
material quantity of each lot varies widely, this method may lead to wrong
results. ----------------------
(2) Weighted Average Method: This method considers not only the price of ----------------------
each lot but also the quantity of the same. In simple average method, if the
quantity of each lot of material received varies widely, then the valuation ----------------------
of issues may lead to wrong results. Weighted average method overcomes ----------------------
this drawback of simple average method.
Illustration: ----------------------
Assume the following situation. ----------------------

March 1, 2015 Received 100 units @ Rs. 10 Rs. 1,000 ----------------------
March 10, 2015 Received 5,000 units @ Rs. 30 Rs. 1,50,000 ----------------------
Total Rs. 1,51,000
----------------------
On March 20, 4800 units were issued to production. As issue can be made
possibly from both the lots, the average of prices of both the lots will be taken ----------------------
into account if simple average method is considered. Hence, per unit issue price
on the basis of simple average method of valuation of issues will be: ----------------------
(Rs. 10 + Rs. 30)/2 = Rs. 20 ----------------------

As such, the issue quantity will be priced at: 4,800 units x Rs.20, i.e. Rs. 96,000. ----------------------
Now, this will not be correct, as considering the quantity of issue, the price
----------------------
of the material received on March 10 should get more weightage. To overcome
this drawback of simple average method, weighted average method may be ----------------------
used, which considers not only the price of each lot but also the quantity of the
same. ----------------------
Though this method involves considerable amount of clerical work, in ----------------------
practice, this method proves to be very useful in the event of varying prices
and quantities. In practice, the calculation of weighted average rate proves to ----------------------
be very simple. The products of quantity and price divided by the total quantity ----------------------
Material Costs 107

Notes of all lots, just before the issue, gives the unit price in respect of the subsequent
issues.
----------------------
Illustration:
---------------------- Following transactions have taken place in respect of a material during March
2015.
----------------------
Date:
----------------------
1 Opening Balance 500 units @ Rs. 6 per unit.
----------------------
---------------------- 7 Issued 400 units.
---------------------- 9 Purchased 300 units @ Rs. 8 per unit.
---------------------- 19 Issued 250 units.

22 Issued 50 units.
----------------------
25 Purchased 300 units @ Rs. 7.50 per unit.
----------------------
30 Issued 250 units.
---------------------- Prepare the Store Ledger assuming that the issues are valued on Weighted Average
---------------------- Basis.
Stores Ledger
---------------------- Description Code Maximumlevd
---------------------- No.
Unit Minimum level
---------------------- Location Re-order level
Dt. Particulars Receipt Issues Balance
---------------------- Qty. Rate Rs. Us Qty Rate Rs. Us Qty Rate Rs. Rs.
---------------------- 1 Op. Bal. 500 6.00 3,000
5 GRN No. 100 7 700 600 6.16 3,700
---------------------- 7 MRN No. 400 6.16 2,467 200 6.16 1,233
9 GRN No. 300 8 2,400 500 7.27 3,633
---------------------- 19 MRN No. 250 7.27 1,817 250 7.27 1,816
22 MRN No. 50 7.27 363 200 7.27 1,453
---------------------- 25 GRN No. 300 7.5 2,250 500 7.41 3,703
30 MRN No. 250 7.41 1,851 250 7.41 1,852
----------------------
---------------------- (iv) Highest In First Out: This method assumes that the stock should always
be shown at the minimum value and hence the issues should always be
---------------------- valued at the highest value of receipts. For example, assume a situation as
---------------------- follows.
March 1 Purchased 100 units @ Rs. 12
----------------------
March 5 Purchased 125 units @ Rs. 18
---------------------- March 10 Purchased 75 units @ Rs. 15
----------------------

On March 20, 120 units are issued to production and they will be valued Notes
at Rs. 18 per unit (as Rs.18 is the highest value of receipts to value issue).
----------------------
This method is not very popular. It always overvalues the issues and
undervalues the closing stock. This method may be useful in case of the ----------------------
organisations dealing with monopoly products, which is a rare possibility.
----------------------
(v) Market Price: Under this method, market price is considered to be the base
for the pricing the issues. In this case, market price may be treated as the ----------------------
latest purchase price, realisable price or replacement price. This method is
----------------------
used mainly in respect of obsolete stock items or non-moving stock items.
The defect in respect of this method is that the price concessions obtained ----------------------
in respect of bulk purchases are not reflected in the cost of material. ----------------------
(vi) Specific Price: If the material is purchased against a specific job or
----------------------
production order, the issue of material is priced at actual purchase price.
This method can be adopted if the purchase prices are fairly stable. ----------------------
(vii) Standard Price: This is the normal or ideal price which will be paid in the ----------------------
normal circumstances, based on the basis of estimated market conditions,
----------------------
transportation costs and normal quantity of purchases. Any issue of material
will be priced at standard prices irrespective of actual prices. This enables ----------------------
the simplification of accounting system with reduced clerical work and also
enables to decide the efficiency of purchase department, ----------------------
III. Valuation of Returns ----------------------
This indicates the material returned by the production department to ----------------------
stores department .The way in which the returned material may be valued can
be as below: ----------------------
i) At the same price at which issued: The original price of issue will be a ----------------------
base for valuing the returns for which original material requisition note
will be the base. ----------------------
ii) At the current price of issues: The method that is followed for valuing ----------------------
the issue on the same date is considered for valuing the returns.
----------------------
This will avoid the clerical efforts, but at the same time the track of
original issue of material cannot be maintained. ----------------------
Treatment of shortages: ----------------------

In some cases, the physical verification of stock may reveal that the ----------------------
physical stock is less than the stock as per the stores ledger. The valuation of
this shortage is done as if it is an issue of material. The treatment given to ----------------------
the valuation of shortages in Cost Accounts depends upon the nature of the ----------------------
shortage, i.e. Normal Shortage or Abnormal Shortage.
----------------------
----------------------
Material Costs 109

Notes
----------------------

1. This method proves to be very useful in the event of varying prices
----------------------
and quantities:_______.
---------------------- 2. These methods may prove to be disadvantageous if the transactions
are too many and are at varying prices_________ and ___________.
----------------------
3. Under this method, the price of the earliest available lot is considered
---------------------- first and if that lot is exhausted, the price of the next available lot is
---------------------- considered____________.
4. Under this method, the price of the latest available lot is considered
---------------------- first and if that lot is exhausted, the price of the lot prior to that is
---------------------- considered___________.
----------------------
Activity 2
----------------------
---------------------- Assume that you have been to a materials department of an organization

and list any two documents prepared while the material is in the storing
---------------------- stage. State the purpose of each of these documents.
----------------------
6.5 INVENTORY CONTROL
----------------------
The object of inventory control is to reduce the investment in the inventory
---------------------- without affecting the efficiency in the area of production and sales. It should be
---------------------- remembered that the object is not only to reduce the investment in inventory.
If that would have been the object, no organisation would have maintained
---------------------- inventory of any kind, thereby making the investment in the inventory as Nil.
However, that is not the ultimate object, as it is likely to affect the production and
---------------------- sales function adversely. For example, if sufficient stock of raw material is not
---------------------- available, the production activity is likely to be interrupted. If sufficient stock
of finished goods is not available, it may not be possible for the organisation to
---------------------- serve the customers properly and they may shift to the competitors.
---------------------- Techniques of Inventory Control: The object of inventory control is to
avoid the situation of over investment as well as under investment. The level
---------------------- of inventories should be maintained at the optimum level. Followings are the
techniques employed for inventory control
----------------------
(I) Economic Order Quantity:
----------------------
It indicates that quantity, which is fixed in such a way that the total variable
---------------------- cost of managing the inventory, can be minimised. Such cost basically consists
of two parts.
----------------------

1. Ordering Cost: It consists of the costs associated with the administrative Notes
efforts connected with preparation of purchase requisitions, purchase
enquiries, comparative statements and handling of more number of bills ----------------------
and receipts)
----------------------
2. Carrying Cost: It is the cost of carrying or holding the inventory, which in
turn consists of the cost like godown rent, handling and upkeep expenses, ----------------------
insurance, opportunity cost of capital blocked, i.e. interest etc.
----------------------
There is a reverse relationship between these two types of costs, i.e. if the
purchase quantity increases, ordering cost may get reduced but the carrying cost ----------------------
increases and vice versa. A balance is to be struck between these two factors
----------------------
and it is possible at Economic Order Quantity where the total variable cost of
managing the inventory is minimum. ----------------------
It is possible to fix the Economic Order Quantity with the help of
----------------------
mathematical formula. The following assumptions may be made for this purpose.
Let Q = Economic Order Quantity (Optimum size of one order) ----------------------
A = Annual Requirement of material in units. ----------------------
O = Cost of placing an order (which is assumed to remain constant, ----------------------
irrespective of size of order.)
----------------------
C = Cost of carrying one unit per year.
Now, if A is the annual requirement and Q is the size of one order, then ----------------------
Total number of orders = A/Q ----------------------
Total ordering cost = (A/Q) x O ----------------------
Similarly, if the size of one order is Q and if it is assumed that the inventory is
reduced at a constant rate from order quantity to zero when it is repurchased, ----------------------
and if the cost of carrying one unit per year is C, then ----------------------
Average inventory = Q/2
----------------------
Total carrying cost = (Q/2) x C
----------------------
Thus, Total Cost = Total Ordering Cost + Total Carrying Cost
i.e. Total cost = (A/Q) × O + (Q/2) x C ----------------------
The intention is that the value of Q should be such that the total cost ----------------------
should be minimum. Hence, taking the first derivative of the equation with
respect to Q and setting the result to zero, ----------------------
do/ dq = 0 ----------------------
=>AO(-1/ Q2 )+C/2=0 ----------------------
Thus, we get
----------------------
2 xA x O
Q= where
C ----------------------
Q = Economic Order Quantity ----------------------
Material Costs 111

2 xA x O
Q= where
C
Notes A = Annual Requirement in Units

O = Cost of Placing an Order
----------------------
C = Cost of Carrying One Unit per Year
----------------------
Illustration:
---------------------- A manufacturer uses 200 units of a component every month and he buys
---------------------- them entirely from the outside supplier. The order placing and receiving cost
is Rs. 100 and annual carrying cost is Rs. 12. From this set of data, calculate
---------------------- Economic Order Quantity.
---------------------- Solution:
2xAx O
---------------------- EOQ =
C
= 2 x 2400 x 100
---------------------- 12
---------------------- = 200 units
---------------------- (II) Fixation of Inventory Levels:
---------------------- Fixation of various inventory levels facilitates the initiating of proper
action in respect of the movement of various materials in time so that the
---------------------- various materials may be controlled in a proper way. However, the following
propositions should be remembered.
----------------------
a. Only the fixation of inventory levels does not facilitate the inventory
---------------------- control. There has to be a constant watch on the actual stock level of
various kinds of materials so that proper action can be taken in time.
----------------------
b. Various levels fixed are not fixed on a permanent basis and are subject to
---------------------- revision regularly.
---------------------- Various levels that can be fixed are as below:
---------------------- 1. Maximum Level:

It indicates the level above which the actual stock should not exceed. If
---------------------- it exceeds, it may involve unnecessary blocking of funds in inventory. While
---------------------- fixing this level, following factors are considered.
i. Maximum usage
----------------------
ii. Lead time
----------------------
iii. Storage facilities available, cost of storage and insurance etc.
---------------------- iv. Prices for the material
---------------------- v. Availability of funds
---------------------- vi. Nature of the material. For example, if a certain type of material is
subject to Government regulations in respect of import of goods etc., the
---------------------- maximum level may be fixed at a higher level.
---------------------- vii. Economic Order Quantity

(III) Minimum Level: Notes
It indicates the level below which the actual stock should not reduce. If
----------------------
it reduces, it may involve the risk of non-availability of material whenever it
is required. While fixing this level, the following factors are considered: Lead ----------------------
time and Rate of consumption.
----------------------
3. Re-order Level:
It indicates the level of material stock at which it is necessarily to take ----------------------
the steps for procurement of further lots of material. This is the level falling in
----------------------
between the two extremes of maximum level and minimum level and is fixed in
such a way that the requirements of production are met properly till the new lot ----------------------
of material is received.
----------------------
4. Danger Level:
This is the level fixed below minimum level. If the stock reaches this ----------------------
level, it indicates the need to take urgent action in respect of getting supply. At
----------------------
this stage, the company may not be able to make the purchases in a systematic
manner, but may have to make rush purchases, which may involve higher costs ----------------------
of purchases.
----------------------
Calculation of various Levels:
Various levels can be decided by using the following mathematical expressions. ----------------------
i. Re-order Level: Maximum Lead Time x Maximum Usage ----------------------
ii. Maximum Level: Reorder Level + Reorder Quantity - (Minimum Usage ----------------------
x Minimum Lead Time)
iii. Minimum Level: Reorder Level - (Normal Usage x Normal Lead Time) ----------------------
iv. Danger Level: Normal Usage x Lead-time for emergency purchases ----------------------
Note: It should be noted that the expression of the Reorder Quantity in the ----------------------
calculation of Maximum Level indicates Economic Order Quantity.
(Calculate Average Level = Maximum Level + Minimum Level in problems) ----------------------
Illustration: ----------------------
Two components X and Y are used as follows. ----------------------
Normal usage – 50 units per week
----------------------
Minimum usage – 20 units per week
----------------------
Maximum usage – 75 units per week
Reorder quantity – X - 400 units ----------------------
Y - 600 units ----------------------
Recorder period – X - 4 to 6 weeks ----------------------
Y- 2 to 4 weeks
----------------------
Calculate for each component:
a. Reorder level ----------------------
Material Costs 113

Notes b. Minimum level
c. Maximum level
----------------------
d. Average stock level
----------------------
Solution:
---------------------- a. Reorder Level:
---------------------- Maximum Lead time x Maximum Usage
X = 6 weeks x 75 units = 450 units
---------------------- Y = 4 weeks x 75 units = 300 units
---------------------- b. Minimum Level:
---------------------- Reorder Level – (Normal Usage x Normal Lead-time)

X = 450 units – (50 units X 5 weeks) = 200 units
---------------------- Y = 300 units – (50 units x 3 weeks) = 150 units
---------------------- c. Maximum Level:

Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Lead-time)
----------------------
X = 450 units + 400 units – (25 units x 4 weeks) = 750 units.
---------------------- Y = 300 units + 600 units – (25 units x 2 weeks) = 850 units.
d. Average Stock Level:
----------------------
= (Minimum Level + Maximum Level)/ 2
----------------------
X= (200 units + 750 units)/2 = 475 units
---------------------- Y= (150 units + 850 units)/2= 500 units
---------------------- The expression of the Reorder Quantity in the calculation of Maximum
level indicates the Economic Order Quantity. Hence, in some cases, it may be
----------------------
necessary to decide the Economic Order Quantity before fixing the inventory
---------------------- levels.
There may be one more way in which the various inventory levels may
----------------------
be fixed and for this, determination of the safety stock (also called as minimum
---------------------- stock or buffer stock) is essential.
Safety stock: It is that level of stock below which the actual should not be
----------------------
allowed to fall. The safety stock may be calculated as
---------------------- (Maximum Usage X Maximum Lead-time) minus (Normal Usage X
---------------------- Normal Lead-time)
According to this method, the various inventory levels as discussed above
---------------------- may be fixed as below.
---------------------- a. Minimum Level: It is equal to safety stock.
---------------------- b. Maximum Level: It can be calculated as (Safety Stock + EOQ)
c. Reorder Level: It can be calculated as Safety Stock + (Normal Usage x
----------------------
Normal Lead-time)
---------------------- d. Average Stock Level: It can be calculated as

(Minimum Level + Maximum Level)/2 = >Safety Stock + (EOQ/2) Notes
Illustration:
----------------------
You have been asked to calculate the following levels for Part No. 007 from the
information given hereunder: ----------------------
(a) Re-ordering level ----------------------
(b) Maximum level ----------------------
(c) Minimum level
----------------------
(d) Danger level
----------------------
(e) Average level
The ordering quantity is to be calculated from the following data: ----------------------
(i) Total cost of purchasing relating to the order: Rs. 20 ----------------------
(ii) Number of units to be purchased during the year: 5,000 ----------------------
(iii) Purchase price per unit including transportation costs: Rs. 50
----------------------
(iv) Annual cost of storage of one unit: Rs. 5
----------------------
Lead times: Average ... 10 days
Maximum... 15 days ----------------------
Minimum... 6 days ----------------------
Maximum for emergency purchases... 4 days ----------------------
Rate of consumption: Average... 15 units per day
----------------------
Maximum... 20 units per day
----------------------
Solution: Working Notes:
(a) Calculation of Safety Stock: (Maximum Usage x Maximum Lead-time) - ----------------------
(Normal Usage x Normal Lead-time) = (20 units x 15 days) – (15 days x ----------------------
10 days) = 300 units - 150 units = 150 units.
(b) Calculation of EOQ: ----------------------
2 xA x O ----------------------
Q= where
EOQ= C
----------------------
Where
A = Annual requirement ----------------------
O = Ordering cost per order ----------------------

C = Carrying cost per unit per year ----------------------
----------------------
----------------------
----------------------
Material Costs2 x A x O 115

EOQ =
C
= 2 x 2400 x 100
12
Notes Hence,
2 xA x O
---------------------- EOQ=
C
----------------------
2 x 5000 x 20
---------------------- EOQ= = 200 units.
5
---------------------- (1) Reordering Level:

---------------------- It can be calculated as -
Safety Stock + (Normal Usage x Normal Lead-time)
----------------------
= 150 units + (15 units x 10 days)
----------------------
= 150 units + 150 units = 300 units
---------------------- (2) Maximum Level:
---------------------- It can be calculated as -
---------------------- Safety Stock + EOQ
---------------------- = 150 units + 200 units = 350 units.

(3) Minimum Level:
----------------------
It is equal to Safety Stock
----------------------
= 150 units.
---------------------- (4) Danger Level:
---------------------- Normal Usage x Lead-time for emergency purchases = 15 units X 4 days
= 60 units
----------------------
(5) Average Level:
----------------------
It can be calculated as
----------------------
Safety stock + (EOQ/2) = 150 units + (200/2 units) = 250 units
---------------------- (2) Inventory Turnover
---------------------- Inventory turnover indicates the ratio of materials consumed to the
average inventory held. It is calculated as below:
----------------------
Inventory turnover ratio =Value of material consumed / Average inventory
---------------------- held
---------------------- Where,
---------------------- Value of material consumed = (Opening Stock + Purchases) - Closing Stock

Average inventory held = (Opening Stock + Closing Stock)/2
----------------------
Inventory turnover can be indicated in terms of number of days in which
---------------------- average inventory is consumed. It can be done by dividing 365 days (a year) by
---------------------- inventory turnover ratio.

Illustration: Notes
From the following data for the year ended 31st March, 2012, calculate
----------------------
the inventory turnover ratio of the two items and put forward your comments
on them. ----------------------
Material A Material B ----------------------
Rs. Rs.
----------------------
Opening Stock 1.4.2011 10,000 9,000
Purchases during the year 52,000 27,000 ----------------------
Closing Stock 31.3.2012 6,000 11,000 ----------------------
Solution: ----------------------
Inventory turnover ratio =Value of material consumed / Average inventory held
----------------------
Material Consumed = Opening Stock (10,000) + Purchases (52,000) –
Closing Stock (6,000) = 56,000 ----------------------
Material A ----------------------
Inventory Turnover = 56000/8000 =7 ----------------------
Inventory Turnover Period = 365/7 = 52 days ----------------------
Material B
----------------------
Inventory Turnover = 25000/10000 = 2.5
----------------------
Inventory Turnover Period = 365/2.5 = 146 days
A high inventory turnover ratio or low inventory turnover period indicates ----------------------
that maximum material can be consumed by holding minimum amount of ----------------------
inventory of the same, thus indicating fast moving items. Thus high inventory
turnover ratio or lower inventory turnover period will always be preferred. ----------------------
Thus, knowledge of inventory turnover ratio or inventory turnover period ----------------------
in case of various types of material will enable reduction of the blocked up
capital in undesirable types of stocks and will enable the organisation to exercise ----------------------
proper inventory control. ----------------------
(IV) ABC Analysis:
----------------------
This technique assumes the basic principle of “Vital Few Trivial Many”
while considering the inventory structure of any organisation and is popularly ----------------------
known as “Always Better Control”. It is an analytical method of inventory ----------------------
control, which aims at concentrating efforts in those areas where attention is
required most. It is usually observed that, in practice, only a few numbers of ----------------------
items of inventory prove to be more important in terms of amount of investment
----------------------
in inventory or value of consumption, while a very large number of items of
inventory account for a very meagre amount of investment in inventory or value ----------------------
of consumption.
----------------------
Material Costs 117

Notes This technique classifies the various inventory items according to their
importance. For example, “A “class items consists of only a small percentage
---------------------- of a total number of items handled, but are most important in nature. “B” Class
items include relatively less important items. “C” Class items consist of a very
----------------------
large number of items, which are less important. The importance of the various
---------------------- items may be decided on the basis of following factors.
---------------------- (i) Amount of investment in inventory

(ii) Value of material consumption
----------------------
(iii) Critical nature of inventory items
----------------------
Illustration
---------------------- An example of ABC Analysis can be given as below.
---------------------- Class No. of Items % of item Consumption % of consumption
out of total Value (In Rs.) value out of total
----------------------
number value
---------------------- A 300 6 5,60,000 70
B 1500 30 1,60,000 20
---------------------- C 3200 64 80,000 10
---------------------- Total 5000 100 8,00,000 100
In order to exercise proper inventory control, A Class items are watched very closely
----------------------
and control is exercised right from initial stages of estimating the requirements,
---------------------- fixing minimum level/lead-times, following proper purchase/ storage procedures etc.
However, in case of C Class of items, only those inventory control measures may be
---------------------- implemented, which are comparatively simple, elaborate and inexpensive in nature.
---------------------- Working Note:
---------------------- A = (560000 x 100)/800000 = 70%
Advantage of ABC Analysis:
----------------------
(a) A close and strict control is facilitated on the most important items,
---------------------- which constitute a major portion of overall inventory valuation or overall
---------------------- material consumption and due to this, the costs associated with inventions
may be reduced.
----------------------
(b) The investment in inventory can be regulated in a proper manner and
---------------------- optimum utilisation of the available funds can be assured.
---------------------- (c) A strict control on inventory items in this manner helps in maintaining
a high inventory turnover ratio. However, it should be noted that the
---------------------- success of ABC analysis depends mainly upon correct categorisation of
inventory items and hence should be handled by only experienced and
----------------------
trained personnel.
----------------------
----------------------

(V) Bill of Materials: Notes
In order to ensure proper inventory control, the ‘basic principle to be kept
----------------------
in mind is that proper material is available for production purposes whenever it
is required. This aim can be achieved by preparing what is normally called as ----------------------
“Bill of Materials”.
----------------------
A bill of materials is the list of all the materials required for a job, process
or production order. It gives the details of the necessary materials as well as ----------------------
the quantity of each item. As soon as the order for the job is received, bill of
----------------------
materials is prepared by the Production Department or the Production Planning
Department. ----------------------
The form in which the bill of materials is usually prepared is as below: ----------------------
Bill of Material
No. Date of Issue Production/Job Order No. ----------------------
Department authorised
S.No. Description of Code Qty. For Department Use only Remarks ----------------------
Material No.
Material Date Quantity ----------------------
Requisition No. demanded
----------------------
----------------------
----------------------
----------------------
The functions of bill of materials are as below:
(1) Bill of materials gives an indication about the orders to be executed to all ----------------------
the persons concerned. ----------------------
(2) Bill of materials gives an indication about the materials to be purchased
by the Purchase Department if the same is not available with the stores. ----------------------
(3) Bill of materials may serve as a base for the Production Department for ----------------------
placing the material requisitions ships.
----------------------
(4) Costing/Accounts Department may be able to compute the material cost
in respect of a job or a production order. A bill of materials prepared and ----------------------
valued in advance may serve as a base for quoting the price for the job or
production order. ----------------------
(VI) Perpetual Inventory System: ----------------------
As discussed earlier, in order to exercise proper inventory control, perpetual
----------------------
inventory system may be implemented. It aims mainly at two facts:
(1) Maintenance of Bin Cards and Stores Ledger in order to know about the ----------------------
stock in quantity and value at any point of time
----------------------
(2) Continuous verification of physical stock to ensure that the physical
balance and the book balance tallies ----------------------
----------------------
Material Costs 119

Notes The continuous stock taking may be advantageous from the following angles:
(1) Physical balances and book balances can be compared and adjusted without
---------------------- waiting for the entire stocktaking to be done at the year-end. Further, it is
---------------------- not necessary to close down the factory for annual stocktaking.
(2) The figures of stock can be readily available for the purpose of periodic
---------------------- Profit and Loss Account.
---------------------- (3) Discrepancies can be located and adjusted in time.
(4) Fixation of various levels and bin cards enables the action to be taken for
----------------------
the placing the order for acquisition of material.
---------------------- (5) A systematic maintenance of perpetual inventory system enables locating
the slow and non-moving items and taking remedial action for the same.
----------------------
(6) Stock details are correctly available for getting the insurance of stock.
----------------------
---------------------- Activity 3
----------------------
Visit the stores department of any organization and try to identify two to
---------------------- three various inventory control techniques used in that organization.
----------------------
Summary
----------------------
●● Material Cost is the first major component of cost in any organization,
----------------------
particularly a manufacturing organization. As such, identifying the material
---------------------- cost with the individual cost centre is necessary.
●● Identification of material cost with the individual cost centre depends
----------------------
upon various stages in the movement of material. Among various stages
---------------------- in the movement of material, valuation of various material movements
plays a very significant role, because the cost calculations depend upon
---------------------- the valuation of material movements.
---------------------- ●● Valuation of receipts of material does not create many problems in reality,
as there is a third party document available for the same, i.e. invoice given
---------------------- by the supplier.
---------------------- ●● Valuation of issues poses a problem in reality, as this movement of
material is within the organization. As such, valuation of issues has to be
----------------------
done based upon various accounting assumptions such as FIFO, LIFO,
---------------------- Simple Average, Weighed Average etc.
●● As material cost constitutes a major component of cost, exercising a
----------------------
proper control is necessary. For exercising proper control over inventory
---------------------- cost, an organization may have various techniques available to it, e.g.
Economic Order Quantity (EOQ), Fixation of Inventory Levels, ABC
---------------------- Analysis, Bill of Materials etc.
----------------------

Keywords Notes
----------------------
●● ABC Analysis: This is the technique for classifying inventory items
according to their significance. This enables the management to ----------------------
concentrate its attention on the most significant inventory items.
----------------------
●● Bill of Materials: This is the listing of all the inventory items, which are
required for the execution of a job. This statement may be prepared by ----------------------
the Production Department or the Design Department. Bill of Materials is
the statement, which is significant in the process of price fixation as well ----------------------
as cost control. ----------------------
●● Comparative Statement: This statement helps the organization decide
----------------------
the final source of supply after alternative sources of supply are generated
by limited tender situation or open tender situation or global tender ----------------------
situation.
●● Economic Order Quantity: This indicates the quantity in which material ----------------------
purchases should be made so that the costs associated with the inventory ----------------------
are at a minimum.
●● First In First Out: This accounting assumption proposes that the ----------------------
material coming in for the first time is issued for the first time. Under this ----------------------
calculation, material issues are valued at the old rate, whereas closing
stock is valued at the current rate. ----------------------
●● Last In First Out: This accounting assumption proposes that the material ----------------------
received for the last time is issued for the first time. Under this calculation,
material issues are valued at the current rate, whereas the closing stock is ----------------------
valued at the old rate.
----------------------
●● Simple Average Method: This accounting assumption considers the
simple average of the rates of the material lots, out of which material ----------------------
issues could have been made. This method reduces the extremity in the
situation of material price variation. However, this method ignores the lot ----------------------
size. ----------------------
●● Weighted Average Method: This accounting assumption is the best
method for valuing material issues. In this accounting assumption, both ----------------------
the lot sizes as well as the prices of the lot are given weightage.
----------------------
Illustrative Problems ----------------------
Problem 1 ----------------------
The particulars related to the import of Sealing Ring made by AB & Co. during ----------------------
December 85 are given below.
----------------------
(a) Sealing Ring 1,000 pieces invoiced @ £ 2 CIF, Bombay Port
(b) Customs Duty was paid @ 100% on invoice value (which was converted ----------------------
to Indian Currency by adopting an Exchange Rate of Rs. 77.20 per £) ----------------------
Material Costs 121

Notes (c) Clearing charges: Rs. 1,800 for the entire consignment
(d) Freight charges: Rs. 1,400 for transporting the consignments from Bombay
----------------------
Port to factory premises
---------------------- It was found on inspection that 100 pieces of the above material were
---------------------- broken and therefore rejected. There is no scrap value for the rejected part. No
refund of the broken material would be admissible as per the terms of contract.
---------------------- The management decided to treat 60 pieces as normal loss and the rest 40 pieces
as abnormal loss. The entire quantity of 900 pieces was issued to production.
----------------------
Calculate:
----------------------
(a) Total cost of material
----------------------
(b) Unit cost of material issued to production
---------------------- Also state briefly how the value of 100 pieces rejected in inspection will be
treated in costs.
----------------------
Solution:
----------------------
As loss of 40 pieces is considered abnormal loss, it will be transferred to Costing
---------------------- Profit and Loss Account.
---------------------- ∴ Abnormal Loss = (Rs. 312,000/1,000 pieces) x 40 pieces= Rs. 12,480
---------------------- Balance of the cost (i.e. Rs. 312,000 - Rs. 12,480 = Rs. 299,520) includes the
cost of units treated as normal loss, i.e. 60 pieces
----------------------
This cost will be borne by good pieces.
---------------------- ∴ Unit cost of good pieces = (Rs. 299,520/9 00 pieces)
----------------------
= Rs. 332.80
----------------------
Total Cost of Material
---------------------- Invoice Price 1,000 pieces x £2 per piece=£ 2,000 Rs
---------------------- £ 2,000 x Rs. 77.2 per UK £ = 154,400
Customs Duty @ 100% 154,400
----------------------
Clearing Charges 1,800
---------------------- Freight charges 1,400
---------------------- Total Cost Rs.312,000
---------------------- Problem 2
From the Following data, work out the EOQ of a particular component.
----------------------
Annual Demand: 5000 Units
----------------------
Ordering Cost: Rs. 60 per Order
----------------------
Price per Unit: Rs. 100
---------------------- Inventory carrying Cost: 15% on average inventory

Solution: Notes
2 x 5000 x 60 = 6, 00, 000
= 40, 000 ----------------------
EOQ = 15% of 100 25 = 200 units
----------------------
Working notes:
----------------------
The total cost of managing inventory will be
Ordering Cost = (5000/200) × 60 i.e. 25 × 60 = Rs. 1,500 ----------------------
Carrying Cost = (200/2) × 15% of 100 = Rs. 1,500
Total cost (Based on average inventory) = Rs. 3,000 ----------------------
Problem 3 ----------------------
Verify whether the purchases in Economic Order Quantity really reduce ----------------------
the total cost of managing inventory to the minimum.
----------------------
Annual Demand: 5000 Units
Ordering Cost: Rs. 60 per Order ----------------------
Price per Unit: Rs. 100 ----------------------

Inventory carrying Cost: 15% on average inventory ----------------------
Solution: ----------------------
We can verify this using the trial and error method,
----------------------
1 2 3 4 5
Order No. of Orders Ordering Cost Carrying Cost Total Cost ----------------------
Quantity A/Q Rs. A/Q x O Rs. Q/2 x Ci Rs.
----------------------
50 100 6,000 375 6,375
100 50 3,000 750 3,750 ----------------------
200 25 1,500 1,500 3,000 ----------------------
250 20 1,200 1,875 3,075 ----------------------
1,000 5 300 7,500 7,800
----------------------
1,250 4 240 9,375 9,615
----------------------
2,500 2 120 18,750 18,870
It can be observed from the above that the order size of 200 units proves ----------------------
to be most economic in terms of minimum total cost. If the purchases are made
----------------------
in any other way, the same may not necessarily result into the minimum total
cost. ----------------------
Working notes:
----------------------
1) Col. 2 = 5000/Col.1 [5000 is Annual demand]
----------------------
2) Col. 3 = Col. 2 × 60 [60 is Ordering Cost]
3) Col. 4 = (Col.1 /2) x (15/100) x100 [(15/100) is Carrying Cost] ----------------------
4) Col. 5 = Col. 3 + Col.4 ----------------------
Material Costs 123

Notes Problem 4
Kapil Motors purchases 9,000 motor spare parts for its annual
----------------------
requirements, ordering one-month usage at a time. Each spare part costs Rs. 20.
---------------------- The ordering cost per order is Rs. 15 and the carrying charges are 15% of the
average inventory per year. You have been asked to suggest a more economical
---------------------- purchasing policy for the company. What advice would you offer and how much
would it save the company per year?
----------------------
Solution:
----------------------
Present Policy:
---------------------- Number of Orders = Annual Requirement /Order size =(9000 /750)=12
---------------------- Ordering Cost = 12 X 15 = 180 .............................. (1)
---------------------- Carrying Cost = (Order size /2)x Cost Price x Carrying cost in %
=(750/2)x15% of Rs. 20 = 375 X 3 = 1,125 ... ....................... (2)
----------------------
Total Cost, i.e. 1 + 2 = 180 + 1125 = 1305 ..............................(3)
----------------------
Proposed Policy:
---------------------- To purchase in Economic Order Quantity, where
---------------------- C= Cxi=15% of 20
---------------------- 2 x A xO
So rewriting EOQ= Cx i
---------------------- 2 x 9000 x 15
= 15% of 20 = 300 units
----------------------
Now, the revised total cost will be
---------------------- Number of Orders = (9000/ 30 ) =300
---------------------- Ordering Cost = (30x15) = 450 .............................................(4)
---------------------- Carrying Cost = (300/2) x (15% of 20)=450................................(5)

So Total Cost i.e. 4 + 5 = (450 + 450) = 900 ...............................(6)
----------------------
Thus, purchases in Economic Order Quantity will result into the yearly
---------------------- saving of Rs. 405 (i.e. Rs. 1305 - Rs. 900)
---------------------- Problem 5
---------------------- Shriram Enterprises manufactures a special product ‘ZED’. The following

particulars are collected for the year 2012.
---------------------- (a) Monthly demand of ZED - 1000 units
---------------------- (b) Cost of placing an Order - Rs. 100
---------------------- (c) Annual carrying cost per unit - Rs. 15
(d) Normal Usage 50 units per week
----------------------
(e) Minimum Usage 25 units per week
----------------------

(f) Maximum Usage 75 units per week Notes
(g) Re-order period 4 to 6 weeks
----------------------
Compute from the above:
----------------------
(1) Economic Order Quantity
(2) Re-order Level ----------------------
(3) Minimum Level ----------------------

(4) Maximum Level ----------------------
(5) Average Stock Level
----------------------
Solution:
----------------------
(1) Economic Order Quantity:
2 xA x O ----------------------
=
C
----------------------
A= Annual Requirement
----------------------
O = Ordering cost per cost
----------------------
C = Carrying cost per unit per year
2 x 12000 x 100 ----------------------
15
----------------------
= 400 units
----------------------
(2) Reorder Level:
----------------------
Maximum Lead Time x Maximum Usage
----------------------
∴ 6 weeks x 75 units = 450 units
(3) Minimum Level: ----------------------
Reorder Level – (Normal Usage x Normal Lead time) ----------------------
∴ 450 units – (50 units x 5 weeks) = 200 units ----------------------
(4) Maximum Level:
----------------------
Reorder Level + Reorder Quantity – (Minimum Usage x Minimum Lead-time)
----------------------
∴ 450 units + 400 units – (25 units x 4 Weeks) = 750 units
(5) Average Stock Level: ----------------------
(Minimum Level + Minimum Level)/2 ----------------------
=> (200 units + 750 units)/2= 475 units ----------------------
----------------------
----------------------
----------------------
Material Costs 125

Notes
----------------------
1. Explain various stages in which the raw material moves in a typical
---------------------- manufacturing organization. Explain in detail the various documents,
which are prepared at each of these stages.
----------------------
2. What do you mean by Inventory Control? Explain in detail the techniques
---------------------- available for exercising inventory control.
---------------------- 3. Write short notes on the following.

a) Economic Order Quantity
----------------------
b) ABC Analysis
----------------------
c) Fixation of Inventory Levels
---------------------- d) Inventory Turnover Ratio
---------------------- e) Bill of Materials

----------------------
---------------------- 1. If excess quantity is already billed in the invoice and it is not approved
then either of the following may be done: the supplier may be asked to
----------------------
give a supplementary invoice or credit note may be issued to the supplier
---------------------- for amending the amount.
---------------------- 2. The process of purchasing the materials involves the following stages:
a. Purchase Requisition
----------------------
b. Selection of Source of Supply
---------------------- c. Purchase Order
---------------------- d. Receipt and Inspection
e. Checking invoice and accounting for purchases
----------------------
3. GNR/GRR may be prepared in quadruplicate to be distributed as follows:
---------------------- One copy to Purchases Department
---------------------- One copy to Accounts Department
One copy to Costing Department
----------------------
One copy to be retained by Stores Department
----------------------
----------------------
----------------------
----------------------

Check your Progress 2 Notes
Fill in the blanks.
----------------------
1. This method proves to be very useful in the event of varying prices and
quantities: Weighted Average Method ----------------------
2. These methods may prove to be disadvantageous if the transactions are ----------------------

too many and are at varying prices FIFO and LIFO.
----------------------
3. Under this method, the price of the earliest available lot is considered first
and if that lot is exhausted, the price of the next available lot is considered ----------------------
First In First Out (FIFO). ----------------------
4. Under this method, the price of the latest available lot is considered first
and if that lot is exhausted, the price of the lot prior to that is considered ----------------------
Last In First Out (LIFO). ----------------------
----------------------
Suggested Reading
----------------------
1. http://220.227.161.86/18528paper5_finalnew_sugg_nove09.pdf
2. http://www.myicwai.com/ ----------------------
3. S. P. Gupta, Cost Accounting ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Material Costs 127

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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----------------------
----------------------
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Labour Costs
UNIT
7
Structure:
7.1 Introduction
7.2 Departments involved with Labour Costs for Cost Accounting
7.3 Methods to ascertain Labour Cost
7.3.1 Time-keeping
7.3.2 Time booking
7.4 Methods of Remunerating the Workers
7.4.1 Time rate system
7.4.5 Non-monetary incentives
7.5 Principles of a Good Wage Payment System
7.6 Important Terms in Case of Labour Cost
7.6.2 Idle time
Summary
Key Words
Suggested Reading
Labour Costs 129

