Cost and Management Accounting

B.Com.-303/ BBA-302/ BCIBF-205

Under Graduate Commerce Programme

(Distance Mode)

Centre for Distance and Online Education-

JAMIA MILLIA ISLAMIA
New Delhi - 110025
EXPERT COMMITTEE

Prof. Najma Akhtar Prof. Jessy Abraham

Patron Vice-Chancellor, Hony. Director,
Jamia Millia Islamia CDOE, Jamia Millia Islamia

Prof. Mohammad Miyan Prof. Y.P. Singh

Hony. Chief Advisor, Founder Department of Commerce,
University of Delhi
CDOE, Jamia Millia Islamia

Prof. Najeeb Uzamman Khan Sherwani Prof. Sunayana

Head, Department of commerce and Business Studies Centre for Management Studies,
Jamia Millia Islamia Jamia Millia Islamia

Prof. Madhu Tyagi Dr. Sabiha Khatoon

School of Management, Assistant Professor, CDOE
IGNOU Jamia Millia Islamia

Dr. Firdous Khanum Dr. Mohd. Afzal Saifi

Assistant Professor, CDOE Jamia Assistant Professor, CDOE
Millia Islamia Jamia Millia Islamia

PROGRAMME COORDINATOR
Dr. Sabiha Khatoon, CDOE, Jamia Milli Islamia
COURSE WRITERS
Dr. Bibhu P. Sahoo, Department of Commerce, SGTB Khalsa College, University of Delhi, New Delhi
Block: 1: to 4 (Block: 1 Basic Concepts, Block 2 Material and Labour, Block 3: Overheads , Block 4: Method of Costing)
Unit : 1 to 12 (Unit 1: Nature and Scope of Cost Accounting, Unit 2: Cost Classification and Cost Sheet, Unit 3: Account
for material (Nature and Scope), Unit 4: Accounting for labour, Unit 5: Accounting for Overheads,
Unit 6: Absorption of Overheads, Unit 7: Single or Output Costing, Unit 8: Job Batch and Contract Costing,
Unit 9: Process Costing, Unit 10: Operating or Service Costing, Unit 11: Reconciliation of Cost and
Financial Accounts, Unit 12: Budgetary Control)

Prof. Abdul Aziz Ansari, Department of Commerce & Business Studies, Jamia Millia Islamia, New Delhi.
Block: 5 (Block 5: Management Accounting)
Unit: 13 & 14 (Unit 13: Financial Statement Analysis, Unit 14: Accounting Ratio)

C.A. Md. Feroz, Department of Humanities, National Institute of Technology, Kruchhetra, Haryana.
Block: 5 (Block 5: Management Accounting)
Unit: 15 & 16 (Unit 15: Budgeting-I, Unit 16: Budgeting-II)

All rights reserved. Printed and published on behalf of the CDOL by Hi-Tech Graphics, Jamia Nagar, New Delhi-110025

March, 2023
ISBN: 978-93-82997-84-9
All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including
photocopying, recording or by any information storage or retrieval system, without permission in writing from the CDOE,
Jamia Millia Islamia, New Delhi.

Cover Credits: Anupma Kumari, Faculty of Fine Arts, Jamia Millia Islamia
 CONTENTS

Block 1: Basic Concepts

Unit 1: Nature and Scope of Cost Accounting 5
Unit 2: Cost Classification and Cost Sheet 23
Unit 3: Account for Material (Nature & Scope) 39

Block 2: Material and Labour

Unit 4: Accounting for Labour 63
Unit 5: Accounting for Overheads 86
Unit 6: Absorption of Overheads 107

Block 3: Overheads
Unit 7: Single or Output Costing 131
Unit 8: Job Batch and Contract Costing 150
Unit 9: Process Costing 175

Block 4: Methods of Costing

Unit 10: Operating or Service Costing 204
Unit 11: Reconciliation of Cost and Financial Accounts 230
Unit 12: Budgetary Control 249

Block 5: Management Accounting

Unit 13: Financial Statement Analysis 204
Unit 14: Accounting Ratios 230
Unit 15: Budgeting-I 249
Unit 16: Budgeting-II 249
 BLOCK-1

Basic Concepts

The present block deals with the introductory part of Cost accounting. The
learners will learn about the meaning, nature, scope of Cost Accounting. Further,
they will have the opportunity to learn about the cost classification, cost sheets
and accounting for materials. How the cost account is maintained and what is it
relevance in the business. The present block refers the following unit;
Unit 1: Nature and Scope of Cost Accounting

Unit 2: Cost Classification and Cost Sheet

Unit 3: Accounting for Material (Nature & Scope)

4
UNIT-1 NATURE AND SCOPE OF COST ACCOUNTING

LEARNING OBJECTIVES

After studying this chapter you will be able to understand.

 Meaning & definition of cost accounting
 Nature and scope of cost accounting
 Objectives of cost accountings
 Difference between cost accounting and financial accounting

STRUCTURE

1.1 Introduction
1.2 Limitation of Accounting
1.3 Distinction between Financial Accounting and Cost Accounting
1.4 Steps of the Installation of a Costing System
1.5 Advantages of Cost Accounting
1.6 Disadvantages of Cost Accounting
1.7 Essential of Good Cost Accounting System
1.8 Cost Centre and Cost Unit
1.9 Method of Costing
1.10 Introduction of Management Accounting
1.11 Characteristics of Management Accounting
1.12 Technique of Management Accounting
1.13 Difference between Management and Cost Accounting
1.14 Limitation of Management Accounting
1.15 Cost Control, Cost Reduction & Cost Management

1.1 INTRODUCTION

Accounting is the process of accumulating, classifying, interpreting and presenting

financial information. Financial accounting is that basic process with management,
investors, creditors and other external parties as the users of the accounting information.
Financial accounting is primarily concerned with record keeping directed towards the
preparation of profit & loss that the business enterprises making and also its financial
position on a particular date. Cost accounting is a branch of accounting and has been
developed due to limitations of financial accounting. Management uses cost accounting.
This technique is very useful for planning and controlling operations and for decision
making. Further the cost data must be accumulated classified, interpreted and presented
in ways that are useful to managers for decision making. Now a days cost accounting was
often the fool used to calculate an inventory cost for balance sheet presentation and to
calculate the cost of goods sold for the income statement.

In brief, cost accounting is a branch of accounting, which has been develops to meet the
managerial needs of business. This concept is relatively a recent development due to
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Cost and Management
Accounting

growth of modern complexities in business. Cost accounting is concerned with

recordings, classifying and summarizing costs for determination of costs of production
such costs and furnishing of information to management for decision making.

1.2 LIMITATION OF FINANCIAL ACCOUNTING

The following limitations of financial accounting have led to the development of cost
accounting.

Limitations of Accounting

i. Accounting information is expressed in terms of money. Non-monetary events

or transactions, however important they may be, are completely omitted.
ii. Fixed assets are recorded in the accounting records at the original costs, that is,
the actual amount spent on them plus, of course, a incidental charges. In this
way the effect of inflation (or deflation) is not taken into consideration. The
direct result of this practice is that balance sheet does not represent the true
financial position of the business.
iii. Accounting information is sometime based on estimates; estimates are often
inaccurate. For example, it is not possible to predict with any degree of
accuracy the actual useful life of an asset for the purpose of depreciation
expense.
iv. Accounting information cannot be used as only test of managerial performance
on the basis of more profits of a period of one year can readily be manipulated
by omitting such cost of advertisement, research and development,
depreciation and soon.
v. Accounting information is not neutral or unbiased, accountants calculate
income as excess of revenue over expenses. But they consider only selected
revenues and expenses. They do not, for example, include cost of such items
as water or air pollution, employee’s injuries.
vi. Accounting like any other discipline has to follow certain principles which in
certain cases are contradictory. For example current assets (e.g., stock of
goods) are valued on the basis of cost or market price whichever is less
following the principle of conservatism. Accordingly the current assets amy be
valued on cost basis in some year and at market price in other year. In this
manner, the rule of consistency is not followed regularly.

Definition of Cost Accounting

According to the institute of cost and management accountant England (ICMA) has
defined cost accounting as “the process of accounting for the cost from the point at which
expenditure increase, to establishment of its ultimate relationship with cost centers and
cost units. In its widest sense, it embraces the preparation of statistical data, the

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 Nature and Scope of
Cost Accounting

application of cost control method and ascertainment of the probability of activities

carried out of planned;

According to Charles T. Horngren “cost accounting is a quantitative method that

accumulates, classifies, summarises and interprets information for three major purposes
(i) operational planning and control, (II) special decision and (iii) product decision”.
According to Wheldon, “costing is the classifying, recording and appropriate allocation
of expenditure for the determination of costs, the relation of these to sales value and the
ascertainment of probability.

From the above definition, it is clear that, cost accounting is a method of accounting in
which all costs incurred in carrying of an activity or accomplishing a purpose are
collected, classified and recorded. This data is then summarised and analyzed to serve at
a selling price or to determine where saving are possible. Cost accounting includes the
principles, convention techniques and system which are employed in a business to plan
and to control the unilisation of its resources. Cost accounting and expected future cost of
a product. Cost accounting is a system of determining cost of production.

Distinction between Costing and Cost Accounting

Costing is a system which determines cost of a product by using any method like
arithmetic process, however, cost accounting denotes the formal accounting mechanism
by means of which costs are ascertained by recording them in the books of accounts.

Cost Accounting: Science and Art

Cost accounting is a science as well as an art. It is a science in the sense that it is a body
of systematic knowledge, which a cost accountant shared possess. It is an art as it
requires the ability and skills on the part of a cost accountant in applying the principle of
cost accountancy to various management problems. Cost accountancy includes costing,
cost accounting, cost control and cost audit.

1.3 DISTINCTION BETWEEN FINANCIAL ACCOUNTING AND

COST ACCOUNTING

BASIS FINANCIAL COST ACCOUNTING

ACCOUNTING
(1) Statutory requirements These accounts are Maintenance of cost
prepared on the basis of accounting is voluntary
rules framed under and the concern may not
company Act and Income maintain these accounts.
Tax Act.
(2) Reporting period Financial accounts Cost accounting is a

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Cost and Management
Accounting

prepared Profit and loss continuous process and it

accounts and balanced sheet may be prepared daily,
are prepared on annual weekly, monthly etc.
basis.
(3) Predetermined cost It is concerned with the It is concerned with
historical cost and it can be historical as well as
understood in the context predetermined costs. It is
for which it was designed. related with plans and
polices to improve the
performance.
(4) Types of transactions It records only external Cost accounting records
transactions like purchase, external as well as internal
sales etc. transactions like issue of
materials from one
department. To another
department.
(5) Types of statements It prepares general purpose Cost accounting presents
statements like profit and special purpose statements
loss account, and balance and reports like time
sheet. reports, variance report etc
(6) Format of presentation It has a single format It has various forms of
presenting information such presenting cost
as P/L A/c and balance information which are
sheet. useful to management.
(7) Control of Aspect It lays emphasis on It provides a detailed
recording of financial and system of controls with the
have no control aspect. help of certain special
techniques like standerd
costing and Budgetary
control.
(8) Analysis of cost and It presents the profit and It shows the detailed cost
profit. loss for the particular and profit data for each
period and does not show product line.
the cost and profit for
individual products.
(9) Purposes The main purpose of The main purpose of cost
financial accounting is to accounting is to provide
prepare profit and loss detailed cost information
account and balance sheet, to management only.
for reporting to owners as
well as to external users.

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 Nature and Scope of
Cost Accounting

1.4 STEPS IN THE INSTALLATION OF A COSTING SYSTEM

The installation of a costing system requires the following steps:

(1) PRELIMINARY INVESTIGATION:- It should be made relating to the technical

aspects of the business.
(2) METHOD OF PURCHASE:- The method of purchase, storage and issue of
materials should be examined as per the requirements of the organization.
(3) ACCOUNTING RECORDS:-Accounting records should be so designed so as to
involve minimum expenditure.
(4) EFFECTIVE:- The system should be an effective one in cost reduction and cost
control.
(5) ECONOMICAL:- The system should be introduced gradually easy to operate.
(6) GRADUAL:- The system should be introduced gradually.
(7) SIMPLE:- The costing system should be simple and easy to operate.
(8) SIZE AND LAYOUT:- The size and layout of the factory should be studied.
(9) LABOUR PAYMENT:- The method of making payment to labour should be
examined for any incentive plan.
(10) ORGANISATION STRUCTURE:- The organization structure of the business
should be studied so that scope of each executive may be decided.

1.5 ADVANTAGES OF COST ACCOUNTING

The advantages of cost accounting are as under:

(1) REVEALS ACTIVITIES:- Cost accounting reveals profitable and unprofitable

activities of the concern so that management may eliminate inefficiencies of the
organization.
(2) DECISION MAKING:- Cost accounting supplies suitable data for managerial
decision making at proper time.
(3) INVENTORY CONTROL:- Perpetual inventory system helps in the preparation of
interim profit and loss account of the concern.
(4) COST REDUCTION:- If helps in the introduction of a cost reduction programme
and finding out new and improved methods of reducing cost.
(5) ACCURACY TESTING:- Cost accounting provides a reliable check on the
accuracy of financial accounting.
(6) PREVENTING FRAUDS:- Cost audit system helps in preventing frauds and
manipulation in account.
(7) IDLE CAPACITY:- A cost accounting system can easily work out the cost of idle
capacity so that it may be improved.
(8) POLICY FORMULATION:- Costing system provides facilities for the policy
formulation regarding production and pricing policies and in preparation of
programmes.
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Cost and Management
Accounting

(9) SELLING PRICES:- Cost accounting guides the management in the fixation of
selling price.
(10) COST CONTROL:- Cost accounting helps in controlling costs with the help of
standard costing and budgetary control.
(11) ADVANTAGES TO SOCIETY: An efficient system will lower down the cost of
production and by it the whole society will be benifitted.
(12) ADVANTAGES TO WORKERS:- Undercost system incentive plans are
introduced which results in higher in productivity and higher earning to the
workers.
(13) ADVANTAGES TO GOVERNMENT:- Cost system produces suitable and
important data for the use by Government, trade unions etc. which are useful in
solving many problems like price fixing, wages fixation, settlement of disputes etc.

1.6 DISADVANTAGES OF COST ACCOUNTING

The main disadvantages of costing accounting are as under:

(1) EXPENSIVE: costing system is quite expensive and small concerns can not afford
for it. It will involve additional expenditure which will reduced profits of the
organizations. Costing system should be treated as an investment and it should
earned more profits. It should not a give a burden on a management. Unnecessary
recording should be avoided.
(2) FAILURE: if this system does not produced desired results it is set that there is a
fault in the system. Generally employee’s oppose this system because they look
this system with the suspected eyes. In order the make the system, a success one,
the utility of the system should be explained to the management and employee’s
and they should be convinced that the system is quite beneficial for them.
(3) UNNESSACERY:- maintenance of cost records is not necessary and it involves
duplication of work. The management must know about the detailed cost
information for taking suitable decision.
(4) NOT APPLICABLE:- costing system is not applicable in many industries. Every
costing system must be specially designed to meet the needs of the business. In
fact, applications of costing are very wide. All types of activities should consider
the use of cost accounting.

1.7 ESSENTIAL OF A GOOD COST ACCOUNTING SYSTEM

(1) DESIGNED SYSTEM:- the cost accounting system should be designed as per the
requirements of business. A common type system will not be useful to each organization.

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 Nature and Scope of
Cost Accounting

1.8 COST CENTRE AND COST UNIT

A cost centre is a location, person or item of equipment for which cost may be
ascertained and used for the purpose of control. Cost centre refers to a section of the
business, to which costs can be charged. The main purpose of ascertaining the cost is
control over the cost. The whole organization is divided into small parts and each section
is treated as a cost centre to which cost is ascertained.

Type of Cost Centre

(1) Personal and (2) Functional
(1) Personal : it is of two types as under:
(a) Personal : it consists of a personal or a group of persons.
(b) Impersonal : it consist of a location or a group of persons.
(2) Functional : it is of the two types as under:
(a) Production centre : These are those centres, where, actual production work
takes place.
(b) Service centre : These centre provide service to production and are ancillary
to production.
Cost Unit

Cost unit is a step which breaks up the cost into smaller sub division. Cost unit is divided
as unit of product, service or time in relation to which cost may be ascertained. A tone or
sugar and metre of clothes are cost units. Hence cost unit is an unit of measurement of
cost.

Cost Unit may be of Two Types as Under

(1) UNIT OF PRODUCTION: a tone of steel, a metre of cable, a ream of paper etc. is
known as unit of production.
(2) UNITS OF SERVICE: Cinemas seats, Hotel room, consulting hours etc. are
include in units of service.

EXAMPLES: Cost units in various industries are as under:

INDUSTRY COST UNIT

Chemical Tones kilogram
Soft drinks Crate of 24 or 12 bottles
Interior decoration Each job
Shoes Per pair
Electricity KWH
Car Each car
Cotton Bale
Timber Cubic feet
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Cost and Management
Accounting

Carpets Square feet

Gas Cubic foot
Cement Tone
Bricks 1000 bricks
Nursing home Bed per day
Flour Tone
Pencils Per dozen
Transport Passenger km/tone kms.
Printing press Thousands copies
Building construction Each flate or building
Mines Tones of mineral
Hotel Room per day

1.9 METHODS OF COSTING

Various methods of costing are as under:

JOB COSTING: A job comprises a specific quantity of a product as per customer’s

specifications. This methods applies where work is under taken to customer’s
requirements. it is used in repair shops, interior decoration, printing press etc.

CONTRACT COSTING : Contract costing is big one and the unit cost is a contract,
which is a long duration and it may continue for more than a year.it is most suited to
construction of dams, roads, bridge, ship, building etc.

PROCESS COSTING: This methods is used in mass production industries, having a

continous process of manufacturing .In this methods raw material has to put through a
number of process up to a completion stage. The finished product of one process is
passed on the next process as raw material for the next process. This method is employed
by textile mills, chemical works, sugar mills etc.

UNIT COSTING : This methods is used to when production is uniform and consist of a
single variety of the same product. If the product is produced in different grades, cost are
as curtained grade wise. per unit cost is calculated by dividing the total cost by the total
number of unit produced. this methods is applicable in mines, bricks, floormills, steel
production etc.

COMPOSITE COSTING : This method is used in industries where a number of

component are manufactured separately and than assembled in a final product requires
another methods of costing. This methods is used in air condition, scooters, car etc.

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 Nature and Scope of
Cost Accounting

SERVICE COSTING: This methods is used where services are produced for example
transport undertakings, hotels, electricity companies, cinemas, hospitals etc. this method
is a variation of process costing.

OPERATION COSTING : Any process may consist of a number of operations and this
costing involves cost ascertainment for each operation. it provides minutes analysis of
costs and ensure greater accuracy and better control.

BATCH COSTING: In this method the cost of a batch of identical products is a cost
unit. This method is used in readymade garments, shoes, tyres and tubes etc.

TECHNIQUES OF COSTING:

The various techniques of costing are as under:

(1)STANDERD COSTING : In this technique standard cost is predetermined and than

actual performanceis measured against the standard .the variation between standard and
actual costs are analysed and reasons for differences are located.

(2)MARGINAL COSTING : In this technique cost is separated into fixed and variable
costs. Marginal cost is related with the variable cost and fixed cost is treated as period
cost as attempts are not made to allocate this cost to individual cost units.it is transferred
to profit and loss account.this technique is used to study the effect on profit of the
changes in output.

(3)BUDGETARY COSTING : Budgetary control is a technique relating a control of total

expenditure on materials, wages and overheads by making comparison of actual
performance with the planned one. The budget is also used for control and coordinationof
business activities.

(4)UNIFORM COSTING: It is defined as the use by several undertakings of the same

costing principles.it helps to compare the performance of one firm with that of another
firms that to derine the benefits.

(5)ABSORPTION COSTING : In this methods total cost are charged to products. It is

complete contrast to marginal costing. But it has a very limited application.

MEANING AND DEFINATION OF MANAGEMENT ACCOUNTING

Due to limitations in financial accounting it has become necessary to bring revolutionary

changes in the field of accounting. In this direction a new concept of accounting emerged
which is known as management accounting. This accounting is generally meant for
managers. Management accounting is very useful to all levels of managers for
decisions making purposes further management accounting has also been useful in
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Cost and Management
Accounting

maximizing profits and minimizing losses. In managerial accounting managers use the
provisions of accounting information in order to decide on the matters with in their
organization. which aids their management and performance of control functions.

In management accounting accounts are classified summarized analysed and presented in

such a manner that all valuable information may be made available managers. It
facilitiates the managers to take suitable decisions For attaining the goals, the managers
get help from various techniques of management accounting such as Marginal costing,
standard costing Radio analysis, Budgetary, control etc.

Definitions

T. G. Rose: Management Accounting is the adoption and analysis of accounting

information and its diagnosis and explanation in such a way to assist management.

L. W. Keler: Management Accounting includes the planning and budgetary functions

along, with present and historical accounting function

Robert Anthony: Management Accounting is concerned with accounting information that

is useful to management.”

C. A. Institute London:- “Any form of accounting which enables a business to be

conducted more efficiently can be regarded as Management accounting.”

J. Bately: Management Accounting is the tern to describe the accounting methods,

systems and techniques which coupled with special knowledge and ability, assist
management in its task of maximizing profits and minimizing losses.’

W. B..Meferland: Management Accounting is concerned with supplying financial data

useful to management at all levels in planning and administering an enterprise.’

Icwa:- According to Institute of cost and works Accounting of India, Management

accounting is a system of collection and presentation of relevant economic informations
relating to an enterprise for planning, controlling and decision making.