Notes
Objectives
----------------------
• Name the departments involved in calculating labour cost
----------------------
• Explain labour cost and its functions
----------------------
• Compute labour cost
---------------------- • Assess the principles and methods of the wage system
---------------------- • Define the important terms of labour cost.
• Analyse the control problems in labour cost
----------------------
----------------------
----------------------
7.1 INTRODUCTION
---------------------- Labour Cost is another important element of cost within manufacturing

cost. It is important even though the production is material-intensive. The basic
---------------------- factor that gives rise to the labour cost is the remuneration paid to the workers.
However, the objective of cost accounting (i.e. cost ascertainment with respect
---------------------- to the individual cost centre and cost control) cannot be fulfilled properly unless
---------------------- and until the functions performed by the related departments are properly
considered.
----------------------
7.2 DEPARTMENTS INVOLVED WITH LABOUR COSTS
----------------------
FOR COST ACCOUNTING
----------------------
The following departments are directly related in calculation of
---------------------- Labour Costs. Their functions can be stated as below:
---------------------- (1) Personnel Department: This ensures the availability of correct workers
to perform the jobs best suited for them. This is done by selecting and
---------------------- training them properly. This department may also be involved with
the maintenance of records of job classification/ wage rates payable to
---------------------- workers, preparation of wages sheet and procedural aspects of wage
---------------------- payment.
(2) Time-keeping Department: This is concerned with the recording of
---------------------- workers’ time. This is not only for the purpose of wage calculations but
---------------------- also for the purpose of cost analysis and apportionment of cost over
various jobs. The main functions performed by this department are time
---------------------- keeping and time booking.
---------------------- (3) Cost Accounting Department: This department accumulates and
classifies cost data with respect to labour cost from the analysis of wages
---------------------- sheet and presents the reports to management to facilitate the control over
labour cost.
----------------------

Notes
----------------------
Multiple Choice Single Response ----------------------
1. This department ensures the availability of correct workers to perform
----------------------
the jobs best suited for them. This is done by selecting and training
them properly. ----------------------
i. Personnel Department
----------------------
ii. Time-keeping Department
----------------------
iii. Cost Accounting Department
iv. Labour Welfare Department ----------------------
----------------------
7.3 METHODS TO ASCERTAIN LABOUR COST ----------------------
The starting point for ascertaining the labour cost is in the form of Time ----------------------
Keeping and Time Booking.
----------------------
7.3.1 Time-keeping
----------------------
This is the process of recording the attendance time of the workers. It
is the responsibility of Time Keeping department, which may function as a ----------------------
separate department in some cases or else may function as the part of Personnel
Department. Attendance time recording may be necessary as the payment of ----------------------
wages depend on the attendance. Even when the payment of wages does not ----------------------
depend on the time attended, say in case of piece rate payment, the recording of
time attended may be necessary from the following angles. ----------------------
(1) Discipline can be maintained. ----------------------
(2) In some cases, the other payments like overtime wages, dearness
allowance etc. may be linked with the attendance. ----------------------
(3) The fringe benefits such as Pension, Gratuity on retirement. Provident ----------------------
Fund etc. may depend on the continuity of service, which will be available
----------------------
only if time attended is recorded properly.
(4) Attendance records may be required for research and other purposes. ----------------------
Methods of Time Keeping ----------------------
Various methods may be followed for time keeping, though the selection ----------------------
of the method may depend upon the nature of the organization and policy of
management. The main methods may be stated as below: ----------------------
(1) Hand-Written Method ----------------------
Under this method, the names of the workers are recorded in the attendance
register with provision of various columns for various days. The attendance of ----------------------
the worker may be recorded either by calling out his name or by a physical ----------------------
Labour Costs 131

Notes check. Alternatively, the workers themselves may sign in the attendance register.
This method, though simple, has become outdated. This method can also result
----------------------
in malpractices with the collusion between workers and time keeping/ personnel
---------------------- department. In addition, recording of late coming, overtime, short leave etc.
may involve more clerical work and may be subject to errors.
----------------------
(2) Token or Disc Method
---------------------- Under this method, each worker is allotted an identification number and
---------------------- a disc or token bearing that number. Immediately before the scheduled opening
time, all the tokens/discs will be placed at the factory gate. Every incoming
---------------------- worker will take out his token and drop it in a separate box or hang it on a
separate board. The tokens/ discs not removed will indicate that the said worker
---------------------- is absent. Similar procedure is followed while the workers leave the factory. In
---------------------- addition to the physical handling of tokens/ discs, it will be required to record
the attendance time separately.
---------------------- Though it is an improved method, as compared to manual/handwritten
---------------------- method, it is also subject to errors, mistakes and frauds. Further care should be
taken to see that a worker does not remove the disc/token of his absent fellow
---------------------- in addition to his own.
---------------------- (3) Time Recording Clock Method
Under this method, every worker is allotted an individual ticket number
----------------------
and a clock card, which bears that ticket number. The cards are placed on two
---------------------- racks on either side of the time recording clock denoting separately ‘In’ rack
and ‘Out’ rack. At opening time, all the cards are placed in the ‘Out’ rack. On
---------------------- arrival, the worker takes out his own card, puts it in the slot available on the
time clock recorder, which punches the time on that card, and places the card in
----------------------
the ‘In’ rack. All the cards, left in the ‘Out’ rack indicate absent workers. At the
---------------------- time of departure, he removes the card from the ‘In’ rack, gets it punched and
places it in the ‘Out’ rack.
----------------------
Though this method involves heavy capital outlay initially, it has certain
---------------------- advantages also.
---------------------- (1) It is economical in the sense it avoids clerical work involved in manual/
handwritten method.
---------------------- (2) It is clean, safe and quick and has printed records to avoid disputes.
---------------------- (3) Chances of fraudulent entries can be avoided.
---------------------- 7.3.2 Time booking
The ultimate aim of costing is to decide the cost of each cost center. As such,
----------------------
the recording of time attended is not sufficient. Equally important is to record the
---------------------- time spent for individual cost centers. This process is in the form of time booking.
The methods followed for this purpose may be considered as below:
----------------------
(a) Daily time sheets
---------------------- Under this method, each worker is provided with a daily time sheet on

which the time spent by him on various jobs/work orders is expected to Notes
be mentioned. If the worker works on various jobs in a particular day, the
daily time sheets move along with the worker. The entries on the same ----------------------
may be made by the worker himself or by the foreman.
----------------------
This method may be conveniently used if the worker works on various
jobs of short duration, say in the case of maintenance jobs. ----------------------
This method is disadvantageous in the sense that it involves a considerable ----------------------
amount of paper work. The form in which the daily time sheets may be
prepared is as below: ----------------------
DAILY TIME SHEET ----------------------
Name of Employee
----------------------
Enployee No.
Job No. Dept. Time Record Time taken ----------------------
ON OFF
----------------------
----------------------
----------------------
----------------------
Checked by Cost office reference ----------------------
(b) Weekly Time Sheets
----------------------
Under this method too, one sheet is allotted to each worker but instead
of recording the work done for only a day, a record of time for all the ----------------------
jobs during the week is made. These types of time sheets are useful
----------------------
for intermittent types of jobs such as building or construction work. It
involves a comparatively less amount of paper work. The form in which ----------------------
the weekly time sheets may be prepared is as below.
----------------------
WEEKLY TIME SHEET
Name of Employee ----------------------
Enployee No. ----------------------
Day Job No. Time Time taken Standard Rate Amount
On Off ----------------------
----------------------
----------------------
----------------------
Total ----------------------
Checked by Cost office reference ----------------------
(c) Job Card: Under this method, the details of time are recorded with
reference to the jobs or production/ work orders undertaken by the workers ----------------------
Labour Costs 133

Notes rather than with reference to individual workers and this facilitates the
computation of labour cost with reference to jobs or production/ work
---------------------- orders. There may be two ways in which job card may be maintained.
---------------------- (1) According to first method, each job or production/work order is allotted a
number. When a worker takes up a job, the time of starting and finishing
---------------------- the job is entered on the card meant for that worker. The summary of this
card states the total time taken by that worker for that job. In order to
----------------------
compute the total time booked for the job as a whole, all cards of all the
---------------------- workers with respect to that job are required to be analysed. The form in
which this card may be prepared is as below.
----------------------
JOB CARD
---------------------- Name of Employee
---------------------- Enployee No.

Day Time On Off Time taken Standard Rate Rs. Amount Rs.
---------------------- FRI
SAT
----------------------
SUN
---------------------- MON
---------------------- TUE
WED
----------------------
Checked by Cost office reference
----------------------
(2) According to this method, a job card is prepared for each job production/
---------------------- work order accepted by the organization for execution. It describes various
operations/ stages involved in the execution of the job. Time taken by
----------------------
various workers to complete the job is entered on the card. This provides
---------------------- the information about the time taken by various workers to complete a
particular job.
----------------------
The form in which this card may be prepared is shown below.
---------------------- JOB CARD WITH OPERATIONS
---------------------- Job No. ______________
Drawing No. _____________
----------------------
Job Description _______________
----------------------
Operation Employee No. On Off Time Taken Rate Amount
---------------------- Cutting
Drilling
----------------------
Grinding
---------------------- Painting
---------------------- Assembly
Total
---------------------- Checked by Cost office reference

(d) Reconciliation of the time attended and the time booked Notes
If a combined time and job card is maintained, the problem of reconciliation
----------------------
will be relatively simple as both the details will be available on the same
card. In other cases, at the end of the wage period or at a shorter interval ----------------------
also, the total time attended has to be compared with the time booked on
job cards on the various jobs. If the time booked as per the job cards is ----------------------
less than the attendance time, this indicates the idle time during which the
----------------------
worker has not done any work, though he was present in the factory.
----------------------
----------------------
1. This is the process of recording the attendance time of the ----------------------
workers:_______________
2. Under this method, the attendance of the worker may be recorded either ----------------------
by calling out his name or by a physical check:__________________ ----------------------
3. Under this method, each worker is allotted an identification number
----------------------
and a disc or token bearing that number:__________________
4. Under this method, every worker is allotted an individual ----------------------
ticket number and a clock card, which bears that ticket
----------------------
number:____________________
----------------------
7.4 METHODS OF REMUNERATING THE WORKERS ----------------------
Remuneration to workers indicates reward for labour and services. The ----------------------
remuneration may be paid in monetary terms (which in turn may be in direct or ----------------------
indirect form) or non-monetary terms. The remuneration paid in the monetary
form may be by way of basic wages or salaries and other allowances and may ----------------------
be paid either on time basis or on work basis. However, payment of only basic
wages or salaries may not be sufficient enough to induce the workers to work ----------------------
efficiently; hence they may be remunerated in the form of some incentives. ----------------------
In case of remuneration in non-monetary form, the workers may not receive
anything in the form of money, but they may get facilities, which induce them ----------------------
to stay with the organization. It may be in the form of the provision of health or
welfare or recreational facilities, provision of working conditions and so on. We ----------------------
will discuss these methods of remuneration under the following heads. ----------------------
1. Remuneration on time basis, i.e. Time rate system
----------------------
2. Remuneration on work basis, i.e. Payment by results
----------------------
3. Incentive/Bonus systems
i. Individual incentive systems ----------------------
ii. Group incentive systems ----------------------
Labour Costs 135

Notes 4. Indirect monetary remuneration
i. Profit sharing
----------------------
ii. Co-partnership
----------------------
5. Non-monetary incentives
---------------------- 7.4.1 Time rate system
---------------------- Under this, a worker is paid on the basis of time attended by him. He is
paid at a specific rate irrespective of the production achieved by him. The pay
---------------------- rate may be fixed on a daily, weekly or monthly basis.
---------------------- This type of remuneration system is helpful in the following circumstances:
---------------------- 1. If the output of the worker is beyond his control, for example, his speed
depends upon the speed of a machine or the speed of other workers
----------------------
2. If the output cannot be measured or the standard time cannot be fixed, for
---------------------- example, maintenance work
---------------------- 3. If close supervision is possible

4. If quality, accuracy and precision in work is of prime importance, as in
---------------------- artists and ad-agency people
---------------------- The time rate system of remunerating the workers is useful due to the
following features:
----------------------
1. Useful for highly efficient and highly inefficient workers
----------------------
2. Easy for calculations
---------------------- 3. Easy to understand for the worker
---------------------- 4. Assurance of minimum wages
---------------------- The time rate system has one most important disadvantage in that the
efficiency of the worker is disregarded while paying remuneration to him. To
---------------------- avoid this difficulty, some variations discussed below can be applied in practice.
---------------------- (i) High Wage Plan:
Under this system, timely wage rate of the workers may be fixed at a level,
----------------------
which is higher as compared to wages paid to workers in the same industry
---------------------- or locality. Suitable working conditions are provided. Correspondingly, a high
standard of efficiency is expected from the workers.
----------------------
Those who are not able to come up to the standard are taken off the
---------------------- scheme.
---------------------- (ii) Differential Time Rate:

Under this method, different hourly rates are fixed for different levels
---------------------- of efficiency. Up to a certain level of efficiency, normal day rate is applicable,
---------------------- which gradually increases as efficiency increases. This can be illustrated as
below:
---------------------- Up to 80% efficiency : Re. 1.00 per hour (Normal Rate)

80% to 90% efficiency : Rs. 1.25 per hour Notes
90% to 100% efficiency : Rs. 1.40 per hour
----------------------
101% to 125% efficiency : Rs. 1.50 per hour
----------------------
Under this system, workers are paid according to the production achieved ----------------------
by them. In many cases, time attended is not material. This system may be ----------------------
further classified as below.
(a) Straight piece rate system: ----------------------
Under this method, each job, production or unit of production is termed as ----------------------
a piece and the rate of payment is fixed per piece. The worker is paid on the basis
of production achieved, irrespective of the time taken for its performance. Thus, ----------------------
the earnings of the worker can be computed as Wages = No. of units produced ----------------------
X Piece rate per unit. This method can be suitably applied if the production is
of standard or repetitive nature. It cannot be applied if the production can’t be ----------------------
measured in suitable units.
----------------------
It can be seen that the crux of this method is to decide the time required
to complete a piece. The fixation of this time should be done in such a way ----------------------
that within that much time, a normal worker can complete the piece. This can
----------------------
be done either on the basis of previous experience or on the basis of time and
motion study. ----------------------
(b) Piece Rate with guaranteed time rate:
----------------------
Under the straight piece rate system, the remuneration of a worker
depends upon the production achieved. If the production is less due to some ----------------------
factors beyond his control, he is likely to be penalised. To remove this difficulty, ----------------------
it may be decided that he will be paid on a time rate if his piece rate earnings fall
below time rate earnings, so that the worker is assured of minimum earnings ----------------------
on a time basis. However, if this guaranteed time rate payment is too high, the
incentive to increase output to get piece rate payment is less. ----------------------
(c) Differential piece rate system: ----------------------
Under this system, higher rewards are guaranteed to more efficient ----------------------
workers. The piece rates are fixed in such a way that normal piece rate is paid for
work performed within and up to the standard level of efficiency. If efficiency ----------------------
exceeds the standard, payment at higher piece rate is made.
----------------------
This can be illustrated as below:
----------------------
Up to 83% efficiency - Normal piece rate
Up to 100% efficiency - 10% above normal piece rate ----------------------
Above 100% efficiency - 30% above normal piece rate ----------------------
This method offers more inducement to the workers to work more efficiently ----------------------
and earn higher wages. However, it is complicated to understand and expensive
to operate. ----------------------
Labour Costs 137

Notes Following systems use this principle of differential piece rates.
(1) Taylor differential piece rate system: This was introduced by F.W.
----------------------
Taylor. It provides two-piece rates, a low piece rate for output below
---------------------- standard and a high piece rate for output above standard and does not
provide for any guaranteed time rate payment.
----------------------
For example, if the standard output is 10 units and piece rate is Re. l per unit,
---------------------- the total wages are:
(i) If actual hourly output is 8 units, i.e. below standard, the piece rate is, say
----------------------
80% of normal piece rate, i.e. Re. 0.80. Hence, total wages are 8 units x
---------------------- Re. 0.80 = Rs.6.40.
---------------------- (ii) If actual hourly output is 12 units, i.e. above standard, the piece rate is,
say 120% of normal piece rate, i.e. Rs. l.20.
---------------------- Hence, total wages are 12 units x Rs.l.20 = Rs. 14.40.
---------------------- The basic defect with this system is that though the efficiency of the
worker is even marginally below standard, he is punished heavily and though
---------------------- the efficiency of the worker is even marginally above standard, he is benefited
---------------------- greatly.
(2) Merrick Differential Piece-rate System: To remove the defect existing
----------------------
in case of Taylor’s System, which heavily punishes the worker who
---------------------- produces below standard, the Merrick System provides for three piece
rates. For example:
----------------------
Efficiency Piece rate up to 83% Normal
---------------------- Up to 100% 110% of normal piece rate
---------------------- Above 100% 130% of normal piece rate
---------------------- It should be noted that under this method also, no guaranteed time rate
payment is provided.
----------------------
Illustration:
---------------------- The following particulars relate to a company.
---------------------- Piece Rate-6 paise per unit.
---------------------- Production of the workers: M- 125 units per day, N- 80 units per day and O- 150
units per day. Standard production per day 120 units.
---------------------- Calculate the wages of the workers on the basis of Merrick’s Differential piece
---------------------- rate system, when basic piece rate is guaranteed below the standard and workers
get 108% of the basic piece rate between 100% and 120% of the basic piece rate
---------------------- above 120% efficiency.
----------------------
----------------------
----------------------

Solution: Notes
Calculation of total wages:
----------------------
(a) Worker M:
----------------------
Actual production 125 units, i.e. 104% efficiency.
∴Applicable piece rate: 108% of normal, i.e. 6.48 paise per unit ----------------------
∴Total wages: 125 units x 6.48 paise = 810 paise, i.e. Rs. 8.10 ----------------------
(b) Worker N: ----------------------
Actual production 80 units i.e. below the standard.
----------------------
∴ Applicable piece rate: basic piece rate i.e. 6 paise per unit
----------------------
∴ Total wages: 80 units x 6 paise = 480 paise, i.e. Rs. 4.80
(c) Worker O: ----------------------
Actual production 150 units, i.e. 125% efficiency. ----------------------

∴ Applicable piece rate: 120% of normal, i.e. 7.20 paise per unit. ----------------------
∴ Total wages: 150 units x 7.20 paise = 1080 paise, i.e. Rs. 10.80
----------------------
----------------------
1) Gantt task bonus system
This system is a combination of time rate and piece rate and provides for ----------------------
minimum time rate payment. A high task or standard is set. The wage structure ----------------------
may be fixed as below:
Output below standard - Minimum time rate payment ----------------------
Output at standard - Time wages plus some increase in wage rates ----------------------
Output above standard - High piece rate for the entire output ----------------------
2) Individual incentive systems
----------------------
In case of time rate systems, the losses due to inefficiency of workers or
benefits due to efficiency of workers are suffered or enjoyed by the employer ----------------------
alone. Similarly, in the case of piece-rate systems, the losses due to inefficiency ----------------------
of workers or benefits due to efficiency of workers are suffered or enjoyed
by the worker alone. (The employer may be indirectly affected in the form of ----------------------
increased or decreased per unit overheads.) The incentive systems differ from
both these systems in such a way that the financial advantages arising out of ----------------------
the efficiency of workers are enjoyed by both employer as well as workers. ----------------------
There are various systems by which incentives may be paid to workers. We will
consider following main systems. ----------------------
(a) Halsey premium system: Under this system, if the actual time taken is ----------------------
equal to or more than the standard time, the worker is paid at the time
rate. If actual time is less than the standard time, the worker, in addition to ----------------------
time wages for hours actually worked, gets a bonus payment. The bonus
is equivalent to the wages for the time saved in the decided percentage to ----------------------
Labour Costs 139

Notes be shared with the employer. The percentage allowed to worker may vary
from 30% to 70% (usually 50%). The total wages payable to the worker
---------------------- under this system can be computed as below:
---------------------- TR + % (S-T) R
Here,
----------------------
S is standard time, T is the Time taken, R is the labour rate per hour and % is the
---------------------- percentage of the wages of time saved to be given as bonus.
---------------------- (b) Halsey - Weir premium system: This system is a deviation of Halsey
Premium System only with the exception that the ratio of sharing between
---------------------- the worker and the employer is fixed as 1/3: 2/3. The computation of
---------------------- total wages is the same as in case of Halsey Premium System, except the
change in this ratio.
---------------------- (c) Rowan premium system: Under this system also, guaranteed time rate
---------------------- payment is made. The amount of bonus paid is a percentage of hourly
rate, which is in proportion to the time saved. The total wages payable to
---------------------- the workers under this system can be computed as below:
---------------------- Bonus = (V / S) X W
Total Earnings = (T X R) + (V / S) X (T X R)
----------------------
V=S–T
----------------------
W=TXR
---------------------- Where, V is the Time Saved, S is the Standard Time, W is the Time Wages, T is
---------------------- the Time Taken and R is the Hourly Rate.
Comparative study of Halsey and Rowan system:
----------------------
A comparative study of total wages under both these systems reveals that
---------------------- if time saved is less than 50% of the standard time, Rowan system assures more
wages than those under Halsey system. But, if time saved exceeds 50% of the
----------------------
standard time, Halsey system proves to be more beneficial. In Rowan System,
---------------------- a less efficient worker gets the same bonus as a more efficient worker. As such,
the Rowan System may be implemented in case of loose fixation of standards.
---------------------- The fall in bonus as time saved increases, offsets the damage done by loose
standards.
----------------------
Illustration:
----------------------
The following are the particulars given to you.
---------------------- Standard time: 10 hours
---------------------- Time rate: Re. 1 per hour
---------------------- Prepare a comparative table under Halsey Premium System and Rowan
Premium System, if time taken is 9 hours, 8 hours, 6 hours, 4 hours and 3 hours.
---------------------- Also calculate the amount of total wages and labour cost per hour under two
methods. What conclusions do you draw from the table?
----------------------

Solution: Notes
Hours Halsey Premium system Rowan Premium system
taken ----------------------
Wages = Actual Hours x Hourly rate + Wages = Actual Hours x Hourly rate +
1/2 (Time Saved x Hourly rate) Time Saved/Time Allowed x Actual Hours
----------------------
x Hourly rate
(a) 9 Wages = 9x1 + 1/2 (1 x 1) = Rs. 9.50 Wages = 9 x 1 + (1/10 x 9 x 1) = Rs. 9.90
----------------------
(b) 8 Wages = 8x1 + 1/2 (2 x 1) = Rs. 9 Wages = 8 x 1+ (2/10 x 8 x 1) = Rs. 9.60
(c) 6 Wages = 6x1 + 1/2 (4 x 1) = Rs. 8 Wages = 6 x 1 + (4/10 x 6 x 1) = Rs. 8.40
----------------------
(d) 4 Wages = 4 x 1 + 1/2 (6 x 1) = Rs. 7.00 Wages = 4 x 1 + (6/10 x 4 x 1) = Rs. 6.40
(e) 3 Wages = 3 X l + 1/2 (7 x 1) = Rs. 6.50 Wages = 3 x 1 + (7/10 x 3 x 1) = Rs. 5.10
----------------------
Conclusion:
----------------------
It can be concluded from the above table that so long as the time saved
is less than 50% of standard time, the total wages are more under the Rowan ----------------------
Premium system than under Halsey Premium System. If the time saved is more
than 50% of standard time, the Halsey system proves to be more beneficial in ----------------------
terms of the total wages. ----------------------
----------------------
This may take the following two forms.
----------------------
(a) Profit Sharing:
According to this method, the workers are entitled to share in profits ----------------------
earned by an organisation, in addition to the regular wages, at a specified ----------------------
percentage. The legal provisions in this regard are enacted by way of Payment
of Bonus Act, 1965. According to the provisions of this Act, all the employees ----------------------
drawing a monthly remuneration of Rs. 2,500 or less are entitled to a bonus at
the minimum rate of 8.33% of wages, subject to the maximum ceiling of 20 % ----------------------
of the wages. ----------------------
It is assumed that profit is shared in the form of bonus with the employees.
However, it should be noted that the statutory requirement of the payment of ----------------------
bonus does not depend on the profit earned necessarily, as the bonus is payable ----------------------
even though there are no profits. It is also worth noting that the statutory
requirement of payment of bonus is the specific percentage of the wages or ----------------------
salaries paid to the workers and hence remains unaffected by any changes,
either upwards or downward, in the profits earned by the organisation. ----------------------
(b) Co-partnership: ----------------------

According to this method, the workers are granted ownership rights in ----------------------
the operations of the organisation by which the workers are in the position to
control the affairs of the organisation. In corporate organisations, it may be ----------------------
in the form of offering the shares of the company to the workers (which, in
----------------------
corporate language is referred to as Employees’ Stock Option Plans – ESOPs)
or granting of loans to the workers to buy company’s shares, according to which ----------------------
the workers get the voting rights to control the affairs of the company. The
workers get a dividend on the shares as bonus. With the help of this method, ----------------------
the morale of the workers is increased. However, certain objections are raised
----------------------
Labour Costs 141

Notes against this method. First, the increase in earnings is too small. Second, the
shareholding of the workers is too small to control the affairs of the company.
---------------------- Third, the workers are not rewarded according to individual efficiency.
---------------------- 7.4.5 Non-monetary incentives
The intention of these incentives is to attract better workers, retain the
----------------------
existing workers, encourage loyalty, reduce labour turnover, provide better
---------------------- working conditions to workers and so on. Various benefits, as stated below,
may be granted to the workers, either free or at reduced rates, remaining amount
---------------------- being contributed by the workers.
---------------------- (1) Health and safety services
---------------------- (2) Education and training to workers and their children

(3) Canteen facility
----------------------
(4) Pension, superannuation fund etc.
----------------------
(5) Loans at reduced rate of interest
----------------------
----------------------
---------------------- 1. The time rate system of remunerating the workers is not useful for
highly efficient and highly inefficient workers
----------------------
2. The remuneration paid in the monetary form may be by the only way
---------------------- of basic wages.
3. The remuneration may be paid either on time basis or on work basis.
----------------------
4. Remuneration to workers indicates reward for labour and services
----------------------
----------------------
Activity 1
----------------------
---------------------- 1. Visit an organization where labour is engaged on need basis. Study

the wage payment system there and prepare a report on it.
----------------------
2. What is meant by ‘Gantt Task Bonus System’?
----------------------
---------------------- 7.5 PRINCIPLES OF A GOOD WAGE PAYMENT SYSTEM

---------------------- Principles of a good wage payment system can be enlisted as under:
---------------------- 1. As a general rule, if the efficiency of the workers can be measured
in objective terms, the wages receivable by a worker should be in
----------------------
conformity with his efficiency. Otherwise, an efficient worker is likely
---------------------- to be demotivated in working efficiently. At the same time, the standards

fixed to measure the efficiency of a worker should be normal, which a Notes
normal worker under normal conditions can attain.
----------------------
2. The wage payment system should be clearly defined and communicated
to the workers leaving no scope for any ambiguity. At the same time, a ----------------------
good wage payment system should be simple to understand and easy to
operate. ----------------------
3. No upper limit should be imposed on the wages that can be earned by an ----------------------
efficient worker.
----------------------
4. A good wage payment system will not punish the workers for matters
beyond the control of the workers. For example, workers should not ----------------------
be punished in terms of reduced wages due to circumstances such as
machinery breakdown, power failures etc. ----------------------
5. A good wage payment system should be reasonably permanent in nature. ----------------------
Frequent changes in the same should be avoided. If any changes are
proposed to be made in the system of wage payment, they should not be ----------------------
thrust upon the workers by force, but should be implemented by having ----------------------
mutual discussions with, and due approval from, the workers.
6. The wage payment system should be properly tied up with quality control ----------------------
procedures to ensure that the workers are paid only for good quality ----------------------
production.
7. The basic objective of the wage payment system should be to get the ----------------------
maximum cooperation from the workers, improve the morale and ----------------------
productivity of the workers and to minimize the cost of supervision and
labour turnover. ----------------------
8. The wage payment system should take into consideration the external ----------------------
obligations to which the organization may be subject. These obligations
may be in the form of various statutes such as Minimum Wage Act, the ----------------------
agreement entered into with the workers and so on.
----------------------
7.6 IMPORTANT TERMS IN CASE OF LABOUR COST ----------------------
In this section, few important terms are discussed in detail in context with ----------------------
Labour Cost.
----------------------
----------------------
In every business organisation, the process of employees leaving the
organisation and new workers being recruited is a normal feature. Labour ----------------------
Turnover indicates this change in the labour force showing a highly increasing
or highly decreasing trend. Labour turnover showing a sharp increasing trend ----------------------
may involve the reduction in labour productivity and increasing costs. Too low
----------------------
a labour turnover trend may be due to inefficient workers who would not like to
leave the organisation. ----------------------
----------------------
Labour Costs 143

Notes Causes of labour turnover:
The causes of labour turnover can be broadly classified as below:
----------------------
●● Avoidable Causes:
----------------------
o Dissatisfaction with job
---------------------- o Dissatisfaction with remuneration
---------------------- o Dissatisfaction with working conditions
---------------------- o Dissatisfaction with hours of work

o Relationship with supervisors and workers
----------------------
●● Unavoidable Causes:
---------------------- o Betterment/Personal
---------------------- o Illness or accident
---------------------- o Move from locality
o Discharge
----------------------
o Marriage
----------------------
o Retirement
---------------------- o Death
---------------------- o National service
---------------------- Costs of labour turnover:
---------------------- The cost of labour turnover may be classified under two headings.
(a) Preventive Costs:
----------------------
These refer to all the costs incurred by the organisation to keep workers
---------------------- happy and discourage them from leaving the job. This, in turn, may include the
following costs:
----------------------
1. Cost of Personnel Administration - To maintain good relations with the
---------------------- workers.
---------------------- 2. Cost of medical services- To keep the workers and their families in healthy
condition, as healthy workers is an asset to the organisation, contributing
---------------------- towards higher efficiency and productivity.
---------------------- 3. Costs of welfare activities - To give facilities such as transport, canteen
etc.
----------------------
4. Other incentive schemes such as pension, provident fund, superannuation
---------------------- fund, bonus etc.
---------------------- (b) Replacement costs:

These refer to the costs incurred for recruitment and training of new
---------------------- workers and the resulting losses, wastages and reduced productivity due to the
---------------------- inefficiency and inexperience of new workers.

This, in turn, may include these costs: Notes
(1) Inefficiency of new workers
----------------------
(2) Cost of selection and placement
----------------------
(3) Training costs
(4) Loss of output due to delay in getting new workers ----------------------
(5) Increased spoilage and defectives ----------------------

(6) Cost of tools and machine breakages ----------------------
Measurement of labour turnover:
----------------------
There are three methods for measuring the labour turnover.
----------------------
(1) Separation method
Under this method, labour turnover is computed as:- ----------------------
No. of Separations in a period x 100 / Average no. of workers ----------------------

(2) Replacement method ----------------------
Under this method, labour turnover is computed as:-
----------------------
No. of Replacements in a period x 100 / Average no. of workers.
----------------------
(3) Flux method
Under this method, labour turnover is computed as:- (No. of separations + No. ----------------------
of replacement) x 100 / Average no. of workers ----------------------
Illustration:
----------------------
From the following data given by Personnel Department, calculate the
labour turnover rate by applying: ----------------------
(a) Separation Method ----------------------
(b) Replacement Method ----------------------
(c) Flux Method
----------------------
No. of workers on pay-roll
----------------------
At the beginning of the month- 900
At the end of the month- 1,100 ----------------------
During the month, 10 workers left, 40 persons were discharged and 150 workers ----------------------
were recruited. Of these, 25 workers are recruited in the vacancies of those
leaving while the rest were for an expansion scheme. ----------------------
Solution: ----------------------
Calculation of Labour Turnover ----------------------
(1) Separation method
----------------------
No. of separations in a period x 100/Average No. of workers = 50 x 100 / 1000
----------------------
=5
Labour Costs 145

Notes Monthly Turnover Rate: 5%
Annual Turnover Rate: 5 x 365 / 30 = 60.83%
----------------------
(2) Replacement method:
----------------------
No. of replacements in a period x 100 / Average No. of workers
---------------------- = 25 x 100 / 1000 = 2.5%
---------------------- Monthly turnover Rate: 2.5%
---------------------- Annual Turnover Rate: 2.5 x 365/30 = 30.42%
(3) Flux method:
----------------------
No. of separations + No. of replacements x 100 / Average No. of workers
----------------------
= (50 +25) x 100 / 1000
---------------------- = 7.5%
---------------------- Monthly Turnover Rate: 7.5%
---------------------- Annual Turnover rate: 7.5 x 365/30 = 91.25%
Working Notes:
----------------------
Average number of workers is calculated as:
----------------------
(No. of workers at beginning + No. of worker at end) / 2
---------------------- = (900 + 1100) / 2
---------------------- = 1000
---------------------- 7.6.2 Idle time
It indicates the time for which wages are paid to the workers but during
----------------------
which no production is obtained. To exercise proper control on idle time, causes
---------------------- of the same should be analysed properly and studied from its controllability
point of view.
----------------------
The causes of idle time can be analysed as below:
---------------------- (a) Productive causes:
---------------------- These can be further classified as:
---------------------- (i) Machine breakdown
(ii) Power failures
----------------------
(iii) Waiting for tools, work or raw materials
----------------------
(iv) Waiting for instructions
---------------------- These causes are supposed to be controllable causes and can be controlled
---------------------- if planned properly.
(b) Administrative causes:
----------------------
Some idle time may be caused due to administrative decisions. For
---------------------- example, the organisation has excess machine capacity or during the depression

period, it does not have sufficient work to be performed, but it has decided not Notes
to get rid of trained workers temporarily. As such, cost of idle time is accepted.
----------------------
(c) Economic causes:
Economic causes may be of seasonal, cyclical or industrial nature. For ----------------------
example, if the product manufactured is of a seasonal nature, for the other
----------------------
periods of the year, the capacity may remain unused, unless some other product
is introduced to take care of the slack season. In case it is not possible to make ----------------------
alternate use of such idle capacity, some idle time is unavoidable. In case of
cyclical causes, the causes are similar to seasonal fluctuations but these causes ----------------------
are beyond the control of management.
----------------------
Treatment of idle time cost:
----------------------
If idle time payment is normal and controllable, it should be classified as
overheads. If it is possible to allocate the same to some department, it should be ----------------------
allocated and absorbed in the production department cost.
----------------------
If idle time is normal and uncontrollable, the labour rates should be
suitably modified. For example, if the time attended is 8 hours, but the time ----------------------
booked is only 7.5 hours and labour cost is Rs. 1.5 per hour, the hourly labour
rate should be computed as ----------------------
8 hours x Rs. 1.5 ----------------------

i.e. Rs. 1.60 for 7.5 hours ----------------------
If idle time payment is uncontrollable and abnormal, it should not be
----------------------
considered as a part of manufacturing cost but should be written off to Costing
Profit and Loss Account. ----------------------
----------------------
In today’s world, labour is one of the most important factors of production
and contributing to a very great extent to the cost of production. As such, it will ----------------------
be the intention of every organisation to have proper control on the labour cost.
----------------------
The implementation of various Internal Control Procedures indicates following
all those methods and procedures, ensuring fluent and smooth running of the ----------------------
operations of the organisation and also achieving protection of assets, prevention
of errors and frauds and proper recording of information whenever necessary. ----------------------
The cost of labour may be high due to the various reasons stated below: ----------------------
1. Excess staffing - Having more staff than the requirement.
----------------------
2. Lack of experienced and efficient personnel.
3. Excessive remuneration pattern - Settlement of the wage rates or piece ----------------------
rates on higher side, which may not be justified on the basis of the ----------------------
efficiency of the workers.
4. Clerical errors or fraudulent practices taking place in the area of time ----------------------
keeping, computation of wages payable, procedure for payment of wages ----------------------
to the workers etc.
5. Idle time or unusual overtime wages. ----------------------
Labour Costs 147

Notes 6. Increase of spoilage due to lack of proper supervision and inspection.
7. High labour turnover.
----------------------
After locating the reasons for increasing labour costs, attempts can be made
---------------------- to keep the same in control after following various internal control measures as
discussed below.
----------------------
1. To avoid the problem of excess staffing, workers should be employed
---------------------- only after the receipt of labour placement requisition from the concerned
---------------------- department. After the receipt of this requisition, it should be seen whether
it is possible to meet the requirement of the said department with the help
---------------------- of existing staff only or at least by transferring the existing excess staff in
other departments. Before proceeding with the actual process of selection
----------------------
of the staff, care should be taken to decide in advance about the nature of
---------------------- work that may be assigned to the individual employee.
---------------------- 2. To ensure that correct personnel is employed to work in the correct places,
care should be taken to analyse the requirements of the job and then to
---------------------- select the personnel that suits these requirements. This process may be
in the form of ‘job evaluation.’ Selection of the proper personnel may
----------------------
not be enough. To train the selected personnel to extract their maximum
---------------------- efficiency is equally necessary.
---------------------- 3. The problem of setting the excessive rate structure in the form of higher
time rate or piece rates or bonus rates may be avoided by setting the
---------------------- standards in the most scientific manner. For this purpose, techniques such
as time and motion study, work study etc. may be implemented.
----------------------
4. To avoid clerical errors or fraudulent practices in the areas of wage sheet
---------------------- preparation or wage payments, a proper internal check procedure may
---------------------- be implemented, so that the work of one person is properly checked by
another person. For this, the following steps may be taken:
---------------------- a. Time recording clock should be installed, wherever possible. Proper
---------------------- supervision is required to ensure that a person punches his own card
only.
----------------------
b. The terms of remuneration should be set and made known to the
---------------------- workers in very clear terms.
---------------------- c. Proper internal checks should be executed while preparing the

wages sheets. The cashier should not be allowed to handle the wages
---------------------- sheets and the person preparing the sheets should not be allowed to
prepare the wage packets. Personnel officer/manager should check
----------------------
and authorize the wages sheets.
---------------------- d. The wages should be paid to workers after they are properly
---------------------- identified. The wages should not be paid to any other person, unless
proper authorization letter is produced in exceptional circumstances.
----------------------

e. Distribution of wages should be made in all the departments at a Notes
time so as to avoid the possibility of one person being present at two
places. ----------------------
f. Existence of idle time should be properly analyzed according to ----------------------
controllability. Attempts should be made to avoid the causes of
controllable idle time. ----------------------
g. If it is necessary to work overtime, it should be properly authorized ----------------------
and should be paid and accounted for properly. Care should be taken
to see that proper returns are obtained for making overtime wages ----------------------
payment.
----------------------
5. If the labour cost is higher due to spoilage of work, which in turn may be
due to lack of proper supervision or inspection, it is a cost which can very ----------------------
well be controlled by having proper supervision or inspection. ----------------------
6. The causes of labour turnover should be analysed according to normality.
All the avoidable causes of labour turnover should be paid proper attention ----------------------
to. Higher trends of labour turnover add to the costs in mainly two ways. It ----------------------
reduces the labour productivity and at the same time, increases the costs. If
the workers have grievances of avoidable nature, say dissatisfaction with ----------------------
remuneration or other benefits or working hours or working conditions or
job itself or relations with the fellow workers or the supervisors, attempts ----------------------
can be made to avoid those causes of labour turnover. ----------------------
----------------------
Fill in the blanks.
----------------------
1. As per Straight Piece Rate System, the earnings of the worker can be
computed as ________________________________________ ----------------------
2. Under this rate system, higher rewards are guaranteed to more efficient
workers: ___________________________ ----------------------
3. This Rate System provides two-piece rates, a low piece rate for ----------------------
output below standard and a high piece rate for output above
standard and does not provide for any guaranteed time rate payment: ----------------------
__________________________
----------------------
4. Under this system, if the actual time taken is equal to or
more than the standard time, the worker is paid at the time ----------------------
rate:____________________
----------------------
5. Under this system also, guaranteed time rate payment is made:
________ ----------------------
----------------------
----------------------
----------------------
Labour Costs 149

Notes Summary
---------------------- ●● Labour Cost is an important element of cost in the manufacturing cost.
It is important element of cost even though the production is material-
----------------------
intensive.
---------------------- ●● The basic factor that gives rise to the labour cost is the remuneration paid
to workers. Ascertaining the labour cost is in the form of Time Keeping
----------------------
and Time Booking.
---------------------- ●● Time Keeping is the process of recording the attendance time of the
workers and for the purpose of time keeping, various methods may be
----------------------
followed such as the Hand-Written Method, Token-Disc method, Time
---------------------- Recording Clock Method etc.
●● Time Booking is to record the time spent for individual cost centers. Methods
---------------------- followed in this are daily time sheets, weekly time sheets Job card etc.
---------------------- ●● Remuneration to workers indicates the reward for labour and services.
The remuneration may be paid in monetary terms (which in turn may be in
---------------------- a direct form or indirect form) or non-monetary terms. The remuneration
---------------------- paid in the monetary form may be by way of basic wages or salaries and
other allowances and may be paid either on time basis or on work basis.
---------------------- ●● The methods of remuneration are on time basis, i.e. Time Rate System, on
---------------------- work basis i.e. Payment by Results, Incentive /Bonus Systems, Indirect
monetary remuneration and non-monetary incentives.
---------------------- ●● In every business organisation, the process of employees leaving the
organisation and new workers being recruited is a normal feature.
----------------------
Labour Turnover indicates this change in labour force showing a highly
---------------------- increasing trend or highly decreasing trend. Labour turnover showing
sharp increasing trend may involve the reduction in labour productivity
---------------------- and increasing costs.
---------------------- ●● In today’s world, labour is one of the most important factors of production,
and contributes to a very great extent to the cost of production. As such,
---------------------- it will be the intention of every organisation to have a proper control on
---------------------- the labour cost.
●● The implementation of various Internal Control Procedures indicates all
---------------------- those methods and procedures which ensure fluent and smooth running of
---------------------- the operations of the organisation and also achieving protection of assets,
prevention of errors and frauds and proper recording of information
---------------------- whenever necessary.
----------------------
Keywords
----------------------
●● Bookkeeping: To ascertain the Labour cost, it is important to record the
---------------------- time spent for individual cost centers. This process is in the form of time
booking. Daily, weekly time Sheets and Job Card are the methods of
---------------------- bookkeeping.