Characteristics of Management Accounting

Management Accounting provides important and necessary financial as well as non

financial information through internal and external sources which is very useful to the
managers for analysing and interpreting, it for making decisions. Nature or characteristics
of management accounting includes the following:

(i) Management accounting increases the efficiency of managers, and it helps them
to take suitable decision.
14
 Nature and Scope of
Cost Accounting

(ii) In management accounting managers get reports from various corners, which
help them to take proper decision.
(iii) The strengths and weakness of the organization can be ascertained easily through
various techniques of management accounting.
(iv) Management accounting provides accounting information to the managers, which
facilitates them in taking suitable decisions.
(v) Management accounting is a managerial function which helps the managers in
preparing plans for business and in other activities.
(vi) Management accounting provides feedback to managers and it facilitates the
manager to control the concern in a better way.
(vii) Decision making: managements accounting helps the manager to take best
decision, so that best financial results may be obtained.
(viii) Management accounting helps the manager to take or make buy decisions in the
interest of the organization.
(ix) Management accounting is an integrated system, under which targets are
achieved through various activities. In its various parts, cost accounts, budgetary
control and financial accounts, statistics effort for the concern.
(x) Management accounting ensures a systematic process in which various methods
and techniques are used. Various activities are coordinated with each other and it
is a systematic effort for the concern.
(xi) Management accounting is related to future activities and managerial decisions
are taken accordingly. Thus managements accounting, various informations, facts
and figures are made available.
(xii) Management accounting is related to information systems and various facts and
systements are necessary oart of the system. It helps in smooth running &
operation of the concern.
(xiii) Management accounting is an analytical system, which explains the reasons for
profitability etc. of the concern. All these facts helps in getting to a correct
conclusion.
(i) Management accounting divides managerial activities into various units and it
helps in the preparation of budgets, cost centers and division of resources. A
close relation is maintained in various departments.
(ii) The objective of management accounting is to maintain cooperation among
various activities. For every department a separate budget is prepared. The
departments help each other and valuable figures and facts are provided.
(iii) On the basis of information received for management accounting valuable
decisions are taken by the managers and best alternatives are selected.
(iv) With the help of management accounting responsibilities are assigned to
different employees and they are expected to perform their duties in a decent
manner.
(v) Management accounting helps in the preparation of managerial policies. Various
plans are formulated through which efforts are to be made to achieve the desired
goals. For casts are made on the basis of this plans. Expected rate of return are
for casted and proper decisions are taken for investing the funds.
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Cost and Management
Accounting

(vi) For the growth of the concern, it is essential that every member should take
active part in the working of the organization. For this purpose, persons working
in the organization are motivated. Policies are framed in the interest of
employees and efforts are made to keep their morale high.
(vii) Various parties may obtain important information regarding business with the
help of management accounting. Managers get information through reporting,
creditors get full information about loans, returns etc. investors get information
about rate of returns, suppliers get information about their payments through
various sources of accounting. In the organization, information system is
developed, so that all relevant information may be made available.
(viii) Management accounting helps in providing reports to managers which facilitates
them for taking decisions. Formulation of policies and control becomes easy on
the basis of these reports.

1.12 TECHNIQUES OF MANAGEMENT ACCOUNTING

The main techniques of management accounting are given below:

(i) Financial accounting: strong financial accounting system is required for

sound management accounting because financial accounting provides
important facts and information to management which are very essential for
performing managerial activities.
(ii) Standard costing: in management accounting, standard costing is applied in
which different variances are located, corrective measure are implemented
and proper decision are taken. Comparison of actual with the standard is
made and corrective measures are taken.
(iii) Ratio Analysis: for measuring profitability, liquidity and efficiency of the
concern,

1.13 DIFFERENCE BETWEEN MANAGEMENT ACCOUNTING AND

COST ACCOUNTING

The difference between management accounting and cost accounting may be given as
under:

BASIS MANAGEMENT CCOUNTING COST ACCOUNTING

Users. Management accounting uses Cost accounting does not use
various techniques of cost techniques of management
accounting. accounting
Basis Management accounting is based Cost accounting is indispensable
on financial accounting. for managerial control.
Information Management accounting provides Cost accounting does not provide
information to managers at various such information.
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 Nature and Scope of
Cost Accounting

levels.
Records Management accounting records Cost accounting does not record
various operations. such operations.
Decision Various information assists Cost accounting does not help in
Making managers in formulating policies making decision.
and decision making.
Techniques Managers use various techniques Cost accounting does not use
of cost accounting such as ratio management technique.
analysis, budgetary control etc.
Nature Where cost accounts ends Cost accounting is related to
management account accounts determination of cost per unit etc.
begins.
Adviser Management accountant has a Cost accounting does not have a
higher position and acts as a main higher position and does not act as
advisor. a main advisor.
Assist Management accounting assists Cost accounting does not help
managers in day to day operations. managers in daily operations.
Scope The scope of management The scope of cost accounts is very
accounting is very wide, as it limited as it does not include
includes financial accounting and financial accounting and
cost accounting. management accounting.

1.14 LIMITATION OF MANAGEMENT ACCOUNTING

The main limitations of management accounting are as under:

(i) More expensive: management accounting is more useful for large scale
organizations on account of its expensive nature. The small concern are not
in a position to bear its burden. The technique of management accounting is
comparatively more expensive.
(ii) Delays in decision: many times the managers are not in a position to take
proper decision. On account of delayed process, relevance of decisions taken
become useless.
(iii) Manipulation: the figures abtained from management accounting may be
misused and there are possibilities of manipulations of information.
(iv) Lack of knowledge: in case of persons not taking decisions at proper time,
due to lack of managerial efficiency, the goal may be effected adversely.
(v) Dependency of data: management accountant has to depend on financial
accounting and cost accounting for accurate information of facts and figures.
If the figures are inaccurate, it will adversely effect the managerial decisions.
(vi) Resistance from existing staff: the existing accounting and management
staff may oppose the introduction of management accounting system in the
organization.
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Cost and Management
Accounting

1.15 COST CONTROL REDUCTION AND COST MANAGEMENT

Business firms, now a day aims at producing the product at the minimum cost. It is
necessary in order to achieve the goal of profit maximation and wealth maximasation.
The success of financial management is judge by the action of the business executives in
controlling and reducing the cost of product.

Cost control

It means a search for better and more economical ways of completing each operation.
Cost control helps to eliminate inefficiencies and wastages with in the existing
environment to increase the profits and to improve the performance by minimizing the
costs. Cost control is defined as the regulation by executive action of the cost of operating
an undertaking. It aims at achieving the target sales. Cost control is the procedure where
by actual results are compared against the predetermined standards. The firm is expected
to adhere to the standards. Deviations of actual performance form the standards are
analysed and reported and corrective action are taken.

Steps in Cost Control

Cost control involves the following steps

(i) Planning: Initially a plan or set of targets is established in the form of budget
and standards.
(ii) Communication: The next step is to communicate the plan to those whose
responsibility is to implement the plan.
(iii) Motivation: After the plan is put into action, evaluation of the performance
starts. Costs are ascertained and information about achievement is called and
reported to higher officials.
(iv) Appraisals: Comparison has to be made with the predetermined targets and
actual performance. Deficiencies are noted and discussion is started to
overcome deficiencies.
(v) Decision making: Finally, the reported variance are received. Corrective
actions and remedial measures are taken or set or target is revised depending
upon the administration understanding of the problem.

18
 Nature and Scope of
Cost Accounting

Definition

According to institute of cost and management accountants (CIMA) London, “cost

control means the guidance and regulation by executive actions of the cost of
operating an undertaking.”

Features of Cost Control

cost control process involves setting targets and standers, ascertaining the variance
and taking corrective action. Some of the important features of cost are:

 It aims at achieving the standards

 It is a preventive function
 It is generally applicable to items which have standards.
 It contains guidelines and directive management such as how to do a thing.

Advantages of Cost Control: some of the merits of cost control are discussed below:

 It help the firms to improve its profitability and competitiveness.

 It helps the firms in reducing its cost.
 It is helpful is achieving greater productivities.
 It helps in increasing sales and employment of work force.

Disadvantages of cost control: some of the disadvantages of cost control are discussed
as below.

 It reduces the flexibility and process improvement in a company.

 It restricts innovation of product.
 It may compromise in quality of a product.

Techniques of cost control: some of the techniques which are generally aploed in cost
controlling techniques are:

 Budgetary control
 Standard costing
 Ratio analysis
 Variance analysis
 Inventory control

Cost Reduction

The process of identifying and eliminating unnecessary costs to improve the profitability
of a business is known as cost reduction. It refers to bringing down the cost of
production. Cost reduction is possible only when the business firms makes the optimum
19
Cost and Management
Accounting

utilization of resources. It is possible by incorporating internal and external economics.

This means that by econmising the cost of manufacturing, administration, selling and
distribution, the everage cost reduction may be achieved. Cost reduction is thus stated as
the real and permanent reduction in unit cost of goods or services rendered without
impairing their suitability for the intended use.

According to the Charted Institute of Management Accounts, London, "Cost reduction

means the achievement of real and permanent reduction in the unit cost of goods
manufactured or service rendered without imparting their suitability for the use
intended."

Features of cost reduction : Some of the important features of cost reduction are:

- It is not concerned with setting targets and standards.

- It is the final result in the cost control process.
- It is continuous, dynamic and innovative in nature and alternative to reduce costs.
- It is a corrective function.
- This is applicable to every activity of the business.
- It adds thinking and analysis to actions at all levels of management.

Techniques of Cost Reduction: The various techniques used for cost reduction are as
follows:

- Organisation and methods

- Work study
- Material handling
- Automation
- Labour and overhead control.
- Material control.
- Quality control.
- Production control and designing.
- Value analysis.

Difference between Cost Control and Cost reduction

Basis Cost Control Cost Reduction

1. Focus It aims at achieving It aims at real and
predetermined standard cost permanent reduction in
2. Nature cost without
It is temporary in nature compromising quality.
3. Basis of application It is routinely applied on a It is permanent in
continuous basis nature.
It is applied when an
4. Process opportunity for cost
20
 Nature and Scope of
Cost Accounting

reduction is identified
It predetermines the cost and which affirms a
5. Function then compares it with actual competitive advantage
6. Uses of Accounting performance for achieving for a longer time.
techniques. the targets.
It is a preventive function It does not lay down the
It heavily depend/upon cost standards in
accounting techniques. advance.

It is a corrective
function.
It may not involve the
use of accounting
techniques.

Cost Management

Cost management is the process of planning and controlling the budget of a business.
Cost Management is a form of management accounting that allows a business to predict
impending expenditures to help in reducing cost. Cost management is a term of recent
origin. It may be defined as follows, "Cost management identifies, collects, measures
classifies and reports information that is useful to management in determining the cost of
products or services, planning, controlling and decision making. Cost Management
includes both cost accounting and management accounting. This techniques helps in
revenue and profit planning. The main two areas for cost managements are (i) to focus on
value-added activities and (ii) to reducing consumption of cost drivers in value added
activities. In brief cost management is activities which is achieved by collecting,
analysing, evaluating and reporting cost information used for budgeting, estimating,
forecasting and monitoring cost. Cost management is process of planning and controlling
the budget of the project. It predicts the expenditure and reduce the project from going
over budget.

1.16 QUESTIONS

1. List out the different methods of costing and explain their practical application.
2. "A costing system that simply records costs for the purpose of fixing sale prices has
accomplished only a small parts of its mission". Discuss, What other functions does
costing perform?
3. "A govt. system of costing series as a means of control over expenditure and helps to
secure economy in manufacture" Discuss.
4. What are the essential principles of a good costing system? What are the objections
to the introduction of a costing system.
5. State and explain main difference between cost accounting and financial accounting.