●● Labour Turnover: Indicates changes in labour force, showing a highly Notes
increasing trend or highly decreasing trend. Labour turnover showing a
sharp increasing trend may involve reduction in labour productivity and ----------------------
increasing costs.
----------------------
●● Time Keeping: Ascertaining the Labour cost is in the form of time
keeping. ----------------------
----------------------
(1) The standard hours for job X is 100 hours. The job can be completed by
A in 60 hours, by B in 70 hours and by C in 95 hours. ----------------------
The bonus system applicable to the job is as follows:
----------------------
% of time saved to time allowed bonus
----------------------
Saving up to 10% - 10% of time saved
Saving from 11% to 20% - 15% of time saved ----------------------

Rate of pay per hour is Rs.1. Calculate the total earnings of each worker and the ----------------------
rate of earnings per hour.
Solution: ----------------------
A B C ----------------------
(1) Standard Hours 100 100 100
----------------------
(2) Actual Hours 60 70 95
(3) Hours Saved 40 30 5 ----------------------
(4) % Hours Saved 40% 30% 5% ----------------------
(5) Applicable bonus rate (% of wages for time saved) 20% 20% 10%
(6) Hourly Rate (Rs.) 1 1 1 ----------------------
(7) Basic wages (Rs.) 2 x 6 60 70 95 ----------------------
i.e. Actual Hours x Hourly rate
----------------------
(8) Wages for time saved (Rs.) 3 x 6 40 30 5
i.e. Hours Saved x Hourly Rate ----------------------
(9) Bonus (Rs.) 8 x 5 i.e. Wages for time saved x 8 6 0.5
----------------------
Bonus Rate
(10) Total - (Rs.) 7+ 9 68 76 95.5 ----------------------
Note: ----------------------
It is assumed that the amount of bonus is not decided on rates of bonus on
----------------------
cumulative basis.
(2) During one week, X makes 200 units. He receives wages for a guaranteed ----------------------
44 hours per week at the rate of Rs. 1.50 per hour. Estimated time to ----------------------
Labour Costs 151

Notes produce one unit is 15 minutes. Time allowed is increased by 20%
allowance on estimated time under incentive scheme. Calculate earnings
---------------------- as per:
---------------------- (i) Time rate
(ii) Piece rate
----------------------
(iii)
Rowan scheme
----------------------
(iv) Halsey scheme
----------------------
Solution:
---------------------- (i) Time Rate:
---------------------- No. of Hours x Hourly Rate
---------------------- = 44 Hours x Rs. 1.50 = Rs. 66

(ii) Piece Rate:
----------------------
Hourly Rate/ Units produced x Units per hour
----------------------
= 200 units/4 units x Rs. 1.50
----------------------
= Rs. 75.
---------------------- (iii) Rowan Scheme:
---------------------- Actual Hours x Hourly Rate + (Time Saved/ Time Allowed) x (Actual
Hours x Hourly rate)
----------------------
= 44 Hours x Rs. 1.50 + (16 Hours/ 60 Hrs) x (44 Hours x Rs. 1.50)
----------------------
= Rs. 66 + Rs. 17.60= Rs. 83.60
---------------------- (iv) Halsey Scheme:
---------------------- Actual Hours x Hourly Rate + 1/2 (Time Saved x Hourly Rate) = 44
Hours x Rs. 1.50 + 1/2 (16 Hours x Rs. 1.50) = Rs. 66 + Rs. 12 = Rs. 78
----------------------
Working Notes:
----------------------
For incentive scheme, time allowed is increased by 20% of estimated
---------------------- time. Estimated time is 15 minutes per unit.
---------------------- ∴ For incentive scheme, time allowed will be 15 minutes + 20% = 18
minutes Time allowed for 200 units will be 18 minutes x 200 units = 60 Hours
----------------------
Actual time taken is 44 Hours.
----------------------
Hence, time saved will be 16 hours (i.e. 60 hours - 44 hours)It is assumed that
---------------------- the allowance of 20% is available only in case of incentive systems and not in
case of time rate or piece rate systems.
----------------------
----------------------
----------------------

Notes
----------------------
1. Explain various steps in the process of identifying the direct labour cost
with the individual cost center. ----------------------
2. What do you mean by idle time? Explain in detail the cost accounting ----------------------
treatment of idle time.
----------------------
3. What is ‘Labour Turnover’? Explain its costs. What are the causes responsible
for labour turnover? How is it measured? ----------------------
4. Briefly discuss various time rates and payment by results system of wages.
----------------------
5. Briefly explain the Individual and Group incentive systems of wages.
----------------------
----------------------
Answers to Check your Progress ----------------------

Fill in the banks. ----------------------
1. This is the process of recording the attendance time of the workers: Time
----------------------
keeping department
2. Under this method, the attendance of the worker may be recorded either ----------------------
by calling out his name or by a physical check: Hand-written method
----------------------
3. Under this method, each worker is allotted an identification number and a
disc or token bearing that number: Token or disc method ----------------------
4. Under this method, every worker is allotted an individual ticket number ----------------------
and a clock card, which bears that ticket number: Time recording clock
method ----------------------
----------------------
State True or False
----------------------
1. False
----------------------
2. False
3. True ----------------------
4. True ----------------------
----------------------
----------------------
----------------------
----------------------
Labour Costs 153

Notes Check your Progress 3
Fill in the blanks.
----------------------
1. As per Straight Piece Rate System, the earnings of the worker can be
---------------------- computed as Wages = No. of units produced X Piece rate per unit.
---------------------- 2. Under this rate system, higher rewards are guaranteed to more efficient
workers: Differential Piece Rate System
----------------------
3. This Rate System provides two-piece rates, a low piece rate for output
---------------------- below standard and a high piece rate for output above standard and does
not provide for any guaranteed time rate payment: Taylor Differential
---------------------- Piece Rate System
---------------------- 4. Under this system, if the actual time taken is equal to or more than the
standard time, the worker is paid at the time rate: Halsey Premium System
----------------------
5. Under this system also, guaranteed time rate payment is made: Rowan
---------------------- Premium System
----------------------
Suggested Reading
----------------------
1. Edward J. Vanderbeck, Maria R. Mitchell, Principles of Cost Accounting
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Overhead Costs
UNIT
8
Structure:
8.1 Introduction
8.2 Overhead Classification
8.3 Procedure for Charging Overheads
8.4 Actual v/s Predetermined Overhead Absorption Rates
8.5 Under and Over Absorption of Overheads
8.6 Treatment of Under/Over Absorbed Overheads
8.7 Control Over Overheads
Summary
Key Words
Suggested Reading
Overhead Costs 155

Notes
Objectives
----------------------
• Define and classify overhead costs
----------------------
• Demonstrate the procedure for charging overheads
---------------------- • Explain under and over absorption of overheads
• Assess the primary and secondary apportionment of overheads
----------------------
• Describe the process of control of overhead costs
----------------------
----------------------
8.1 INTRODUCTION
----------------------
The term ‘Cost’ can be classified as Direct Cost and Indirect Cost. Direct
---------------------- Cost indicates all the costs, which can be identified with the individual cost
centre and indirect cost indicates all the costs, which cannot be identified with
---------------------- the individual cost centre. The totals of indirect costs are termed as overheads.
----------------------
8.2 OVERHEAD CLASSIFICATION
----------------------
Overheads can be classified as follows:
----------------------
(1) Element-wise classification:
---------------------- As the cost can be classified as per the elements of cost, i.e. material
---------------------- cost, labour cost and expenses, the indirect cost, i.e. overheads may be
classified as per the elements of cost. This classification of overheads
---------------------- takes the form of:
---------------------- a. Indirect material

b. Indirect labour
----------------------
c. Indirect expenses
----------------------
The meaning and the type of expenses included in this classification have
---------------------- already been discussed in the Unit on Cost Sheet.
---------------------- (2) Function-wise classification:

Under this classification, the overheads are classified according to the
---------------------- functions they perform. This classification of overheads takes the form of:
---------------------- a. Factory Overheads (also termed as production or works or
manufacturing overheads)
----------------------
b. Administration Overheads
----------------------
c. Selling and Distribution Overheads
---------------------- The meaning and the type of expenses included in this classification have
already been discussed in the Unit on Cost Sheet.
----------------------

(3) Variability-wise classification: Notes
(i) Fixed overheads: These overheads indicate the costs that remain
----------------------
unaffected by variations in volume of output, e.g. rent, insurance
on building, salary to administrative staff etc. Per unit cost of ----------------------
overheads may reduce as the volume of output increases, but the
total overheads remain constant. ----------------------
(ii) Variable overheads: These overheads indicate the costs that vary ----------------------
directly in proportion to volume of output, e.g. consumables, nuts/
bolts, loose tools etc. Per unit cost of overheads remains the same, ----------------------
but total overheads may increase or decrease as per volume of
----------------------
output.
(iii) Semi-variable overheads: These overheads indicate the costs ----------------------
that are neither fixed nor variable in nature. These may remain
----------------------
fixed at certain levels of activity and may vary proportionately at
other levels of activity, e.g. maintenance cost, power, electricity, ----------------------
supervision cost etc.
----------------------
(4) Controllability-wise classification:
nder this classification, the overheads are classified according to their ----------------------
controllable nature. This classification takes the form of: ----------------------
a. Controllable overheads
----------------------
b. Uncontrollable overheads
----------------------
This classification has already been discussed.
(5) Normality-wise classification: ----------------------
Under this classification, the overheads are classified according to the fact ----------------------
as to whether the overheads are normally incurred at a certain level of
output under normal circumstances. This classification takes the form of: ----------------------
a. Normal overheads ----------------------

b. Abnormal overheads ----------------------
The above classification refers to the classification of same amount of
----------------------
overheads in different forms to suit the individual requirements. For example,
for the purpose of preparing the cost statement, overheads may be classified ----------------------
according to functions while for the purpose of marginal costing applications,
overheads may be classified according to variability ----------------------
----------------------
Activity 1
----------------------
Which type of classification of overhead is best suited for a unit ----------------------

manufacturing white goods such as refrigerators, washing machines etc.
----------------------
List any four types classification of overheads used in such industries.
----------------------
Overhead Costs 157

Notes 8.3 PROCEDURE FOR CHARGING OVERHEADS
---------------------- The basic aim of costing is to find out the cost of each cost centre. The
cost of each cost center can be either the direct cost or the indirect cost. The
----------------------
direct cost can be identified with the individual cost centre and hence poses
---------------------- no difficulties. To charge the indirect costs, i.e. overheads, to the individual
cost centers is the major problem. To overcome this problem, generally the
---------------------- following procedure may be followed.
---------------------- 1. Allocation/Primary Apportionment:
---------------------- There can be some overheads, which are incurred for the company
as a whole, as for all the departments such as Production and Service
---------------------- departments. To identify the common costs with the individual departments
is the first stage problem. This can be solved in two ways.
----------------------
a. If it is possible to identify some overheads with the individual
---------------------- departments, overheads should be charged to the respective
department. For example, wages paid to the maintenance department
---------------------- workers can be obtained from the wages sheet and can be allocated
---------------------- to the maintenance department. Similarly, the cost of indirect
material can be allocated to individual departments by pricing
---------------------- material requisition slips.
---------------------- b. It may not be possible in all the cases to allocate the overheads,
i.e. in case of common expenses for the entire factory. In this case,
---------------------- they can be apportioned among the various departments on some
suitable basis, i.e. to all production as well as service departments.
----------------------
This process is in the form of primary apportionment or distribution
---------------------- of overheads. The selection of the base on which overheads are or
should be apportioned depends on the following principles:
----------------------
●● Service or use basis: If the benefit obtained by various
---------------------- departments from the overheads can be measured, overheads
can be apportioned on that basis.
----------------------
●● Survey basis: If amount of services rendered cannot be
---------------------- measured, survey basis may be applied. For example, if it can
be noted that a supervisor is giving 60% of his services to
---------------------- department ‘A’ and 40 % to department ‘B’, his wages can be
apportioned on that basis.
----------------------
●● Ability to pay basis: In this case, the apportionment may
---------------------- depend upon the factors like total sales/profitability. It may
not be fair in some cases, as most efficient departments may
---------------------- have to bear higher amounts of overheads, though actual
---------------------- overheads of that department may be lower than those of the
other departments.
----------------------
----------------------

Primary apportionment of overheads may be based on the following: Notes
Item of expenditure Base
----------------------
Canteen expenses/Staff Supervision Number of workers
Rent/Taxes Area ----------------------
Power HP/KWh
General lighting Number of light points/area ----------------------
Depreciation Value of assets
Supervision Number of employees/wages paid ----------------------
Telephone expenses Number of telephone calls made ----------------------
Fire insurance Value of stocks held/value of assets
The Omega Co. has four departments. A, B and C are production ----------------------
departments and D is a servicing department. The actual costs for a period are ----------------------
as follows:
Rs. ----------------------
Rent 2,000
Repairs 1,200 ----------------------
Depreciation 900
Light 200 ----------------------
Supervision 3,000
Insurance 1,000 ----------------------
Employees Insurance (Employer’s liability) 300
Power 1,800 ----------------------
The following data are also available in respect of departments. ----------------------
Dept. A Dept. B Dept. C Dept. D
----------------------
Area sq. ft. 150 110 90 50
Number of workers 24 16 12 8 ----------------------
Total wages (Rs.) 8,000 6,000 4,000 2,000
Value of plant (Rs.) 24,000 18,000 12,000 6,000 ----------------------
Value of stock (Rs.) 15,000 9,000 6,000 -
----------------------
Apportion the cost to the various departments on the most equitable basis:
----------------------
Solution:
Apportionment of Overheads ----------------------
Particulars Base Total Dept. Dept. Dept. Dept. ----------------------
Rs. A B C D
Rs. Rs. Rs. Rs. ----------------------
Rent Area sq. ft. 2,000 750 550 450 250
Repairs Total wages 1,200 480 360 240 120 ----------------------
Depreciation Value of Plant 900 360 270 180 90 ----------------------
Light Area – sq. ft. 200 75 55 45 25
Supervision No. of workers 3,000 1,200 800 600 400 ----------------------
Insurance Value of stock 1,000 500 300 200 -
Employees’ Insurance No. of workers 300 120 80 60 40 ----------------------
(Employer’s Liabilities)
----------------------
Power Value of Plant 1,800 720 540 360 180
10,400 4,205 2,955 2,135 1,105 ----------------------
Overhead Costs 159

Notes Notes:
It is assumed that the insurance is payable only on stock. Had it been assumed
----------------------
that it is payable on stock as well as plant, the base would have been the
---------------------- combined value of stock and plant.
For the apportionment of power cost, Kwh/HP rating would have been an ideal
----------------------
base. As relevant data is not available, it is apportioned on the basis of value of
---------------------- plant.
Repairs are apportioned on the basis of total wages, assuming that repair charges
----------------------
consist of mainly the labour charges.
---------------------- (2) Secondary Apportionment:
---------------------- With the process of primary apportionment or distribution, the loading of
overheads for all the departments, i.e. production as well as service departments,
---------------------- can be obtained. The next step is to transfer the overheads of non-production
---------------------- departments to the production departments, as the various cost centers move
through the production departments only. This is in the form of ‘Secondary
---------------------- apportionment or distribution of overheads’.
---------------------- The usual bases that can be selected for the secondary apportionment may be
as below:
----------------------
(1) Maintenance Dept. - Number of hours worked
---------------------- (2) Stores Dept. - Number of requisitions
---------------------- (3) Purchase Dept. - Number of Purchase orders
---------------------- (4) Building Service Dept. - Area

(5) Welfare/ Canteen and other facilities - Number of employees
----------------------
(6) Personnel or Time keeping Dept. - Number of employees
----------------------
(7) Internal Transport - Weight/value of goods moved
---------------------- While apportioning the overheads of non-production departments to
production departments, a problem will arise if non-production departments are
----------------------
rendering the services inter-se.
---------------------- There can be two ways to handle the situation like this:
---------------------- (A) Ignore the services given by one service department to another. The
defects involved with this method are very obvious.
----------------------
Illustration:
----------------------
The following figures are extracted from the accounts of M/s. Vasant
---------------------- Works for the month of July 2018.
----------------------
----------------------
----------------------

Production Depts. Service Depts. Notes
PI P2 SI S2 S3
Indirect Material 280 140 170 350 160 ----------------------
Indirect Wages 324 312 2% 190 218
----------------------
Power and Light Rs. 3,000
Supervision Charges Rs. 2,200 ----------------------
Rent and Taxes Rs. 500
Insurance on assets Rs. 60 ----------------------
Depreciation at the rate of 12% p.a. on capital value of assets has to be ----------------------
considered. From the above information and the following departmental data,
prepare overhead recovery rates for the production departments PI and P2 on ----------------------
the basis of direct labour hours. The expenses of service departments should be
apportioned straight to the production dept. with the information that SI is tool ----------------------
room, S2 is maintenance department and S3 is stores department. ----------------------
Departmental Data: PI P2 SI S2 S3
----------------------
Area (sq.ft.) 400 200 100 200 100
Capital Value of Assets (Ps.) 8000 4000 7000 5000 6000 ----------------------
Kilowatt Hours 4000 3000 1000 1000 1000
Number of employees 150 100 75 100 125 ----------------------
Direct Labour Hours 5000 5000
Number of requisitions 1000 300 ----------------------
Solution: ----------------------
Statement showing apportionment of overheads ----------------------
Items Base P1 P2 S1 S2 S3
Rs. Rs. Rs. Rs. Rs. ----------------------
Indirect Material Allocation 280 140 170 350 100 ----------------------
Indirect wages Allocation 324 312 296 190 218
Power & Light Kilowatt Hrs 1200 900 300 300 300 ----------------------
Supervision No. of employees 600 400 300 400 500
Rent & Taxes Area 200 100 50 100 50 ----------------------
Insurance on Assets Value of assets 16 8 14 10 12
Depreciation Value of assets 80 40 70 50 60 ----------------------
2700 1900 1200 1400 1300
Dept. S1 Labour Hours 600 600 (-) 1200 ----------------------
Dept. S2 Labour Hours 700 700 (-) 1400
----------------------
Dept. S3 No. of requisitions 1000 300 (-) 1300
5,000 3,500 ----------------------
(B) If it is decided to consider the services rendered by one service
----------------------
department to another, the first problem will be to decide the percentage
in which services are given by the service departments inter-se. After ----------------------
such percentage is decided, the secondary apportionment can be made by
either of the following methods. ----------------------
(i) Simultaneous Equation Method: Under this method, the amount ----------------------
of overheads of each production department can be obtained by
solving simultaneous equations. ----------------------
Overhead Costs 161

Notes (ii) Repeated Distribution Method: Under this method, service dept.
overheads are distributed to other departments, production as well
---------------------- as service, on agreed percentage and this process is repeated till
the figures of service departments are exhausted or are too small to
---------------------- consider further apportionment.
---------------------- Illustration:
---------------------- A company has 3 production depts. and 2 service depts. and for a period,
departmental distribution summary has the following totals.
----------------------
Production Depts: A- Rs. 800 B- Rs. 700 C- Rs. 500 Service Depts. 1- Rs.
---------------------- 234 2- Rs. 300 The expenses of service depts. are charged out on a percentage
basis as follows:
----------------------
A B C 1 2
---------------------- Service Dept. 1 20% 40% 30% - 10%
Service Dept. 2 40% 20% 20% 20% -
----------------------
You are required to show the apportionment of overheads.
---------------------- Solution:
---------------------- (a) Simultaneous Equation Method:
---------------------- Let x = total overheads of Dept. 1
y = total overheads of Dept. 2
----------------------
∴ x = 234 +2/10 y
----------------------
and y = 300 +1/10 x
---------------------- ∴ 10 x = 2340 + 2y
---------------------- and 10 y = 3000+ x
---------------------- Rearranging equation 1 and multiplying equation 1 by 5
– 10y = 11700 - 50x
----------------------
10y = 3000+ x
----------------------
Adding 0 = 14700 - 49x
---------------------- ∴ 49 x = 14700
---------------------- 49
---------------------- ∴ x = 300
However, Y = 300 + 1/10 x
----------------------
Y = 300 + 1/10 x 300
----------------------
Y = 330
---------------------- Total overheads can be apportioned on the basis of agreed percentages to
production departments as below.
----------------------
----------------------

Total Rs. Dept. A Dept. B Dept. C Notes
Rs. Rs. Rs.
As per Primary appointment 2,000 800 700 500 ----------------------
Dept. 1 (90% of Rs. 300) 270 60 120 90
----------------------
Dept. 2 (80% of Rs. 330) 264 132 66 66
2534 992 886 656 ----------------------
(b) Repeated Distribution Method:
----------------------
Dept. A Dept. B Dept. C Dept. 1 Dept. 2
Rs. Rs. Rs. Rs. Rs. ----------------------
As per primary appointment 800 700 500 234 300
----------------------
Dept. 1 47 94 70 (-) 234 23
Dept. 2 129 65 64 65 (-) 323 ----------------------
Dept. 1 13 26 20 (-) 65 6
Dept. 2 3 1 2 - (-) 6 ----------------------
992 886 656 - -
----------------------
(3) Absorption:
----------------------
The process of secondary apportionment of overheads ensures the loading
of overheads to the production departments. Now the next stage is that each job ----------------------
or product should get the loading of the overheads while it is moving through the
production department and this process is in the form of absorption or recovery ----------------------
of overheads. There can be a number of methods for absorbing the overheads
----------------------
but the ultimate selection of method has to be made after considering various
factors such as type of industry, nature of products, manufacturing process, ----------------------
requirements and policy of management, cost of operating the system etc.
----------------------
The various methods, which can be considered for deciding the rates of
overhead absorption, are as below: ----------------------
(1) Direct materials cost percentage rate: ----------------------
This is calculated as:
----------------------
Amount of overheads to be absorbed
X 100 ----------------------
Direct Materials cost
For example, If production overheads to be absorbed are Rs. 25,000/- and Direct ----------------------
materials cost is Rs. 50,000, the absorption rate will be:
----------------------
25,000
X 100 i.e. 50% ----------------------
50,000
Now if the direct materials cost of a job is Rs. 500, it will get the loading of ----------------------
overheads to the extent of 50% of direct materials cost, i.e. Rs. 250. This method ----------------------
is useful if material cost forms a major part of production cost and is normally
used if material costs are stable and equipment used remains unchanged. ----------------------
This method leads to unsatisfactory results due to following reasons. ----------------------
----------------------
Overhead Costs 163

Notes 1. There can be some situations where material prices vary without any
change in the amount of overheads, in which case, this method may show
---------------------- wrong results.
---------------------- 2. If this method is used, a job using expensive material may get high loading
of overheads as compared to a job using cheap material, which may not
---------------------- be fair.
---------------------- (2) Direct wages percentage rate:
----------------------
----------------------
---------------------- X 100
Direct wages cost
----------------------
For example, if the production overheads to be absorbed are Rs. 10,000 and
---------------------- direct wages cost is Rs. 40,000, the absorption rate will be:
10,000
---------------------- X 100 i.e. 25%
40,000
----------------------
Now if the direct wages cost of a job is Rs. 400, it will get the loading of
---------------------- overheads to the extent of 25% of direct wages cost, i.e. Rs. 100. This method is
useful if labour cost forms a major part of production cost and also if the work
---------------------- performed by all the workers is uniform, ratio of skilled and unskilled workers
---------------------- is constant and labour rates do not fluctuate widely.
The problem with this method is that there is very little relationship
----------------------
between direct wages and overhead expenses. It may give wrong results if the
---------------------- workers vary in ability.
(3) Prime cost percentage rate:
----------------------
---------------------- Amount of overheads to be absorbed
X 100
---------------------- Prime cost
---------------------- For example, if the production overheads to be absorbed are Rs. 16,000 and
prime cost is Rs. 80,000, the absorption rate will be:
----------------------
16,000
---------------------- X 100 i.e. 20%
80,000
---------------------- Now if the prime cost of a job is Rs. 250, it will get the loading of
---------------------- overheads to the extent of 20% of prime cost, i.e. Rs. 50.
This method is useful in the sense that it considers both the materials cost
---------------------- as well as labour cost.
----------------------
----------------------

(4) Labour hour rate: This is calculated as: Notes
----------------------
Labour hours required for production
----------------------
For example, if production overheads to be absorbed are Rs. 50,000 and labour
hours worked are 100,000, the absorption rate will be: ----------------------
Rs. 50,000
i.e. Re. 0.50 per labour hour. ----------------------
100,000
----------------------
Now, if a job requires 20 labour hours to complete it, the loading of
overheads to the same will be Re. 0.50 per labour hour, i.e. Rs. 10/-. ----------------------
This method is useful if labour is the most important element of cost. ----------------------
However, additional records are required to be kept for time booking per
----------------------
job. Further, if machinery forms a dominant portion in production cost, this
method may lead to wrong results. ----------------------
(5) Machine hour rate: ----------------------
----------------------
----------------------
Number of Machine Hours
For example, if production overheads to be absorbed are Rs. 20,000 and machine ----------------------
hours worked as 5000, the absorption rate will be
----------------------
Rs. 20,000
i.e. Rs. 4 per machine hour. ----------------------
5,000
Now if a job requires 25 machine hours to complete, the loading of ----------------------
overheads to the same will be Rs. 4 per machine hour, i.e. Rs. 100. ----------------------
If the machine use accounts for a large element of cost in the overall
----------------------
production cost, then this method can be used conveniently. This rate can be
considered useful and ideal especially in the days of high mechanisation and ----------------------
automation.
----------------------
While computing the machine hour rate, it is necessary to consider the
various overheads required to be incurred for running a machine or group of ----------------------
machines treating the same as distinct cost centres.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Overhead Costs 165

Notes Illustration:
Following information relates to activities of a production department of
----------------------
a factory for a certain period.
----------------------
Direct materials used Rs. 4,000
---------------------- Direct wages Rs. 6,000
---------------------- Direct labour hours worked
---------------------- (Including 20,000 hrs. of Machine operations) 24,000
Overheads chargeable to the dept. Rs. 5,000
----------------------
For order No. 156 carried out in dept., relevant figures were
----------------------
Direct Materials used Rs. 200
----------------------
Direct wages Rs. 165
---------------------- 820
Direct labour hours (Including 800 machine hours)
---------------------- Calculate the overheads chargeable to Order No. 156 by 5 cost rates.
---------------------- Solution:
---------------------- Calculation of overhead absorption rate

(a) Direct Material Cost percentage:
----------------------
Amount of overheads
---------------------- X 100
Direct Material Cost
---------------------- Rs. 5,000
= X 100 = 125%
---------------------- Rs. 4,000
---------------------- (b) Direct Labour Cost percentage:
---------------------- Amount of overheads
X 100
---------------------- Direct Labour Cost
Rs. 5,000
---------------------- = X 100 = 83 1/3%%
Rs. 6,000
----------------------
(c) Direct Cost percentage:
----------------------
Amount of overheads
----------------------
Prime Cost
---------------------- Rs. 5,000
= X 100 = 50%
---------------------- Rs. 10,000
----------------------
----------------------

Notes
(d) Labour Hour Rate:
----------------------
Amount of overheads
X 100 ----------------------
Direct Labour Hours
Rs. 5,000 ----------------------
= Re. 0.2083 / Labour Hour
24,000 ----------------------
(e) Machine Hour Rate: ----------------------

Amount of overheads ----------------------
Machine Hours ----------------------
Rs. 5,000
= = Rs. 0.25 / Machine Hour ----------------------
20,000
----------------------
The overheads chargeable to Order No. 156 and the total cost of the same
----------------------
can be calculated as below:
Material Labour Overheads Total Rs. ----------------------
Rs. Rs. Rs. ----------------------
a Direct Material Cost Percentage 200.00 165.00 250.00* 615.00
b Direct Labour Cost Percentage 200.00 165.00 137.50 502.50 ----------------------
c Prime Cost Percentage 200.00 165.00 182.50 547.50
d Labour Hour Rate 200.00 165.00 170.83 535.83 ----------------------
e Machine Hour Rate 200.00 165.00 200.00 565.00
----------------------
* 200 x 125% = 250
----------------------
Illustration:
Compute the machine hour rate from the following data: ----------------------
Cost of the machine Rs. 1,00,000 ----------------------

Installation charges Rs. 10,000
Estimated scrap value after the expiry of life (15 years) Rs. 5,000 ----------------------
Rent and Rates for the shop per month Rs. 200 ----------------------
General lighting for the shop per month Rs. 300
Insurance charges for the machine per annum Rs. 960 ----------------------
Repairs and Maintenance expenses per month Rs. 1,000
Power consumption 10 Units per hour ----------------------
Estimated working hours per annum 2,200 (This includes
----------------------
setting up time of
200 hours) ----------------------
Rate of power per 100 Units Rs. 20
Shop supervisor’s salary per month Rs. 600 ----------------------
The machine occupies 1/4 of the total area of the shop. The supervisor is ----------------------
expected to devote 1/5 of the total time for the supervision of the machine.
----------------------
Overhead Costs 167

Notes Calculation of Machine Hour Rate:
(a) Standing Charges Rs.
----------------------
Depreciation 7,000.00
---------------------- Rent and Rates 600.00
General lighting 900.00
---------------------- Insurance Charges 960.00
Repairs and Maintenance 12,000.00
---------------------- Shop Supervisor’s salary 1,440.00
---------------------- Annual standing charges 22,900.00
Annual Machine Hours ((Excluding setting up time) 2000
---------------------- Hourly standing charges Rs. 11.45
(b) Running charges
---------------------- Power Expenses
Rate of power 20 paise per unit
----------------------
Power consumption - 10 units per hour
---------------------- Hourly power expenses Rs. 2.00
(c) Machine Hour Rate i.e. a + b Rs. 13.45
---------------------- Working Notes:
---------------------- 1. It is assumed that during the setting up time, the machine will not be
used for the intended purpose and hence the said time is ignored for the
----------------------
calculation of machine hour rate.
---------------------- 2. It is assumed that the depreciation is charged on straight-line basis.
---------------------- Hence, it is calculated as:
Cost of Machine + Installation charges – Estimated scrap value
----------------------
Estimated life of machine
----------------------
Rs. 100,000 + Rs. 10,000 – Rs. 5,000
---------------------- = = Rs. 7,000 p.a.
15 years
----------------------
3. It is assumed that the Repairs and Maintenance expenses are incurred
---------------------- only for the machine.
----------------------
Activity 2
----------------------
---------------------- Meet the finance manager of any manufacturing company and discuss the
methods followed for absorption of overheads.
----------------------
---------------------- 8.4 ACTUAL V/S PREDETERMINED OVERHEAD

ABSORPTION RATES
----------------------
---------------------- The overhead absorption rates can be considered on actual basis or

predetermined basis. For computing the absorption rates on actual basis, the
---------------------- actual data for the previous period is considered, i.e. actual overheads, actual

direct materials/wages cost, actual prime cost, actual labour hours worked, Notes
actual machine hours worked etc. However, the actual overhead absorption
rates have certain limitations. ----------------------
1. The actual details are available only after the end of actual accounting ----------------------
period and required details may not be available either for proper control
of overheads or for price fixation. ----------------------
2. If the production is of seasonal nature, overhead absorption rates will not ----------------------
be constant month-wise and comparison of month-wise production costs
will be difficult. ----------------------
As such, it is customary to consider predetermined overheads absorption ----------------------
rates instead of actual overhead absorption rates. By predetermined rates, it is
meant that instead of considering actual data in respect of Direct Materials/ ----------------------
Wages/Prime Cost or Labour/Machine Hours, estimations are made in respect
----------------------
of the same and predetermined overhead absorption rate is applied whenever
computations are to be made in respect of product cost of a job. ----------------------
8.5 UNDER AND OVER ABSORPTION OF OVERHEADS ----------------------
----------------------
If the organization follows the policy of considering predetermined
overhead absorption rates, it may face the problem of under or over absorption of ----------------------
overheads if the actual overheads to be absorbed or the bases for the absorption,
i.e. Materials/ Wages/ Prime cost or Labour/Machine Hours etc. vary from the ----------------------
assumption. For example, a company considers the overhead absorption rate
----------------------
as a direct materials cost percentage rate. It is decided that the predetermined
overhead absorption rate should be considered for the forthcoming year 1989. As ----------------------
such, the predetermined overhead rate was estimated on the basis of following
details. ----------------------
Estimated amount of overheads ----------------------
X 100
Estimated Direct Material Cost ----------------------
----------------------
Rs. 10,000
X 100 i.e. 20% ----------------------
Rs. 50,000
----------------------
Now, on this basis, all the jobs moving through that department during
1989 will be getting the loading of overheads @ 20% of direct materials costs. ----------------------
After the end of 1989, the actual details are computed and it is found out ----------------------
that whereas direct materials cost was as estimated, i.e. Rs. 50,000, the actual
amount of overheads was reduced to Rs. 9,000. As such, the rate at which the ----------------------
overheads should have been absorbed, should have been:
----------------------
Rs. 9,000
X 100 i.e. 18% and not 20% as originally considered ----------------------
Rs. 50,000
----------------------
Overhead Costs 169

Notes Such a situation gives rise to under absorption or over absorption of
overheads.
----------------------
The situation of under absorption arises if the overheads absorbed are
---------------------- less than the actual overheads. The situation of over absorption arises if the
overheads absorbed are more than the actual overheads.
----------------------
Example Overheads Actual Remarks
---------------------- Period Absorbed Rs. Overheads Rs.
I 7,500 9,000 Under-absorption
---------------------- II 10,000 8,000 Over-absorption
---------------------- Under-absorption of overheads may take place due to the following reasons:
●● Actual overheads being more than the estimated overheads
----------------------
●● Actual output or hours worked being less than those as estimated
----------------------
Over - absorption of overheads may take place due to the following reasons:
---------------------- ●● Actual overheads being less than the estimated overheads
---------------------- ●● Actual output or hours worked being more than those as estimated
---------------------- 8.6 TREATMENT OF UNDER OR OVER ABSORBED

---------------------- OVERHEADS
---------------------- The overheads, which are under or over absorbed, may be treated in either
of the following ways:
----------------------
(1) Use of supplementary rate: If the amount of under or over absorbed
---------------------- overheads is considerably significant, the cost of the cost centers may
be adjusted by means of the use of supplementary overhead absorption
---------------------- rate. This method of treating the over or under absorption of overheads is
most important where the cost is considered as a base for quoting selling
----------------------
prices, for example, cost plus contracts.
---------------------- For example, the predetermined overhead absorption rate, for the
---------------------- forthcoming period of months, was decided as below.
Amount of overheads Rs. 50,000
---------------------- = = Rs. 2 / Labour Hour
Total labour Hours 25,000
----------------------
A mid-term review of six monthly operations revealed that whereas the total
----------------------
labour hours during the period were 12,500, the amount of overheads incurred
---------------------- was Rs. 30,000. The overheads actually absorbed will be 12,500 hours x Rs.
2, i.e. Rs. 25,000. Considering the same trend of amount of overheads, the
---------------------- total annual overheads are likely to be Rs. 60,000, out of which Rs. 25,000 are
already absorbed. As such, for the remaining 6 months, the overhead absorption
----------------------
rate may be calculated as:
---------------------- Revised amount of overheads
---------------------- Number of Labour Hours

Rs. 60,000 – Rs. 25,000 Notes
=
12,500 ----------------------
Rs. 35,000 ----------------------
= = Rs. 2.80 / Labour Hour
12,500 ----------------------
(2) Carrying over to the remaining period: In case of the seasonal types ----------------------
of organization, the overheads under or over absorbed during a certain
period may be carried over to the remaining part of the accounting period ----------------------
with the hope that they may be compensated during the remaining period ----------------------
of time.
----------------------
(3) Writing off to Costing Profit and Loss Account: In case of the
under or over absorption of the overheads arising out of the abnormal ----------------------
circumstances, they are written off to Costing Profit and Loss Account.
----------------------
Illustration:
The budgeted working conditions of a cost centre are as follows: Normal ----------------------
working per week -42 hours No. of machines -14 Normal weekly loss of hours
----------------------
on maintenance etc. -5 hours per machine No. of weeks worked per year -48
Estimated annual overheads -Rs. 1,24,320 Estimated direct wage rate -Rs. 4 ----------------------
per hour. Actual result in respect of a 4 week period are: Wages incurred -Rs.
9,000 Overheads incurred -Rs. 10,200 Machine hours produced -2,000 You are ----------------------
required to calculate:
----------------------
(a) The overhead rate per machine hour
----------------------
(b) The amount of under or overabsorption of wages and overheads.
Solution: ----------------------
(a) Normal working hours per year – 42 weekly hours per machine ----------------------
(For all 14 machines) x 14 machines x 48 weeks = 28,224 machine ----------------------
hours.
----------------------
(b) Hours lost on maintenance – 5 hours per week x 14 machines
x 48 weeks = 3,360 machine hours. ----------------------
(c) Effective machine hours i.e., a - b – 24,864 machine hours. ----------------------

(d) Estimated annual overheads – Rs. 1,24,320 ----------------------
(e) Machine hour rate i.e., d / c – Rs. 5
----------------------
(f) Overheads absorbed – 2000 machine hours x Rs. 5 – = Rs. 10,000
----------------------
(g) Overheads actually incurred – Rs. 10,200
(h) Overheads underabsorbed i.e., g - f – Rs. 200 ----------------------
----------------------
----------------------
Overhead Costs 171

Notes WAGES
(a) Labour hours for 4 weeks – 42 hours x 4 week = 168 hours
----------------------
(b) For 14 machines – 168 hours x 14 machines = 2,352 hours
---------------------- (c) Estimated direct wage rate – Rs. 4 per hour
---------------------- (d) Estimated direct wages for 4 weeks i.e., b x c – Rs. 9,408
(e) Wages actually incurred – Rs. 9,000
---------------------- (f) Wages over absorbed i.e., d-e – Rs. 408
----------------------

---------------------- 1. The overhead absorption rates can be considered on actual basis or
predetermined basis.
----------------------
2. Fixed costs tend to vary with time rather than level of activity.
----------------------
3. Margin of Safety can be expressed as a ratio or as a percentage.
---------------------- 4. Product mix refers to the proportion of the component in the production
process.
----------------------
5. A business will like to have high Margin of Safety because this is Safe
---------------------- production technique.
----------------------
----------------------
Activity 3
----------------------
Go to a nearby manufacturing unit and discuss with the manager the
---------------------- effects of under and over absorption of overheads in costing. Mention any
---------------------- two distinguishing points in this regard.
----------------------
8.7 CONTROL OVER OVERHEADS
----------------------
As the basic intention of cost accounting is to exercise control over the costs
----------------------
and as the overheads is a part of the cost, cost accounting procedures attempt to
---------------------- control the overheads also. For this purpose, the following propositions should
be remembered:
----------------------
(1) The success of procedures to control the overheads largely depends upon
---------------------- the correct classification of the overheads. This classification can be done
from various angles.
----------------------
(a) Function wise: This takes the form of classification in the form
---------------------- of factory overheads, administration overheads and selling and
distribution overheads.
----------------------

(b) Variability wise: This takes the form of classification in the form Notes
of fixed overheads, variable overheads and semi-fixed or semi-
variable overheads. ----------------------
(c) Normality wise: This takes the form of classification in the form of ----------------------
normal overheads and abnormal overheads.
----------------------
Fixed overheads normally arise as a result of policy and are largely
uncontrollable at the lower level of management. They can be controlled ----------------------
at the top level of management. However, variable overheads can be
controlled at the lower or middle level of management as well. ----------------------
Most of the administration overheads are fixed in nature and can be ----------------------
controlled mainly at top management level. However, the factory
overheads can be controlled at lower or middle management level also. ----------------------
(2) After the correct classification of overheads, use may be made of the ----------------------
following two techniques with the intention to exercise proper control
over overheads. ----------------------
(a) Budgetary control ----------------------

(b) Standard costing ----------------------
Both these techniques are discussed in detail in the following units.
----------------------
These techniques necessarily involve the following stages in the process of
implementation. ----------------------
(i) Planning: This lays down the course of action to be taken in future.
----------------------
In case of budgetary control, it is in the form of the budgets and in
case of standard costing, it is in the form of the standard cost. ----------------------
(ii) Implementation of plan: This indicates actual steps to execute the ----------------------
plan. For this, downward communication may be necessary from
top management level to lower management level. ----------------------
(iii) Measuring actual performance, comparison with plans and ----------------------

computing variances: Measurement of actual performance may
be in terms of actual costs or actual output. Actual costs and actual ----------------------
output is compared with the planned performance and variations, if ----------------------
any, are calculated.
----------------------
(iv) Analysis of variances and decision-making: Variations between
the actual performance and the planned performance is required ----------------------
to be analyzed as to the causes and proper corrective actions are
required to be taken to remove unfavorable variations or maintain ----------------------
favorable variations.
----------------------
(3) Classification of overheads as fixed and variable facilitates the preparation
of flexible budgets, which provides proper base for comparison in the ----------------------
form of budgeted overheads for any level of activity actually attained.
----------------------
Flexible budgets may be treated as an improved method to control the
overheads. ----------------------
Overhead Costs 173

Notes
Activity 4
----------------------
“The success of procedures to control the overheads largely depends upon
----------------------
the correct classification of these overheads.” Discuss this with the manager
---------------------- of a manufacturing unit.
----------------------
Summary
----------------------
●● The sum total of indirect costs is termed as overheads. The classification
----------------------
of overheads is done element-wise, function-wise, variability-wise,
---------------------- controllability-wise, normality-wise etc. The basic aim of costing is to
find out the cost of each cost centre. To charge the indirect costs, i.e.
---------------------- overheads, to the individual cost centres, the procedure followed is
through the apportionment, as identifying the common costs with the
----------------------
individual departments is the first stage, called as primary apportionment
---------------------- of cost. Next is to transfer the overheads of non-production departments
to production departments, as the various cost centres move through
---------------------- the production departments only. This is in the form of ‘secondary
apportionment or distribution of overheads’. Now the next stage is that
----------------------
each job or product should get the loading of the overheads while it is
---------------------- moving through the production department and this process is in the form
of absorption or recovery of overheads.
----------------------
●● Various methods that can be considered for deciding the rates of
---------------------- overhead absorption are Direct Materials Cost Percentage Rate, Direct
Wages Percentage Rate, Prime Cost Percentage Rate, Labour Hour Rate,
---------------------- Machine Hour Rate. The overhead absorption rates can be considered
on an actual or predetermined basis. For computing the absorption rates
----------------------
on actual basis, the actual data for the previous period is considered, i.e.
---------------------- actual overheads, actual direct materials/wages cost, actual prime cost,
actual labour hours worked and actual machine hours worked. If the
---------------------- organization follows the policy of considering predetermined overhead
absorption rates, it may face the problem of under or over absorption
----------------------
of overheads if the actual overheads to be absorbed or the bases for the
---------------------- absorption, i.e. materials/ wages/ prime cost or labour/machine hours etc.
vary from the assumption.
---------------------- ●● The overheads, which are under or over absorbed, may be treated the use of
---------------------- supplement rate, carrying over the overheads to remaining period or writing
off the overheads to Profit and Loss account. The basic intention of cost
---------------------- accounting is to exercise control over the costs and as the overheads is a part
of cost, cost accounting procedures attempt to control the overheads also.
---------------------- The success of procedures to control the overheads largely depends upon
---------------------- the correct classification of the overheads. This classification can be done
from various angles such as function-wise, variability-wise, normality-
---------------------- wise. After the correct classification of overheads, use may be made of two

techniques with the intention to exercise proper control over overheads: (a) Notes
budgetary control (b) standard costing.
----------------------
Keywords ----------------------
●● Element-wise classification of overheads: Overheads may be classified ----------------------
as per the elements of cost, i.e. indirect material cost, indirect labour cost
and indirect expenses ----------------------
●● Function-wise classification of overheads: Overheads are classified ----------------------
according to the functions they perform, e.g. factory overheads (also termed
as production or works or manufacturing overheads), administration ----------------------
overheads, selling and distribution overheads.
----------------------
●● Fixed Overheads: These overheads indicate the costs that remain
unaffected by variations in volume of output. Per unit cost of overheads ----------------------
may reduce, as the volume of output increases but the total overheads
remain constant. ----------------------
●● Primary apportionment or distribution of overheads: It is not possible ----------------------
in all the cases to allocate the overheads, i.e. in case of common expenses
for the entire factory. Hence, they can be apportioned among the various ----------------------
departments on some suitable basis, i.e. to all production as well as service ----------------------
departments. Such apportionment is termed as primary apportionment.
●● Secondary apportionment or distribution of overheads: This is ----------------------
the process of transferring the overheads of service departments to ----------------------
production departments. As a result of secondary apportionment of
overheads, overheads of the organization as a whole are identified only ----------------------
with production departments.
----------------------
●● Semi-variable Overheads: These overheads are neither fixed nor
variable in nature. These may remain fixed at certain levels of activity but ----------------------
may vary proportionately at other levels of activity.
----------------------
●● Variable Overheads: These overheads indicate the costs, which vary
directly in proportion to volume of output. Per unit cost of overheads ----------------------
remains the same but total overheads may increase or decrease as per
volume of output. ----------------------
----------------------
----------------------
(1) Meera Industries Limited is a single product organization having a
manufacturing capacity of 6,000 units per week of 48 hours. The output ----------------------
data vis-a-vis different elements of cost for three consecutive weeks are
given below: ----------------------
Units Direct Direct Total factory overheads ----------------------

Produced Material Rs. Labour Rs. (Variable and Fixed) Rs. ----------------------
2,400 4,800 6,000 37,200
----------------------
Overhead Costs 175

Notes 2,800 5,600 7,000 38,400
---------------------- 3,600 7,200 9,000 40,800
---------------------- As a cost Accountant, you are asked by the company to work out the selling
price, assuming level of 4,000 units per week and a profit of 20% on selling
---------------------- price.
---------------------- Solution:
It can be observed that an increase in production by 400 units increases the total
----------------------
factory overheads by Rs. 1,200 indicating that per unit variable overheads are
---------------------- Rs. 3. Hence, at the activity level of 2,400 units, the total variable overheads
are Rs. 7,200, i.e. 2400 units x Rs.3 per unit, out of total overheads of Rs. 37,
---------------------- 200. Hence, the balance amount represents fixed overheads. It should be noted
that the direct material cost and direct labour cost represents the variable cost of
----------------------
production. At 2,400 units, per unit cost is as below:
---------------------- Direct material - Rs. 4800 / 2400 units = Rs. 2 / per unit.
---------------------- Direct Labour - Rs. 6000 / 2400 units = Rs. 2.5 per unit
---------------------- The cost sheet for the production of 4000 units can be worked out as below:
Cost Sheet - 4000 units
----------------------
Per Unit Rs. Total Rs.
---------------------- Direct Material Cost 2.00 8,000
Direct Labour Cost 2.50 10,000
----------------------
Variable Overheads 3.00 12,000
---------------------- Fixed Overheads 7.50 30,000
Total Cost 15.00 60,000
---------------------- Add: Profit, i.e. 20% of selling price or 25% of
total cost 3.75 15,000
---------------------- Sales 18.75 75,000
----------------------
----------------------
1. Discuss the factors that would create under-absorbed and over-absorbed
----------------------
factory overheads.
---------------------- 2. Mention the broad principles on which overhead expenses are generally
apportioned. Upon what basis would you apportion the following expenses
----------------------
to individual cost centres in an engineering unit?
---------------------- a. Rent
---------------------- b. Power
c. Fire insurance premium
----------------------
d. Lighting
---------------------- 3. Explain the terms ‘under-absorption’ and ‘over-absorption’ of overheads.
Explain any three methods of absorbing production overheads into the
----------------------
cost of production.
4. Distinguish between actual and predetermined rates for absorption of Notes
factory overheads. Cite the major problems involved in using actual rates
and discuss how predetermined rates eliminate this problem. ----------------------
5. How do you deal with under or over absorption of overheads? Mention ----------------------
various items that go into:
----------------------
(a) Manufacturing overheads
(b) Administration overheads ----------------------
(c) Selling overheads
----------------------
(d) Distribution overheads
----------------------
6. Which basis would you recommend for the apportionment of the following
items of expenses to production departments? Give your justification for ----------------------
the suggested one.
----------------------
(a) Internal transport
(b) Air-conditioning ----------------------
(c) General factory maintenance ----------------------
(d) Stores
(e) Rent ----------------------
(f) Labour office ----------------------
7. What is meant by apportionment of overheads? What can be considered ----------------------
as a good base for apportioning the following overheads with reference to
a diesel engine manufacturing company? ----------------------
i. Internal transport ----------------------
ii. Timekeeping expenses
iii. Shop supervision ----------------------
iv. Power, lighting and other utilities ----------------------
Q8. Write short notes: ----------------------
(a) Machine hour rate
(b) Control of overheads ----------------------
(c) Under-absorption and over-absorption of overheads
----------------------
(d) Treatment of over- absorption of overheads
(e) Primary and secondary apportionment of overheads ----------------------
Problems
----------------------
Problem (1) XYZ Ltd., a manufacturing company, having an extensive marketing
network throughout the country sells its products through four zonal sales offices, ----------------------
viz. A, B, C and D. The budgeted expenditure for the year is given below: ----------------------
Rs.
----------------------
Sales manager’s salary 1,20,000
Expenses relating to Sales Manager’s office 80,000 ----------------------
Travelling salesmen’s salaries 3,20,000
----------------------
Overhead Costs 177

Notes Travelling expenses 36,000
Advertisement 30,000
---------------------- Godown Rent-Zone A 15,000
B 25,200
----------------------
C 9,800
---------------------- D 18,000
68,000
---------------------- Insurance on inventories 20,000
Commission on sales @ 5% on sales 6,00,000
----------------------
The following further particulars are also available:
----------------------
A B C D
---------------------- Sales (Rs. in lakhs) 36 48 16 20
No. of salesmen 5 6 2 3
----------------------
Total mileage covered 6000 14000 4500 5500
---------------------- Allocation of Advertisement 30% 30% 20% 20%
---------------------- Average stock (Rs. in lakhs) 6 8 4 2
Based on the above details, compute zone-wise selling overheads, as a
----------------------
percentage to sales.
---------------------- Problem (2) The following yearly charges are incurred in respect of a machine
where work is done by means of 5 machines of exactly the same type.
----------------------
(1) Rent and rates Rs. 4,800
---------------------- (2) Depreciation on each machine Rs. 500
---------------------- (3) Repairs and maintenance of 5 machines Rs. 1,000
(4) Power consumed (as per meter, at 5 paise per unit) Rs. 3,000
---------------------- (5) Electric charges for the shop Rs. 450
(6) Two attendants looking after 5 machines and being
---------------------- paid Rs. 700 per year each Rs. 1,400
Supervision – One supervisor looking after 5 machines Rs. 3,000
---------------------- (7)
and paid
---------------------- (8) Sundry supplies for the shop Rs. 450
The machine uses 10 units of power per hour. Calculate the machine hour rate.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Solutions Notes
Problem 1
----------------------
Solution:
----------------------
Calculation of Sales Overheads - Zone wise
Items Base Total A B C D ----------------------
Rs. Rs. Rs. Rs. Rs.
1. Sales Manager’s Sales 1,20,000 36,000 48,000 16,000 20,000 ----------------------
Salary
2. Expenses of Sales Sales 80,000 24,000 32,000 10,667 13,333
----------------------
Manager’s office
3. Travelling No. of 3,20,000 1,00,000 1,20,000 40,000 60,000
----------------------
salesmen’s Salaries Salesman
----------------------
4. Travelling Mileage 36,000 7,200 16,800 5,400 6,600
Expenses covered
----------------------
5. Advertisement Allocation 30,000 9,000 9,000 6,000 6,000
6. Godown Rent Allocation 68,000 15,000 25,200 9,800 18,000 ----------------------
7. Insurance on Average stock 20,000 6,000 8,000 4,000 2,000
inventories ----------------------
8. Sales Commission Sales 6,00,000 1,80,000 2,40,000 80,000 1,00,000
Total Overheads 12,74,000 3,77,200 4,99,000 1,71,867 2,25,933 ----------------------
Sales in lakh Rs. 120 36 48 16 20
Overheads as % of 10.62% 10.48% 10.40% 10.74% 11.30% ----------------------
sales
Problem 2 ----------------------
Solution: ----------------------
Calculation of Machine Hour Rate ----------------------
Rs.
(a) Standing charges: ----------------------
Rent and rates 960
----------------------
Depreciation 500
Repairs and maintenance 200 ----------------------
Electricity charges 90
Attendants’ salary 280 ----------------------
Supervisors’ salary 600
Sundry supplies 90 ----------------------
Annual standing charges 2,720
----------------------
Annual machine working hours 1,200
Hourly standing charges Rs. 2.27 ----------------------
----------------------
(b) Running charges:
Power charges - Rate of power - 5 paise per unit ----------------------
Power consumption - 10 units per hour
----------------------
Hourly power expenses Rs. 0.50
----------------------
----------------------
Overhead Costs 179

Notes (c) Machine Hour Rate, i.e. a + b Rs. 2.77
Working Notes:
---------------------- Number of machine working hours is calculated as below:
(a) Total power cost for the shop - Rs. 3.000
----------------------
(b) Power cost relating to the machine -Rs. 600
---------------------- (c) Rate of power - 5 paise per unit
(d) Total power consumption in units -
---------------------- Rs. 600 = 12.000 units Paise 5
(e) Rate of power consumption -10 units per
---------------------- hour
---------------------- (f) If total units consumed are 12.000 and if rate of
power consumption is 10 units per hour, it means that the
---------------------- machine must have worked for 1,200 hours.

----------------------
1. True
---------------------- 2. True
3. True
----------------------
4. False
---------------------- 5. False
----------------------
Suggested Reading
----------------------
1. http://www.leanuk.leanconstruction.org/pdf/IGLC02Kim-Ballard.pdf
---------------------- 2. Edward J. Vanderbeck, Maria R. Mitchell, Principles of Cost Accounting
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Marginal Costing
UNIT
9
Structure:
9.1 Introduction
9.2 Classification of Cost
9.3 Concept of Marginal Costing
9.4 Forms of Operating Statement
9.5 Basic Concepts of Marginal Costing
9.6 Graphical Presentation of Cost-Volume-Profit Relationships
9.7 Practical Applications of Marginal Costing
9.8 Problem of the Key Factor
9.9 Multiplicity of the Key Factor
9.10 Limitations of Marginal Costing
Summary
Key Words
Suggested Reading
Marginal Costing 181

Notes
Objectives
----------------------
• State the behaviour of cost and its classification.
----------------------
• Explain the concept of marginal costing.
---------------------- • Evaluate the limitations of marginal costing.
• Construct the operating statement.
----------------------
• Assess the applied concepts of marginal costing.
---------------------- • Analyse and criticize the uses, application, merits of marginal
---------------------- costing techniques.
----------------------
9.1 INTRODUCTION
----------------------
In the conventional system of cost ascertainment, the direct cost may be
---------------------- identified with the individual cost centre. However, the indirect costs, i.e. the
---------------------- overheads, are identified with the individual cost centre on the most equitable
basis. This results into some problems in the process of managerial decision-
---------------------- making.
---------------------- a) The above process does not take into consideration the behaviour of cost.
All the costs in the practical circumstances do not behave in the same
---------------------- manner. Some of the costs tend to remain constant despite the changes
in the level of activity or volume of operations. These types of costs are
---------------------- comparatively irrelevant in the managerial decision-making.
---------------------- b) The above process results into under absorption or over absorption of
overheads.
----------------------
The said limitations have given rise to a managerial decision-making
---------------------- technique that tries to classify the costs based upon the behaviour of cost. The
technique is referred to as Marginal Costing. The basic proposition made by this
----------------------
technique is that the costs should be classified on the basis of behaviour of the
---------------------- costs. From this angle, the costs can be viewed as fixed costs and variable costs.
---------------------- 9.2 CLASSIFICATION OF COST

---------------------- Fixed Cost is the cost that tends to remain constant irrespective of the
---------------------- level of activity or volume of operations. Fixed Cost tends to vary with time
rather than with the level of activity. The basic characteristic feature of the
---------------------- fixed cost is that this cost in terms of amount may remain constant at all the
levels of activities. However, the per unit fixed cost goes on decreasing with the
---------------------- increasing level of activity and vice-a-versa.
---------------------- Variable Cost is the cost that varies in direct proportion with the level
of activity or volume of operations. Basic characteristic feature of variable
----------------------

cost is that variable cost in terms of amount may increase or decrease with the Notes
changing level of activity or volume of operations. However, per unit variable
cost remains constant. ----------------------
In practical circumstances, some costs may not be entirely fixed or entirely ----------------------
variable. They are technically in the form of semi-fixed costs or semi-variable
costs. For the purpose of marginal costing, the semi-fixed costs or semi-variable ----------------------
costs are required to be classified in the individual components of fixed cost and
----------------------
variable cost.
For segregating the semi-fixed or semi-variable cost into the individual ----------------------
components of fixed cost and variable cost, various techniques or methods may
----------------------
be available:
●● Comparison by period or level of activity ----------------------
●● Range or High and Low method ----------------------
●● Analytical method ----------------------
●● Scatter graph method
----------------------
●● Lease Square method
----------------------
Based upon the above discussions, let us make some calculations for
a manufacturing organization manufacturing and selling a single product, ----------------------
operating at various levels of activities.
----------------------
Level of Activity – Units 1000 1500 2000
----------------------
Per Unit Selling Price – Rs. 100 100 100
----------------------
Total Sales – Rs. 1,00,000 1,50,000 2,00,000
Variable Cost – Rs. 60,000 90,000 1,20,000 ----------------------
Fixed Cost – Rs. 30,000 30,000 30,000 ----------------------
Total Cost – Rs. 90,000 1,20,000 1,50,000
----------------------
Per Unit Variable Cost – Rs. 60 60 60
----------------------
Per Unit Fixed Cost – Rs. 30 20 15
Per Unit Total Cost – Rs. 90 80 75 ----------------------
It can be observed from the above calculations that if the fixed cost ----------------------
is included in the calculation of total cost, per unit total cost becomes non-
----------------------
comparable with the changes in the level of activity in one cost-period to another
cost-period. To avoid this non-comparability, it is necessary to eliminate the ----------------------
fixed costs while determining the total cost.
----------------------
As such, the technique of marginal costing proposes that fixed cost tends
to remain stagnant at least over a shorter period of time and hence should ----------------------
be ignored in the entire decision-making process. As such, marginal costing
considers only the variable cost as the relevant cost in the decision-making ----------------------
process.
----------------------

Notes
----------------------
---------------------- Fill in the blanks:

1. ____________________Cost is the cost that tends to remain constant
----------------------
irrespective of the level of activity or volume of operations
---------------------- 2. ____________________ Cost is the cost that varies in direct
---------------------- proportion with the level of activity or volume of operations
----------------------
---------------------- Activity 1
---------------------- Briefly explain the fixed and variable costs of a manufacturing process
---------------------- of a concern and list any two techniques to segregate these costs.
---------------------- 9.3 CONCEPT OF MARGINAL COSTING

----------------------
Marginal cost is defined as the amount at any given volume of output
---------------------- by which the aggregate costs are changed if the volume of output is increased
or decreased by one unit. The aggregate cost consists of both fixed cost and
---------------------- variable cost. In the short run, fixed costs remain constant irrespective of changes
in the volume, aggregate costs may increase or decrease with the changes in
----------------------
volume, specifically due to variable cost. As such, in simple words, marginal
---------------------- cost indicates the Per Unit Variable Cost.
Marginal costing is defined as the ascertainment, by differentiating
----------------------
between fixed and variable costs, of the marginal costs and of the effect on
---------------------- profit of changes in volume and type of output.
Basic assumptions made by marginal costing
----------------------
The entire technique of marginal costing is based upon the following assumptions.
----------------------
a) Variable cost varies in direct proportion with the level of activity. However,
---------------------- per unit variable cost remains constant at all the levels of activities.
---------------------- b) Per unit selling price remains constant at all the levels of activities.
c) Whatever is produced by the organization is sold off. In other words,
----------------------
there are no variations due to the stock.
---------------------- Features of Marginal Costing
---------------------- 1. The product costs are classified as fixed costs and variable costs. Semi-
variable costs are also classified in their individual components of fixed
---------------------- cost and variable cost.
---------------------- 2. Only variable costs are considered while computing the product costs.
The closing stock of finished goods and semi-finished goods is valued
---------------------- after considering variable costs only.

3. Fixed costs are written off during the period of incurrence and hence do not Notes
find a place in the product cost determination or the inventory valuation.
----------------------
4. Prices of the products are based on variable costs only.
5. Profitability of the products or departments is decided in terms of marginal ----------------------
contribution.
----------------------
Marginal costing and cost-volume-profit relationship
----------------------
The definition of the term “marginal costing” requires the computation
of: ----------------------
a) Marginal Cost ----------------------
As stated earlier, marginal cost is the additional cost for manufacturing
one additional unit, which is nothing else but the variable cost per unit. ----------------------
Thus, the marginal cost or variable cost includes the direct cost plus the ----------------------
variable overheads. Fixed overheads are clubbed with the fixed cost.
----------------------
b) Cost volume-profit relationship
The intention of every business activity is to earn and maximize profit. ----------------------
Determination of the profits depends upon the interplay between the
----------------------
following factors and there exists a close relationship among these factors:
(1) Selling price per unit and total sales amount. ----------------------
(2) Total cost, which in its turn may be in the form of variable cost or fixed cost. ----------------------
(3) Volume of sales. ----------------------
Cost-volume-profit analysis aims at studying the relationships existing
----------------------
among these factors and its impact on the amount of profits.
The relationships existing among these factors may be basically presented in ----------------------
two forms.
----------------------
(a) In statement or report form
----------------------
(b) In graphical form, the graphs or charts taking the form of breakeven chart,
contribution breakeven chart or profit chart. ----------------------
CVP Grap h
Profit area ----------------------
Sales
30,000
Total Costs ----------------------
25,000
----------------------
20,000
Variable
$
15,000
Costs ----------------------
Break-even
10,000 ----------------------
5,000 Fi xex
Costs ----------------------
0 10,000 20,000 30,000 40,000 50,000 60,000 70,000
Loss area ----------------------
Units
[Source: http://media.wiley.com/Lux/52/21152.ngr006.jpg] ----------------------

Notes
----------------------
---------------------- Fill in the blanks:

1. The _____________cost consists of both fixed cost and variable cost.
----------------------
2. _____________cost is defined as the amount at any given volume
---------------------- of output by which the aggregate costs are changed if the volume of
output is increased or decreased by one unit.
----------------------
3. Per unit ____________ price remains constant at all the levels of
---------------------- activities.
----------------------
---------------------- Activity 2
---------------------- Discuss any four assumptions and features of marginal costing. Name an
---------------------- organization where you have found the application of this concept.
----------------------
9.4 FORMS OF OPERATING STATEMENT
----------------------
Under the marginal costing technique, the operating statement takes the
---------------------- form as specified below.
---------------------- (a) In case of a single product company
---------------------- Sales Rs.
Less: Marginal cost xxx
---------------------- Direct Material Cost xxx
Direct Labour Cost xxx
----------------------
Direct Expenses xxx
---------------------- Variable Overheads xxx
Contribution xxxx
---------------------- Less: Fixed costs xxxx
Profit xxxx
----------------------
(b) In case of a multi - product company
---------------------- Product A Product B Product C Total
---------------------- Rs. Rs. Rs. Rs.
Sales x x x x
---------------------- Less: Marginal cost
---------------------- Direct Material Cost x x x x
Direct Labour Cost x x x x
---------------------- Direct Expenses x x x x
Variable Overheads x x x x
---------------------- Contribution x x x x
Less: Fixed costs x
----------------------
Profit x
9.5 BASIC CONCEPTS OF MARGINAL COSTING Notes
(1) Basic equation of Marginal Costing: ----------------------

The basic intention of the business is to earn the profit, which is the excess ----------------------
of sales over the total costs.
----------------------
∴ Profit = Sales - Total Cost
However, total cost can be either fixed cost or variable cost. As such, the ----------------------
basic equation takes the following forms.
----------------------
∴ Profit = Sales - (Variable Cost + Fixed Cost)
----------------------
∴ Profit = Sales - Variable cost - Fixed cost
∴ Profit + Fixed cost = Sales - Variable cost ----------------------
This is the basic equation of marginal costing. Both the expressions ----------------------
of (Sales - Variable Cost) and (Profit + Fixed cost) are technically termed as
----------------------
contribution.
∴ Sales - Variable Cost = Contribution = Fixed Cost + Profit ----------------------
∴ Contribution - Fixed cost = Profit ----------------------
(2) Contribution: ----------------------
As discussed earlier, the term contribution can be expressed in two ways:
----------------------
(a) Sales - Variable Cost
----------------------
(b) Fixed cost + Profit
As in the short period, fixed costs are ineffective due to their stagnant ----------------------
nature; variable cost becomes the most important cost in deciding the
----------------------
profitability. As such, the situation that generates higher contribution is treated
as profitable situation. ----------------------
Further, the term contribution plays an important role in a situation where ----------------------
there are more than one product and the profits on individual products cannot
be ascertained due to the problems of apportionment of fixed costs to different ----------------------
products. This is because the fixed costs are ignored by marginal costing.
----------------------
(3) Profit Volume (P/V) Ratio:
This ratio indicates the contribution earned with respect to one rupee of ----------------------
sales. As such, it is expressed as ----------------------
Contribution
X 100 ----------------------
Sales
----------------------
As, in the short run, fixed cost remains the same, if there is any change in
profits, that is only due to change in contribution. Hence, P/V ratio may also be ----------------------
expressed as:
Change in Profits ----------------------
X 100
Change in Sales ----------------------

Notes Illustration
If Sales price is Rs. 10 per unit, variable cost is Rs.6 per unit and fixed
----------------------
costs are Rs.300, then for 100 and 150 units, work out P/V ratio.
---------------------- Solution:
---------------------- P/V ratio works out as
---------------------- 100 Units 150 Units

Rs. Rs.
---------------------- Sales 1,000 1,500
Variable cost 600 900
---------------------- Contribution 400 600
Fixed cost 300 300
----------------------
Profit 100 300
---------------------- Hence, P/V ratio is
---------------------- Formula 1:
Contribution
---------------------- X 100
Sales
----------------------
So
----------------------
100 UNnits 150 Units
---------------------- 400 600
X 100 X 100
1,000 1,500
----------------------
= 40% = 40%
----------------------
Formula 2:
---------------------- Change in Profits
X 100
---------------------- Change in Sales
---------------------- So
(300-100)
---------------------- X 100 = 40%
1500-1000
----------------------
The fundamental property of P/V Ratio is that it remains constant at all
---------------------- the levels of activities, provided per unit sales price and variable cost remains
constant. It should be noted that P/V Ratio remains unaffected by any variation
---------------------- in fixed costs though overall profits may change due to this variation.
---------------------- A high P/V Ratio indicates that a slight increase in sales without
corresponding increase in fixed costs will result in higher profits and vice-versa.
---------------------- This is a pointer to increased sales promotion efforts to increase sales volume.
---------------------- A low P/V Ratio indicates low profitability so that efforts can be made
to increase the profits by increasing selling price or by reducing variable cost.
----------------------
Overall profitability may also be increased by concentrating more on products
---------------------- having high P/V ratio.