21
Cost and Management
Accounting

1.17 SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

22
UNIT-2 COST CLASSIFICATION AND COST SHEET

LEARNING OBJECTIVES

After studying this unit a student will be able to understand

 Meaning of cost sheet
 Preparation of cost sheet
 Classification of cost
 Element of cost

STRUCTURE

2.1 Introduction
2.2 Classification of Cost
2.3 Meaning of Cost Sheet
2.4 Specimen of Cost Sheet
2.5 Element of Cost Sheet
2.6 Questions

2.1 INTRODUCTION

A cost sheet is a report on which is accumulated all of the costs associated with a product
or production job. A cost sheet is used to compile the margin earned on a product or job,
and can form the basis for the selling of process on similar products in the future. It can
also be used as the basis for a variety of cost control measure. According to CIMA
London cost sheet, is „a statement which provides for the assembly of the detailed cost of
a centre or a cost unit.‟ It is also a periodic statement. The expenditure which has been
incurred up on product for a period is extracted from the financial books and the store
records and set out in a memorandum statement. If this statement is confined to the
disclosure of the costs of units produced dividing the period, it is known as cost sheet, but
where the statement records both total cost, profit and loss. It is known as statement of
cost or production account. If information derived from the books is set on usually in the
form of a statement, it is cost sheet but where it is set out in the form of an account
recordings the cost incurred, there being separate accounts to show also sell and profits, it
would be known as production or manufacturing account. It is desirable that beside total
expenditure incurred, cost per unit of input, cost per unit of output in case of each
element of cost should be calculated. Therefore “Cost sheet is a document, which
provides for the assembly of the detailed cost of a cost unit.” Cost sheet is a periodical
statement of cost showing in detail the various elements of cost of goods produced. It is
prepared at regular intervals. Comparative figures of the previous period may be shown
in the cost sheet.

When the details of cost sheet are shown in a T-shape account, it is known as production
account.

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Cost and Management
Accounting

Purpose: Cost sheet serves the following purpose –

(i) It provides a comparative study of the cost of current period with that of the
previous period.
(ii) It represents the total cost as well as per unit cost.
(iii) It discloses the breakup of total cost into different elements of cost.
(iv) It acts as a guide in fixation of selling prices.

2.2 CLASSIFICATION OF COST

Cost may be classified into different categories depending upon the purpose of
classification, some of the important categories in which the costs are as follows.

1. Classification of cost methods on the basis of nature of production or

manufacturing process.
(i) Job costing and
(ii) (ii) Process costing.

2. Classification of cost on the basis of their variability in relation to product:

(i) Fixed cost, (ii) Variable cost, (iii) Semi variable cost, (iv) Product cost, (v)
Period cost and (vi) Direct and indirect cost,

3. Cost according to function

1. Prime cost
(i) Manufacturing/Producing cost,
(ii) Administrative Cost,
(iii) Selling and distribution cost, and
(iv) Research & development cost

4. Cost for managerial decision making

1. Relevant and irrelevant cost

(i) Marginal cost,
(ii) Differential cost/incremental cost,
(iii) Uniform costing,
(iv) Opportunity cost,
(v) Replacement cost,
(vi) Sunk cost & shut down cost,
(vii) Conversion cost,
(viii) Imputed cost and Out of pocket cost
5. Classification of cost methods on the basis of time
(i) Historical cost and (ii) Pre-determinate cost.

24
 Cost Classification and
Cost Sheet

6. Classification of cost based on establishment

(i) Engineering cost and (ii) Managed cost, discretionary or programmed cost
7. Cost which are used for particular purpose.
(i) Conversion cost, (ii) Common cost, (iii) Traceable cost, (iv) Joint cost, (v)
Unavoidable cost and (vi) Total cost

Let us Discuss one by one

1. Classification of cost in the basis of nature of production:
(i) Job costing : An order specific costing technique, which is use in situation where
each job is different and is performed to the customer‟s specification. Job costing
involves keeping an account of direct and indirect cost. It helps in finding out the
cost of production of every order and thus helps in calculations profit or loss
made of on its execution.
(ii) Process costing: This technique computed for each process over a period of time
i.e. production for a process during a given period. Process costing is used when
nearly identical in its are mass produced. It applies in textile industry, sugar
industries etc.

2. Classification of cost on the basis of variability

(i) Fixed cost: Fixed cost is a cost which does not change in total for a given time
period. For example, a retailer must pay rent and utility bills irrespective of sales.
This cost is a basic operating expenses of a business that cannot be avoided.

(ii) Variable cost: The cost which varies directly in proportion with every increase or
decrease in the volume of output or production is known as variable cost. Some
of the examples are: wages of labourers, cost of direct material etc.

25
Cost and Management
Accounting

(iii) Semi variable cost: A semi variable cost is a cost the contains both fixed and
variable cost elements. The fixed element of the cost will be incurred repeatedly
over time, while the variable element will only be incurred, irrespective of
volume. This concept is used to project financial performance at different level of
activity.
For example: commercial leases: which often have a fixed rent per month plus an
additional rent based on the amount of production or sales.

(iv) Product cost: The cost which are a part of the cost of a product rather than
expenses of the period in which they are incurred are called as product cost. For
example: cost of raw material and direct wages, depreciation or plan etc.

(v) Period cost: The cost which are not associated with production are called period
costs. They are treated as an expenses of the period in which they are incurred. It
may be fixed as well as variable cost. Such cost include general administration,
salesman salaries, commission etc.
26
 Cost Classification and
Cost Sheet

(vi) Direct and indirect cost: The expenses incurred on material and labour which are
economically and easily traceable for a product, service or job considered as
direct-costs. For example: in the process of manufacturing of production of
articles, materials are purchased, labourers are employed and wages are paid to
them.

The expenses incurred on those items which are not directly chargeable to
production are known as direct cost. For example, salary of storekeeper, watch
man etc.

3. Cost according to function

(i) Manufacturing/production cost: it includes the following cost:

a. Direct material cost:- materials that can be physically and conveniently
traced to a product.
b. Direct labour cost:- labour cost that can be physically and conveniently
traced to a product such as assembly line workers in a plant etc.
c. Direct expenses:- These are expenses which can be directly, conveniently
and wholly allocated to specific cost. It may be also described as chargeable
or productive expenses.
d. Prime cost:- it consist of cost of direct material, direct labor and direct
expenses.
e. Manufacturing or factory overhead: all cost of manufacturing a product other
than direct material, direct labour and direct expenses. It includes all indirect
material, indirect labour and factory expenses.
(ii) Administration cost: All cost associated with the general management of a
company as a whole are known as administration cost. For example office rent,
legal charges, director salary, furniture, bank charges etc.
(iii) Selling and distribution cost: All cost necessary to secure customer is known as
selling and distribution cost. For example: sales man commission, advertising,
delivery charges etc.
(iv) Research and development cost
Any expenses associated with the research and development of a company‟s
goods and services. This type of expenses is incurred in the process of finding
and creating new products or services.

Cost for Managerial Decision

(i) Relevant cost Irrelevant costs: Relevant costs are those cost which change by
managerial decision. This cost have to satisfy at least two conditions (i) this cost
are those which are to used in future (ii) this cost changes with alternative.
Irrelevant cost are those which do not get affected by the decision. It does not
change by a decision of the management. All future cost are relevant cost and all
past costs are irrelevant cost
27
Cost and Management
Accounting

(ii) Marginal cost: It means the increase or decrease in the total cost of a production
run for making one additional unit of an item. It is computed in a situation where
the break even point has been reached. Marginal costs are variable costs
consisting of labour and material costs plus an estimated portion of fixed costs.

(iii) Differential cost: Difference in the costs of two alternatives is known as

differential cost. For example, two alternatives may be two levels of activity and
the difference in the costs of two levels of activity differential cost. Such
differential cost may be either incremental or detrimental cost. When cost under
an alternative increases, it is called incremental cost and when a cost under an
alternative decreases, it is called detrimental cost.

(iv) Uniform costing: Uniform costing is the application of the same accounting and
costing principles methods or procedures uniformly by various under takings in
the same industry. It is a particular technique which applies the usual accounting
methods. Like standard costing, marginal costing and budgetary control.

(v) Replacement cost: This is the cost or replacing an asset which is being used, for
example, the replacement cost of material is the present market price of material
on the date of issue to the production department. It is the actual cost to replace
an asset or an item or structure at its pre-loss condition. It means replace the
assets of a company or property of the same or equal value.

(vi) Shut down and sunk cost: A manufacturer or an organization may have to
suspend its operations for a period on account of some temporary problems. For
example, shortage of raw material, non-availability of skilled laboures etc. during
this period, no work is done yet, certain fixed costs, such as rent and insurance of
building, depreciation etc. for the entire plant will have to be incurred. Such cost
is known as shut down cost.
Sunk cost are historical or past cost. These are the costs which have been created
by a decision that will be made in the near future. For example: investment in
plant and machine, building etc.

(vii) Opportunity cost: This is the cost of an alternative that must be foregone on order
to pursue a certain action. This concept is used in problems of alternative choice.
For example, when a fixed deposit in a bank is converted in to debenture of a
company, interest on fixed deposit on the bank will not be received but interest
on debenture will be received. It means interest on bank fixed deposit has been
sacrificed to earn interest on debenture, therefore, the interest on bank deposit is
an opportunity cost for the investor who has purchased debenture.

(viii) Conversion cost: It is the total of direct wages and factory over heads. Hence,
conversion cost = production cost – cost of raw materials.

28
 Cost Classification and
Cost Sheet

(ix) Imputed cost: A cost that is incurred by virtue of using an asset instead of
investing it or undertaking an alternative course of action. An imputed cost is an
invisible cost that is not incurred directly.

For example: When a building is owned then no rent is paid. The national rent or
the rental value of such a building is an imputed cost which is used for decision
making purposes.

(x) Out of pocket cost: Out of pocket costs in management accounting are expenses
that could be incurred or avoided depending on management‟s decisions. In other
words, out of pocket expenses is a potential future outlay of cash that-
management needs to decide whether or not make. It is an expense that requires a
future disbursement of cash. For example; depreciation of plant is not payable in
cash but is a part of the cost. It is not an out of pocket cost.

2.3 MEANING OF COST SHEET

Cost sheet is a document, which provides for the assembly of the detailed cost of a cost
unit.” Cost sheet is a periodical statement of cost showing in detail the various elements
of cost of goods produced. It is prepared at regular intervals. Comparative figures of the
previous period may be shown in the cost sheet.
When the details of cost sheet are shown in a T-shape account, it is known as production
account.

Purposes: cost sheet serves the following purposes –

(i) it provides a comparative study of the cost of current period with that of the
previous period.
(ii) It represents the total cost as well as per unit cost.
(iii) It discloses the break up of total cost into different lements of cost.
(iv) It acts as a guide in fixation of selling prices.

2.4 SPECIMEN OF COST SHEET

Particular Details Amount

Rs Rs
Opening stock of raw material Xxx
Add purchases of raw material Xxx
Add purchase expenses Xxx
Less closing stock of raw material Xxx
Value of raw material Xxx
Add direct labour Xxx
Add direct expenses Xxx
Prime cost Xxx
29
Cost and Management
Accounting

Add factory overheads:

Factory rent Xxx
Factory power Xxx
Indirect material Xxx
Indirect labor Xxx
Supervision salary Xxx
Drawing office salary Xxx
Factory insurance Xxx
Factory asset depreciation etc xxx
Work cost incurred Xxx
Add opening work-in-progress Xxx
Less closing work-in-progress xxx
Work cost xxx
Add office & administration overhead:
Office rent Xxx
Office asset depreciation Xxx
General charges Xxx
Audit fees Xxx
Bank charges Xxx
Legal charges Xxx
Other office expenses Xxx
Cost of production Xxx
Add: opening stock of finished goods Xxx
Less: closing stock of finished goods Xxx
Cost of production goods sold Xxx
Add selling and distribution over head:
Salesman commission Xxx
Salesman salary Xxx
Travelling expenses Xxx
Advertisement bad debts Xxx
Were housing charges Xxx
Delivery man expenses Xxx
Sales tax Xxx
Cost of sales Xxx
Profit/loss Xxx
Sales-selling price Xxx

2.5 ELEMENTS OF COST

(i) DIRECT MATERIAL: Since there will be only one product and process of
manufacture is also simple, the raw material if any is directly charged to the
production of the period in told. The openings stocks purchases and the closing

30
 Cost Classification and
Cost Sheet

stock of raw material should not be shown separately but suitably adjusted to
give one figure of raw material consumed or use.