Note: The basic expression of P/V ratio, i.e. Contribution/Sales may lead to Notes
other useful conclusion as
----------------------
(a) Sales x P/V Ratio = Contribution
Change in Profits ----------------------
(b) X 100
Change in Sales ----------------------
(4) Break Even Point (BEP): ----------------------
This is a situation of no profit no loss. It means that at this stage, ----------------------
contribution is just enough to cover the fixed costs, i.e. Contribution = Fixed
Cost. It also means that contribution generated by all sales beyond breakeven ----------------------
point will directly result into profits. As such, it will be the intention of every
business to reach the breakeven point as early as possible. ----------------------
The breakeven point may be expressed in two ways: ----------------------

Fixed Costs
(a) In terms of quantity ----------------------
Contribution per unit
----------------------
Fixed Costs
(b) In term of amount ----------------------
P/V Ratio
----------------------
(5) Margin of safety: ----------------------
These are the sales beyond breakeven point. A business will like to have a
high margin of safety because this is the amount of sales that generates profits. ----------------------
As such, the soundness of the business is indicated by the margin of safety. ----------------------
A high margin of safety indicates that the breakeven point is much below the
actual sales and even if there is reduction in sales, business will be still in ----------------------
profits. A low margin of safety accompanied by high fixed cost and high P/V
ratio indicates that efforts are required to be made for reducing the fixed cost ----------------------
or increasing sales volume. A low margin of safety accompanied by a low P/V ----------------------
ratio indicates that efforts are required to be made for reducing the variable cost
or increasing the selling price. ----------------------
Margin of safety may be expressed as below: ----------------------
Margin of Safety =
Sales - Break Even Sales
----------------------
Fixed Costs
= Sales ----------------------
P/V Ratio
Sales x P/V Ratio - Fixed Cost ----------------------
Margin of Safety =
P/V Ratio ----------------------
Contribution - Fixed Cost ----------------------
=
P/V Ratio ----------------------
Profit
= ----------------------
P/V Ratio
Notes Margin of safety may be expressed as a ratio or as a percentage.
As an example, if actual sales are Rs.l,00,000 and breakeven sales are
----------------------
Rs.60,000, Margin of safety as % of sales will be
---------------------- Sales - Break Even Sales
X 100
---------------------- Sales
----------------------
1,00,000 - 60,000 40,000
---------------------- i.e. X 100 = X 100
1,00,000 1,00,000
----------------------
= 40% of sales
----------------------

----------------------
State True or False
---------------------- 1. Break Even Point means that contribution generated by all sales
---------------------- beyond breakeven point will directly result into loss.
2. Break Even Point is a situation of more profit than loss.
----------------------
3. A business will like to have a low margin of safety because this is the
---------------------- amount of sales that generates profits.
----------------------
----------------------
Activity 3
---------------------- From the financial statements of Coke and Pepsi, compare the marginal
costing of carbonated drinks.
----------------------
----------------------
9.6 GRAPHICAL PRESENTATION OF COST-VOLUME-
----------------------
PROFIT RELATIONSHIPS
----------------------
As discussed earlier, the Cost-Volume-Profit relationships may be
---------------------- expressed in the form of visual aids such as graphs and charts. There may be
various ways in which these charts and graphs can be prepared, depending upon
---------------------- the purpose for which they are prepared. We will discuss three of these ways.
---------------------- (1) Simple breakeven chart
---------------------- It can be prepared as below.
----------------------
----------------------
----------------------

Y TS Notes
TC
----------------------
E
BE P a
----------------------
COST/REVENU
----------------------
SS
LO
FC ----------------------
MO S
X ----------------------
}
O VOLUME SL
----------------------
Where
TS = Total Sales Line ----------------------
TC = Total Cost Line ----------------------
BEP = Break Even Point ----------------------
SL = Selected Level of Activity
----------------------
FS = Fixed Cost
----------------------
MOS = Margin of Safety
Angle a = Angle of Incidence ----------------------
Note: It will be observed from the above chart that the angle formed by total ----------------------
sales line and total cost line is termed as Angle of Incidence. As the difference
between total sales and total cost is in the form of profits, higher the angle of ----------------------
incidence, better will be the situation. ----------------------
The limitation of Simple Break Even Chart is that contribution cannot
be shown separately. As such, the following type of breakeven chart may be ----------------------
prepared, i.e. Contribution Break Even Chart. ----------------------
(2) Contribution breakeven chart:
----------------------
This is a chart where the contribution is shown more clearly and specifically
than in a simple breakeven chart. It can be prepared as below. ----------------------
TS
Y ----------------------
TC
----------------------
a
E
FC
BE P VC ----------------------
COST/REVENU
----------------------
VC ----------------------
MO S
----------------------
X
}
O VOLUME SL
----------------------
----------------------

Notes Where
TSL = Total Sales Line
----------------------
TCL = Total Cost Line
----------------------
BEP = Break Even Point
---------------------- SL = Selected Level of Activity
---------------------- TS-VC = Contribution
---------------------- TC-VC = Fixed Cost
VC = Variable Cost
----------------------
MOS = Margin of Safety
----------------------
Angle a = Angle of Incidence.
---------------------- (3) Profit Graph:
---------------------- In case of this type of breakeven chart, horizontal axis represents sales
volume and vertical axis represents profit or loss. The diagonal line represents
---------------------- contribution. The point where the contribution line cuts horizontal axis indicates
---------------------- sales at the breakeven point indicating that at this point, there is no profit or no
loss.
----------------------
PL
----------------------
---------------------- BE P P
L Sales
---------------------- } FC
----------------------
---------------------- Where
PL = Profit Line
----------------------
FC = Fixed Cost
----------------------
P = Profit Area
---------------------- L = Loss Area
---------------------- BEP = breakeven point
----------------------
Activity 4
----------------------
---------------------- Search on the Internet and compare the operating statements of HUL and
P&G.
----------------------
----------------------
----------------------

9.7 PRACTICAL APPLICATIONS OF MARGINAL COSTING Notes
The technique of marginal costing can be profitably employed in the ----------------------

following situations.
----------------------
(1) Evaluation of performance:
----------------------
The performance of various segments of a business, say a department or a
product or a branch and so on, can be evaluated with the help of marginal costing ----------------------
and the evaluation of the performance will be based upon the contribution
generating capacity of these segments. If the fixed costs are apportioned over ----------------------
these segments on any basis whatsoever, it will be ignored while evaluating the
----------------------
performance.
Illustration: ----------------------
Following details are available in respect of three products. ----------------------
Products ----------------------
A Rs. B Rs. C Rs.
Sales 1,00,000 1,50,000 2,50,000 ----------------------
Variable Cost 90,000 1,00,000 1,50,000
----------------------
Fixed cost (Apportioned on the basis of sales) 20,000 30,000 50,000
Total Cost 1,10,000 1,30,000 2,00,000 ----------------------
∴ Profit (Loss) (10,000) 20,000 50,000
----------------------
As product A is incurring the losses, it is decided to close down its
production. Advise the management. ----------------------
Solution:
----------------------
It will not be advisable to close down the production of product A,
because it is generating positive contribution (i.e. Rs. 1,00,000 - Rs. 90,000 = ----------------------
Rs. 10,000). ----------------------
Closing down of product A will mean loss of contribution generated by it,
fixed cost still remaining the same. ----------------------
Illustration: ----------------------
Assuming that the production of product A in above example is closed ----------------------
down, what will be the effect on profitability?
----------------------
Solution:
Let us verify by applying marginal costing principles. ----------------------
Product B Product C Total ----------------------

Rs. Rs. Rs.
Sales 1,50,000 2,50,000 4,00,000 ----------------------
Variable Cost 1,00,000 1,50,000 2,50,000 ----------------------
∴ Contribution 50,000 1,00,000 1,50,000
Fixed costs 1,00,000 ----------------------
∴ Profits 50,000
----------------------

Notes It means that existing total profits of Rs. 60,000 [50,000 + 20,000 - 10,000]
will reduce to Rs. 50,000. It will affect profitability adversely.
----------------------
(2) Profit Planning:
---------------------- Marginal costing, through the calculations of P/V ratio, enables
the management to plan the activities in such a way that the profits can be
----------------------
maximised or to maintain a specific level of profits. As such, this technique
---------------------- helps the planning of profits.
Illustration:
----------------------
(1) M/s. C and P Ltd. produces and sells industrial containers and packing
---------------------- cases. Due to competition, the company proposes to reduce the selling
---------------------- price. If the present level of profit is to be maintained, indicate the number
of units to be sold if the proposed reduction in price is (a) 10% and (b)
---------------------- 15%.
---------------------- Following information is available:

Rs. Rs.
----------------------
1 Present Sales (30,000 Units) 6,00,000
---------------------- 2 Variable Cost (30,000 Units) 3,60,000
1,40,000
---------------------- 3 Fixed Cost 5,00,000
4 Net Profit 1,00,000
----------------------
Solution:
----------------------
The present cost structure can be stated as below:
---------------------- Per Unit Total
Rs. Rs.
----------------------
Sales 20 6,00,000
---------------------- Variable Cost 12 3,60,000
Contribution 8 2,40,000
---------------------- Fixed Cost 1,40,000
Net Profit 1,00,000
----------------------
If the price is reduced by 10% or 15%, the per unit cost structure is going
---------------------- to change as below:
---------------------- Present 10% Price 15% Price
Rs. Reduction Reduction
---------------------- Rs. Rs.
Sales 20 18 17
---------------------- Variable Cost 12 12 12
---------------------- Contribution 8 6 5
If the present level of profits is to be maintained, i.e. Rs. 1,00,000, the
---------------------- revised total contribution, which the sales will have to generate with reduced
---------------------- per unit contribution will be
= Expected Profit + Fixed Cost,
----------------------

And the number of units, which will have to be sold will be: Notes
Expected Profit + Fixed Cost
----------------------
Revised per unit contribution
----------------------
As such, the number of units, which will have to be sold in the above
cases of price reduction, will be ----------------------
10% Price Reduction 15% Price Reduction ----------------------
Rs. 1,00,000 + Rs. 1,40,000 Rs. 1,00,000 + Rs. 1,40,000 ----------------------
Rs. 6 Rs. 5
----------------------
Rs. 2,40,000 Rs. 2,40,000
= = ----------------------
Rs. 6 Rs. 5
= 40,000 Units = 48,000 Units ----------------------
Illustration: ----------------------
Per Unit cost structure of a single product manufacturing company is as below:
----------------------
Selling price Rs. 100
Direct material Rs. 60 ----------------------
Direct labour Rs. 10
----------------------
Variable overheads Rs. 10
Number of Units sold in the year are 5,035. As per the agreement with the ----------------------
employee’s union, there will be an increase of 10% in direct wages.
----------------------
Work out:
----------------------
(a) How many more units have to be sold next year to maintain same quantum
of profits? ----------------------
(b) By what percentage should the selling price be raised to maintain the ame ----------------------
P/V ratio?
Solution: ----------------------
The present profitability structure is as below: ----------------------

(i) Total numbr of units sold 5,035 ----------------------
(ii) Per unit cost structure
Selling price Rs. 100 ----------------------
Variable cost
----------------------
Direct Material Rs. 60
Direct Labour Rs. 10 ----------------------
Variable Overheads Rs. 10
Rs. 80 ----------------------
Contribution per unit Rs. 20
(iii) Total Contribution Rs. 1,00,700 ----------------------
----------------------
----------------------

Notes In the next year, as per the agreement, the per unit Direct Labour Cost will
be more by 10%, i.e. Rs. 11 per unit, which will reduce the per unit contribution
---------------------- to Rs. 19.
---------------------- Alternative (a):
If the same quantum of profits is to be maintained, same amount of
----------------------
contribution will have to be generated with reduced per unit contribution.
---------------------- As such, number of units required to be sold will be:
---------------------- Amount of contribution
=
Revised per unit contribution
----------------------
---------------------- Rs. 1,00,700

=
Rs. 19
----------------------
---------------------- = 5,300 Units

Hence, the company will have to sell 265 units more (i.e. 5,300 Units -
----------------------
5,035 Units) to maintain same quantum of profits.
---------------------- Alternative (b):
---------------------- At present, when selling price is Rs. 100, contribution is Rs. 20, meaning
that per unit variable cost is Rs. 80.
----------------------
In future, the variable cost is likely to be Rs. 81 per unit instead of Rs.
---------------------- 80. Accordingly, the selling price will also be required to be increased if it is
intended that the same P/V ratio should be maintained.
----------------------
The new selling price will be:
---------------------- Rs. 81
X 100 = Rs. 101.25
---------------------- Rs. 80
---------------------- As such, the selling price has to be raised by 1.25% to maintain the same
P/V ratio. The profitability structure will be:
----------------------
Selling Price Rs. 101.25
---------------------- Variable Cost Rs. 81.00
---------------------- Contribution Rs. 20.25
---------------------- Contribution per unit
P/V Ratio = X 100
Selling Price per unit
----------------------
20.25
---------------------- X 100 = 20%
101.25
----------------------
---------------------- (3) Fixation of Selling Price:

The technique of marginal costing may be applied in the area of price
---------------------- fixation in such a way that prices fixed should cover at least the variable cost.

As in the short run, the fixed cost is a stagnant cost. It can be ignored, though Notes
it cannot be ignored in the long run because of the simple fact that it is a cost.
----------------------
In the short run, the prices fixed above the variable cost may generate some
positive contribution, which may help in the recovery of fixed cost. However, ----------------------
if the fixed cost is ignored in the long run, it may put the business into serious
trouble, as the business will never be able to earn the profits. ----------------------
In this connection, following propositions should be kept in mind. ----------------------
(a) In some exceptional circumstances, viz. during the phase of depression,
----------------------
serious competition in the market, introduction of a new product in the
market by keeping the price as low as possible in the initial stages, disposal ----------------------
of a product that may deteriorate in quality etc., it may be necessary to fix
the selling price even below the variable cost; however, it is a deliberate ----------------------
decision taken by the management.
----------------------
(b) The above principle is equally applicable while fixing the export price as
well. The export price over and above the variable cost will result into ----------------------
increased amounts of profits if the fixed costs can be taken care of by the ----------------------
inland sales and if the home market is not likely to get affected by the
export price fixed. However, if certain specific costs, fixed or variable, are ----------------------
required to be incurred specifically for the execution of the export order,
they will have to be recovered while fixing the export price as if it is a part ----------------------
of the variable cost. ----------------------
Illustration:
----------------------
(1) The operating statement of a company is as follows:
----------------------
Rs.
Sales (80,000 Units @ Rs. 15) 12,00,000 ----------------------
Costs - Variable
Materials 2,40,000 ----------------------
Labour 3,20,000
Overheads 1,60,000 ----------------------
7,20,000 ----------------------
Fixed 3,20,000
Total Costs 10,40,000 ----------------------
1,60,000
----------------------
The plant capacity is 1,00,000 units. A customer from U.S.A. is desirous
of buying 20,000 units at a net price of Rs. 10 each unit. Advise the company ----------------------
whether the offer should be accepted. Will your advice be different if the
customer is a local one? ----------------------
Solution: ----------------------
At present, variable cost per unit is Rs. 9, i.e. ----------------------
Rs. 7,20,000
----------------------
80,000 units
----------------------

Notes So long as the export price is more than Rs. 9, it is going to generate
additional contribution, which is going to increase the profits, as the fixed costs
---------------------- are already covered by the local sales. As the export price offered is Rs. 10, i.e.
Re. 1 more than the variable cost per unit, the company should accept the offer.
----------------------
The advice will be the same even it the customer is a local one, provided
---------------------- the price discrimination, i.e. Rs. 15 per unit for 80,000 units and Rs. 10 per unit
for 20,000 units is not going to adversely affect the current market for 80,000
----------------------
units at the current price of Rs. 15.
---------------------- If the company accepts the export offer of Rs. 10 per unit, the revised profitability
structure will be as below:
----------------------
Rs.
---------------------- Sales : 80,000 units @ Rs. 15 12,00,000
20,000 units @ Rs. 10 2,00,000
----------------------
14,00,000
---------------------- Costs : Variable
1,00,000 units @ Rs. 9 9,00,000
---------------------- Fixed 3,20,000
Total costs 12,20,000
---------------------- Profit (Sales - Total Cost) 1,80,000
---------------------- The revised amount of profit will be more by Rs. 20,000 as compared to
the existing amount of profits. Hence, the export order should be accepted by
---------------------- the company.
---------------------- (4) Make or buy decision:
---------------------- If the management is facing problem to decide whether a component or
a product, which can be purchased from an outside source as well, should be
---------------------- manufactured in house, the technique of marginal costing may render useful
assistance. For example, the following cost data is made available in respect of
----------------------
two components A and B.
---------------------- Component A Component B
Rs. per unit Rs. per unit
----------------------
If manufactured
----------------------
Variable Cost 30 30
----------------------
Fixed Cost 25 20
---------------------- Total Cost 55 50
---------------------- If purchased, buying price 40 25
---------------------- If the above data is viewed from total cost point of view, without considering
the classification of cost in fixed or variable, it may be concluded that the purchase
---------------------- proposition may be profitable for both the components A and B.
----------------------
----------------------

However, the conclusion may be misleading, as the total cost in case of Notes
component A, if purchased, is not going to be only Rs. 40 per unit, but it is
going to be Rs. 65 (i.e. Rs. 40 purchase price per unit + Rs. 25 fixed cost per ----------------------
unit) which being more than present total cost, manufacturing proposition will
be beneficial. ----------------------
On the other hand, in case of component B, total cost, if purchased, is ----------------------

going to be Rs. 45/- per unit (i.e. Rs. 25 purchase price per unit + Rs. 20 fixed
----------------------
cost per unit) which, being less than present total cost, buying proposition will
be beneficial. ----------------------
The above conclusions may be simplified in the following way:
----------------------
If Purchases Price < Variable Cost, go in for purchase proposition.
----------------------
If Purchase Price > Variable Cost, go in for manufacturing proposition.
Before taking any make or buy decision based only on marginal cost ----------------------
analysis, following points should also be taken into consideration. ----------------------
(1) If the buying proposition is beneficial in case of a component or product,
the final decision to buy may depend on other factors also viz. whether the ----------------------
supplier is reliable one, whether the supplier can assure required quality, ----------------------
whether the supplier can assure uninterrupted supply etc.
----------------------
(2) If it is decided to buy a component or a product that was being manufactured
till now, the manufacturing capacity released should be profitably used for ----------------------
some other purposes. If it is decided to manufacture a component that was
being purchased till now, there may be two possibilities. One, production ----------------------
capacity used for the same component or product may be diverted to
----------------------
manufacture another component or product. In this case, the loss of
contribution of that another component or product should be considered ----------------------
as a part of cost. Second, if additional production facilities are required to
be acquired for the manufacturing proposition, the additional fixed costs ----------------------
attached with the manufacturing proposition should be considered.
----------------------
(5) Optimizing product mix:
----------------------
Product mix refers to the proportion in which various products of a
company can be sold. If a concern is dealing in a number of products, a problem ----------------------
that usually arises is to decide a mix or proportion in which the sales of the
various products should be made so that the profits can be maximized. Such a ----------------------
problem can be solved by studying the contributions generated by the various ----------------------
products individually and by selecting the mix that generates the maximum
total contribution. ----------------------
Illustration: ----------------------
Following information has been made available from the cost records of
Universal Automobiles Ltd., manufacturing spare parts ----------------------
----------------------
----------------------

Notes Direct Materials Cost per unit
X Rs. 8
----------------------
Y Rs. 6
----------------------
Direct wages
---------------------- X 24 hours @ 25 paise per hour
---------------------- Y 16 hours @ 25 paise per hour
---------------------- Variable overheads - 150% of wages

Fixed overheads - Rs. 750
----------------------
Selling price
----------------------
X - Rs. 25
---------------------- Y - Rs. 20
---------------------- The Directors want to be acquainted with the desirability of adopting any one of
the following alternative sales mixes in the budget for the next period.
----------------------
(a) 250 units of X and 250 units of Y
----------------------
(b) 400 units of Y only
---------------------- (c) 400 units of X and 100 units of Y
---------------------- (d) 150 units of X and 350 units of Y
---------------------- State which of the alternatives you would recommend to the management.
Solution:
----------------------
Productwise profitability structure
----------------------
Product X Product Y
---------------------- Rs. Rs.
(1) Selling Price per unit 25 20
---------------------- (2) Variable cost per unit
Direct Material 8 6
----------------------
Direct Wages 6 4
---------------------- Variable Overheads 9 6
Total Variable cost per unit 23 16
---------------------- (3) Contribution per unit 2 4
---------------------- Evaluation of various alternative sales mixes as per total contribution
---------------------- Alternative Product X Product Y Total

Rs. Rs. Rs.
---------------------- a. 250 x 2 = 500 250 x 4 = 1,000 1,500
b. – 400 x 4 = 1,600 1,600
---------------------- c. 400 x 2 = 800 100 x 4 = 400 1,200
d. 150 x 2 = 300 350 x 4 = 1,400 1,700
----------------------
----------------------

Fixed overheads are going to be the same in all these alternatives. As Notes
such, the alternative that generates maximum contribution is the maximum
profitable one. ----------------------
As alternative d, i.e. 150 units of X and 350 mills of Y generates maximum ----------------------
of contribution, it will be recommended to the management.
----------------------
(6) Cost control:
Marginal costing is necessarily a technique of cost classification and cost ----------------------
presentation. The segregation of total costs in fixed and variable costs itself
----------------------
facilitates the cost control.
Variable costs are the controllable costs at the lower level of management ----------------------
whereas fixed costs can be controlled only on the top level of management and ----------------------
that too, to a limited extent only.
Classification of costs in fixed and variable costs enables the management ----------------------
to concentrate on the controllable costs. At the same time, the fixed costs are ----------------------
not completely ignored. The only thing is that they are collected and reported
separately as an amount deducted from total contribution. ----------------------
As such, the fixed costs can also be controlled as they can be programmed ----------------------
and estimated in advance.
----------------------
(7) Flexible Budget Preparation:
Marginal costing technique and more particularly, the classification of ----------------------
costs as fixed and variable, facilitates the preparation of flexible budgets, which
----------------------
is discussed in detail in the next unit.
----------------------
Activity 5
----------------------
Identify an organization, which you feel would benefit from the application ----------------------
of marginal costing in the practical application of decision-making process
of business. List two reasons with an explanation. ----------------------
----------------------
9.8 PROBLEM OF THE KEY FACTOR ----------------------
Under the marginal costing technique, profitability is measured in terms ----------------------

of contribution. The products generating maximum contribution or having
----------------------
maximum P/V ratio are treated as the maximum profitable products.
As the intention of every business is to maximize the profits, the company ----------------------
will concentrate maximum on the products having highest P/V Ratio and will ----------------------
thus maximize the profits.
However, in practice, there may be some factors that may come into ----------------------
play and restrict the company’s intention or capability to maximize the profits. ----------------------
For example, in case of the products having highest P/V ratio, market may be
limited, or in case of a maximum profitable product, raw material may not be ----------------------

Notes available.
These factors are in the form of ‘Key Factor’ or ‘Limiting Factor’ or
----------------------
‘Scarce Factor’.
---------------------- A key factor is defined as the factor, which, at a particular point of time or
over a period, will limit the volume of output. The key factor may be in various
----------------------
forms, viz. sales/market, material, labour, machine availability and so on.
---------------------- In order to evaluate the profitability of a product under key factor situations,
the contribution per unit of key factor is the basic criteria. A product generating
----------------------
maximum contribution per unit of key factor is the maximum profitable product.
---------------------- Illustration:
---------------------- From the following details, which product would be recommended if time
were the key factor?
----------------------
Product A Product B
---------------------- Direct Material Cost per unit Rs. 24 Rs. 14
Direct Labour @ Rs. 2 per hour Rs. 20 Rs. 30
---------------------- Variable Overheads (% of labour cost) 200% 300%
---------------------- Selling Price per unit Rs. 150 Rs. 200
Solution:
----------------------
Product A Product B
---------------------- (1) Selling Price Unit Rs. 150 200
---------------------- (2) Variable Cost per unit Rs.
Direct Material Cost 24 14
----------------------
Direct Labour Cost 20 30
---------------------- Variable Overheads 40 90
---------------------- Total Variable Cost per unit 84 134
(3) Contribution per unit Rs. ( 3 = 1-2) 66 66
---------------------- (4) Number of labour hours 10 15
---------------------- (5) Contribution per labour hour Rs. (5 = 3-4) 6.6 4.4
----------------------
As labour hours are the key factor and contribution per labour hour is
---------------------- more in case of product A, it will be recommended for production.
----------------------
9.9 MULTIPLICITY OF THE KEY FACTOR
----------------------
In practice, more than one key factor may come into play and any decision
---------------------- regarding product mix ascertainment or profitability ascertainment will have to
---------------------- be decided on the basis of consideration of multiplicity of key factors. The
situation of multiplicity of key factors is more complex, the solutions to which
---------------------- may be found in the more advanced techniques such as linear programming.
---------------------- Illustration:

Following data is available to decide the product mix. Notes
A B C
----------------------
Raw material per unit 10 kg 6 kg 15 kg
Labour Hours required (Rate Rs. 1 per hour) 15 25 20 ----------------------
Selling price per unit Rs. ----------------------
Maximum production possible Units 125 100 200 ----------------------
6,000 4,000 3,000
----------------------
1,00,000 kg of raw material is available at Rs. 10 per kg. Maximum
production hours are 1,84,000 with a facility for a further 15,000 hours on ----------------------
overtime basis at twice the normal wage rate.
----------------------
Solution:
----------------------
Product A Product B Product C
(1) Selling Price per units Rs. 125 100 200 ----------------------
(2) Variable cost per unit
Material Cost (10 per kg) 100 60 150 ----------------------
Labour Cost (1 per hour) 15 25 20
----------------------
Total Variable Cost per unit 115 85 170
(3) Contribution per unit Rs. ----------------------
10 15 30
(3 = 1-2)
(4) Contribution per Kg of Raw ----------------------
1.00 2.50 2.00
material - Rs.
(5) Contribution per labour hrs Rs. 0.66 0.60 1.50 ----------------------
Considering the contribution per kg of raw material as well as per labour ----------------------
hour, the rankings among the various products will be as this: I -Product C; II
-Product B; III -Product A ----------------------
Hence, the available raw material and labour hours will be used for the ----------------------
manufacture of Product C and Product B respectively.
----------------------
Product Units Raw Material Kgs. Labour Hours No.
----------------------
C 3,000 45,000 60,000
B 4,000 24,000 1,00,000 ----------------------
Total 69,000 1,60,000 ----------------------
Hence, the balance of raw material and labour hours available for ----------------------
manufacturing of Product A will be as below.
----------------------
Raw Material - Kg. -31,000 kg. (i.e. 1,00,000 kg - 69,000 kg)
----------------------
Labour Hours - 24,000 (i.e. 1,84,000 - 1,60,000) Plus 15,000 extra hours
by paying double the normal wage rate. ----------------------
If extra labour hours are used for the manufacture of product A by paying
----------------------
double the normal wage rate, the cost structure of product A will be as below:
----------------------

Notes (1) Selling Price per unit Rs. 125
----------------------
Material Cost Rs.100
---------------------- Labour Cost Rs. 30
Total Variable Cost Rs. 130
---------------------- (3) Contribution per unit (-) Rs. 5
---------------------- From the above, we have seen that as there could not be any positive
contribution generated, it would not be advisable to use the labour hours, which
---------------------- require the payment of wages at double the normal wage rate. As such, product
A will be manufactured by utilising the labour hours that require the payment
----------------------
of wages at the normal wage rate only, i.e. 24,000 hours, with the help of which
---------------------- 1,600 units of A (24,000 Hours/ 15 Hours per unit) can be manufactured. As
such, the final product mix will be as below.
----------------------
Product A 1,600 Units
---------------------- Product B 4,000 Units
---------------------- Product C 3,000 Units
---------------------- One alternate solution is possible to solve the problem of key factors.
If the labour hours, which require the payment of wages at double the normal
---------------------- wage rate, can be utilised for the manufacture of Product C, its cost structure
will be as below.
----------------------
(1) Selling Price per Unit Rs. 200
----------------------
---------------------- Material Rs. 150
---------------------- Labour Rs. _40
---------------------- Rs. 190

(3) Contribution per unit Rs. 10
----------------------
As such, apparently it may be possible to utilise the labour hours carrying
---------------------- double the normal wage rate for manufacturing product C and utilise the
released labour hours carrying the normal wage rate for manufacturing Product
----------------------
A (i.e. 15,000 hours). In this case, the final product mix will be as below.
---------------------- Product A – 2,600 Units
---------------------- Product B – 4,000 Units
---------------------- Product C – 3,000 Units

The calculation of total contribution generated under both those
---------------------- alternatives is as below.
----------------------
----------------------
----------------------

Alternative I (without overtime) Notes
Product No. of Units Contribution Total Contribution
----------------------
Per Unit Rs. Rs.
A 1,600 10 16,000 ----------------------
B 4,000 15 60,000 ----------------------
C 3,000 30 90,000 ----------------------
1,66,000
----------------------
Alternative II (on overtime basis)
----------------------
Product No. of Units Contribution Total Contribution
Per Unit Rs. Rs. ----------------------
A 2,600 10 26,000
----------------------
B 4,000 15 60,000
----------------------
C 2,250 30 67,500
C 750 10 7,500 ----------------------
1,61,000 ----------------------
As in the second alternative, the total contribution generated is less ----------------------
than the one generated in the first alternative, the second alternative cannot be
accepted. As such, it will be advisable for the company not to utilise the labour ----------------------
hours requiring the payment of wages at double the normal wage rate.
----------------------
9.10 LIMITATIONS OF MARGINAL COSTING ----------------------
(1) The classification of total cost in variable and fixed cost is difficult. No ----------------------
cost can be completely variable or completely fixed. In some cases, the
cost that is considered variable may not be variable in practical terms, for ----------------------
example, direct labour cost. Under normal situations, this cost is treated ----------------------
as variable cost. However, in India, considering the tremendous legal
backing the workers have, the direct labour cost may not be variable in ----------------------
nature. As such, it may be necessary to consider the direct labour cost as
a part of fixed cost. ----------------------
(2) Under the marginal costing, the fixed costs are eliminated for the valuation ----------------------
of inventory of finished goods and semi-finished goods, in spite of the fact
that they might have been actually incurred. As such, it is not correct to ----------------------
eliminate the fixed costs. Further, such elimination affects the profitability
----------------------
adversely.
(3) In the age of increased automation and technological development, the ----------------------
component of fixed costs in the overall cost structure may be sizeable.
Any technique such as marginal costing, which ignores the fixed costs ----------------------
altogether, may not be proper under these circumstances as a major ----------------------
portion of cost is not taken care of.
(4) Marginal costing technique does not provide any standard for the ----------------------

Notes evaluation of performance. In that sense, the techniques of budgetary
control and standard costing may be considered better techniques from
---------------------- cost control point of view.
(5) Fixation of selling price on marginal cost basis may be useful for short
----------------------
term only. Here also, an undue importance given to only variable cost may
---------------------- result into taking on heavy business with low margin, which in turn may
increase the fixed costs. As such, over the long run, the prices should be
---------------------- decided on total cost basis only. Fixation of selling price on the marginal
cost basis in the long run may be dangerous. Moreover, consideration of
----------------------
fixed costs may be necessary in price fixation under certain circumstances
---------------------- like cost plus contracts unless a very high percentage over the marginal
cost is considered to take care of both fixed costs as well as profit margin.
----------------------
(6) Marginal costing does not take into consideration the fixed overheads,
---------------------- as such the problem of under or over absorption of fixed overheads can
be avoided. But the problem of under or over absorption of variable
---------------------- overheads cannot be avoided.
---------------------- (7) Marginal costing can be used for assessment of profitability only in the
short run. However, in the long run, one has to consider the fixed costs
---------------------- also in order to assess the profitability. Moreover, interpretation of the
term ‘short run’ is a subjective concept. For how long the decision can be
---------------------- taken on the basis of marginal costing principles cannot be decided in the
---------------------- objective manner.

----------------------
----------------------
1. Marginal costing does take into consideration the fixed overheads
----------------------
2. Under the marginal costing, the variable costs are eliminated for the
---------------------- valuation of inventory of finished goods and semi-finished goods, in
spite of the fact that they might have been actually incurred
----------------------
3. The classification of total cost in variable and fixed cost is easier.
----------------------
---------------------- Summary
---------------------- ●● Marginal costing basically tries to classify the cost on the basis of
behavior of cost. From this angle, the costs can be viewed as fixed costs
---------------------- and variable costs. Fixed cost is the cost that tends to remain constant
irrespective of the level of activity or volume of operations.
----------------------
●● Fixed cost tends to vary with time rather than with level of activity. Basic
---------------------- characteristic feature of fixed cost is that this cost in terms of amount may
remain constant at all the levels of activities; however per unit fixed cost
----------------------
goes on decreasing with the increasing level of activity and vice-a-versa.
---------------------- ●● Variable cost is the cost that varies in direct proportion with the level of

activity or volume of operations. Basic characteristic feature of variable Notes
cost is that variable cost in terms of amount may increase or decrease
with the changing level of activity or volume of operations. However, ----------------------
per unit variable cost remains constant. In practical circumstances, some
costs may not be entirely fixed or entirely variable. They are technically ----------------------
in the form of semi-fixed costs or semi-variable costs. ----------------------
●● For the purpose of marginal costing, the semi-fixed costs or semi-variable
costs are required to be classified in the individual components of fixed ----------------------
cost and variable cost. For segregating the semi-fixed or semi-variable
----------------------
cost into the individual components of fixed cost and variable cost, various
techniques or methods may be available, viz. comparison by period or ----------------------
level of activity, range or high and low method, analytical method, scatter
graph method, lease square method. ----------------------
●● Marginal costing is defined as the ascertainment, by differentiating ----------------------
between fixed and variable costs, of the marginal costs and of the effect
on profit of changes in volume and type of output. ----------------------
●● The entire technique of marginal costing is based upon certain assumptions. ----------------------
The definition of the term “marginal costing” requires the computation
of marginal cost and cost-volume profit relationship. There are certain ----------------------
basic concepts in marginal costing, which help us to understand various
calculations, such as contribution, cost-volume profit ratio, break-even ----------------------
analysis, margin of safety etc. ----------------------
●● The practical application of marginal costing can be profitably employed
in evaluating the performance, profit planning, fixation of selling price, ----------------------
make or buy decision, optimising product mix, cost control, flexible
----------------------
budget preparation etc.,
----------------------
Keywords
----------------------
●● Break Even Point (BEP): This is a situation of no profit no loss. It means
----------------------
that at this stage, contribution is just enough to cover the fixed costs, i.e.
contribution = fixed cost. It also means that contribution generated by all ----------------------
sales beyond breakeven point will directly result into profits. As such, it
will be intention of every business to reach the Break Even Point, as early ----------------------
as possible.
----------------------
●● Contribution: Sales - Variable Cost, or Fixed cost + Profit.
●● Fixed Cost: The cost that tends to remain constant irrespective of the ----------------------
level of activity or volume of operations. ----------------------
●● Marginal Cost: It is defined as the amount at any given volume of output
by which the aggregate costs are changed if the volume of output is ----------------------
increased or decreased by one unit.
----------------------
●● Variable Cost: This cost varies in direct proportion with the level of
activity or volume of operations. Basic characteristic feature of variable ----------------------
cost is that variable cost in terms of amount may increase or decrease with
the changing level of activity or volume of operations. ----------------------

Notes Illustrative Problems
---------------------- Problem 1
---------------------- Following details are available:

Sales Total Cost
----------------------
Rs. Rs.
----------------------
Period I 39,000 34,800
---------------------- Period II 43,000 37,600
---------------------- Calculate variable cost, fixed cost and contribution for each period.
---------------------- Problem 2
Following details are available:
----------------------
Sales Profit
----------------------
Rs. Rs.
---------------------- Period I 2,00,000 20,000
---------------------- Period II 3,00,000 40,000
---------------------- Find out breakeven sales.

Problem 3
----------------------
----------------------
Actual Sales Rs. 20,000
---------------------- Break Even Sales Rs. 10,000
---------------------- Fixed Cost Rs. 5,000
---------------------- Find out the profit at actual sales.

Problem 4
----------------------
----------------------
Break Even Sales Rs. 20,000
---------------------- Fixed cost Rs. 10,000
---------------------- Profit Rs. 5,000
---------------------- Find out the margin of safety.
----------------------
----------------------
----------------------
----------------------
----------------------

Solutions Notes
Problem 1
----------------------
----------------------
Sales Total Cost
Rs. Rs. ----------------------
Period I 39,000 34,800 ----------------------
Period II 43,000 37,600 ----------------------
Calculate variable cost, fixed cost and contribution for each period.
----------------------
Solution:
----------------------
As we know, Sales - Total Cost = Profit, so
Sales Rs. Total Cost Rs. Profit Rs. ----------------------
Period I 39,000 34,800 4,200 ----------------------
Period II 43,000 37,600 5,400
As P/V ratio = (Increase in profits / Increase in sales) x 100 ----------------------
8400 - 4200 ----------------------
X 100
43000 - 39000 ----------------------
As Sales x P/V ratio = Contribution, ----------------------

For period I, Contribution = 39,000 x 30% = 11,700 ----------------------
For period II, Contribution = 43,000 x 30% = 12,900
----------------------
As Sales - Contribution = Variable cost
----------------------
For period I, variable cost = 39,000 - 11,700 = 27,300
----------------------
For period II, variable cost = 43,000 - 12,900 = 30,100
As Contribution - Profit = Fixed cost ----------------------
For period I, fixed cost = 11,700- 4,200 = 7,500 ----------------------
For period II, fixed cost = 12,900 - 5,400 = 7,500 ----------------------
To summarise,
----------------------
Period I Period II
----------------------
Rs. Rs.
Contribution 11,700 12,900 ----------------------
Variable cost 27,300 30,100 ----------------------
Fixed cost 7,500 7,500 ----------------------
----------------------
----------------------

Notes Problem 2
----------------------
Sales Profit
----------------------
Rs. Rs.
---------------------- Period I 2,00,000 20,000
---------------------- Period II 3,00,000 40,000
---------------------- Find out breakeven sales.

Solution:
----------------------
We know that
---------------------- Increase in profits
P/V ratio = X 100
---------------------- Increase in sales
----------------------
= (40000-20000) x100/(300000-200000)
---------------------- = 20%
---------------------- Profit
Margin of safety = X 100
P/V Ratio
----------------------
20,000
---------------------- For period I, Margin of Safety is = = 1,00,000
20%
----------------------
---------------------- As Break Even Sales = Sales - Margin of Safety.

Considering Period I,
----------------------
Break Even Sales = 2,00,000 - 1,00,000 = 1,00,000
----------------------
Problem 3
---------------------- Following details are available:
---------------------- Actual Sales Rs. 20,000
---------------------- Break Even Sales Rs. 10,000
Fixed Cost Rs. 5,000
----------------------
Find out the profit at actual sales.
----------------------
Solution:
---------------------- At breakeven point, Contribution = Fixed Cost
---------------------- At breakeven point, sales are Rs. 10,000 and contribution Rs. 5,000
---------------------- However, we know that
Contribution 5,000
---------------------- P/V Ratio = X 100 = X 100 = 50%
Sales 10,000
----------------------

We also know that Sales x P/V Ratio = Contribution Notes
∴ At actual sales of Rs. 20,000
----------------------
Contribution = 20,000 x 50% = 10,000
----------------------
We know that Contribution - Fixed cost = Profit
∴ Profit = 10,000 - 5,000 = 5,000 ----------------------
Problem 4 ----------------------
Following details are available: ----------------------
Breakeven Sales Rs. 20,000
----------------------
Fixed cost Rs. 10,000
----------------------
Profit Rs. 5,000
Find out the margin of safety. ----------------------
Solution: ----------------------
At breakeven point, Fixed Cost = Contribution ----------------------
∴ When sales are Rs. 20,000, Contribution is Rs. 10,000
----------------------
However, we know that
Contribution ----------------------
X 100 = P/V Ratio
Sales ----------------------
10,000 ----------------------
P/V Ratio = X 100 = 50%
20,000 ----------------------
We also know that
----------------------
Profit
Margin of safety =
P/V Ratio ----------------------
5,000 ----------------------
= = 10,000
50% ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. What do you understand by the terms breakeven point, contribution and
---------------------- margin of safety? Explain your answer by drawing a chart with assumed
figures.
----------------------
2. How does breakeven analysis help in business decisions?
---------------------- 3. Describe the importance of the following terms in relation to marginal
---------------------- costing.
(a) Breakeven point
----------------------
(b) Profit volume ratio
----------------------
(c) Margin of safety
---------------------- 4. Explain what breakeven analysis means. Also discuss the assumptions
involved in this technique and various uses of this technique.
----------------------
5. Explain any four circumstances in which the technique of marginal costing
---------------------- will help the management in making decisions. What are the limitations
---------------------- of this technique?
6. “The rate of earning profit mainly depends upon the magnitude of the
---------------------- angle of incidence projected on breakeven chart.” Explain as to whether
---------------------- this statement is correct. What measures can be adopted to increase the
magnitude of the angle of incidence?
---------------------- 7. Write a critical note about the uses, applications, advantages and
---------------------- limitations of Marginal Costing technique.
8. “The work of separating the overheads into fixed and variable costs is
----------------------
purely academic, but practically very difficult and as such the technique
---------------------- of Marginal Costing is of very little use in managerial decisions.” How
will yon make out a case for introducing the technique of marginal costing
---------------------- when encountered with the above argument?
---------------------- 9. Discuss the most important areas of managerial decisions opened up by
the application of the marginal costing technique.
----------------------
10. Write short notes on
---------------------- (a) Profit volume ratio
---------------------- (b) Contribution
---------------------- (c) Breakeven point
(d) Margin of Safety
----------------------
(e) Marginal Costing
----------------------
----------------------
----------------------

Answers to Check your Progress Notes
Fill in the blanks ----------------------
1. Fixed Cost is the cost that tends to remain constant irrespective of the
level of activity or volume of operations ----------------------
2. Variable Cost is the cost that varies in direct proportion with the level of ----------------------
activity or volume of operations
----------------------
----------------------
1. The aggregate cost consists of both fixed cost and variable cost. ----------------------
2. Marginal cost is defined as the amount at any given volume of output by ----------------------
which the aggregate costs are changed if the volume of output is increased
or decreased by one unit. ----------------------
3. Per unit selling price remains constant at all the levels of activities. ----------------------
----------------------
State True or False
----------------------
1. False
2. False ----------------------
3. False ----------------------
----------------------
----------------------
State True or False
----------------------
1. False
2. False ----------------------
3. False ----------------------
----------------------
1. Edward J. Vanderbeck, Maria R. Mitchell, Principles of Cost Accounting ----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Budgetary Control
UNIT
10
Structure:
10.1 Introduction
10.2 Advantages of Budgetary Control
10.3 Pre-requisites for the Implementation of Budgetary Control
10.4 Types of Budgets
10.5 Fixed and Flexible Budget
Summary
Key Words
Suggested Reading
Budgetary Control 215

Notes
Objectives
----------------------
• Define budget and budgetary control
----------------------
• Classify the different types of budgets
----------------------
• Analyse the prerequisites of a budgetary control system
---------------------- • Assess the advantages and application of different types of budgets
---------------------- • Evaluate the limitations of various functional/operational budgets
---------------------- • Illustrate the different types of budgets with the help of solved problems
• Compare different budgets
----------------------
----------------------
----------------------
10.1 INTRODUCTION
---------------------- The term ‘Budget’ is defined as a financial and/or quantitative statement,

prepared prior to a defined period of time, of the policy to be pursued during
---------------------- that period for attaining a given objective.
---------------------- The analysis of this definition reveals the following characteristics of the
budget.
----------------------
1. It may be prepared in terms of quantity or money or both.
---------------------- 2. It is prepared for a fixed or set period of time.
---------------------- 3. It is prepared before the defined period of time commences.
---------------------- 4. It spells out the objects to be attained and the policies to be pursued to
achieve that objective.
---------------------- The term ‘Budgetary Control’ is defined as the establishment of budgets,
---------------------- relating the responsibilities of executives to the requirements of a policy and
the continuous comparison of actual with budgeted results, either to secure
---------------------- by individual action the objective of that policy or to provide the basis for its
revision.
----------------------
The analysis of this definition reveals the following facts about budgetary
---------------------- control.
---------------------- 1. It deals with the establishment of the budgets.
2. It deals with the comparison of budgeted results with the actual results.
----------------------
3. It deals with computation of the variations and the actions to be taken for
---------------------- maintaining the favourable variations, removing the adverse variation or
---------------------- revising the Budgets themselves.
----------------------

10.2 ADVANTAGES OF BUDGETARY CONTROL Notes
Budgetary control is advantageous for the following reasons: ----------------------

It is a powerful tool available to the management for the purpose of cost ----------------------
control and maximization of profits through the same. It enables the management
to utilize the available resources in the most profitable manner. ----------------------
A budget sets the plan of action. Plans in respect of various functional ----------------------
areas of operations are expressed in the form of the budgets. As such, the
budgetary control system acts as a means of declaration of the policies of the ----------------------
management. ----------------------
It acts a means of communication. The plans and objects laid down by
----------------------
top-level management are communicated to the middle level and lower level
management by way of budgets. As such, each and every person working in the ----------------------
organisation is aware of his duties and responsibilities in relation to those of the
others. This maximises the utilization of resources. ----------------------
It acts as a means of improving the co-ordination. The budgets prepared ----------------------
in the various functional areas of operations are prepared in such a way that the
efforts are coordinated in the direction of achievement of common and defined ----------------------
objective. It develops the team spirit and help of various people can be sought
----------------------
to solve the common problem.
Comparison between the budgeted results and the actual results may ----------------------
reveal the areas where there are adverse variations, which may be identified
----------------------
as weak areas or delicate areas. As such, efforts can be made to remove these
adverse variations, keeping aside the areas where there are no variations. This ----------------------
enables the concentration of efforts of the management on a smaller portion of
activities, which facilitates ‘Management by exception.’ ----------------------
Budgetary control system enables the delegation of authority and makes ----------------------
possible the principles of Responsibility Accounting.
----------------------
It is a powerful tool available to the management for Performance
Appraisal. The executives responsible for those functions where there is ----------------------
favourable variation may be rewarded, whereas the executives responsible
for those functions where there is adverse variation may be punished. In this ----------------------
sense, the budgetary control system provides a basis for the establishment of the ----------------------
incentive systems.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
---------------------- Fill in the blanks

1. __________ deals with computation of the variations and the actions
----------------------
to be taken.
---------------------- 2. _______________is a financial statement, prepared prior to a defined
period of time.
----------------------
3. ___________ spells out the objects to be attained and the policies to
---------------------- be pursued to achieve that objective.
---------------------- 1. Budgetary control system disables the delegation of authority.

2. Comparison between the budgeted results and the actual results may
----------------------
reveal the areas where there are favorable variations.
---------------------- 3. Budgetary control is a weaker tool for the purpose of cost control.
---------------------- 4. Budgetary control acts a means of communication.
----------------------
----------------------
Activity 1
---------------------- Assume that you are the Finance Manager in an organisation. Prepare
a hypothetical organisational budget and mention any two points
----------------------
distinguishing the concept of budgetary control.
----------------------
---------------------- 10.3 PRE-REQUISITES FOR THE IMPLEMENTATION OF

BUDGETARY CONTROL
----------------------
If the organisation decides to install the Budgetary Control system as a
---------------------- cost control technique, it will have to comply with the following preliminaries.
---------------------- 1. Deciding the Budget Centre: A budget centre is that section of the
organisation with respect to which the budgets will be prepared. A budget
---------------------- centre may be in the form of a product or a department or a branch of
---------------------- the company and so on. A budget centre should be clearly defined and
established, as the budgets will be prepared with respect to each and every
---------------------- budget centre.
---------------------- 2. Deciding the Budget Period: A Budget Period is that period of time
for which the budget will be prepared and operated. The selection of the
---------------------- budget period should be made very carefully; too long a budget period
makes the correct estimation more difficult while too short a budget
----------------------
period may prove to be more costly.
---------------------- The selection of Budget Period may depend upon the nature of operations

and the purpose of preparing the budgets. As such, in case of industries like the Notes
ones engaged in generation and distribution of electricity, transport operations
etc., where capital expenditure is too high, budgets may be prepared even for ----------------------
a period of 5 to 10 years, while in case of industries like the ones engaged in
manufacturing of motor vehicles or radios etc., where the customer demand ----------------------
may change more frequently, the budget period may be shorter. Similarly, a ----------------------
sales budget may be prepared for a period of 5 years, whereas the short-term
cash budget may be prepared on weekly or even daily basis. ----------------------
3. Establishment of Accounting Records: There should be an efficient and ----------------------
proper system of accounting so that the information and data as required
for the efficient implementation of the Budgetary Control system will be ----------------------
available in time.
----------------------
4. Organisation for Budgetary Control: A properly prepared organisation
chart may make the duties and responsibilities of each level of executive ----------------------
very clear to himself. The budgetary control organisation will be headed
----------------------
by a senior executive in the form of budget controller or budget officer.
In small or medium sized organisations, he himself will be involved in all ----------------------
types of works involved with the budgetary control system.
----------------------
However, in case of large organisations, he may have a budget committee
under him consisting of Chief Executive, budget officer himself and heads of ----------------------
main departments. The role of budget committee may be only advisory and its
decision may become binding only if accepted by the Chief Executive. The ----------------------
functions performed by the budget committee can be broadly stated as below.
----------------------
a. To receive and scrutinise the functional budgets
----------------------
b. To revise the functional budgets, if necessary
c. To approve the revised budgets ----------------------
d. To receive the budget reports and comparative statements ----------------------

e. To locate the responsibilities and recommend corrective and remedial ----------------------
action
----------------------
The usual and normal organisation for the budgetary control may be
expressed by way of the following organisation chart. ----------------------
Chief Executive ----------------------
Budget Officer ----------------------
Budget Committee ----------------------
----------------------
Production Personnel Finance Purchase Sales
Manager Manager Manager Manager Manager ----------------------
----------------------
5. Preparation of a Budget Manual: A budget manual is a document
setting out the responsibilities of the persons engaged in and the forms ----------------------

Notes and procedures required for the budgetary control. A budget manual
enables the standardization of the methods and procedures in relation to
---------------------- the budgetary control. It should be well written, indexed and divided into
the sections. It may be in bound book form or loose leaf form. A budget
---------------------- manual may contain the following particulars.
---------------------- a. Introduction of principles and objectives of budgetary control and
the definitions and brief explanations.
---------------------- b. Duties and responsibilities of the various executives and the
---------------------- organisation chart.
c. Functions and duties of budget officer and budget committee.
----------------------
d. Scope of the budget and areas to be covered, whether budget will be
---------------------- a fixed budget or flexible budget.
e. Accounts codes, budget center codes and other codes operated.
----------------------
f. The forms of reports and statements to be used.
---------------------- g. The last date for submission of budgets.
---------------------- h. Budget diagrams.
---------------------- 6. Determination of Budget Key Factor: A budget key factor is that the
impact of which should be assessed first before other functional budgets are
---------------------- prepared to ensure that other functional budgets are capable of fulfillment.
The key factor may take various forms like sales, raw material, labour,
---------------------- production capacity, availability of funds and Government restrictions.
Once the key factor is established, the budget with respect to that function
---------------------- will be prepared first and the other budgets will be prepared to conform
to that. For example, if sales are the key factor, the sales manager will
----------------------
prepare and submit sales forecast first. The production manager will then
---------------------- decide whether it is possible to produce the quantity to meet sales demand.
In case of the situations where there are more than one key factor, the
---------------------- importance of the key factors themselves will be assessed first.
The problem of multiplicity of key factors may be solved with the help of
----------------------
techniques like linear programming, operations research etc.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. A _____________ is that __________ of time for which the budget
----------------------
will be prepared and operated
2. A ______________ is that section of the organisation with respect to ----------------------
which the budgets will be prepared
----------------------
3. A ________________ is a document setting out the responsibilities
of the persons engaged in and the forms and procedures required for ----------------------
the budgetary control. ----------------------
4. A __________________ is that the impact of which should be
assessed first before other functional budgets are prepared to ensure ----------------------
that other functional budgets are capable of fulfillment. ----------------------
----------------------
Activity 2
----------------------
Assuming that you are a finance manager, list four advantages of the ----------------------
budgetary control system, which you think would help make a positive
change. ----------------------
----------------------
10.4 TYPES OF BUDGETS ----------------------
There can be basically four areas in which management can function and ----------------------
the types of budgets can be studied with respect to these functional areas of
management. They are discussed below. ----------------------
1. Sales/Marketing Budgets ----------------------
The budgets in this area may be of following types:
----------------------
a. Sales Budget
----------------------
b. Selling and Distribution Cost Budget
c. Advertising Cost Budget ----------------------
a. Sales Budget ----------------------
It is a forecast of total sales expressed in terms of quantity and or money.
----------------------
It is inevitably the interplay between two factors, i.e. sales quantity
and selling price. Sales quantity may be forecasted after taking into ----------------------
consideration various factors.
i. Analysis of Past Trend: Analysis of the past trend over the last ----------------------
5-10 years may reveal the long-term trends, seasonal trends and ----------------------
the cyclical trends. With the help of this trend analysis, the future
trend can be established. For this purpose, reference can be made ----------------------

Notes to the reports published by trade organisations and Government
publications.
---------------------- ii. Reports by Salesmen: Being in the actual field, probably the sales
---------------------- staff may be best able to estimate the quantity, which can be sold
in the market. Before using this estimate as official sales forecast,
---------------------- necessary adjustments may be made for error of judgment or to
avoid the possibility of overestimation on the part of the salesmen.
----------------------
iii. Market Research and Market Survey: This is a very specialized
---------------------- technique available to assess which of the company’s products can
be sold, in which market, in what quantity and at what selling price.
---------------------- Such an analysis will facilitate the preparation of sales forecast area
wise, product wise, salesmen wise and channel of distribution wise.
----------------------
iv. General Economic Conditions: General trade and business
---------------------- conditions affect the sales forecast of the company. They may be
in the form of competition from other companies, supply condition
---------------------- for material and labour, trade conditions of the customers of the
---------------------- company and so on.
●● Cost price of the product
----------------------
●● Selling price charged by the competitors
---------------------- ●● Expected amount of profits
---------------------- ●● Advertisement and other sales promotion efforts carried out by the
company
----------------------
Selling price at which products of the company can be sold may depend
---------------------- upon various factors as explained further. If the company envisages selling
higher quantity than the past sales or the existing production capacity, and
---------------------- if some capital investment proposal is involved to increase the production,
then the feasibility of the proposal and the availability of funds may also be
---------------------- required to be considered. If the sales forecast is less than the past sales but the
---------------------- top management insists upon a certain amount of additional profits, then the
possibility of increasing the selling price or selling efforts and reduction in the
---------------------- cost price may be required to be considered.
---------------------- b. Selling and Distribution Cost Budget
It shows the selling and distribution cost for selling the quantities
---------------------- considered in sales budget. The sales manager, the distribution manager,
---------------------- the advertising manager and the finance manager will be the persons
involved in the preparation of this budget. This budget may be prepared
---------------------- on the principles of flexible budgeting (as discussed later in this unit) for
each head of selling and distribution costs, on the basis of volume of sales
---------------------- to be achieved.
---------------------- c. Advertising Cost Budget
---------------------- This cost is closely associated with sales. The intention of incurring this
cost is to increase the sales. However, the result of incurring this cost
---------------------- i.e. increased sales may not be immediate and even if there is increase

in sales, it is difficult to measure the portion of increased sales which Notes
is due to advertising cost. As such, normally, advertising cost budget is
established in the form of a fixed amount for a specific period. ----------------------
The various ways in which the amount of budgeted advertising cost can ----------------------
be decided are as below:
----------------------
●● Percentage of Sales or Profits: Here the advertising cost may be decided
as a fixed percentage of sales or profits. However, the past data may not ----------------------
be suitable in view of recent business situations.
----------------------
●● Funds Available: Here the advertising cost depends upon the capability of
the company to spend on advertising. This may be a hypothetical method ----------------------
and may not necessarily consider the relationship between advertising ----------------------
cost and benefits there from.
----------------------
●● Competitor’s Policy: Here the advertising cost may depend upon the
amount which the competitors are spending on advertising. This method ----------------------
may pose some difficulty as the amount spent by competitors may not be
known and it may be wrong to assume that the company may be able to ----------------------
derive the same benefits from advertising as the competitors derive.
----------------------
2. Production Budgets
----------------------
The budgets in this area may be of the following types:
----------------------
a. Production Budget
----------------------
It is a forecast of production for the budget period. It may be prepared from two
angles. ----------------------
i. Production Budget in terms of Quantity ----------------------

ii. Production Budget in terms of money, i.e. the production Cost Budget ----------------------
further classified under each element of cost such as Direct Material Cost,
Direct Labour Cost and Overheads Cost. ----------------------
The material cost can be estimated by preparing the materials budget, ----------------------
which indicates the estimated quantities as well as costs of various materials
----------------------
required for carrying out production as per production budget.
----------------------
The labour cost can be estimated by preparing the Direct Labour Cost
budget, which indicates the direct labour requirements required to produce the ----------------------
quantity as specified in the production budget. For the purpose of this budget,
labour requirement in terms of number of workers of different grades will be ----------------------
decided first. Afterwards, the rates of pay and allowances will be considered to
----------------------
decide the labour cost.
----------------------
The production overheads can be estimated by preparing production
overhead budget, which indicates all items of production overheads classified as ----------------------
fixed, variable and semi-variable. The process of allocation and apportionment
can be followed to decide the loading of overheads to each budget centre. ----------------------

Notes Following factors will have to be considered before preparing the
production budget in terms of quantity.
----------------------
i. Coordination with Sales Forecast: Before the quantity to be produced
---------------------- is decided, it will be necessary to confirm whether it is possible to sell the
quantity which is produced during the budget period. If it is not possible
---------------------- to sell whatever can be produced, in spite of all the sales promotion
efforts, then the production budget should be adjusted to conform to
----------------------
the sales forecast. If the expected sales exceed existing production
---------------------- capacity, possibility of overtime working or extra shift working should be
considered.
----------------------
ii. Production Capacity: Production Budget estimates the quantity to be
---------------------- produced. If it is not possible to produce the quantity with the existing
capacity available, it will be necessary to increase the capacity by
---------------------- incurring additional capital expenditure.
---------------------- iii. Consideration of Stocks: Whatever is to be sold need not be produced
necessarily.The quantity to be produced, after giving due consideration
---------------------- to the sales forecast, may depend upon the opening and closing stock of
finished goods. The quantity to be produced during the budget period may
----------------------
be decided as:
---------------------- Estimated Closing stock of finished goods
---------------------- Add: Quantity to be sold,
---------------------- Less: Opening Stock of Finished Goods.

iv. Management Policy: Sometimes, the policy decisions taken by the
---------------------- management are required to be considered before setting the production
---------------------- budget. For example, it will have to be considered whether certain
components are decided to be produced instead of purchasing or vice
---------------------- versa.
---------------------- b. Purchases Budget:

It is a forecast of quantity and value of materials, direct or indirect,
---------------------- required to be purchased during the budget period. It is needless to
---------------------- state that the purchases budget is closely connected to the production
budget. Following factors are required to be considered before setting the
---------------------- purchases budget:
---------------------- i. Orders already placed for the purchases of materials

ii. Material already purchased but reserved for some specific purposes
----------------------
iii. Opening and closing stocks
----------------------
iv. Storing facilities and economic order quantity
---------------------- v. Availability of funds
---------------------- vi. Prices of the materials
----------------------

3. Personnel Budgets Notes
In this functional area, the budget to be prepared takes the form of a
personnel budget, which indicates the requirement of personnel or labour ----------------------
force, either direct or indirect, to conform to the sales forecast and the ----------------------
production budget. The labour requirement may be decided in terms of
number and grade of workers, number of labour hours, rupee value etc. ----------------------
Consideration is also required to be made of the overtime working or
shift working. This budget may also indicate the training plans for new ----------------------
workers. ----------------------
4. Finance Budgets
----------------------
The most important budget which is prepared under this functional area
is the cash budget. It is an estimate of the expected cash receipts and cash ----------------------
payments during the budget period. Thus by preparing the cash budget,
it is possible to predict whether at any point of time, there is likely to be ----------------------
excess or shortage of cash. If the shortage of cash is estimated, it may be ----------------------
required to arrange the cash from some other source. If the excess of cash
is estimated, it may be possible to explore the investment opportunities. ----------------------
Before preparing the cash budget, the following principles should be kept
in mind. ----------------------
a. The period for which cash budget is prepared should be selected very ----------------------
carefully. There is no fixed rule as to the period to be covered by the
cash budget. It may vary from company to company depending upon ----------------------
the individual requirements. As a general rule, the period covered by the ----------------------
cash budget should neither be too long or too short. If it is too long, it
is possible that the estimate will not be accurate. If it is too short, the ----------------------
factors which are beyond the control of management will not be given
due consideration. ----------------------
b. The items that should appear in the cash budget should be carefully ----------------------
decided. Naturally, all those items, which do not involve cash flow,
will not be considered while preparing the cash budget. For example, ----------------------
as the cost of depreciation does not involve any cash outflow, it does ----------------------
not affect the cash budget, though the amount of depreciation affects the
determination of tax liability which involves cash outflow. ----------------------
A cash budget may be prepared in any of the following three methods: ----------------------
i. Receipts and Payments Method: This method is useful for short term
----------------------
estimations. It lists the various estimated sources of cash receipts on one
hand and the various estimated applications of cash on the other. ----------------------
While preparing the cash budget by this method, the various items
----------------------
appearing on the same may be classified under the following two categories:
●● Operating Cash Flows: These are the items of cash flow which arise as ----------------------
a result of regular operations of the business.
----------------------
●● Non operating Cash Flows: These are the items of cash flow which arise
as the result of other operations of the business. ----------------------

Notes The standard items which may appear on the cash budget prepared by this
method may be stated as below:
----------------------
Cash Inflow Operating: Cash Inflow Operating:
---------------------- Cash sales Payment to creditors Collection
---------------------- from debtors Cash Purchases of raw materials

Dividend received Interest/
----------------------
Various kinds of overheads. Wages/Salaries
----------------------
(To the extent they are actually paid)
---------------------- Non-operating Non-operating
Issue of shares/debentures Redemption of shares/debentures.
----------------------
Receipt of loans/borrowings Loan Installments Sales of Fixed
----------------------
Assets Purchases of Fixed Assets Sales of
---------------------- Interest Investments
---------------------- Taxes
---------------------- Dividends.
---------------------- Thus, finally cash budget appears in the form of opening cash balance, to
which various estimated cash receipts are added, the estimated cash payments
---------------------- being deducted from this sum to arrive at the closing cash balance.
---------------------- ii. Balance Sheet Method: This method is useful for long term estimates.
According to this method, the budgeted Balance Sheet is prepared for the
---------------------- following budget period, after considering the various terms viz. Capital,
Long Term Liabilities, Current liabilities, Fixed Assets, Current Assets,
---------------------- but except cash. After both the sides of Balance Sheet are balanced, the
---------------------- balancing figure indicates the estimated cash balance in hand at the end of
that period.
---------------------- This method does not consider the expenses and assumes the regular
---------------------- pattern of inflow and outflow of cash. Further, it indicates the cash requirement
only at the end of budget period, any excess or shortage of cash during the
---------------------- budget period are not considered.
---------------------- iii. Adjusted Profits/Losses Method: This method also is useful for long-
term estimates. According to this method, the cash budget is prepared in
---------------------- the following way to show the estimated cash balance at the end of the
budget period.
----------------------
Opening cash balance.
----------------------
Add: Profit before depreciation, provisions and other non-cash expenses
---------------------- Add: Decrease in Current Assets or Increase in Current Liabilities
---------------------- Add: Capital Receipts
---------------------- Add: Receipt of loans/borrowings

Less: Capital Expenditure Notes
Less: Repayment of loan installments
----------------------
Less: Payment of dividends/taxes
----------------------
Less: Increase in Current Assets or Decrease in Current Liabilities
In other words, cash budget prepared as per this method is in the form of ----------------------
cash flow statement. ----------------------
5. Miscellaneous Budgets
----------------------
In addition to various budgets as described above, which can be prepared
in prime functional areas of marketing, production, personnel and finance, some ----------------------
other types of budgets may also be prepared.
----------------------
a. Overheads Cost Budget: It indicates the various types of overheads
to be incurred during the budget period. For the correct establishment ----------------------
of overheads cost budget, it will be necessary to classify the various
----------------------
overheads. In order to exercise proper control on the overheads, it will be
necessary to analyse the overheads as fixed, variable and semi-variable. ----------------------
The semi-variable overheads are further required to be split into fixed and
variable elements. ----------------------
b. Capital Expenditure Budget: It is the plan of proposed investment in ----------------------
the fixed assets. It is closely related to the sales budget, production budget
and cash budget. As such, capital expenditure budget should be properly ----------------------
coordinated with other functional budgets.
----------------------
The capital expenditure may be required to be incurred for the replacement
purposes or expansion purposes. The requirements of capital expenditure may ----------------------
be basically received from the various functional executives viz. production ----------------------
manager, sales manager, finance manager and so on.
If the investment in fixed assets is considered to be economically and ----------------------
financially feasible, then the arrangement is required to be made for the ----------------------
acquisition of the same. If the cash budget reveals the excess funds available,
it may not be necessary to arrange the funds for acquiring the fixed assets from ----------------------
outside source. However, if no excess cash balance is available, then it may be
necessary to borrow the funds from some outside source. ----------------------
c. Master Budget: After all the functional budgets are prepared individually ----------------------
and are properly coordinated with each other, the master budget can
be prepared by incorporating all the functional budgets. The ultimate ----------------------
incorporation of all the functional budgets takes the form of budgeted ----------------------
Profit and Loss Account and the Budgeted Balance Sheet.
----------------------
It may involve the presentation of current year’s budgeted figures as well
as those of the previous year showing clearly why there is a change. ----------------------
----------------------
----------------------

Notes 10.5 FIXED AND FLEXIBLE BUDGET
---------------------- Any budget in any functional area of operation can be established as a
fixed budget or a flexible budget.
----------------------
A fixed budget is established for a specific level of activity and is not
---------------------- adjusted to the actual level of activity attained at the time of comparison between
the budgeted and actual results. Naturally, fixed budget is established only for
---------------------- a short period of time where the budgeted level of activity is expected to be
---------------------- attained to the maximum possible extent. Fixed budgets are more suitable for
fixed expenses i.e. the expenses which have no relation with the level of activity.
---------------------- The fixed budgets do not indicate that they cannot be changed at all. A fixed
budget can be revised if the actual level of activity is likely to differ widely from
---------------------- the budgeted level of activity. Fixed budget cannot be used as a effective tool of
---------------------- cost control while computing the variations between the budgeted result and the
actual result, the variance cannot be explained properly and it is not possible to
---------------------- say whether the variance is due to the changes in the level of activity or due to
the efficiency or inefficiency of the executive responsible for the execution of
---------------------- the budget.
---------------------- A flexible budget is designed to change with the fluctuations in the level
of activity and provides a basis for comparison for any level of activity actually
---------------------- attained. A flexible budget is more elastic, and practical. It can be properly
---------------------- used as an effective tool for the evaluation of performance and cost control. It
explains the variations between the budgeted results and actual results stating
---------------------- the variations, which are due to changes in the level of activity (beyond the
control of operating executive) and which are due to the operational efficiency
---------------------- or inefficiency (for which the operating executive is responsible.)
---------------------- For the purpose of establishment of the flexible budgets, it is necessary
to classify the costs as fixed costs, variable costs and semi-variable costs. The
----------------------
fixed costs remain the same at all the levels of activity whereas the variable
---------------------- costs change directly in proportion to the level of activity. So far as the semi-
variable costs are concerned, each item of cost is examined and classified into
---------------------- its fixed and variable elements and a trend is established regarding the nature
and behavior of each item of cost.
----------------------
----------------------
Fill in the blanks:
----------------------
1. ____________ estimates the quantity to be produced.
---------------------- 2. _______________ is a forecast of quantity and value of materials,
---------------------- direct or indirect, required to be purchased during the budget period.
3. _______________ method is useful for short-term estimations.
----------------------
4. ________________ method is useful for long term estimates.
----------------------

Notes
Activity 3
----------------------
Prepare a list of three types of budgets, which your organisation might be ----------------------
interested in from a budgetary control’s point of view.
----------------------
Summary ----------------------
----------------------
●● Budget is defined as a financial and/or quantitative statement, prepared
prior to a defined period of time, of the policy to be pursued during that ----------------------
period for the purpose of attaining a given objective.
----------------------
●● Budgetary Control’ is defined as the establishment of budgets, relating
the responsibilities of executives to the requirements of a policy and the ----------------------
continuous comparison of actual with budgeted results, either to secure
----------------------
by individual action the objective of that policy or to provide the basis for
its revision. ----------------------
●● This unit discusses the prerequisites of implementing the budgetary ----------------------
control, which involves various steps such as deciding the budget centre,
budget period, establishing of accounting records, and organisation for ----------------------
budgetary control, preparation of budget manual and determination of
----------------------
budget key factor.
●● There are different types of budgets with respect of functional areas ----------------------
of management. They are sales budget, purchases budget, production
----------------------
budget, finance budget, personnel budget and cash budget.
●● We come across fixed and flexible budget that is; a fixed budget is ----------------------
established for a specific level of activity and is not adjusted to the actual ----------------------
level of activity attained at the time of comparison between the budgeted
and actual results. Naturally, fixed budget is established only for a short ----------------------
period of time where the budgeted level of activity is expected to be
attained to the maximum possible extent. ----------------------
●● Fixed budgets are more suitable for fixed expenses, i.e. the expenses that ----------------------
have no relation with the level of activity.
----------------------
●● A flexible budget is designed to change with the fluctuations in the level
of activity and provides a basis for comparison for any level of activity ----------------------
actually attained.
----------------------
●● A flexible budget is more elastic, and practical. It can be properly used
as an effective tool for the evaluation of performance and cost control. It ----------------------
explains the variations between the budgeted results and actual results,
stating the variations which are due to changes in the level of activity ----------------------
(beyond the control of operating executive) and which are due to the
----------------------
operational efficiency or inefficiency (for which the operating executive
is responsible.) ----------------------

Notes Keywords
---------------------- ●● Budget: Is defined as a financial and/or quantitative statement, prepared
prior to a defined period of time, of the policy to be pursued during that
---------------------- period for the purpose of attaining a given objective.
---------------------- ●● Budgetary Control: Is defined as the establishment of budgets, relating
the responsibilities of executives to the requirements of a policy and the
---------------------- continuous comparison of actual with budgeted results, either to secure
by individual action the objective of that policy or to provide the basis for
----------------------
its revision.
---------------------- ●● Budget Centre: Is that section of the organisation with respect to which
the budgets will be prepared. A budget centre may be in the form of a
---------------------- product or a department or a branch of the company and so on.
---------------------- ●● Budget Period: Is that period of time for which the budget will be
prepared and operated.
----------------------
●● Budget Manual: Is a document setting out the responsibility of the
---------------------- persons engaged in and the forms and procedures required for the
budgetary control. A budget manual enables the standardization of the
---------------------- methods and procedures in relation to the budgetary control.
---------------------- ●● Capital Expenditure Budget: It is the plan of proposed investment in
the fixed assets. It is closely related to the sales budget, production budget
---------------------- and cash budget. As such, capital expenditure budget should be properly
coordinated with other functional budgets.
----------------------
●● Finance Budget: The most important budget, which is prepared under
---------------------- this functional area, is the cash budget. It is an estimate of the expected
cash receipts and cash payments during the budget period.
----------------------
●● Fixed Budget: A fixed budget is established for a specific level of activity
---------------------- and is not adjusted to the actual level of activity attained at the time of
comparison between the budgeted and actual results. Naturally, fixed
----------------------
budget is established only for a short period of time where the budgeted
---------------------- level of activity is expected to be attained to the maximum possible extent.
Fixed budgets are more suitable for fixed expenses, i.e. the expenses,
---------------------- which have no relation with the level of activity.
---------------------- ●● Flexible Budget: It can be properly used as an effective tool for evaluation
of performance and cost control. It explains the variations between the
----------------------
budgeted results and actual results stating the variations, which are due to
---------------------- changes in the level of activity.
●● Master Budget: After all the functional budgets are prepared individually
----------------------
and are properly coordinated with each other, the master budget can
---------------------- be prepared by incorporating all the functional budgets. The ultimate
incorporation of all the functional budgets takes the form of budgeted
----------------------
----------------------

Profit and Loss Account and the Budgeted Balance Sheet. It involves the Notes
presentation of current year’s budgeted figures as well as those of the
previous year showing clearly why there is a change. ----------------------
●● Overheads Cost Budget: It indicates the various types of overheads ----------------------

to be incurred during the budget period. For the correct establishment
----------------------
of overheads cost budget, it will be necessary to classify the various
overheads. ----------------------
●● Production Budget: It is a forecast of production for the budget period.
----------------------
●● Purchases Budget: It is a forecast of quantity and value of materials,
direct or indirect, required to be purchased during the budget period. It ----------------------
is needless to state that the purchases budget is closely connected to the
----------------------
production budget.
●● Personnel Budget: Indicates the requirement of personnel or labour ----------------------
force, either direct or indirect, to conform to the sales forecast and the ----------------------
production budget. The labour requirement may be decided in terms of
number and grade of workers, number of labour hours, rupee value etc. ----------------------
Consideration is also required to be made of the overtime working or
----------------------
shift working. This budget may also indicate the training plans for new
workers. ----------------------
●● Sales Budget: It is a forecast of total sales expressed in terms of quantity
----------------------
and or money. It is inevitably the interplay between two factors i.e. sales
quantity and selling price. ----------------------
----------------------
1. An estimate shows that there is a market for 10,00,000 units of an electric
bell. Two big companies producing this electric bell will probably divide ----------------------
80% of the market. Among other companies, producing the bell, Ghatanad
Ltd. should get 15% of the total market. 60% of the Ghatanad sales will ----------------------
probably be evenly divided between the first and last calendar quarters,
----------------------
with twice as many sales being made in the second quarter as in the third.
The bell sells for Rs.30 per unit, with the manufacturing cost as follows. ----------------------
The cost is worked out with reference to normal working capacity for the
----------------------
production which is 1,50,000 bells a year.
----------------------
Direct Materials Cost Rs. 15.00
Direct Labour Cost Rs. 7.50 ----------------------
Variable overheads Cost Rs. 2.50 ----------------------
Fixed overhead Cost Rs. 1,00,000 ----------------------
Prepare a sales budget for the year showing cost of production and gross profit
----------------------
by calendar quarters. Assume no change in the inventory levels during the year.
----------------------

Notes Solution:
---------------------- SALES BUDGET
Particulars Qtr. I Qtr. II Qtr. III Qtr. IV Total
----------------------
(A) Sales - Units 45,000 40.000 20.000 45,000 1.50.000
----------------------
Rs. 13.50.000 12.00.000 6.00.000 13.50.000 45.00.000
---------------------- (B) Cost of Production
---------------------- Direct Materials Rs. 6.75.000 6.00.000 3.00.000 6.75.000 22.50.000
Direct Labour Rs. 3.37.500 3.00.000 1.50.000 3.37.500 11.25.000
----------------------
Variable Overheads Rs. 1.12.500 1.00.000 50,000 1.12.500 3.75.000
----------------------
Fixed Overhead Rs. 25.000 25.000 25.000 25.000 1,00.000
---------------------- 11.50.000 10.25.000 5,25.000 11.50.000 38.50.000
---------------------- (c) Gross Profit i.e. A - B 2.00.000 1.75.000 75.000 2.00.000 6.50.000
---------------------- Note: It is assumed that the fixed overheads are apportioned evenly over the
various quarters.
----------------------
(2) XYZ Ltd. manufactures product C and G. During January, it expects
---------------------- to sell 5,000 Kg of C and 20,000 Kg of G at Rs. 20 and Rs. 10 each
respectively.
----------------------
Direct materials A, B and E are mixed in equal proportion to produce
---------------------- product C. Materials D, B and E are mixed in the proportion of 5:3:2 to produce
product G. There is no loss of weight in the production.
----------------------
Actual and budgeted inventories in quantities and costs for the month are
---------------------- as follows:
---------------------- Opening Inventory Desired Closing Anticipated Cost
---------------------- Kgs. Inventory Kgs. per kg.
Material A 1,500 1,000 5.50
---------------------- B 1,000 2,000 5.00
---------------------- D 10,000 3,000 1.00
E 5,000 6,000 3.50
---------------------- Product C 1,000 500 —
---------------------- G 5,000 6,000 —
You are required to prepare (i) the production budget (ii) the materials
----------------------
purchase budget, indicating the expenditure on raw materials for January.
----------------------
----------------------
----------------------
----------------------

Solution: Notes
(A) Production Budget: January 1987
----------------------
Product C Product G
Anticipated Sales - kgs. 5,000 20,000 ----------------------
Desired closing stock - kgs 500 6,000 ----------------------
5,500 26,000
Less: Opening stock kgs. 1,000 5,000 ----------------------
Production during month kgs. 4,500 21,000 ----------------------
(B) Materials Purchase Budget - January 1987 ----------------------
A B D E
----------------------
(a) Requirement for production
(As per production Budget) ----------------------
For product C - kgs 1,500 1,500 — 1,500
----------------------
For product G - kgs. — 6,300 10,500 4,200
Total requirement - kgs. 1,500 7,800 10,500 5,700 ----------------------
(b) Desired closing stock - kgs 1,000 2,000 3,000 6,000 ----------------------
(c) Sub total a +b kgs 2,500 9,800 13,500 11,700
(d) Opening stock kgs 1,500 1,000 10,000 5,000 ----------------------
(e) To be purchased during month kgs. c - d 1,000 8,800 3,500 6,700 ----------------------
(f) Anticipated cost per kg. Rs. 5.50 5.00 1.00 3.50
----------------------
(g) Anticipated cost of purchases Rs. 5,500 44,000 3,500 23,450
----------------------
1. What do you mean by Budget and Budgetary Control? What are the ----------------------
advantages of budgetary control as a cost control technique? What are the
prerequisites for the successful implementation of the Budgetary Control ----------------------
System?
----------------------
2. What is the meaning of Budget and Budgetary Control? State and explain
the various budgets which can be established in the following functional ----------------------
areas of operation:
----------------------
a. Sales/Marketing
----------------------
b. Production
c. Finance ----------------------
3. Write short notes. ----------------------

a. Budget Manual ----------------------
b. Fixed and Flexible Budgets
----------------------
c. Cash Budget
----------------------

Notes Answers to Check your Progress
---------------------- Check you Progress 1
---------------------- 1. Budgetary Control deals with computation of the variations and the
actions to be taken.
----------------------
2. Budget is a financial statement, prepared prior to a defined period of time.
---------------------- 3. Budget spells out the objects to be attained and the policies to be pursued
---------------------- to achieve that objective.
----------------------
1. False
----------------------
2. False
---------------------- 3. False
---------------------- 4. True
----------------------
---------------------- Check you Progress 2

Fill in the blanks.
----------------------
1. A Budget Period is that period of time for which the budget will be
---------------------- prepared and operated
---------------------- 2. A budget centre is that section of the organisation with respect to which
the budgets will be prepared
----------------------
3. A budget manual is a document setting out the responsibilities of
---------------------- the persons engaged in and the forms and procedures required for the
---------------------- budgetary control.
4. A budget key factor is that the impact of which should be assessed first
---------------------- before other functional budgets are prepared to ensure that other functional
---------------------- budgets are capable of fulfillment.
Check you Progress 3
----------------------
Fill in the blanks.
----------------------
1. Production Budget estimates the quantity to be produced
---------------------- 2. Purchases Budget is a forecast of quantity and value of materials, direct
---------------------- or indirect, required to be purchased during the budget period
3. Receipts and Payments method is useful for short term estimations.
----------------------
4. Balance Sheet method is useful for long term estimates
----------------------
----------------------

Notes
Suggested Reading
----------------------
1. http://www.fao.org/docrep/W4343E/w4343e05.htm
2. Rautenstrauch, Walter and Villers, Raymond. Budgetary Control ----------------------
3. Edward J. Vanderbeck, Maria R. Mitchell, Principles of Cost Accounting ----------------------
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Standard Costing
UNIT
11
Structure:
11.1 Introduction
11.2 Concept of Standard Cost and Standard Costing
11.2.1 Advantages of Standard Costing
11.2.2 Limitations of Standard Costing
11.2.4 Preliminaries for Establishing Standard Costing System
11.3 Types of Standards
11.3.1 Current Standards
11.4 Analysis of Variances
11.4.2 Labour Cost Variances
11.4.3 Overhead Cost Variances
Summary
Key Words
Suggested Reading
Standard Costing 237

Notes
Objectives
----------------------
• Define the concept of standard cost and costing
----------------------
• Evaluate the advantages and limitations of standard costing
----------------------
• Compare standard costing and budgetary control
---------------------- • Choose the preliminaries for establishing the standard costing system.
---------------------- • Analyze the concept of variances in the elements of costs
---------------------- • Determine the application of standard costing with the help of
illustrative problems
----------------------
---------------------- 11.1 INTRODUCTION

---------------------- The determination of the actual cost on the basis of the various costing
---------------------- records maintained is no doubt important, but such actual cost (or historical
cost) involves some limitations as to its utility. The actual cost information is
---------------------- available only after the completion of the job, process or service and hence is
of no practical utility from control point of view, as no basis is provided with
---------------------- which the actual costs can be compared.
---------------------- There are various kinds of managerial decisions where cost is an inevitable
basis as in price fixation or submission of quotations. However, if the details of
---------------------- actual costs are available too late, such cost details are of no practical utility for
---------------------- the purpose of price fixation or submission of quotation. The actual costs may
be affected due to inefficient functioning. The actual costs may be excessive due
---------------------- to abnormal expenses, avoidable wastes, inefficient use of labour and excessive
use of materials.
----------------------
As such, actual costs are not useful for providing a yardstick for measuring
---------------------- efficiency of performance. Actual costing is comparatively expensive, as it
involves the maintenance of various records and documents. The above stated
----------------------
limitations involved with the determination of actual costs have given rise to
---------------------- the technique of standard costing.
---------------------- 11.2 CONCEPT OF STANDARD COST AND STANDARD

---------------------- COSTING
---------------------- The term ‘standard cost’ has been defined as a pre-determined cost, which
is calculated from the management’s standards of efficient operation and the
---------------------- relevant necessary expenditure.
---------------------- The term ‘standard costing’ has been defined as ‘the preparation and use
of standard costs, their comparison with actual costs and the measurement and
---------------------- analysis of variances to their causes and points of incidence.’