(ii) DIRECT LABOUR: The labor cost are directly charged to production is known
as direct labour.

(iii) DIRECT EXPENSES: Expense other then direct labour and direct material are
known as direct expense: for example excise duty, expense on decisions.

(iv) PRIME COST: The total of direct material consume, direct labour and other
direct expense is known as prime cost.

(v) OVERHEAD: It is to be noted that the term overheads has a wider meaning than
the term indirect expenses. Overheads includes the cost of indirect material,
indirect labor besides indirect expenses. Indirect expenses may be classified
under the following three categories –

a. Manufacturing (works, factory or production) expenses. Such indirect

expenses which are incurred in the factory and concerned with the running of
the factory or plant are known as manufacturing expenses. Expenses relating
to production management and administration are include therein. Following
are a few items of such expenses:
Rent, rates and insurance of factory premises power used in factory building,
plant and machinery, etc.

b. Office and administrative expenses are not related to factory but they
pertain to the management and administration of business. Such expenses are
incurred on the direction and control of an undertaking. Examples are: Office
rent, lighting and heating, postage and telegrams, telephones and other
charges; depreciation of office building, furniture and equipment, bank
charges, legal charges, audit fee.

c. Selling and distribution expenses. Expenses incurred for marketing of a

commodity, or securing orders for the articles, dispatching goods sold, and
for making efforts to find and maintain customers, are called selling and
distribution expenses. Example are:
Advertisement expenses, cost of preparing tenders, travelling expenses, bad
debts, collection.

(vi) Work in progress: It rarely happens that unit initiated during a period is finished
in that very period. These incomplete units are called „work-in-progress‟. It may
be valued either on the basis of prime cost or works cost. However, its valuation
on works cost basis i.e. prime cost plus proportionate factory overheads, is more

31
Cost and Management
Accounting

scientific. Treatment of work-in-progress in the costsheet or production account

is made as follows:

Prime cost + factory overheads + opening balance (stock) of work-in-progress –

closing balance (stock) of work-in-progress

(vii) Finished goods: Of the opening and closing stocks of finished goods are also
given, these must be adjusted before calculating cost of goods sold as follows:
Cost of production + opening stock of finished goods – closing stock of finished
goods = cost of goods sold
Illustration 1. compute cost of raw material purchased from the data given below
RS
Opening stock of raw materials 10,000
Closing stock of raw materials 15,000
Expenses of purchases 5,000
Direct wages 50,000
Prime cost 1,00,000
[B.com. (pass) Delhi]
Solution: COMPUTATION OF RAW MATERIALS PURCHASED
Particular RS RS
Prime cost 1,00,000
Less: direct Wages 50,000
Direct material 50,000
15,000
Add: Closing Stock 65,000
10,000
Less: Opening stock 5,000 15,000
Expenses on purchase 50,000
Materials purchased

Illustration 2. From the following information prepare cost sheet and find out the
amount of profit:
RS
Raw material purchased 24,000
Works overhead 20,000
Stocks:
Raw material as on 1st January, 2015 4,000
Finished goods (800 quintals as on 1st January, 2015 3,200
Work-in-progress:
1st January, 2015 960
st
31 January, 2015 3,200
Office and administrative overheads 1,600
Sales (finished goods) 60,000

32
 Cost Classification and
Cost Sheet

Advertising discount allowed and selling cost is Rs. 0.40 per quintal. During the month
12,800 quintals of the commodity were produced.
[B.Com. Delhi]
Solution:
COST SHEET
Output: 12,800 quintals
Particulars Amount
RS
Opening stock of raw materials 4,000
Add: Raw materials purchased 24,000
Value of Raw Material 28,000
Add: Works Overhead 20,000
48,000
Add: Opening work-in-progress 960
48,960
Less: Closing work-in-progress 3,200
Works Cost 45,760
Add: office & Administrative Overheads 1,600
Cost of Production 47,360
Add: opening stock of finished goods 3,200
Cost of production of goods sold 50,560
Add: selling & distribution overheads”
Advertising, discount allowed & selling cost 5,440
(13,600*0.40) 56,000
Cost of sales 4,000
Add: profit (balancing figure) 60,000
sales

Illustration 3. Prepare cost sheet from the following data provided by Aruna Industries
Ltd. For the year ending 31st March, 2012:
Raw Materials Rs 15,000
Direct Labor RS 9,000
Machine Hours 900 hours
Machine hour rate Rs 5
Production 17,100 units
Sales 16,000 units
Selling Price per unit Rs 4
Selling overhead per unit 50 paise
Office overheads are 20% of works cost.
[B.com. (Pass) Delhi, 2007]

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Cost and Management
Accounting

Solution: COST SHEET

PARTICULAR RS RS
Raw materials 15,000
Direct labor 9,000
Prime cost 24,000
Factory overheads (900*5) 4,500
Works cost 28,500
Office overheads 20% of works cost 5,700
Total cost of production 34,200
Less: closing stock of finished goods (1,000*Rs2) 2,200
Cost of goods sold 32,000
Selling overhead (0.50 paise*16,000) 8,000
Selling cost 40,000
Profit 24,000
Sales (Rs 4* 16,000) 64,000

Illustration 4. Mr. A furnishes the following data relating to the manufacture of a

standard product during the month of January, 2015:
Raw material purchased Rs.15000
Opening stock of raw material Rs.4000
Closing stock of raw material Rs.5000
Direct labour cost Rs.9000
Machine hours worked 900 hours
Machine hour rate Rs.5
Carriage In wards Rs.1,000
Administrative over heads 20%on works cost
Selling overheads 50p.per unit sold
Units produced 17,100
Opening stock of finished products 2,000 units @Rs1.50per
unit
Unit sold 16,000 units
Selling pric per unit Rs.4
You are required to prepare:

(i) Cost sheet, (ii)a statement showing profit for the period. [B.com Delhi,1991]
Solution:
Particular RS RS
Opening stock of raw materials 4,000
Add: raw materials purchased 15,000
Carriage inwards 1,000
20,000
Less: Closing stock of raw materials 5,000
Cost of raw materials consumed 15,000
Direct labor 9,000
34
 Cost Classification and
Cost Sheet

Prime cost 24,000

Factory overheads
900 machine hours @Rs 5 per hour 4,500
Works Cost 28,500
Administration overheads (20% an Rs28,500) 5,700
Cost of production 34,200
Cost per unit=34,200/17,100 = Rs2

STATEMENT OF PROFIT
PARTICULAR RS
Cost of production 34,200
Add: Opening Stock of finished Goods:
2,000 units @ Rs 1.50 per unit 3,000
Less: Closing Stock of Finished goods 37,200
3,1000 unit @ Rs 2 per unit 6,200
Cost of goods sold 31,000
Selling and distribution overheads
(16,000*Rs. 0.5) 8,000
Total cost 39,000
Profit 25,000
sales 64,000

Illustration 5 Vijay industries manufactures a product x. on 1st January 2015 there

were 5,000 units of finished product in stock .other stocks on 1 st January ,2015 were
follows:
Work in progress Rs.57,400
Raw material Rs1,16,20,0
The information available from cost records for the year ended 31st December ,2015
was as follows:
Rs
Direct material 9,06,900
Direct labour 3,26,400
Freighton raw materials purchased 55,700
Indirect labour 1,21,600
Other factory over heads 3,17,300
Stock of raw materials on 31-12-2015 96,400
Work in progress on 31-12-2015 78,200
Sales(1,50,000)units 30,00,000
Indirect material 2,13,900

There are 15000units of finished stock in hand on 31st December, 2015.

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Cost and Management
Accounting

Solution STATEMENT OF COST AND PROFIT

PARTICULAR Rs Rs
Opening stock of raw material 1,16,200
Add: Direct material purchased 9,06,900
Add: Freight on purchases 55,700
10,78,800
Less: Closing stock of raw materials 96,400
Cost of raw materials consumed 9,82,400
Direct wages 3,26,400
Prime cost 13,08,800
Add: factory overheads:
Indirect wages 2,13,900
Indirect materials 1,21,600
Other overheads 3,17,300
Add: opening stock of WIP 57,400
7,10,200
Less: closing stock of WIP 78,200 6,32,000
Cost of production 19,40,800
add: opening stock of finished goods (5,000*Rs12.13) 60,650
20,01,450
less: closing stock of finished goods (15,000*Rs12.13) 1,81,950
cost of production of goods sold 18,19,500
profit 11,80,500
sales 30,00,000

Total cost of Production Rs.19,40,800

Cost per unit = =  Rs.12.13
Total Output 1,60,000
Question
1. Explain fully the concept of cost?
2. What do you mean by elements of cost? Explain the different elements of cost.
3. What are the different ways in which costs may be classified? Discuss the
sensitizing ofi each classification?
4. Find out the cost of Raw Materials Purchased from the data given below:
Prime Cost 2,00,000
Closing Stock of Raw Material 20,000
Direct Labour Cost 1,00,000
Expenses on Purchases 10,000
[B, Com. (Pass) Delhi, 1995]
[Ans.? 1,10,000.] –
5. From the following prepare a Cost Sheet:
Raw materials 6,000
Direct Wages 5,000
Factory Overheads 2,400

36
 Cost Classification and
Cost Sheet

Opening Stock of finished goods 800 [200 kg.]

Closing Stock of finished goods [400 kg]
Sale of finished product 20,000, 3,000 kg.l
Advertising & Selling Expenses. +1,475
Profit desired is 30% on sales.
B. Com. (Pass) Delhi-2010]
[Ans. Profit Rs.6,000]
6. Compute manufacturing expenses from the data given below :
Opening Stock of Raw Material 5.000
Purchases 25.000
Expenses on Purchases 1,000
Direct Wages 20,000
Direct Expenses 1,000
• Closing Stock of Raw Materials 7,000
Manufacturing Cost 80,000
[B. Com. (Pass) Delhi]
[Ans. Rs. 35,000]
7. Below is the enumerated expenditure in the manufacture of A product :
Raw Materials 28,000
Fuel 6,900
Electric power 1,340
Process and general wages 63,500
Repairs 2,400
Haulage
1,060
Light and water 400
Rent 2,000
Rates and insurance 300
Office salaries and general expenses 7.000
Administration (office) 5,000
Depreciation on Machinery 2,500
Total 1,20,000
Quintals manufactured 17,200
Prepare a cost-sheet-showing the cost per each item of expenses and the total cost
per quintal.
[B. Corn. (Phiis) Delhi]
[Ans. Prime Cost Rs. 91,500, Works Cost Rs. 1,08,400, Total Cost Rs. 1,20,400]

2.6 SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.

37
Cost and Management
Accounting

 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication

House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

38
UNIT-3 ACCOUNT FOR MATERIAL (NATURE & SCOPE)

LEARNING OBJECTIVES

After studying this unit you will be able to understand

- Material control
- Procedure and Pricing issue of Material
- Method of Pricing of Materials
- FIFO, LIFO, Simple and Weighted Average
- Stock Level and EOQ
- Material Turnover Ratio

STRUCTURE

3.1 Introduction
3.2 Material Control procedure
3.3 Pricing Issue of Material
3.4 Methods of Pricing of Materials
3.5 First on First out (FIFO)
3.6 Last ion First Out (LIFO)
3.7 Simple average method
3.8 Weighted average method
3.9 Techniques of Material Control
3.10 Material Turnover Ratio
3.11 Stock Levels
3.12 Economic Ordering Quantity.

3.1 INTRODUCTION

The term materials refers to raw materials which are used in production and assembling .
Here, the term raw materials means inventory. It also includes work-in, process goods
and completely finished goods. Material control aims at efficient purchasing of materials,
their efficient storing and efficient use or consumption. Further, it can be defined as a
comprehensive framework for the accounting and control of material cost designed with
the object of maintaining material supplies at a level so as to ensure uninterrupted
production but at the same time minimising investment of funds.

Material Control

It includes procuring, storing and supplying of materials required for production, at the
lowest cost per unit, consistent with the required quality and with the least investment in
inventory. In other words, material control involves systematic control and regulation of
procurement, storage and usage of materials so as to maintain smooth flow of production
with an optimum investment in inventory. Material control is to be done in three stages:

39
Cost and Management
Accounting

 Control on policies, systems and procedures connected with the procurement of

materials
 Control on storage of materials; and
 Control on issue and usage of materials.

Objectives of material control

The important objectives of material control are given below:

(i). Purchasing of all the materials at the lowest possible price with good quality and
reliability of delivery
(ii) Ensuring that no activity, particularly production, suffers for want of materials and
stores,
(iii) Minimisation of the total cost involved, both for acquiring stocks and for holding
them.
(iv) Avoidance of unnecessary losses and wastages of materials that may arise from
deterioration in quality of materials due to defective or long storage or from
obsolescence.
(v) Making available reliable information about all the items of materials and stores.
(vi) Materials should be protected against loss by fire, theft and pilferage.

Important requirement of material control system: The following are the important
requirements of a successful material control system:

 There should be proper co-ordination and co-operation various departments

concerned. viz., production, purchasing, receiving, inspection, storage and
accounting.
 Purchasing should be centralized under the control of a competent manager.
 There should be proper planning of materials.
 There should be proper classification of materials with codes, material
standardisation and simplication.

Inventory in a company includes stock, of raw materials, work-in-progress, finished

goods, semi-finished products, spare components and by-products. Therefore, material
control is an important feature of cost accounting systems.

3.2 MATERIAL CONTROL PROCEDURES

The following steps are to be followed for controlling material in a company.

 Establishing optimal stock levels which is vital importance in controlling of stock.

 Once the optimal stock levels are established the store department is fully responsible
for ensuring that optimal stock levels are maintained for each items of materials ion

40
 Account for Material
(Nature & Scope)

stock. Usually, a bin card is used to record the quantity of materials in stock for each
item.
 When items of material have reached their recorder point, the storekeeper will make
a purchase requisition requesting the purchasing department to contact with
appropriate suppliers or vendors.
 When the purchasing department receives the purchase requisition, the purchasing
officer will examine the different sources of supply for the purposes of securing the
highest quality materials at the lowest-reasonable price.
 On the receipt of the goods, the stores department will inspect and compare the
supply with the purchase order.
 When the departmental foreman receives a production order, he will give a material
requisition to the storekeeper. On the receipt of requisition, the storekeeper checks
for correctness and authorisation. If satisfactory the issue will be made and entered
the details in bincards. He then forwards the store requisition to account department.
 When the account department receives the store requisitions, it will price each of the
items listed on it by appropriate pricing methods. Then the amount of materials issued
is charged to appropriate job or overhead account and the stock values are reduced.

3.3 PRICING OF THE ISSUE OF MATERIAL

The important point regarding pricing of the issue of material are discussed below:

 Pricing of materials may change from time to time.

 Materials are usually purchase by several delivers at different process.
 Actual costs can then tae an several different values.
 Therefore, the materials pricing system adopted should be simplest and most
effective one.
 When materials are issued from stores to production departments a question
arises regarding the price at which materials issued are to be charged.

3.4 IMPORTANT METHODS OF PRICING OF MATERIALS

The important methods of pricing of issue of materials to the production departments are:
 First in First out Price (FIFO).
 Last in First out price (LIFO).
 Simple average price.
 Weighted average price.

Let us discuss one by one:

3.5 FIRST IN FIRST OUT-METHOD (FIFO)

The main features of this method are:

 This method assumes that the first stock to be received is the first to be sold.
41
Cost and Management
Accounting

 The cost of materials used is based on the oldest prices.

 The closing stock will be valued at the most recent prices.
 Under this method, the material received first will be issued first.

Merits of FIFO Method

The important merits of FIFO method are:

 This method is very simple to understand and easy to operate.
 This method is based on the principles that materials received first should be used
first.
 The materials should be charged on cost price only.
 This method is very essential when there is prices are falling and the consumption
rate of inventory is low.

Limitations of FIFO Method

The important weaknesses of this method are given below:
 The issue price differs from issue to issue. Therefore, cost comparison get distorted.
 It involves considerable clerical work.
 During periods of rising prices, product costs are understated and Profit are
overstated.
 The issue price may not reflect current price when purchases a frequent.

Distinction between FIFO and LIFO Method:

Basic LIFO Method FIFO Method
1. Assumption Material received last are issued Material received first are
2. Cost of first. issued first.
Goods Sold Cost of goods sold is on the basis Cost of goods sold is on
of latest purchases. Therefore, the basis of earliest
3. Closing current costs are matched with purchases. Therefore,
Stock or current revenue. current costs are not
Inventory Closing Stock is on the basis of matched with current
4. Rising earliest purchases. revenue;
Prices Income is reported at lower Closing Stock is on the
amount as latest costs are included basis of recent purchases.
in cost of goods sold. Income is reported at
higher amount as earliest
costs are included in cost
of goods sold.

3.6 LAST IN FIRST OUT (LIFO)

The main features of this method are :

 This method assumes that the last stock to be received is the first to be sold.
42
 Account for Material
(Nature & Scope)

 In this method issues of material are priced at the price of the latest purchase of
materials.
 In this method, closing stock gets priced at the price of the earliest purchases of
material lying unissued as per record, That is the closing stock is valued at the oldest
price.
 In this method, both issue and stocks are priced at the actual cost.
 This method suggest cost of material should be used on the most recent price.

Advantages of LIFO Method

The important advantages of this method are given below:

 This method is simple to understand and easy to operate.
 Material cost represents recent prices because the materials are issued from the latest
purchases. Thus, the effect of current market prices of materials is reflected in the
cost of sales.
 There is better matching of cost and revenue.
 All issues are priced at the last cost price so that the entire cost price of materials is
recovered from production.

Disadvantages of LIFO Method

The main drawbacks of this method are :

 Like the FIFO method. It may lead to clerical error.
 Stock of materials shown in the balance sheet may not truely reflect the value of the
closing stock
 Comparison of cost of similar jobs is not possible in this method became of variation
in process.
 This method may give higher valuation of closing stock, during the period of falling
of prices.

Illustration 1: [B.Com. (Delhi)]

From the following information prepare Store Ledger Account as per LIFO and FIFO
method:
Jan. 1, 2015 Received 1,000 Units @ Re. 1 per unit
Jan. 10, 2015 Received 260 Units @Rs. 1.05 per unit
Jan. 20, 2015 Issued 700 Units
Jan. 21, 2015 Received 400 Units ®Rs. 1.15 per unit
Jan. 22, 2015 Received 300 Units @Rs.l.25 per unit
Jan. 23, 2015 Issued 620 Units
Jan. 24, 2015 Issued 240 Units
Jan. 25, 2015 Received 500 Units @Rs. 1. 10 per unit
Jan. 26, 2015 Issued 380 Units

43
Cost and Management
Accounting

Stores Ledger by LIFO Method

Receipts Issues Balance
Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount
Date 2015 Units Rs. Rs Units Rs. Rs Units Rs. Rs
Jan. 1 1,000 1.00 1,000 - - - 1,000 1.00 1,000
1,000 1.00 1,000
Jan. 10 260 1.05 273 - - -
260 1.05 273
Jan. 20 - - - 260 1.05 273
440 1.00 440 560 1,00 560
Jan. 21 400 1.15 460 560 1.00 560 460
400 1.15
560 1.00 560
Jan. 22 300 1.25 375 400 1.15 460
300 1.25 375
300 1.25 375 560 1.00 560
Jan. 23
320 1,15 368 80 1.15 92
Jan. 24 80 1.15 92
160 1.00 160 400 1.00 400
400 1.00 400
Jan. 25 500 1.10 550 •
500 1.10 550
Jan. 26 380 1.10 418 400 1.00 400
120 1.10 132

FIFO Method
Date Receipts Issue Balance
201 Quantit Rat Amoun Quantit Rat Amoun Quantit Rat Amou
5 y Units e t Rs. y Units e t Rs. y Units e nt Rs.
Rs. Rs. Rs.
Jan 1000 1.00 1000 - - - 1000 1.00 1000
1
Jan 260 1.05 273 - - - 1000 1.00 1000
10 260 1.05 273
Jan - - - 700 1.00 700 300 260 1.00 300
20 1.05 273
Jan 400 1.15 460 - - - 300 1.00 300
21 260 1.05 273
400 1.15 460
Jan 300 1.25 375 - - - 300 1.00 300
22 260 1.05 273
400 1.15 460
300 1.25 375
Jan - - - 300 1.00 300 340 1.15 391
23 260 1.05 273 300 1.25 375
44
 Account for Material
(Nature & Scope)

60 1.15 69
Jan - - - 240 1.15 276 100 1.15 115
24 300 1.25 375
Jan 500 1.10 550 - - - 100 1.15 115
25 300 1.75 375
500 1.10 550
Jan - - - 100 1.15 115 20 1.25 25
26 280 1.75 350 500 1.10 550

Illustration 2 [B.com (Delhi)]

From the following information prepare store ledger card under LIFO and FIFO system.
Calculate the value of closing stock under both the system.
2015 Jan
Jan1 Opening Stock 200 Pieces @ Rs. 2.00 each
Jan 5 Purchases 100 pieces @ Rs.2.20 each
Jan 10 Purchases 150 pieces @ Rs. 2.40 each
Jan 20 Purchases 120 Pieces @ Rs. 2.40 each
Jan 22 Issue 150 Pieces
Jan 25 Issue 100 Pieces
Jan 27 Issue 100 Pieces
Jan 28 Issue 200 Pieces

Solution:
LIFO
Receipts Issues Balance
Date- Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount
2015 Pieces Rs. Rs, Pieces Rs. Rs, Pieces Rs. Rs,
Jan. 1 200 2.00 400
Jan. 5 100 2.20 220 200 2.00 400
100 2.20 220

Jan. 10 150 2.40 360 200 2.00 400

100 2.20 220
150 2.40 360
Jan. 20 120 2.50 300 200 2.00 400
100 2.20 220
150 2.40 360
. 120 2.50 300
Jan. 22 200 2.00
120 2.50 300 400 220
100 2.20
30 2,40 72 120 2.40 288
200 2.00 400
45
Cost and Management
Accounting

Jan. 25 100 2.40 240 100 2-20 220

20 2.40 48
20 2.40 48 200 2.00
Jan. 27 400 44
80 2.20 176 20 2.20
20 2.20 44
Jan. 28 180 2.00 360 20 2,00 40

Simple Average Method: This method of pricing materials is based on the principle that
materials are to be issued to production or job on an average price. A simple average of
prices is calculated by dividing all the prices of different lots of a material in stock at the
time of issue by total number of prices. For example, before making an issue of250 units
the following three lots of materials are in store :
400 units @ Rs. 35 per unit
900 units @ Rs. 36 per unit
200 units @Rs.37 per unit
35  36  37
Simple Average Price =  Rs.36
3
Thus, according to this method, 350 units will be issued at Rs. 36 per unit.
Though this method is very easy to operate, but it is crude and usually produces
unsatisfactory results. The value' of closing stock may be quite absurd. Moreover,
materials are not charged out of actual cost and, therefore, a profit or loss will usually
arise out of pricing.