Thus, standard cost is the normal cost under the ideal circumstances. Notes
It may be used as a base for the purpose of price fixation and submission of
quotations. Moreover, the standards, when compared with the actual cost, may ----------------------
also be used as tools for cost control and as a yardstick for measuring efficiency
----------------------
of performance, which is possible with standard costing system. As such, the
process of standard costing involves the following stages. ----------------------
1. Pre-determination of technical data related to production, i.e. details of ----------------------
materials and labour operations required for each product, the quantum of
inevitable losses, level of activity etc. ----------------------
2. Pre-determination of standard costs in full details under each element of ----------------------
cost, i.e. labour, material and overhead.
----------------------
3. Comparison of actual performance and costs with standards and working
out the variances, i.e. the difference between the actual and the standards. ----------------------
4. Analysis of variances in order to determine the reasons for deviations of ----------------------
actuals from the standards.
----------------------
5. Presentation of information to the appropriate level of management to
enable suitable action being taken or revision of standards. ----------------------
It should be noted in this connection that standard costing is not a separate ----------------------
system of accounting but only a technique used with the intention of controlling
the costs. Though it can be used in case of all methods of costing such as job ----------------------
costing, process costing etc., it can be more effective in case of industries
----------------------
producing the standard products on continuous basis.
11.2.1 Advantages of Standard Costing ----------------------
Standard costing provides a yardstick with reference to which the ----------------------

efficiency/ inefficiency in performance may be established. This facilitates
----------------------
the basic management function of cost control. Other advantages of Standard
Costing are given below. ----------------------
1. Standard costing provides the incentive and motivation to work with ----------------------
greater effort for achieving the standard.
----------------------
2. Standard costs may be used as the basis for the process of price fixation,
filing tenders and offering quotations. If the prices are to be quoted on ----------------------
cost plus basis, actual costs may not be available, in which case standard
costs can be the base for fixation of selling prices. ----------------------
3. Standard costing system facilitates delegation of authority and fixation of ----------------------

responsibility for each individual or department. This also tones up the
----------------------
general organization of the concern.
4. Variance analysis and reporting is based on the principle of management ----------------------
by exception. The top management may not be interested in details of ----------------------
actual performances but only in the variations from the standard, so that
corrective measures may be taken in time. ----------------------

Notes 5. When constantly reviewed, the standards provide means for and encourage
action for cost reduction. Focus on out of control situations leads to cost
---------------------- reduction through the improved methods, improved quality of products,
better material and workers, effective selection and use of capital resource
---------------------- etc.
---------------------- 6. A properly laid down system of standard costing may facilitate the correct
implementation of the technique of budgetary control, which also is a
----------------------
good system of cost control.
---------------------- 11.2.2 Limitations of Standard Costing
---------------------- Establishment of standard costs is difficult in practice. Even though
standards are fixed after defining them properly, there is no guarantee that the
---------------------- standards established will have the same tightness or looseness as envisaged.
Followings are the limitations of standard costing:
----------------------
1. In the course of time, even in a short period, the standards become rigid.
---------------------- It may not be possible to maintain the standards to keep pace with the
---------------------- changes in manufacturing conditions. Revision of standards is costly.
2. Sometimes, standards set create adverse effects. If standards are set tightly
---------------------- and there is non-achievement of the same, it creates frustration.
---------------------- 3. The standard costing may not be suitable in all types of organizations, for
example,
----------------------
(i) In case of small concerns, where the production cannot be properly
---------------------- scheduled. In small concerns, personal contacts may be more
effective than the standard costing.
----------------------
(ii) In case of industries having non-standardized products.
----------------------
(iii) In case of industries having repair jobs, which keep changing as per
---------------------- customer requirements.
---------------------- (iv) In case of industries where products take more than one accounting
period to complete, for example, contract jobs.
---------------------- 4. Due to the play of random factors, it may be difficult to properly examine
---------------------- the variance and distinguish between controllable and uncontrollable
variances. For example, adverse labour time variance may be due to poor
---------------------- grade of labour, poor quality of material, defective plant and machinery
and lack of trained workers.
----------------------
5. Lack of interest in standard costing on the part of the management makes
---------------------- the system ineffective and cannot be used as a proper means of cost
control.
----------------------
----------------------
Both standard costing and budgetary control are the best possible tools
---------------------- available to the management for the purpose of controlling the costs. Both the
techniques involve the process of setting the targets or standards, measurement
---------------------- of actual performance, comparison of actual performance with targets or

standard set, computation and analysis of variations and the attempts to maintain Notes
favourable variations and remove unfavourable variations.
----------------------
The technique of budgetary control can be used effectively if the system
of standard costing is prevailing. Thus, both the techniques complement each ----------------------
other but are not necessarily dependent upon each other. On the other hand,
in spite of various similarities, both the techniques differ from each other in ----------------------
certain respects.
----------------------
1. System of budgetary control may be operated even if no standard costing
system is in use in the concern. ----------------------
2. Budgets are the ceilings or limits on expenses above which actual ----------------------
expenditure should not normally exceed and if it does, the planned profits
will be reduced. Standard costs are minimum targets to be attained by the ----------------------
actual performance.
----------------------
3. Budgets may be prepared in various areas of activities such as sales,
production, purchases, capital investment etc., whereas standard costing ----------------------
specifically relates to the function of production and manufacturing costs. ----------------------
4. A more searching analysis is required to be made in case of standard costing
variances than in case of budgetary control variances. Variances in case of ----------------------
budgets may point out efficiency or inefficiency. But variances in case of ----------------------
standard costing provide material for further probe and investigation.
5. The scope of standard costing is much wider than that of budgetary control. ----------------------
Adherence to budgeted performance may indicate that the business is out ----------------------
of difficulties. A genuine attempt to attain the standards always provides
scope for improved performance. ----------------------
6. Budgets are based upon the future or estimated costs, which may be ----------------------
used for forecasting the requirements of various factors of production
such as material, labour, finance etc. Standard costs are planned or ideal ----------------------
costs under the ideal situations as to operating efficiency, capacity level
----------------------
attainment and so on. Standard costs may not be necessarily useful for
forecasting purposes. ----------------------
11.2.4 Preliminaries for establishing Standard Costing System
----------------------
Before the standard costing system is established in an organization, the
following preliminaries will have to be complied with. ----------------------
(1) Establishment of cost centres: As explained before, a cost centre is any ----------------------
unit, with respect to which, the costs will be ascertained. If the standard
costing system is to be implemented, the cost centres should be defined ----------------------
very clearly so that the responsibility can be fixed in case of non standard ----------------------
performance.
(2) Design of accounts: As the standard costing essentially involves the ----------------------
process of comparing the actual performance to standard performance and ----------------------
computation of variances therefrom, the accounts should be designed in
such a way that the information about the actual performance is available ----------------------

Notes as correctly as possible and as speedily as possible. For this purpose, the
codification of accounts may be considered.
----------------------
(3) Establishment of standards: This is probably the most critical part of the
---------------------- implementation of standard costing, i.e. to establish the standards with
respect to the individual elements of cost, i.e. Direct Material Cost, Direct
---------------------- Labour Cost and Overheads. It is necessary to exercise maximum care
while establishing the standards, as wrongly established standards may
----------------------
defeat the purpose of standard costing.
---------------------- Following steps are involved in the process of establishing the standards:
---------------------- 1. Study of technical and operational details of the organization, e.g. the
manufacturing process, levels of managements and their responsibilities,
---------------------- units and nature of inputs and outputs, details regarding wastes and losses,
expected efficiency and capacity utilization etc.
----------------------
2. Study of existing cost accounting systems and formats in use.
----------------------
3. Decision about the types of standards to be used. It may be noted that
---------------------- there may be various types of standards.
----------------------
----------------------
---------------------- 1. The term ‘standard cost’ has been defined as a _________ cost, which
is calculated from the management’s standards of efficient operation
---------------------- and the relevant necessary expenditure.
---------------------- 2. Standard costs may be used as the basis for the process of ________,
____________tenders and offering _____________.
----------------------
3. Budgets are based upon the ___________ or _____________ costs
----------------------
----------------------
11.3 TYPES OF STANDARDS
----------------------
Basic Standards
----------------------
These are established for an unaltered use over a longer period of time
---------------------- and they do not reflect the current conditions. These types of standards are not
useful from the cost control point of view and can be used in case of industries
---------------------- where technical processes are fully established or in the case of those types of
costs, which are fixed in nature, viz. rent, remuneration to managerial personnel
----------------------
etc.
---------------------- 11.3.1 Current Standards
---------------------- These are established for a shorter period and are adaptable to change
in current conditions. As current conditions are likely to change, the current
---------------------- standards are also subject to revision as per the changes in current conditions.

Current standards may be of three types. Notes
i. Ideal Standards: These are the standards, which are set and which are
----------------------
attainable under the most favourable conditions possible and assume the
maximum utilization of various factors of production (like men, material ----------------------
and machines), which is not practicable and attainable. Thus, the ideal
standards are generally theoretical in nature and the variances always ----------------------
show an unfavorable trend. The basic limitation of these types of standards
----------------------
is that the constant non-achievement of these standards causes frustration
among the staff and the constant reporting of unfavorable variances is ----------------------
presumed, which results into lost impact of system itself.
----------------------
ii. Expected Standards: These are the standards, which are anticipated to
be attained during the budget period. These are based upon the expected ----------------------
performance based upon the conditions likely to prevail during the budget
period. Allowances are provided for the unavoidable deviations from ----------------------
the ideal performance, e.g. labour time wastage, excess material use,
----------------------
breakdown of machinery etc. Thus, these standards are more realistic in
nature and are more useful from cost control point of view. ----------------------
iii. Normal Standards: These are the standards, which may be anticipated
----------------------
to be achieved in future, over a longer period, considering the past
performance. As such, the inefficiencies of the past performance, if any, ----------------------
get reflected in these types of standards. Further, the problems faced in
estimating the future over a longer period of time also restrict the use of ----------------------
these standards for cost control purposes.
----------------------
----------------------
After the consideration of various types of standards that may be used, the
process of establishment of standards with respect to various elements of costs ----------------------
comes into operation.
----------------------
As discussed above, the standards may be set for various elements of
costs, i.e. Direct Material Cost, Direct Labour Cost and Overheads. ----------------------
(a) Direct Material Cost: Setting the standard cost for Direct Material ----------------------
involves two stages, i.e. to decide the Price Standard and to decide the
Use Standard. ----------------------
• Price Standard: It may involve the consideration of following ----------------------
factors:
----------------------
(i) Current market conditions and likely changes.
(ii) Prices of current supply orders. ----------------------
(iii) Prices of long term supply contracts. ----------------------

Along with the basic prices, it may involve the consideration of the factors ----------------------
such as discount, packing charges, insurance, sales tax, octroi etc. It may
be the primary responsibility of the Purchase Department to supply the ----------------------
details required for this purpose.
----------------------

Notes • Use Standard: It may be the primary responsibility of Engineering or
Design Department to supply the details required for this purpose, on
---------------------- the basis of standard bill of material. This may involve the process of
product study. Sufficient provisions should be made for unavoidable
---------------------- scrap or wastages.
---------------------- (b) Direct Labour Cost: Setting the standard cost for Direct Labour involves
two stages, i.e. to decide the wage rate standard and to decide labour
---------------------- efficiency standard.
---------------------- • Wage Rate Standards: It may involve the consideration of following
factors:
----------------------
i. The system of wages payments prevailing, i.e. Piece Rate
---------------------- Wages or Time Rate Wages.
ii. Systems prevailing for bonus payments.
----------------------
iii. The provisions of agreements with workers covering a future
---------------------- time.
---------------------- iv. Provisions of various laws and guidelines governing the

fixation of wage rates.
---------------------- v. Grades of workers required and likely trends of market
---------------------- conditions in respect of availability thereof.
• Labour Efficiency Standards: It may be decided on the basis of the
---------------------- consideration of following factors:
---------------------- (i) Records of past performance.
---------------------- (ii) Time and motion study considering the details in respect of an
average worker as the base.
----------------------
(iii) Trial runs, specifically in respect of a new product. Sufficient
---------------------- provision should be made in respect of the unavoidable idle time.
(c) Overheads Cost: Setting the standard cost of overheads involves the
----------------------
following stages:
---------------------- (i) Estimation of standard overheads cost.
---------------------- (ii) Estimation of standard level of activity (in terms of labour hours,
machine hours or units of production).
----------------------
(iii) Estimation of standard overhead absorption rate, which may be
---------------------- decided as Standard Overhead Cost / Standard Level of Activity
---------------------- Thus, the standard absorption rate may be per unit of production, per labour
hour or per machine hour. For better control purposes, the standards for
---------------------- overhead cost may be decided separately for fixed overheads and variable
overheads, as fixed overheads are normally uncontrollable at the lower
---------------------- level of management.
---------------------- (d) Reporting of Variances: The basic intention of implementation of
standard costing system as a cost control device is not complete till the
---------------------- variances computed in respect of each element of cost are properly reported

to the relevant level of management for decision-making purposes. For Notes
this purpose, the following propositions should be considered.
----------------------
i. For effective cost control, the organizational structure should be
clearly defined and responsibility of each individual should be ----------------------
clearly defined.
----------------------
ii. The reports reporting the variances should be simple, clear and
quick. ----------------------
iii. The computation and analysis of variances in respect of each
----------------------
element of cost should be accurate. A wrong analysis of variances
may result into misleading conclusions. ----------------------
iv. For more effectiveness, the variances should be segregated as ----------------------
controllable variances and non-controllable variances. However,
the analysis of uncontrollable variances should be made with the ----------------------
same care as in case of controllable variances.
----------------------
v. The reporting of variances should contain a comparison with the
planned results. ----------------------
vi. The format and the contents of reports reporting the variances may ----------------------
depend upon the level of management to whom reports are being
made. The reports to top management would be obviously formal ----------------------
containing only the broad details and final results. The reports to
lower level of management may contain the full analysis of each ----------------------
variance showing the causes and locating the responsibilities. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. Standard costing specifically relates to the function of ____________
and ____________ costs. ----------------------
2. ______________ Standards are the standards, which may be ----------------------
anticipated to be achieved in future, over a longer period, considering
the past performance. ----------------------
3. ___________________ Standards are the standards, which are ----------------------
anticipated to be attained during the budget period.
----------------------
----------------------
11.4 ANALYSIS OF VARIANCES
----------------------
As stated earlier, the process of standard costing involves the establishment
of standard costs and the computation of actual costs under each element of cost ----------------------
and the comparison between standard costs and actual costs. The difference
between standard cost and actual cost is termed as ‘variance’. If the actual cost ----------------------
is less than the standard cost, the variance is a favourable variance. If the actual
----------------------

Notes cost is more than the standard cost, the variance is an unfavorable or adverse
variance.
----------------------
The utility of standard costing as a technique of cost control is not
---------------------- complete only by the computation of variances unless these variances are further
analysed as to the causes responsible for these variances. The basic objective of
---------------------- variance analysis is to classify the variances as controllable and uncontrollable
ones. For example, if material actually used is in excess of standard quantity or
----------------------
if time actually taken by the workers is more than standard time, the variance
---------------------- will be an unfavourable one, for which the responsibility can be assigned on the
executives concerned.
----------------------
However, if the variances occur due to general strike, general increase
---------------------- in wage rates, devaluation of currency, change in customers’ demands etc., the
variances will be uncontrollable ones, for which no responsibility can be assigned
---------------------- to any executive. By concentrating most on controllable and adverse variances,
it is possible for the management to exercise control through exception, which
----------------------
is the basic objective of standard costing.
---------------------- Thus, the stress can be laid on variances only and no further action will
be necessary in cases where standard costs are matching with the actual costs,
----------------------
provided the conditions underlying the fixation of standards remain unchanged.
---------------------- The variances arising in one period may be compared with variances in
---------------------- the previous period for a better control.
Thus a detailed analysis of variances, specifically the controllable ones,
---------------------- as to the causes leading to these variances and the corrective actions required to
---------------------- be taken to reduce these variances enables the management to exercise proper
cost control. However, it does not mean that the favourable variances need
---------------------- no investigation. A constant occurrence of favourable variance may indicate
incorrect fixation of standards that need to be revised. A constant favourable
---------------------- variance may be due to a genuine improvement in performance or due to the
---------------------- manufacture of sub-standard products.
We will now discuss the variance under each element of cost.
----------------------
----------------------
Material cost variance is the difference between standard material cost and
---------------------- actual material cost. It may be further analysed under Material Price Variance
and Material Usage Variance.
----------------------
1. Material Price Variance: It is that portion, which is due to difference
---------------------- between standard price specified and actual price paid. It is calculated as
Actual Quantity (Actual Price - Standard Price)
----------------------
The causes for this may be traced as below:
---------------------- a. Change in price of material.
---------------------- b. Change in quantity of purchase or uneconomical size of purchase order.
---------------------- c. Rush order to meet shortage of supply or purchase in less favourable market.

d. Failure to take advantage of off-season prices. Notes
e. Failure to get cash/trade discounts.
----------------------
f. Weak purchase organization.
g. Payment of excess/less freight. ----------------------
h. Transit losses/discrepancies, if prices include them. ----------------------
i. Change in quality or specification of material purchased.
----------------------
j. Use of substitute materials at different prices.
----------------------
k. Change in pattern or amount of taxes or duties.
From the above, it can be seen that the responsibility for this type of ----------------------
variance may be normally placed on purchase department. However, there may
----------------------
be some situations where the responsibility for this type of variance cannot be
placed on purchase department. For example, when the purchases are made in ----------------------
uneconomic quantities due to the lack of working capital.
----------------------
2. Material Usage Variance: It is that portion, which is due to the
difference between standard quantity specified and actual quantity used. ----------------------
It is calculated as Standard Price (Actual Quantity - Standard Quantity)
----------------------
The causes to this may be traced as below:
a. Inefficient or careless use of materials. ----------------------
b. Change in specification/design of the product. ----------------------
c. Inefficient/inadequate inspection of materials. ----------------------
d. Change in quality of material or purchases of inferior material.
----------------------
e. Production inefficiency resulting in wastages.
f. Use of substitute materials. ----------------------
g. Theft/pilferage of materials. ----------------------
h. Inefficient labour not able to handle material properly.
----------------------
i. Defective machines and not proper maintenance of the same.
j. Change in the composition of material mix. If more than one materials are ----------------------
mixed to get the final product, any change in the standard mix may result ----------------------
into material usage variance. It may arise in case of textile, chemical,
rubber industries etc. ----------------------
k. Change in the yield. If a certain amount of standard output is expected ----------------------
from some inputs, any variance in actual output may result in material
usage variance. It may arise in case of processing industries. ----------------------
The material usage variances may further be analysed in the following ----------------------
ways:
----------------------
i. Materials Mix Variance: As stated above, it is that part of usage variance,
which may arise due to change in the standard composition of material ----------------------
mix where more than one materials are required to be mixed together
to get the final product. This may be a peculiar feature of the industries ----------------------

Notes such as textile, chemical, rubber etc. The actual mix of materials may
be different than the standard mix due to non-availability of specified
---------------------- material. Increased proportion of costly material in the mix results into
adverse materials mix variance and vice-versa.
----------------------
This variance is calculated as Standard price (Actual mix - Standard mix)
----------------------
ii. Materials Yield Variance: As stated above, it is that part of usage variance,
---------------------- which may arise due to difference between standard yield expected and
the actual yield obtained, where a certain specified yield is expected from
---------------------- a given input of materials. This may be a peculiar feature of the processing
industries. A low actual yield indicates consumption of materials in excess
----------------------
of standards set resulting into an adverse variance and vice versa.
---------------------- This variance is calculated as Standard Yield Price (Actual Loss - Standard
Loss), where Standard Yield Price is calculated as Total Standard Cost / Total
----------------------
Standard Output.
---------------------- Illustration 1:
---------------------- Material Standard Actual
---------------------- Qty. Price Total Qty. Price Total
Rs. Rs. Rs. Rs.
---------------------- A 500 6.00 3,000 400 6.00 2400
B 400 3.75 1500 500 3.60 1800
----------------------
C 300 3.00 900 400 2.80 1120
---------------------- 1200 1300
---------------------- Less: 10% Actual
Normal Loss 120 Loss
---------------------- 220
1080 5400 1080 5320
----------------------
Calculate material cost variances.
----------------------
Solution:
---------------------- a. Material Cost Variance
---------------------- Standard Material Cost - Actual Material Cost
---------------------- ∴ 5,400 - 5,320
---------------------- = 80 (Favourable)
b. Material Price Variance
----------------------
----------------------
Material A = 400 (6.00 - 6.00) = Nil
---------------------- Material B = 500 (3.60 - 3.75) = 75 (Favourable)
---------------------- Material C = 400 (2.80 - 3.00) = 80 (Favourable)
---------------------- 155 (Favourable)

c. Material Usage Variance Notes
Standard Price (Actual Quantity - Standard Quantity)
----------------------
Material A = 6.00 (400 - 500) = 600 (Favourable)
----------------------
Material B = 3.75 (500 - 400) = 375 (Adverse)
Material C = 3.00 (400 - 300) = 300 (Adverse) ----------------------
75 (Adverse) ----------------------
d. Materials Mix Variance ----------------------
Standard Price (Actual Mix - Standard Mix)
----------------------
Material A = 6.00 (400 - 541.67) = 850 (Favourable)
----------------------
Material B = 3.75 (500 - 433.33) = 250 (Adverse)
Material C = 3.00 (400 - 325) = 225 (Adverse) ----------------------
375 (Favourable) ----------------------

Note: The standard mix is calculated as below. ----------------------
When total input is 1,200 Kg, the Materials A, B, and C are mixed in the
----------------------
proportion of 500 Kg, 400 Kg and 300 Kg respectively. When total input is
1,300 Kg., the materials should have been mixed in the following proportion: ----------------------
Material A = 500 / 1200 X 1300 = 541.67 Kg.
----------------------
Material B = 400 /1200 X 1300 = 433.33 Kg.
----------------------
Material C = 300 / 1200 X 1300 = 325.00 Kg.
e. Materials Yield Variance ----------------------
Standard Yield Price (Actual Loss - Standard Loss) ----------------------

5 (220 - 130) ----------------------
= 450 (adverse)
----------------------
Note: Standard Yield Price is calculated as below:
----------------------
Total Standard Cost / Total standard Output = Rs. 5400 / 1080 Kg. = Rs.5/
Kg. ----------------------
Check: ----------------------
Material Cost Variance = Materials Price Variance + Material Usage
----------------------
Variance
Materials Usage Variance = Materials Mix Variance + Materials Yield ----------------------
Variance
----------------------
80 (F) = 155 (F) + 375 (F) + 450 (A)
----------------------
where F indicates favourable and A indicates adverse variance.
----------------------
----------------------

Notes 11.4.2 Labour Cost Variances
Labour cost variance is the difference between standard direct wages
----------------------
specified and actual wages paid. It is further analysed as:
---------------------- 1. Wage/Labour Rate Variance: It is that portion, which is due to
difference between standard pay of wages specified and actual rate paid.
----------------------
It is calculated as Actual Hours (Standard Rate - Actual Rate)
---------------------- The causes of this may be traced as below:
---------------------- a. Change in wage structure or piecework rate.
---------------------- b. Variation due to different grades of workers and their wages differing
from those specified.
---------------------- c. Use of different methods of payment, for example, actual payment on the
---------------------- time basis whereas standards are set on the piece rate basis.
d. Employment of casual/temporary workers to meet seasonal demands.
----------------------
e. New workers not being allowed full normal wages.
----------------------
f. Overtime or night shift allowance more or less than standard.
---------------------- g. Composition of gang as regards the skill and rates of wages different from
---------------------- specified standards.
Though the responsibility of wages/labour rate variances can be placed
---------------------- on Personnel Department, in practice, this type of variance is usually an
---------------------- uncontrollable one.
2. Labour Efficiency Time Variance: It is that portion, which is due to
----------------------
difference between standard labour hours specified and the actual labour
---------------------- hours expended.
It is calculated as Standard Rate (Standard Hours - Actual Hours)
----------------------
The causes of this may be traced as:
----------------------
a. Lack of proper supervision.
---------------------- b. Poor working conditions.
---------------------- c. Delays due to waiting for materials, tools, instructions etc., if not treated
as idle time.
----------------------
d. Defective tools, equipment etc.
----------------------
e. Machine breakdown, if not treated as idle time.
---------------------- f. Work on new machines requiring less time.
---------------------- g. Basic inefficiency of workers due to lack of morale, insufficient training,
faulty instructions etc.
----------------------
h. Use of non-standard material requiring higher lime for processing.
----------------------
i. Operations not provided for and booking them under direct wages.
---------------------- j. Wrong selection of workers.

k. Increase in labour turnover. Notes
l. Incorrect recording of performance, i.e. time or output.
----------------------
The labour efficiency variance may be further analysed in the following manner.
----------------------
i. Idle Time Variance: It is the standard cost of actual hours recorded as idle
time due to abnormal circumstances like strike, lockout, power failure, ----------------------
machinery breakdown etc. It is calculated as Standard Rate x Idle Hours.
----------------------
This type of variance is normally calculated separately and not kept only
as a part of efficiency variance, as the employees should not be blamed ----------------------
for inefficiency when the idle time arises due to circumstances beyond
their control, say power failure. It is needless to state that this variance ----------------------
is always unfavorable and needs further investigation as to the causes for ----------------------
abnormal idle time.
ii. Labour Mix Variance (Gang Composition Variance): It indicates that ----------------------
part at efficiency variance, which arises due to change in Actual Gang of ----------------------
labour from that of Standard Gang of labour if various grades of labour
are included in a gang and if certain grades of labour are not available. It ----------------------
is calculated as Standard Rate (Revised Standard Hours- Actual Hours),
where the revised standard hours indicate the actual labour hours divided ----------------------
in the ratio of standard hours. It should be noted that if the idle time ----------------------
variance is calculated separately, the idle time hours should be excluded
from actual total hours in standard ratio. ----------------------
iii. Labour Yield Variance: In many cases, this variance is calculated separately, ----------------------
which indicates the effect on labour cost of actual yield or output being
different from standard yield or output. ----------------------
In numerical terms, it is equal to revised efficiency variance, i.e. after ----------------------
separating Mix Variance and Idle Time Variance from Efficiency Variance, which
is calculated as Standard Rate (Standard Hours - Revised Standard Hours). ----------------------
Illustration 2: ----------------------
Following details are available from the records of a limited company for ----------------------
a month regarding the standard labour hours and rates of an hour for a product.
----------------------
Hours Rate per Hour Rs. Total Rs.
Skilled 10 3.00 30.00 ----------------------
Semi-skilled 8 1.50 12.00 ----------------------
Unskilled 16 1.00 16.00
58.00 ----------------------
----------------------
----------------------
----------------------
----------------------

Notes The actual production for the product was 1,500 units, for which the
actual hours worked and rates were as below.
----------------------
Hours Rate per Hour Rs. Total Rs.
---------------------- Skilled 13,500 3.50 47,250
Semi-skilled 12,600 1.80 22,680
----------------------
Unskilled 30,000 1.20 36,000
---------------------- Compute:
---------------------- a. Labour Cost Variance
---------------------- b. Labour Rate Variance
c. Labour Efficiency Variance
----------------------
d. Labour Mix Variance
----------------------
Solution:
----------------------
(a) Labour Cost Variance
---------------------- Standard Actual
---------------------- Hours Rate Total Hours Rate Total Rs.
per Hr. per Hr.
---------------------- Skilled 15;000 3.00 45;000 13=500 3.50 47;250
---------------------- Semi-skilled 12:000 1.50 18:000 12=600 1.80 22:680
Unskilled 24=000 1.00 24=000 30=000 1.20 36=000
---------------------- 5L000 87=000 56=100 1=05=930
---------------------- Standard Cost - Actual Cost
---------------------- ∴ 1,05,930 - 87,000 = 18,930 (A)
(b) Labour Rate Variance:
----------------------
Actual Hours (Standard Rate - Actual Rate)
---------------------- 13,500 (3.50 - 3.00) = 6,750 (A)
---------------------- 12,600 (1.80 - 1.50) = 3,780 (A)
30,000 (1.20 - 1.00) = 6,000 (A)
----------------------
16,530 (A)
---------------------- (c) Labour Efficiency Variance:
Standard Rate (Standard Hours - Actual Hours)
----------------------
3.00 (13,500 - 15,000) = 4,500 (F)
---------------------- 1.50 (12,600 - 12,000) = 900 (A)
---------------------- 1.00 (30,000 - 24,000)= 6,000 (A)
2,400 (A)
----------------------
(d) Labour Mix Variance:
---------------------- Standard Rate (Standard Hours - Revised Actual Hours)
---------------------- 3.00 (13,500 - 16,500) = 9,000 (F)

1.50 (12,600 - 13,200) = 900 (F) Notes
1.00 (30,000 - 26,400)= 3,600 (A)
----------------------
6,300 (F)
11.4.3 Overhead Cost Variances ----------------------
The analysis of overheads variances is different and the most complex ----------------------
task than the calculation of material and labour variances. It is so due to the fact
----------------------
that establishment of a standard overhead absorption rate is difficult, as a part
of total overheads is fixed, which affects the overhead absorption rate with the ----------------------
change in volume.
----------------------
It should be noted in this connection that the overhead absorption rate can
be computed in the following way. ----------------------
a) If the overhead rate is expressed in terms of labour hours:
----------------------
Hourly Rate = Budgeted Overhead Cost / Budgeted Labour Hours
----------------------
b) If the overhead rate is expressed in terms of units produced:
Unit Rate = Budgeted Overhead cost / Budgeted output in units ----------------------
As the overheads can be either the variable overheads or fixed overheads, ----------------------
the overhead cost variances may be separately calculated for variable overheads
----------------------
and fixed overheads.
1. Variable Overheads Variance ----------------------
It is that amount of overheads that change directly with the level of ----------------------
activity and per unit variable overheads remain constant. As such, the variable
overheads are not affected with the change in volume of operations. ----------------------
The common method of analyzing the variable overheads variances is ----------------------
shown in the chart below:
----------------------
Overhead Cost Variance
----------------------
----------------------
Expenditure Variance Efficiency Variance
----------------------
a. Overheads Cost Variance: It is the difference between standard ----------------------
overheads cost absorbed and actual overheads cost incurred. It is
calculated as: ----------------------
[Standard Hour for Actual Production X Standard Hourly ----------------------
rate] – Actual Overhead
b. Overheads Expenditure Variance: It is the difference between the ----------------------
standard allowances for the output achieved and actual overheads ----------------------
cost incurred.
----------------------
It is calculated as:
Revised Budgeted Overheads for Actual Hours - Actual Overheads ----------------------

Notes c. Overheads Efficiency Variance: It is due to the difference between
budgeted efficiency of production and actual efficiency attained. It
---------------------- is calculated as
Standard Hourly rate X [Standard Hours for Actual Production –
----------------------
Actual Overheads]
---------------------- 2. Fixed Overheads Variances
---------------------- In modern times, especially in the days of rapid mechanization of
production processes, the fixed overheads form a major portion of the production
---------------------- cost. As such, it is necessary that the management is properly informed about
---------------------- the standard fixed overheads or any deviations therefrom. The common method
of analyzing the fixed overheads variances is shown in the chart below.
----------------------
Overhead Cost Variance
----------------------
----------------------
Expenditure Variance Volume Variance
----------------------
----------------------
Efficiency Capacity Calendar
---------------------- Variance Variance Variance
---------------------- Each of the above variances can be computed on the basis of either units
of production or hours. We will first study the nature of the above variances and
----------------------
then the methods of computation.
---------------------- a. Overheads Cost Variance: It is the difference between the total standard
overheads cost absorbed in the output achieved and the total actual
----------------------
overheads cost. Thus, it can be seen that the overheads cost variance is
---------------------- simply the under or over absorption of overheads.
---------------------- b. Expenditure Variance: It is the difference between the standard

allowance for the output achieved and the actual overheads cost incurred.
---------------------- The causes of this variance may be as follows:
---------------------- i. Change in the quality/price of indirect material.
---------------------- ii. Change in the labour rates for indirect workers or change in the
grade of indirect workers.
---------------------- iii. Change in the rate of power, insurance and other overheads.
---------------------- c. Volume Variance: It is that portion of the overhead variance which is due
to the difference between the budgeted level of output and the actual level
---------------------- of output.
---------------------- The causes of this variance may be as below.
---------------------- i. Labour problems such as strikes, lockouts etc.

ii. Material shortage
---------------------- iii. Machinery breakdown

iv. Waiting for tools/instructions/material Notes
v. Power failure
----------------------
vi. Change in the demand for product
It should be mentioned here that in case of the variable overheads, per ----------------------
unit or per hour overheads remain constant and are not affected by the change in
----------------------
the level of output. As such, volume variance does not arise in case of variable
overheads. ----------------------
d. Efficiency Variance: It is that portion of the overhead variances, as a
----------------------
part of volume variance, which is due to the difference between budgeted
efficiency of production and the actual efficiency attained. The causes of ----------------------
this variance may be as below.
----------------------
i. Poor working conditions
ii. Change in the labour performance ----------------------
iii. Defective and faulty tools ----------------------
iv. Incorrect machine operations
v. Defective or inferior material ----------------------
e. Capacity Variance: It is that portion of the overhead variances, as a part ----------------------

volume variance, which is due to the working at higher or lower capacity
----------------------
than standard.
The causes of this variance may be as below. ----------------------
i. Seasonal variations ----------------------
ii. Shortage of labour force
----------------------
iii. Abnormal idle time due to reasons such as power failures, strikes,
lockouts etc. ----------------------
iv. Change in the customer demand
----------------------
f. Calendar Variance: It is that portion of overhead variances, as a part of
volume variance, which is due to the difference between the number of ----------------------
working days in the budget period and the actual number of working days
----------------------
in the period in which the budget is applied.
Calendar Variance arises only if there is abnormal increase or decrease ----------------------
in the number of working days, as the normal holidays are already considered ----------------------
while setting the standard. Thus, the declaration of an unexpected day as holiday
may result into calendar variance. ----------------------
Computation of Fixed Overheads Variances ----------------------
As discussed earlier, the fixed overheads variances may be computed on
----------------------
the basis of units of production or hours. These wo types are discussed below
with separate illustrations. ----------------------
On the basis of units of production
----------------------
a. Overheads Cost Variance = Standard Overhead Cost - Actual Overhead
Cost ----------------------

Notes b. Expenditure Variance = Budgeted Overhead Cost - Actual Overhead
Cost
---------------------- c. Volume Variance = Standard Rate per Unit X [Actual Production –
Budgeted Production]
----------------------
d. Efficiency Variance = Standard Rate per Unit X [Actual Production –
---------------------- Standard Production in Actual Hours]
---------------------- e. Capacity Variance = Standard Rate per Unit X [Standard Production in
Actual Hours – Revised Budgeted Production]
---------------------- f. Calendar Variance = Standard Rate per unit X [Revised Budgeted
Production – Budgeted Production]
----------------------
Illustration 3:
----------------------
An Engineering Company has furnished you the following data.
---------------------- Budget Actual
---------------------- July 1986
No of working days 25 27
----------------------
Production in Units 20,000 22,000
---------------------- Fixed overheads in Rs. 30,000 34,000
Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual
----------------------
hours worked were 31,500.
---------------------- Calculate the following variances.
---------------------- a. Total overheads Variance
b. Expenditure Variance
----------------------
c. Volume Variance
---------------------- d. Efficiency Variance
e. Capacity Variance
----------------------
f. Calendar variance
----------------------
Solution:
---------------------- [F = Favourable, A = Adverse]
---------------------- a. Total Overheads Variance = Standard Overheads Cost - Actual
Overheads Cost
---------------------- ∴ 33,000 - 34,000 = 1,000 (A)
---------------------- b. Expenditure Variance = Budgeted Overheads Cost - Actual Overheads Cost
∴ 30,000 - 34,000 = 4,000 (A)
----------------------
c. Volume Variance = Standard Rate per unit x [Actual Production -
---------------------- Budgeted Production]
∴ 1.5 X (22,000 - 20,000) = 3,000 (F)
----------------------
d. Efficiency Variance = Standard Rate per unit x [Actual Production -
---------------------- Standard Production in Actual Hours]
∴ 1.5 X (22,000 - 21,000) = 1,500 (F)
----------------------

e. Capacity Variance = Standard Rate per unit x [Standard Production in Notes
Actual Hours - Revised Budgeted Production]
∴ 1.5 X (21,000 - 21,600) = 900 (A) ----------------------
f. Calendar Variance = Standard Rate per Unit x [Revised Budgeted ----------------------
Production - Budgeted Production]
----------------------
∴ 1.5 x (21,600 - 20,000) = 2,400 (F)
Check: ----------------------
Volume variance = Efficiency Variance + Capacity Variance + Calendar Variance ----------------------
3000 (F) = 1500 (F) + 900 (A) + 2400 (F) Total Variance = Expenditure Variance ----------------------
+ Volume Variance 1000 (A) = 4000 (A) + 3000 (F)
Working Notes: ----------------------
1. Standard Rate per unit is calculated as below: ----------------------

Budgeted Overhead Cost / Budgeted Production ----------------------
Therefore, 30,000 / 20,000 = Rs. 1.5 per Unit
----------------------
2. Standard Production in actual hours is calculated as below:
----------------------
Budgeted overheads are Rs.30,000 while budgeted fixed overhead rate
is Rs. l per hour. Therefore, budgeted hours are 30,000, while budgeted ----------------------
production is 20,000 units. It means that one unit requires 1.5 hours
(standard). As actual hours worked are 31.500, the standard production in ----------------------
those many hours will be: ----------------------
31,000 / 1.5 = 21,000 units
----------------------
3. Revised Budgeted Production is calculated as below.
----------------------
Budgeted Number of working days are 25 while budgeted production is
20,000 units. It means that standard production in one day is: ----------------------
20,000 Units / 25 Days = 800 Units ----------------------
As actual number of working days is 27, the standard production in those
many days will be: ----------------------
800 units x 27 days = 21,600 units ----------------------