3.8 WEIGHTED AVERAGE METHOD

This method assumes that the cost of materials used and closing stock are valued at the
weighted average cost. According to CIMA, Weighted Average price is, "a price which is
calculated by dividing the total cost of materials in the stock from which the materials to
be priced could be divided by the total quantity of materials in that stock". Thus, the
weighted average price takes into account both the price and quantity of the materials in
store.

Advantages of Weighted average price method: Advantages of Weighted average

price method has the following advantages :
 This method is logical, rational and consistent.
 This method recovers full cost of materials from production.
 Under this method materials are issued at a price which is close to the market
price.
 It is considered to be the best especially when prices fluctuate considerably.
 Closing stock represents the average cost price of materials in hand.

Disadvantages : This method has the following disadvantages

 Fresh issue rate needs to be calculated after every fresh receipt of materials.
46
 Account for Material
(Nature & Scope)

 Calculation of issue rate is difficult.

 Issue price is different from actual cost.
 A profit or loss may arise out of pricing.

Illustration 3 [B.Com. (Delhi]

From the following details in respect of a material item for the month of December 2015
calculate cost of material consumed and the value of closing stock, under (I) LIFO, and
(II). Simple average price methods.
December 2015
Opening Stock (1st Dec.): 500 units @ Rs. 2 per unit
Purchases:
5th Dec.: 1,000 units @ Rs. 3 per unit /
8th Dec.: 1,500 units @ Rs. 4 per unit
Issued to Production :
10th Dec: 1,600 units

LIFO Method
Date Receipts Issue Balance
201 Quantit Rat Amoun Quantit Rat Amoun Quantit Rat Amou
5 y Units e t Rs. y Units e t Rs. y Units e nt Rs.
Rs. Rs. Rs.
Dec. - - - - - - 500 2 1000
1
Dec 1000 3 3000 - - - 500 2 1000
5 1000 3 3000
Dec. 1500 4 6000 - - - 500 2 1000
8 1000 3 3000
1500 4 6000
Dec. 1500 4 6000 500 2 1000
10 100 3 300 900 3 2700
1600 6300 1400 3700

Cost of Raw Material Consumed = Rs.6300

Value of Closing Stock (1400 Units) = Rs. 3700
Simple Average Method
Date Receipt Issue Balance
2015 Quantity Rate Amount Quantity Rate Amount Quantity Amount
Units Rs. Rs. Units Rs. Rs. Units Rs.
Dec.1 - - - - - - 500 1000
Dec. 5 1000 3 3000 - - - 1500 4000
Dec.8 1500 4 6000 - - - 3000 10,000
Dec.10 - - - 1600 3 4800 1400 5200
1400 5200

47
Cost and Management
Accounting

Illustration 4. [B.Com. (Delhi)]

Solution
The following transaction took place in March 2015 in respect of a material item.
Particulars Receipt on Quantity Rate (Rs.) Issue in Quantity
March 2 200 Units 2.00
March 10 300 Unit 2.40
March 15 - - 250 Units
March 18 250 units 2.60 -
March 20 - - 200 units

Calculate LIFO and Weighted average price method

Solution:
LIFO Method

Date Receipts Issues Balance

2015 Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount
(Units) (Rs.) (Rs.) (Units) (Rs.) (Rs.) (Units) (Rs.) (Rs.)
March 200 2.00 400 - - - 200 2.00 400
2
10 300 2.40 720 - - - 200 2.00 400
300 2.40 720
15 - - - 250 2.40 600 200 2.00 408
50 2.40 120
18 250 2.60 650 - - - 200 2.00 400
50 2.40 120
250 2.60 650
20 - - - 200 2.60 520 200 2.00 400
50 2.40 120
50 2.60 130
- 300 650

Stores Ledger Account Weighted Average Method

Date Receipts Issues Balance

2015 Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount
(Units) (Rs.) (Rs.) (Units) (Rs.) (Rs.) (Units) (Rs.) (Rs.)
March 200 2.00 400 - - - 200 2.00 400
10 300 2.40 720 - - - 500 2.24 1120
15 - - - 250 2.24 560 250 2.24 560
18 250 2.60 650 - - - 500 2.42 1210
20 - - - 200 2.42 484 300 2.42 726

48
 Account for Material
(Nature & Scope)

Technique of Material Control

The important techniques of material control are :
(i) ABC Analysis
(ii) Perpetual inventory system.
(iii) Just in time purchasing
(iv) Mateiral turnover ratio
(v) Stock levels.
(vi) Economic Order Quantity

Let us discuss each of the techniques one by one.

(1) ABC Analysis

The ABC analysis is a business term used to define an inventory categorization technique
often used in inventory management. It is also known as selective inventory control.
ABC method of inventory control means 'Always Best Control' which aims at giving
more attention to those items which are costliest and less attention to those materials
which are used in a large quantity~but are of comparatively low value. All items of
materials are classified into three types—A, B and C. 'A' items are costliest but used in
the smallest quantity, 'B' items are of middle value and middle quantity and 'C' type of
items are those which are cheap but used in largest quantities.

The ABC analysis is an extension of the principle of 'Management by Exceptions' in the

area of 'Material Control'. According to this, materials or items of high value are subject
to stricter control than other items of lesser value. This method is also known as method
of 'Selective Control'. The various items of materials used in a factory are classified on
the basis of their 'weights' assigned as per this formula.
Cost per unit of item  Quantity consumed in production

Advantages of ABC Analysis:

 Stricter control over materials is possible.
 Smooth flow of production process as far as availability of materials is
concerned.
 Investment in inventory (of atleast high value items) is minimised which releases
working capital for other requirements of business.
 Cost of placing orders as well as inventory carrying costs are also minimised
through proper Economic Order Quantity (EOQ).
 Helps in high inventory turnover rate.

On the basis of Physical quantities and value of material used a table is given for the
better understanding of the students

49
Cost and Management
Accounting

Material Categories Percentage Share in Total Percentage Share in Total

Value of Total Inventories quantities
A (High Value, Low 70 10
Volume)
B (Medium Value) 20 20
C (Low Value, High 10 70
volume)

(2) Perpetual Inventory System

In business perpetual inventory or continuous inventory describes systems of trading

stock where information on inventory quantity and available is updated on a continuous
basis as a function of doing business. It means this system maintain an inventory records,
which reflects the physical movement of stocks and their current balance after each
receipt and issue of material. The accuracy of perpetual inventory record is ensured by
continuous stock-taking. The Institute of Cost and Management Accountants, London,
has denned the Perpetual Inventory System and has also clarified the relationship
between Perpetual Inventory System and Continuous Stock-taking in the following
definition:

Perpetual Inventory System is "a system of records maintained by the controlling

department which reflects the physical movement of stocks and their current balance. A
perpetual inventory is usually checked by a programme of continuous stock-taking, and
the two terms are sometimes loosely considered synonymous. Perpetual inventory means
the system of records, whereas continuous stock-taking means the physical checking of
those records with actual stocks." The perpetual inventory system is intended as an did to
material control. In other words, when the records are maintained up-to-date, the balance
shown by the Bin card or store ledger should agree with physical balance. When there are
discrepancies, proper investigation will have to be made.

Advantages of the Perpetual-Inventory System

 Quantity in hand and its value is known for each type of material after each
receipt and issue.
 Like periodic inventory, it does not hamper production,
 A detailed and more reliable check on the stores is possible.
 Continuous stock-taking makes the store-keeper and stores accountant carry out
their work in a manner that up-to-date and accurate records are maintained.
 Errors and shortages of stock are easily discovered.
 Capital investment in stores can be kept under control because actual stocks can
always be compared with the maximum and minimum levels.
 Since stock figures are available quickly, it helps in preparation of interim Profit
and Loss Account and balance sheet.
 In case of accidental loss, claims with the insurance company can be lodged with
accurate stock figures.
50
 Account for Material
(Nature & Scope)

Periodic Inventory System : Under this system stock-taking for each item of material is
done only at the end of a specified period, generally at the end of the accounting year.
Periodically, all inventory items physically verified are valued according to the method of
valuation, i.e., FIFO (First in First Out). LIFO (Last In First Out), etc. The value of the
closing inventory, arrived at, is used to compute Cost of Goods sold in the following
manner:

Cost of Goods Sold = Opening Stock (Inventory) + Purchases  Closing Stock

(Inventory) .

Periodic inventory system is particularly suited for small value items and materials
consumed.

(3) Just in time Inventory System

This is a type of inventory system which is designed to produce efficient output with
minimum lead time at the lowest possible cost, minimizing waste with great consistency.
According to CIMA, London JIT Purchasing is 'Matching receipts of materials closely
with usage so that raw materials. Inventory is reduced to near zero level. It means that
materials purchased should directly go to the assembly line i.e. to the production
department. The main objective of this system are:
- It produce at products of consistent high quality.
- It minimise wastage of labour, material and equipment.

Advantages of just in time inventory system:

The main advantages are given below:
- It improved quality of product.
- It provide better and efficient customer service.
- It helps in reducing the cost price of the product
- It helps in improving material handling and inventory control.

Disadvantages
Important disadvantages of just in time invenotry systme are given below.
- This system is very difficult to implement and maintain
- It may not give accurate forecasting.

This system of inventory control was pioneered by MC Donald. He mastered just-in-time

inventory management through a commitment of significant investment in technology
and resources to design a system that will produce consistent quality food with minimal
inventory, with a production process that maximizes efficiency and minimizes waste.

51
Cost and Management
Accounting

3.10 MATERIAL TURNOVER RATIO

This ratio is popularly known as Inventory turnover Ratio. This ratio shows how many
times a company's inventory is sold and replaced over a period. The days on the period
can then be divided by the inventory turnover formula to calculate the days it takes to sell
the inventory on hand or inventory turnover days. The inventory turnover formula
measures the rate at which inventory is used over a measurement period. One can use the
formula to see IF a business has an excessive Inventory Investment in comparison to its
sales level, which can indicate either unexpectedly low sales or poor inventory planning.
This ratio establishes a relationship between cost of raw materials consumed during the
period and average stock of materials during the period. Thus, the formula is
Cost of materials consumed during the period
Inventory turnover Ratio =
Average stock of material during the period
Inventory turnover ratio may also be calculated in terms of days. This is done by dividing
365 days by the Inventory turnover ratio. Thus, the formula is
Days of the period
Stock conversion period =
Stock turnover rate
Note|: If the length of the stock turnover period as short, it is considered good for
organisation. It will indicates that material is considered to be fast moving.

Illustration 5
The following information relates to the year 2014-15 given below:
Particulars Material X (Rs.) Material Y (Rs.)
Opening Stock 30,000 90,000
Closing Stock 15,000 60,000
Purchases 200,000 125,000

Calculate stock turnover ratio of X and Y and give your comments.