On the basis of hours ----------------------
a. Overheads Cost Variance = Standard Overheads Cost - Actual Overheads
----------------------
Cost
b. Expenditure Variance = Budgeted Overheads Cost - Actual Overheads ----------------------
Cost
----------------------
c. Volume Variance = Standard Hourly Rate x [Standard Hours for Actual
Production - Budgeted Hours] ----------------------
d. Efficiency Variance = Standard Hourly Rate x [Standard Hours for ----------------------

Actual Production - Actual Hours]
----------------------

Notes e. Capacity Variance: Standard Hourly Rate x [Actual Hours - Revised
Budgeted Hours]
----------------------
f. Calendar Variance: Standard Hourly Rate x [Revised Budgeted Hours -
---------------------- Budgeted Hours]
Illustration 4:
----------------------
An engineering company has furnished you with the following data.
----------------------
Budget Actual (July 1986)
---------------------- No. of working days 25 27
---------------------- Production in Units 20,000 22,000
Fixed Overheads (in Rs.) 30,000 34,000
----------------------
Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual
---------------------- hours worked were 31,500.
---------------------- Calculate the following variances.

a. Total Overheads Variance
----------------------
b. Expenditure Variance
---------------------- c. Volume Variance
---------------------- d. Efficiency Variance
e. Capacity Variance
----------------------
f. Calendar Variance
---------------------- Solution:
---------------------- Calculation of overhead variances will be as below.
---------------------- a. Total Overheads Variance:

Standard Overheads - Actual Overheads
----------------------
∴ 33,000 - 34,000 = 1,000 (A)
----------------------
b. Expenditure Variance:
---------------------- Budgeted Overheads - Actual Overheads
---------------------- ∴ 30,000 - 34,000 = 4,000 (A)
---------------------- c. Volume Variance:

Standard Hourly Rate X [Standard Hours for Actual Production - Budgeted
---------------------- Hours] = 1 (33,000 - 30,000) = 3,000 (F)
---------------------- d. Efficiency Variance:
---------------------- Standard Hourly Rate (Standard hours - Actual hours)
∴ 1 (33,000 - 31,500)= 1,500 (F)
----------------------
e. Capacity Variance:
----------------------
Standard Hourly Rate (Actual hours - Revised Budgeted Hours)
---------------------- ∴ 1 (31,500 - 32,400)= 900 (A)

f. Calendar Variance: Notes
Standard Hourly Rate (Revised Budgeted Hours - Budgeted Hours)
----------------------
∴ 1 (32,400 - 30,000)= 2,400 (F)
----------------------
Check:
Volume Variance = Efficiency Variance + Capacity Variance + Calendar ----------------------
Variance ----------------------
3000 (F) = 1500 (F)+900 (A)+ 2400 (F)
----------------------
Total Overhead Cost Variance = Expenditure Variance + Volume Variance
----------------------
1000 (A) = 4000 (A) + 3000 (F)
Working Notes: ----------------------
1. Standard rate per hour is known to be Rs. 1. As Budgeted overheads are ----------------------
Rs.30,000, Budgeted Hours will be 30,000.
----------------------
2. Budgeted Hours are known to be 30,000 for the Budgeted production of
20,000 units, indicating that standard time required for one unit is 1½ ----------------------
hours. If the actual production is 22,000 units, the standard time required
for actual production will be 33,000 hours. ----------------------
3. The budgeted number of working days are 25 and budgeted hours are ----------------------
30,000, indicating that the standard hours available in one day are 1,200.
If the company has actually worked for 27 days, the revised budgeted ----------------------
hours will be 32,400, i.e. 1,200 hours per day x 27 days. ----------------------
3. Sales Variances
----------------------
While standard costing principles are mainly applied in the area of costs,
i.e. Material cost, Labour cost and Overheads cost, some companies ----------------------
calculate the sales variances also, which is the difference between
----------------------
budgeted sales and actual sales and its impact on profits.
There may be two ways to calculate sales variances. They are discussed ----------------------
below with separate illustrations.
----------------------
1. The Turnover/Value Method: The common method of analysing sales
variances under this method is shown in the chart below: ----------------------
----------------------
Sales Value Variance
----------------------
----------------------
Sales Price Variance Sales Volume Variance
----------------------
----------------------
Mix Quantity
Variance Variance ----------------------
----------------------

Notes a. Sales Value Variance: It is the difference between the budgeted sales and
the actual sales. It is calculated as Actual Sales - Budgeted Sales
----------------------
b. Sales Price Variance: It is that portion of sales variance, which is due
---------------------- to the difference between standard price specified and the actual price
charged. It is calculated as Actual Sales Volume x [Actual Price - Standard
---------------------- Price]
---------------------- c. Sales Volume Variance: It is that portion of sales variance, which is due
to the difference between the standard quantity specified and the actual
---------------------- quantity sold. It is calculated as Standard Price x [Actual sales volume -
Standard sales volume]
----------------------
d. Sales Mix Variance: It is that portion of sales volume variance, which may
---------------------- arise due to change in actual composition of sales mix from the standard
composition of sales mix, where more than one product is dealt with. It
----------------------
is calculated as Standard Sales - Revised Standard Sales, where Standard
---------------------- Sales are actual quantity sold at budgeted price. Revised Budgeted sales
are standard sales rearranged in the budgeted ratio.
----------------------
Note: It should be noted that the sales mix variance, under turnover
---------------------- method would always be zero. This is so because though the sales mix is
varied, the actual sales at budgeted price are rearranged in the budgeted
---------------------- ratio.
---------------------- e. Sales Quantity Variance: It is that portion of sales volume variance,
which may arise due to the difference between standard value of actual
---------------------- sales at standard mix and budgeted sales. It is calculated as Revised
---------------------- Standard Sales - Budgeted Sales.
Illustration 5:
----------------------

---------------------- Standard Actual
---------------------- Product Qty. Sale Price Total Qty. Sale Price Total
Rs. Rs. Rs. Rs.
---------------------- A. 500 5 2.500 500 5.40 2.700
---------------------- B. 400 6 2.400 600 5.50 3.300
C. 300 7 2.100 400 7.50 3.000
---------------------- 1200
---------------------- 7.000 1500
9.000
----------------------
Calculate the Sales Variances.
----------------------
Solution:
---------------------- a. Sales Value Variance:
---------------------- Actual Sales - Budgeted Sales
---------------------- ∴ 9,000 - 7,000 = 2,000 (F)

b. Sales Price Variance: Notes
Actual Sales Volume (Actual Price - Standard Price)
----------------------
A - 500 (5.40 - 5.00) = 200 (F)
----------------------
B - 600 (5.50 - 6.00) = 300 (A)
C - 400 (7.50 - 7.00) = 200 (F) ----------------------
100 (F) ----------------------
c. Sales Volume Variance: ----------------------
Standard Price (Actual Sales Volume - Standard Sales Volume)
----------------------
A - 5 (500 - 500) = Nil
----------------------
B - 6 (600 - 400) = 1200 (F)
C - 7 (400 - 300) = 700 (F) ----------------------
1900 (F) ----------------------

d. Sales Mix Variance: ----------------------
Standard Sales - Revised Standard Sales
----------------------
where standard sales are actual quantity at standard price and revised
standard sales are standard sales rearranged in budgeted ratio. ----------------------
Quantity Standard Sales Revised Standard Sales ----------------------

Price Rs. Total Rs. Ratio Total
----------------------
A 500 5 2500 35.71% 3178
B 600 6 3600 34.29% 3052 ----------------------
C 400 7 2800 30.00% 2670 ----------------------
8900 8900
----------------------
Ratio is calculated as below:
A = (2500/7000) X 100 = 35.71% ----------------------
B = (2400/7000) X 100 = 34.29% ----------------------
C = (2100/7000) X 100 = 30% ----------------------
∴ Sales Mix Variance:
----------------------
A = 2500 - 3178 = 678 (A)
----------------------
B = 3600 - 3052 = 548 (F)
C = 2800 - 2670 = 130 (F) ----------------------
Nil ----------------------
e. Sales Quantity Variance ----------------------
Revised Standard Sales - Budgeted Sales
----------------------
A = 3178 - 2500 = 678 (F)
----------------------

Notes B = 3052 - 2400 = 652 (F)
C = 2670 - 2100 = 570 (F)
----------------------
= 1900 (F)
----------------------
Check:
---------------------- Sales Value Variance = Sales Price Variance + Sales Mix Variance + Sales
---------------------- Quantity Variance
= 2000 (F) = 100(F) + Nil + 1900 (F)
----------------------
2. The Margin/Profit Method
----------------------
This method of sales variances measures the effect of actual sales and
---------------------- budgeted sales on profit. As this method does not consider the cost variances, all
costs are assumed to be standard costs. The common method of analysing sales
---------------------- variances under this method is shown in the chart below.
---------------------- Total Sales Margin Variance
----------------------
Sales Margin Price Variance Sales Margin Volume Variance
----------------------
---------------------- Sales Margin Mix Variance Sales Margin Quantity Variance

---------------------- a. Total Sales Margin Variance:
---------------------- It is the difference between actual margin (by considering standard costs)
and budgeted margin. It is calculated as Actual Profit - Budgeted Profit.
----------------------
(1) Sales Margin Price Variance: It is that portion of total sales margin
---------------------- variance, which is due to the difference between standard price of actual
sales made and actual price. It is calculated as Actual Profit - Standard
---------------------- Profit.
---------------------- (2) Sales Margin Volume Variance: It is that portion of total sales-margin
variance, which is due to the difference between standard profit and
---------------------- budgeted profit. It is calculated as Standard Profit - Budgeted Profit.
---------------------- (3) Sales Margin Mix Variance: It is that portion of sales margin volume
variance, which is due to the difference between standard profit and
---------------------- revised standard profits. It is calculated as Standard Profit - Revised
---------------------- Standard Profit.
(4) Sales Margin Quantity Variance: It is that portion of sales margin volume
----------------------
variance, which is due to the difference between budgeted profit and
---------------------- revised standard profits. It is calculated as Revised Standard Profits -
Budgeted Profit.
----------------------
----------------------
----------------------

Notes
----------------------
State True or False. ----------------------
1. Favourable variances need no investigation
----------------------
2. A constant favourable variance may be due to a marginal improvement
in performance or due to the manufacture of standard products. ----------------------
3. If the variances occur due to general strike, general increase in wage ----------------------
rates, devaluation of currency, change in customers’ demands etc., the
variances will be controllable ones ----------------------
4. The process of standard costing involves the establishment of standard ----------------------
costs and the computation of actual costs under each element of cost
and the comparison between standard costs and actual costs. ----------------------
----------------------
Summary ----------------------
• The term ‘standard cost’ has been defined as a pre-determined cost, which ----------------------
is calculated from the management’s standards of efficient operation and
----------------------
the relevant necessary expenditure.
• The term ‘standard costing’ has been defined as the preparation and use ----------------------
of standard costs, their comparison with actual costs and the measurement ----------------------
and analysis of variances to their causes and points of incidence.
• Standard costing and budgetary control are the best possible tools available to ----------------------
the management for the purpose of controlling the costs. Both the techniques ----------------------
involve the process of setting the targets or standards, measurement of actual
performance, comparison of actual performance with targets or standard ----------------------
set, computation and analysis of variations and the attempts to maintain
favourable variations and remove unfavourable variations. ----------------------
• Basic standards are established for an unaltered use over a longer period ----------------------
and they do not reflect the current conditions. These types of standards
are not useful from the cost control point of view and can be used in case ----------------------
of industries where technical processes are fully established or in case of ----------------------
those types of costs, which are fixed in nature, viz. rent, remuneration to
managerial personnel etc. ----------------------
• Current standards are established for a shorter period and are adaptable ----------------------
to change in current conditions. These are of three types- ideal, expected
and normal standards. ----------------------
• The process of standard costing involves the establishment of standard ----------------------
costs and the computation of actual costs under each element of cost and
the comparison between standard costs and actual costs. The difference ----------------------
between standard cost and actual cost is termed as ‘Variance’.
----------------------

Notes • If the actual cost is less than the standard cost, the variance is a favourable
variance (F).
----------------------
• If the actual cost is more than the standard cost, the variance is an
---------------------- unfavourable or adverse variance (A).
• The basic objective of variance analysis is to classify the variances as
----------------------
controllable and uncontrollable ones. Variance analysis includes material
---------------------- cost variance, labour cost variance and overhead cost variance.
----------------------
Keywords
----------------------
• Labour Cost Variance: It is the difference between standard direct wages
---------------------- specified and actual wages paid.
---------------------- • Material Cost Variance: It is the difference between standard material

cost and actual material cost. Further, it includes material price and usage
---------------------- variance.
---------------------- • Overhead Cost Variance: This can be explained with the help of variable
and fixed cost variances.
----------------------
• Sales Variances: It is the difference between budgeted sales and actual
---------------------- sales. This can be calculated through the turn over value method and
margin profit method.
----------------------
• Standard Cost: It is a pre-determined cost, which is calculated from the
---------------------- management’s standards of efficient operation and the relevant necessary
expenditure.
----------------------
• Standard Costing: defined as ‘the preparation and use of standard costs,
---------------------- their comparison with actual costs and the measurement and analysis of
variances to their causes and points of incidence.’
----------------------
• Basic Standards: are established for an unaltered use over a longer
---------------------- period and they do not reflect the current conditions.
---------------------- • Current Standards: are established for a shorter period and are adaptable
to change in current conditions.
----------------------
• Variance: The difference between standard cost and actual cost is termed
---------------------- as ‘Variance’.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Illustrative Problems Notes
Problem 1. Following standard and actual data relates to a manufacturing ----------------------
concern.
----------------------
Material Standard
X 40 kg. at Rs. 6 240 ----------------------
Y 60 kg. at Rs. 4 240 ----------------------

480 ----------------------
Standard output is 80% of input i.e. 80 units. Process loss is 20%.
----------------------
Material Actual
----------------------
X 600 kg. at Rs. 4
Y 400 kg. at Rs. 6 ----------------------
Actual output is 70% of input, i.e. 700 units. Process loss is 30%. ----------------------
Calculate ----------------------
a. Cost variance
----------------------
b. Price variance
c. Total Quantity usage variance ----------------------
d. Mix variance ----------------------
e. Revised usage variance
----------------------
Problem (2) Revised standard quantity is calculated as below.
Total input is 1000 kg. The standard proportion of the materials is 40% for X ----------------------
and 60% for Y. As such, the revised standard quantity should have been ----------------------
X - 40% of 1000 kg. i.e. 400 kg.
----------------------
Y - 60% of 1000 kg. i.e. 600 kg.
----------------------
1. XYZ forecasts its overhead expenditure for a period as under.
Rs. 30,000 for 10,000 hours. ----------------------
Rs. 27,500 for 9,000 hours. ----------------------
Rs. 25,000 for 8,000 hours. ----------------------
The normal volume of activity is 10,000 hours. During a period, 8,750
hours were utilised for a total overhead expenditure of Rs. 28,750, of which ----------------------
fixed overheads totalled to Rs. 5,250. The standard utilisation of labour should ----------------------
have been less by 5%.
----------------------
How will you analyse the overhead variance?
Problem 3. The sales manager of a company engaged in the manufacture ----------------------
and sale of three products P, Q and R gives you are following information for
----------------------
the month of October 1982.
----------------------

Notes Budgeted Sales:
Selling Price per Standard Margin
---------------------- Product Units sold
unit Rs. per unit Rs.
---------------------- P 2,000 12 6
Q 2,000 8 4
----------------------
R 2,000 5 1
---------------------- Actual Sales
---------------------- P - 1,500 units for Rs. 15,000
Q - 2,500 units for Rs. l7,500
----------------------
R - 3,500 units for Rs. 21,000
---------------------- You are required to calculate the following variances:
---------------------- 1. The Sales Price Variance
2. The Sales Volume Variance
----------------------
3. The Sales Quantity Variance
---------------------- 4. The Sales Mix Variance
----------------------
Answers to Problems
----------------------
Problem 1.
----------------------
Calculate
---------------------- f. Cost variance
---------------------- g. Price variance
---------------------- h. Total Quantity usage variance
i. Mix variance
----------------------
j. Revised usage variance
----------------------
Solution:
---------------------- (1) Cost Variance:
---------------------- Actual Material Cost - Standard material Cost
---------------------- ∴ 4800 - 4200 = 600 (A)
(2) Price Variance:
----------------------
----------------------
X 600 (4-6) = 1200 (F)
---------------------- Y 400 (6-4) = 800 (A)
---------------------- 400 (F)
----------------------
----------------------

(3) Total Usage Variance: Notes
Standard Price (Actual Quantity - Standard Quantity)
----------------------
X - 6 (600 - 350) = 1500 (A)
----------------------
Y - 4 (400 - 525) = 500 (F)
1000 (A) ----------------------
(4) Mix Variance: ----------------------
Standard Price (Actual Mix- Revised Standard Quantity) ----------------------
X - 6 (600 - 400) = 1200 (A)
----------------------
Y - 4 (400-600) = 800 (F)
----------------------
400 (A)
(5) Revised Usage Variance: ----------------------
Standard Price (Revised Standard Quantity - Standard Quantity) ----------------------

X - 6 (400 - 350) = 300 (A) ----------------------
Y - 4 (600 - 525) = 300 (A)
----------------------
600 (A)
----------------------
(6) Yield Variance:
Standard Cost per unit (Actual Loss - Standard Loss) ----------------------
∴ 6 (300 - 200) = 600 (A) ----------------------

Check: ----------------------
Cost Variance = Price Variance + Mix Variance + Yield Variance
----------------------
600 (A) = 400 (F) + 400 (A) + 600 (A)
----------------------
Notes:
(1) Standard Cost is calculated as below. ----------------------
Standard input for the output of 80 units is 100 kgs. ----------------------

If the actual output is 700 units, the standard input for the same will be ----------------------
(77 X 100) / 80 = 875 kg.
----------------------
The standard proportion of the materials is 40% for X and 60% for Y. As
such, for the standard input of 875 kg, the standard proportion will be ----------------------
X - 40% of 875 kg, i.e. 350 kg. ----------------------
Y - 60% of 875 kg, i.e. 5:25 kg. ----------------------
----------------------
----------------------
----------------------

Notes The standard cost will be as follows.
Material Standard Standard Cost
----------------------
Quantity Price Rs.
----------------------
kg. Rs.
---------------------- X 350 6 2,100
---------------------- Y 525 4 2,100
---------------------- 4,200
Problem (2)
----------------------
How will you analyse the overhead variance?
----------------------
Solution:
---------------------- From the variation of total overheads, it is noted that for the variation
---------------------- of 1,000 hours, the overheads vary to the extent of Rs. 2,500. This indicates
that the rate of variable overheads is Rs. 2.50 per hour. At the normal level of
---------------------- activity, the distribution of overheads will be as below.
---------------------- Variable Overheads - 10,000 hours x Rs.2.50 Rs. 25,000

Fixed Overheads - Balance Rs. 5,000
----------------------
Rs. 30,000
---------------------- Variable Overheads Variances:
---------------------- (1) Overheads Cost Variance:
---------------------- Standard Hours for actual Production X Standard Hourly Rate - Actual
Overheads
---------------------- ∴ 8930 X 2.50 - 23.500
---------------------- = 22,325 - 23,500 = 1,175 (A)
---------------------- (2) Expenditure Variance:
[Revised Budgeted Overheads for Actual hours] - Actual Overheads.
----------------------
∴ 8,750 x 2.50 - 23,500
----------------------
= 21,875 - 23,500 = 1,625 (A)
---------------------- (3) Efficiency Variance:
---------------------- [Standard Hours for Actual Production - Actual Hours] x Standard Hourly
Rate
----------------------
∴ [8,930 - 8.750] x 2.50 = 450 (F)
----------------------
Notes:
---------------------- 1. Total overheads cost actually incurred is Rs. 28,750, out of which fixed
---------------------- overheads are Rs. 5,250. Hence, balance is variable overheads i.e. Rs.
28,750 - Rs. 5,250 = Rs. 23,500
----------------------

2. Standard Hourly Rate is calculated as below. Total Budgeted Variable Notes
Overheads/Total Budgeted Hours.
= Rs. 25,000 / 10,000 = Rs. 2.50 per hour ----------------------
Problem3 . ----------------------
You are required to calculate the following variances: ----------------------
5. The Sales Price Variance
----------------------
6. The Sales Volume Variance
7. The Sales Quantity Variance ----------------------
8. The Sales Mix Variance
----------------------
Solution:
----------------------
(A) As per Turnover/Value Method:
(1) Sales Price Variance: ----------------------
Actual Sales Volume (Actual Price - Standard Price) ----------------------

P - 1,500 (10 - 12) = 3,000 (A) ----------------------
Q - 2,500 (7 - 8) = 2,500 (A)
----------------------
R - 3,500 (6 - 5) = 3,500 (F)
2,000 (A) ----------------------
(2) Sales Volume Variance: ----------------------
Standard Price (Actual Sales Volume - Standard Sales Volume) ----------------------
P - 12 (1,500 - 2,000) = 6,000 (A)
----------------------
Q - 8 (2,500 - 2,000) = 4,000 (F)
R - 5 (3,500 - 2,000) = 7,500 (F) ----------------------
5,500 (F) ----------------------

(3) Sales Mix Variance: ----------------------
Standard Sales ─ Revised Standard Sales, where standard sales are actual
----------------------
quantity at standard price and revised standard sales are standard sales
rearranged in budgeted ratio. ----------------------
Standard Sales Revised Standard Sales ----------------------
Quantity Price Rs. Total Rs. Ratio Total Rs.
P 1,500 12 18,000 1/3 18,500 ----------------------
Q 2,500 8 20,000 1/3 18,500
R 3,500 5 17,500 1/3 18,500 ----------------------
55,500 55,500
----------------------
Sales Mix Variance:
P 18,000 -18,500 = 500 (A) ----------------------
Q 20,000 -18,500 = 1,500 (F) ----------------------
R 17,500 -18,500 = 1,000 (A)
----------------------
NIL

Notes (4) Sales Quantity Variance:
Revised Standard Sales - Budgeted Sales:
----------------------
P -18,500 - 2,000 x 12 = 5,500 (A)
---------------------- Q -18,500 - 2,000 x 8 = 2,500 (F)
R -18,500 - 2,000 X 5 = 8,500 (F)
----------------------
5,500 (F)
---------------------- (B) As per Margin/Profit Method
---------------------- Cost per unit = Selling price per unit - Contribution per unit
---------------------- P - 12 - 6 = 6
Q-8-4=4
---------------------- R-5-l=4
---------------------- SALES COST OF SALES PROFIT
PRODUCT
---------------------- Qty Price Total Rs. Price Total Rs. Price Total
Rs. Unit Rs. Unit Rs. Rs.
---------------------- Budgeted
P 2,000 12 24,000 6 12,000 6 12,000
---------------------- Q 2,000 8 16,000 4 8,000 4 8,000
R 2,000 5 10,000 4 8,000 1 2,000
----------------------
50,000 28,000 22,000
---------------------- Actual
P 1,500 10 15,000 6 9,000 4 6,000
---------------------- Q 2,500 7 17,500 4 10,000 3 7,500
R 3,500 6 21,000 4 14,000 2 7,000
----------------------
Standard sales and revised Sales are calculated as below:
---------------------- Standard Sales
P 1,500 12 18,000 6 9,000 6 9,000
---------------------- Q 2,500 8 20,000 4 10,000 4 10,000
R 3,500 5 17,500 4 14,000 1 3,500
----------------------
55,500 22,500
----------------------
Revised Standard Sales
----------------------
Revised Standard Revised Standard
---------------------- Sales Rs. Profit Rs.
---------------------- P 25,680 12,840
---------------------- Q 17,120 8,560
R 10,700 2,140
----------------------
53,500 23,540
----------------------
----------------------
----------------------

(1) Sales Margin Price Variance: Actual Profit - Standard Profit Notes
∴ 20,500 - 22,500 = 2,000 (A)
----------------------
(2) Sales Margin Volume Variance: Standard Profit - Budgeted Profit
----------------------
∴ 22,500 - 22,000 = 500 (F)
(3) Sales Margin Mix Variance: Standard Profit - Revised Standard Profit ----------------------
∴ 22,500 - 23,540 = 1,040 (A) ----------------------

(4) Sales Margin Quantity Variance: ----------------------
Revised standard Profit - Budgeted Profit
----------------------
∴ 23,540 - 22,000 = 1,540 (F)
----------------------
1. What do you mean by standard costing? Differentiate between standard ----------------------

costing and budgetary control as cost control techniques.
----------------------
2. What preliminaries will have to be compiled with before introducing the
technique of standard costing? State the advantages and limitations of ----------------------
standard costing.
----------------------
3. Describe the procedure of establishing standard costs in the area of
materials costs, labour costs and overheads cost. ----------------------
4. What do you mean by variances and variances analysis? Explain the ----------------------
various factors affecting the variances in the area of materials cost, labour
cost and overheads cost. ----------------------
----------------------
----------------------
----------------------
Fill in the blanks.
1. The term ‘standard cost’ has been defined as a pre-determined cost, which ----------------------
is calculated from the management’s standards of efficient operation and ----------------------
the relevant necessary expenditure.
2. Standard costs may be used as the basis for the process of price fixation, ----------------------
filing tenders and offering quotations. ----------------------
3. Budgets are based upon the future or estimated costs.
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Check your Progress 2
Fill in the blanks.
----------------------
1. Standard costing specifically relates to the function of production and
---------------------- manufacturing costs.
---------------------- 2. Normal Standards are the standards, which may be anticipated to be achieved
in future, over a longer period, considering the past performance.
----------------------
3. Expected Standards are the standards, which are anticipated to be attained
---------------------- during the budget period.
----------------------
----------------------
State True or False
----------------------
1. False
---------------------- 2. False.
---------------------- 3. False
---------------------- 4. True
----------------------
Suggested Reading
----------------------
1. Edward J. Vanderbeck, Maria R. Mitchell, Principles of Cost Accounting
---------------------- 2. Rajasekaran V.; Cost Accounting
---------------------- 3. Bhattacharyya Debarshi; Management Accounting
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Annexure : Introduction to IFRS Notes
----------------------
What is IFRS?
----------------------
IFRS stands for International Financial Reporting Standards. IFRS is a set
of international accounting standards stating how particular types of transactions ----------------------
and other events should be reported in financial statements. Standards and
----------------------
Interpretations for the IFRS are issued by IASB (International Accounting
Standard Board). ----------------------
The International Accounting Standard Board is an independent, private- ----------------------
sector body that develops and approves International Financial Reporting
Standards. The IASB operates under the oversight of the International ----------------------
Accounting Standards Committee Foundation (IASCF). The IASB was formed
----------------------
in 2001
Prior to IFRS, International Accounting Standards were used. Broadly, ----------------------
IFRSs refers to the entire body of IASB pronouncements, including standards ----------------------
and interpretations approved by the IASB. However the IAS are still in use until
they are superceded by IFRS. ----------------------
Some of the Key Divergences between Indian GAAP and IFRS ----------------------
The key divergences between Indian GAAP and IFRS have arisen due to:
----------------------
1. Conceptual differences
2. Legal and regulatory requirements ----------------------
3. Present economic conditions ----------------------
4. Level of preparedness
----------------------
The divergences are both in terms of accounting treatment as well as
disclosures in the financial statements. Some of the divergences between Indian ----------------------
GAAP and IFRS are summarized as under:
----------------------
1. Special Purpose Entities (SPE) falling under the definition of ‘control’ as
per IAS 27 on “Consolidated and Separate Financial Statements” shall be ----------------------
consolidated
----------------------
2. ‘Potential Voting Rights’ that are currently exercisable or convertible
shall be considered to assess the existence of ‘control’ ----------------------
3. All business combinations shall be accounted as per purchase method at ----------------------
fair values
----------------------
4. Contingent liabilities, taken over in a business combination, shall be
included in Net Assets, measured at fair value, if contingencies have since ----------------------
been resolved, a reliable estimate can be made and payment is probable
----------------------
5. Negative goodwill arising on business combinations / consolidation shall
be accounted as income instead of capital reserve ----------------------
6. Goodwill shall not be amortised. It shall only be tested for impairment ----------------------
Annexure I: Introduction to IFRS 273

Notes 7. PP&E and Intangible assets shall be measured either at cost or at revalued
amount. Periodical valuation of entire classes of assets is required when
---------------------- revaluation option is chosen
---------------------- 8. Intangible assets can be revalued only when there is an active market for
the same
---------------------- 9. Depreciation on revalued portion cannot be recouped out of revaluation
---------------------- reserve
10. Depreciation to be calculated based on useful life, which along with
---------------------- residual value and depreciation method shall be reviewed annually
---------------------- 11. Intangible assets may have an indefinite life e.g. Trademarks, Goodwill,
Franchise
----------------------
12. Investment property, i.e. land or building held to earn rentals or for capital
---------------------- appreciation, shall be measured either at cost or fair value
---------------------- 13. If fair value model is adopted, changes in fair value, measured annually,
shall be recognised in the income statement
---------------------- 14. No distinction shall be made between integral and non-integral foreign
---------------------- operations. All foreign operations to be consolidated using non-integral
approach
---------------------- 15. Exchange differences shall not be capitalised except to the extent of that
---------------------- allowed by IAS 23 Borrowing Costs
16. Share Based Payments shall be measured at fair value
----------------------
17. Deferred tax shall be created on temporary difference instead of timing
---------------------- differences
---------------------- 18. Liability portion of compound financial instruments, such as convertible
debentures, shall be separately accounted for
---------------------- 19. Financial assets and liabilities shall be classified and measured accordingly
---------------------- as per the requirements of IAS 39
20. Financial Instruments: Recognition and Measurement
----------------------
21. All derivative financial assets and liabilities including embedded derivatives
---------------------- shall be accounted for as on the balance sheet items
---------------------- 22. Derivatives classified as ‘hedge’ shall have to comply with various
requirements of IAS 39 viz. documentation, hedge effectiveness testing and
---------------------- ineffectiveness measurement
---------------------- 23. Derecognition of financial assets, as in the case of securitization, shall be
based on risks and rewards, transfer of ‘control’ being a secondary test
----------------------
24. Provisions shall be created only to the extent they relate to a specified risk
---------------------- that can be measured reliably and for incurred losses. No provisions are
permitted for future or expected losses i.e. general provisions
----------------------
----------------------

25. Interest income / expense on financial assets and liabilities, such as loans, Notes
shall be recorded on an effective interest rate basis after considering
associated income and expenses e.g. agency commission, loan processing ----------------------
fees, etc.
----------------------
26. Prior period errors shall be adjusted in the opening balances of assets,
liabilities and equity of the earliest period presented i.e. the figures relating ----------------------
to prior years are restated
----------------------
Benefits of adopting IFRS
----------------------
The move to IFRS it not just a technical accounting exercise. It is an exercise
in change management and offers opportunities for improvement. IFRS conversion ----------------------
offers companies an opportunity to improve their business in several ways.
----------------------
The company can:
l Reshape its management reporting systems to better manage both its ----------------------
financial accounting and its financial statement generation and provide ----------------------
company leadership with essential information
----------------------
l Improve disclosure — to analysts, investors, regulators and other
stakeholders — of your company’s financial results and position and ----------------------
other performance indicators
----------------------
l Improve the metrics used to evaluate both company and executive performance
l Benchmark itself against its global peers ----------------------
l Ensure all finance team members have the training, knowledge and skills ----------------------
needed to perform their roles
----------------------
l Make accounting policy choices that are aligned with global industry
practice ----------------------
The forces of globalisation prompt more and more countries to open their ----------------------
doors to foreign investment and as businesses expand across borders the need
arises to recognise the benefits of having commonly accepted and understood ----------------------
financial reporting standards. ----------------------
Following are some of the benefits of adopting IFRS -
----------------------
1. Increase in the growth of business worldwide.
----------------------
2. Increase in investment and inflow of foreign currency from overseas market
3. Information will be more reliable and comparable as the Balance Sheet ----------------------
and Profit & Loss Account will be prepared using a common set of
----------------------
accounting standards (i.e. IFRS). Such information will help investors to
explore investment opportunities easily & quickly as against the financial ----------------------
statements prepared using a local or different set of accounting standards.
----------------------
4. As IFRS is accepted worldwide, convergence with IFRS will increase
investor’s confidence. ----------------------
----------------------

Notes 5. Companies will be able to raise money not only from domestic market
but also from overseas markets at lower cost if their financial statements
---------------------- comply with globally accepted accounting standards.
---------------------- 6. Load of preparing financial reporting as per each countries requirement
is reduced with the convergence of IFRS because of the worldwide
---------------------- acceptance of IFRS.
---------------------- 7. Convergence also reduces the costs of preparing the financial statements
as only one set of financial statements needs to be prepared instead of
---------------------- different sets of financial statements as per different countries requirement.
---------------------- Intended benefits External benefits challenges
---------------------- Group-wide harmonization Convergence

Support of changes in the group Increased consistency between internal
---------------------- structure through integration of legal and and external reporting
management reporting entities
---------------------- Reporting speed Transparency
Reduction in number of GAAP bases Comparability with international
----------------------
followed competitors (benchmarking)
---------------------- • Prompt provision of actual financial
information
---------------------- • Potential shortening of reporting
cycles through automation
----------------------
Planning/forecasting Market capitalization
---------------------- Potential improvement in quality, speed Increased access to international markets
and scope of planning, forecasting and
---------------------- performance management
Management support Improvement in risk rating
---------------------- Consistent reports for all legal entities and Improvement in the comparability of
business units group reporting and consistent evaluation
----------------------
• Proactive management of business of the insolvency risk through external
---------------------- units under consistent framework rated agencies
---------------------- Challenges in adopting IFRS

l Regulatory endorsement and acceptance
----------------------
l Shortage of skilled resources
----------------------
l Huge cost of enhancement of IT systems
---------------------- l Acceptance by tax authorities
---------------------- l Managing market expectations and investor relationships
---------------------- l Managing day to day business issues – MIS, tax planning, performance
indicators, mergers and acquisitions, etc.
----------------------
----------------------
----------------------

SEBI – Amendments to Equity Listing Agreement Notes
Securities and Exchange Board of India (SEBI), via its circular dated April
----------------------
5, 2010, has provided an option to listed entities having subsidiaries to submit
their consolidated financial results either in accordance with the accounting ----------------------
standards specified in section 211 (3C) of the Companies Act, 1956 or IFRS.
----------------------
Further, where the figures for the current period are as per IFRS and the
figures for the corresponding previous period are as per the notified accounting ----------------------
standards, the company shall provide a reconciliation in respect of significant
differences between the figures as disclosed as per IFRS and the figures as they ----------------------
would have been if the notified Accounting Standards were adopted.
----------------------
Submission of stand-alone financial results to the stock exchanges shall
continue to be in accordance with the Indian GAAP. ----------------------
Impact of IFRS on Indian Banking Industry ----------------------
1. The financial impact of convergence with IFRS will be significant for ----------------------
banks in India, particularly in areas relating to loan loss provisioning,
financial instruments and derivative accounting. ----------------------
2. In banking companies, financial reporting policies are specified by the ----------------------
Reserve Bank of India. Adoption of IFRS requires a significant change to
such existing policies and could have a material impact on the financial ----------------------
statements of the companies.
----------------------
3. In addition to the financial accounting impact, the convergence process
will have a huge impact on the financial reporting systems (including IT ----------------------
systems) and compliance processes.
----------------------
4. Banks operates in a regulated industry (in India it is regulated by RBI)
and hence is subject to strict regulatory compliances. Applicability of ----------------------
IFRS may amount to increase in losses and impairment in loans which
----------------------
would ultimately affect the available capital and capital adequacy ratios.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

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MANAGEMENT ACCOUNTING

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2019 Symbiosis Open Education Society

Unit No. TITLE Page No.

---------------------- • Analyse the advantages and limitations of management accounting

The management accounting team of the Anglo-American Council ----------------------

Examine a financial statement and try to understand the difference ----------------------

---------------------- 4. Presenting to the management the operating and financial statements at

---------------------- Thus, we can say that:

---------------------- Thus, Management Accounting is an extension of managerial aspects of

---------------------- Suggested Reading

Basics of Financial Accounting 15

iii. Convention of Consistency ----------------------

Liabilities Assets ----------------------

Capital 50,000 Cash 10,000 ----------------------

Basics of Financial Accounting 17

---------------------- 55,000 55,000

Basics of Financial Accounting 19

---------------------- Fill in the blanks.

---------------------- The communication is generally in the form of financial statements that

Basics of Financial Accounting 21

---------------------- State True or False.

---------------------- 3. Bank / Financial Institutions

---------------------- 5. Vehicles Account

6. Interest paid or Received Account ----------------------

2.5 LIST OF COMMON TERMS USED IN FINANCIAL ----------------------

Basics of Financial Accounting 23

Basics of Financial Accounting 25

Let us study Depreciation accouting in detail: ----------------------

Basics of Financial Accounting 27

---------------------- c. Production Unit Method

b. Written Down Value (Reducing Balance) Method ----------------------

Year Balance Cost Depreciation Written Down ----------------------

Basics of Financial Accounting 29

---------------------- 2,500 hours x Rs. 4 per hour = Rs. 10,000

(a) On time basis - Rs. 50,000 ----------------------

Time basis Rs. 5,000 ----------------------

Basics of Financial Accounting 31

---------------------- 1. Buildings - Factory buildings as well as administration buildings

---------------------- Buildings - Administrative 5% 1.63%

Basics of Financial Accounting 33

---------------------- ●● For the purpose of correct valuation of assets, depreciation is charged on

Basics of Financial Accounting 35

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

---------------------- State True or False

1. Michael P. Griffin, MBA Fundamentals Accounting and Finance ----------------------

Basics of Financial Accounting 37

Check your Progress 1 ----------------------

3.4 SUBSIDIARY BOOKS ----------------------

The Cash and Bank Book looks as follows: ----------------------

---------------------- Date Name of the Supplier L.F. Invoice No. Amount

Date Particulars Folio Rs. Date Particulars Folio Rs. ----------------------

---------------------- Fill in the blanks.

---------------------- 3.6 CONTROL LEDGERS

Date Particulars Folio Rs. Date Particulars Folio Rs. ----------------------

b. Difference between both the sides is Rs. 85,000. ----------------------

Machinery Account ----------------------

Date Particulars Folio Rs. Date Particulars Folio Rs. ----------------------

---------------------- 3.9 PREPARATION OF FINAL ACCOUNTS FROM

Particulars Amount Particulars Amount ----------------------