Solution:
Opening Stock + Closing Stock
Average Stock =
2
30,000+15,000
Average stock (Material X) =  Rs.22500
2
90,000+60,000
Average stock (Material Y) =  Rs.75, 000
2
Calculation of cost of Material Consumed:
Cost of Material consumed = Opening Stock + Purchase  Closing Stock.
Material X = 30,000 + 200,000  15,000 = Rs. 215,000
Material Y = 90,000 + 125,000  60,000 = Rs. 155,000
Cost of Material Consumed
Stock Turnover Ratio =
Average Stock

52
 Account for Material
(Nature & Scope)

Rs.215,000
Material X =  9.55 Time.
Rs.22,500
Rs.155,000
Material Y =  2.07 time.
Rs.75,000
Stock turnover ratio can be expressed in number of days.
365 (No. of days in a year)
Formula =
Stock turnover Ratio
365
Material X =  38 days (approx.)
9.55
365
Material Y =  176 days (approx.).
2.07
Comment:
Thus, material X is fast moving than Material Y. Because it takes only 38 days to
consume the average stock. However, in the case of material Y, it takes 176 days to
consume the average stock.

3.11 STOCK LEVELS

In order to maintain uninterrupted production a sufficient stock levels of material should

be maintain in the organisation. Further, to guard against under stocking and over-
stocking, most of the large companies adopt on scientific approaches of fixing stock
levles. These levels are
(i) Maximum stoc level
(ii) Minimum stoc level
(iii) Re-ordering level
(iv) Average stock level
(v) Danger level

Let us discuss one by one

(i) Maximum Level

This represents the stock level above which stock should not be allowed to rise. The main
purpose of this level is to ensure that capital is not blocked up unnecessarily in stores.
This maximum level may be exceeded in certain special cases. For example, if a
particular lot is available at a reasonably low price, the maximum level may be crossed.
The maximum stock level should be fixed after taking into account the following factors:
 Rate of consumption of material.
 Necessary time to obtain delivery of material from the date of order (lead time).
 Availability of storage space.
 Re-order quantity.
 Possibility of price fluctuations
 Availability of finance.
 Economic ordering quantity.
53
Cost and Management
Accounting

The formula for calculating maximum stock level is given below:

Maximum Stock level = Re-order level + Re-order quantity  (Minimum consumption 
Minimum re-order period)
(ii) Minimum stock level
Minimum stock level which is otherwise called as safety stock level. This is the level of
inventory, below which the stock of materials should not be fall. If the stock goes below
minimum level, there is a possibility that the production may be interrupted due to lack of
material. In other words, this level represents the minimum quantity of stock that should
be held at all times. This level is generally fixed after considering the following factors
- Average rate of consumption of materials.
- Lead time i.e. the time required to receive materials from the point of placing
order.
The formula for calculating minimum stock level as under:
Minimum stock level = Re-ordering level  (Normal Consumption + Normal Re-order
Period)

(iii) Re-order Level

Re-order level (or recorder point) is the inventory level at which a company would place
a new order. This is that level of martial at which a new order for material is to be placed.
When stock of material reach at this point, t he store keeper will initiate purchase
requisition. This level is generally fixed some where between maximum stock level and
minimum stock level. This level is usually fixed after taking into account the following
factors: (i) Rate of consumption (ii) minimum level and (iii) delivery time. The formula
for calculating this level is given below:
Re-order level = (Maximum Consumption)  Maximum re-order period).

Illustration-6 [B.Com. (Delhi)]

Calculate minimum stock level, and re-order level from the following data
Re-order period = 8 to 12 days.
Daily consumption = 400 to 600 days.
Solution:
Re-order level = Maximum consumption  Maximum Re-order period.
= 600  12 = 7200 units.
Minimum stock level = Re-order level  (Normal Consumption  Normal Re-order
period)
= 7200  (500  10) = 2200 units.

(iv) Average stock level

Average stock level shows the average stock held by a company. The average stock level
can be calculate with the help of following formula.
1 
Average stock level = Minimum stock level +  Reorder quantity 
2 
Or
(Minimum stock level + Maximum stock level)
Average Stock Level =
2
54
 Account for Material
(Nature & Scope)

Illustration 7 : Calculate average stock level from the following data.

Reorder quantity = 2000 units
Minimum stock level = 500 units.
Solution
1 1
Average stock level = Minimum level + Recorder quantity = 500 + 200 = 1500
2 2
Units.

(v) Danger stock level

Danger level is a level of fixed usually below the minimum stock level. When the stock
reaches danger level, an urgent action for purchase is initiated. When stock reaches the
minimum level, the storekeeper must make special arrangements to get fresh materials, so
that the production may not be interrupted due to the shortage of material. The formula
for calculating the danger level is:
Danger level = Normal consumption  Maximum re-order period for emergency
purchase.

Illustration 8
Calculate Danger stock level from the following particulars.
Daily consumption = 100 to 200 units.
Maximum re-order period for emergency purchase = 5 days

Solution:
Danger level = Normal Consumption  Maximum re-order period for emergency
purchase
= 150  5 = 750 units.

Illustration 9. [B.Com. Delhi]

The following information is available in respect of material number 30: /
Re-order quantity 1,500 units
Re-order period 4 to 6 weeks
Maximum consumption 400 units per week
Normal consumption 300 units per week
Minimum consumption 250 units per week
Calculate:
(i) Re-order level, (ii) Minimum level, (iii) Maximum level and (iv) Average stock level
Solution
Re-order quantity 1,500 units.
Re-order period 4 to 6 weeks
Maximum consumption , 400 units per week
Normal consumption 300 units per week
Minimum consumption 250 units per week
(i) Re-order Level = Maximum Consumption x Maximum Re-order Period = 400  6 =
2,400 units.
55
Cost and Management
Accounting

(ii) Minimum Level = Re-order Level - (Normal/Average Consumption

 Normal/Average Re-order Period)
4+6
Since Normal Re-order Period is not given, we take Average Re-order Period = 5
2
weeks
Minimum stock Level = (2,400 - 300 x 5) = 2,400 -1,500 = 900 units
(iii) Maximum stock Level = Re-order Level + Re-order Quantity  (Minimum
Consumption x Minimum Re-order Period)
= 2,400 +1,500 - (250  4) =-3,900 -1,000 = 2,900 units.
1
(iv) Average Stock Level = (Minimum Stock Level + Maximum Stock Level)
2
1 1
= (900 -r 2,900) =  3,800 = 1,900 units
2 2
OR
1
Average Stock Level = Minimum Stock Level + (Re-order Quantity!
2
1
= 900 + (1,500) = 900 + 750 – 1,650 units.
2
Illustration 10. B.Com. Delhi.
From the following information, Calculate Re-order quantity.
Maximum re-order period = 8 weeks
Average stock = 400 units
Average usage = 50 units per week
Maximum usage = 80 units per week
Average re-order period = 6 weeks
Solution:
Re-order level = Maximum Consumption x Maximum Re-order period.
= 80 x 8 = 640 Units
Minimum Stock level = Re-order level  (Average Consumption x Average Re-order
period)
= 640 - (50 x 6) = 640 - 300 '= 340 Units
Minimum stock level + Maximum stock level
Average stock level =
2
340 + Maximum stock level
400 
2
800 = 340 + Maximum stock level
 Maximum stock level = 800  340 = 460 units.
Maximum stock level = Re-order level - (Minimum 'consumption  Minimum Re-order
period)
+ Re-order quantity.
460 = 640 - (20 x 4) + Re-order quantity
460 = 640 - 80 + Re-order quantity
460 = 560 + Re-order quantity

56
 Account for Material
(Nature & Scope)

 Re-order quantity = 460 – 560 = 100 Units

It can be also calculate ion the following ways.
Re-order level = Maximum consumption  Maximum Re-order period
= 80  8 = 640 units
Minimum stock-level = Re-order level  (Average Consumption  Average Re-order
period)
= 640 - (50  6) = 640  300 = 340 units
1
Average Stock level = Minimum stock level + Re-order quantity
2
1
400 = 340 + Re-order quantity /
2
1
60 = Re-order quantity
2
Re-order quantity = 120 units

3.12 ECONOMIC ORDER QUANTITY (EOQ)

EOQ is the order quantity which minimizes the total inventory holding cost and ordering
cost. EOQ represents the most favourable (optimum) quantity to be ordered each time
fresh supplies are required In purchasing materials one of the important problem to be
faced is how much to buy at a time. If large quantities are purchased, the cost of carrying
the inventory would be high. On the other hand, if purchases are made frequently in small
quantities, ordering cost will be high. In deciding the optimum quantity to order, the
problem is to balance the above two costs, carrying costs against the ordering costs. The
sum of the two represents the total costs of ordering and holding inventories.

The following formula has been evolved for fixing EOQ :

2UP
EOQ =
S
where U = Annual usage in units.
S = Carrying costs per unit of inventory, and .
P = Ordering cost per order.

Illustration 11.
Monthly usage : 250 units
Carrying cost: 10% of inventory value
Cost of placing and receiving one order : Rs 30
Cost of materials per unit: Rs. 5
Find out the EOQ.

57
Cost and Management
Accounting

Solution.
2UP
EOQ 
S
Here, U = 250  12 = 3000 units
P = Rs. 30
10
S = Rs. 5  = Re. 0.50
100
2  3000  30
EOQ 
50
 3, 60, 000 = 600 units.

The EOQ is given in figure-A. In this figure, we plot carryings costs and ordering costs.
Carrying costs vary directly with the size of the' order (units) whereas ordering costs vary
inversely with the size of the order. If these two cost curves are added, the sum represents
the total costs of ordering and holding inventories. The total inventory-associated costs
curves has a minimum point and this point is known as EOQ or optimum order quantity.
The total costs line declines first when costs of ordering are spread over more units.
Subsequently, it begins to rise when the decrease in average ordering cost is more than
offset by the additional carrying costs. Thus, point E represents the optimum order which
minimise the total costs of inventory management.

EOQ can also be determined using the tabular method to determine EOQ, a comparison
of total costs at different order size is made. The optimum order quantity is corresponding
to the minimum total costs- at this point both carry-it and ordering costs & would
balance.
Illustration 12: From the following data calculate EOQ by applying tabular method.
Annual Demand = 3000 nits
Cost per unit = Rs. 5.00
Carrying Cost 10% of Inventory
Ordering cost = Rs. 30 per order.
58
 Account for Material
(Nature & Scope)

Statement of inventory costs at different order sizes

Annual No. of Units Value per Average Carrying Order Total
requirement orders per Order inventory costs costs@ costs
per year order value Rs.30
Rs. Rs. Rs. Rs. Rs.
3,000 1 3,000 15,000 7,500 750 30 '780
units 2 1,500 7,500 3,750 375 60 435
3 1,000 5,000 2,500 250 90 340
4 750 3,750 1,875 188 120 308
5 600 3,000 1,500 150 150 300
6 500 2,500 1,250 125 180 305
7 375 1,875 938 94 240 334

Illustration 13: From the following data calculate EOQ and RC-Order level.
Maximum consumption per week = 6600 kg.
Recorders period = 6 to 8 weeks
Annual Usage = 2000 units.
Cost of placing an order (B) = Rs. 100
Purchase price of raw material (C) = Rs. 20 per kg. Carrying cost of inventory (S) =
20% per annum
2UP 2  20, 000 100 40, 00, 000
EOQ     10, 00, 000  1, 000 kg.
S 20  20% 4
 Re-order Quantity (EOQ) = 1,000 kg.
i) Re-order level = Maximum Consumption  Maximum Re-order period
Maximum consumption per week = 600 kg.
Maximum Re-order period = 8 weeks
Re-order level = 600  8 = 4,800 kg.

Illustration 14:
A manufacturer requires 800 units of a certain component monthly. This is currently
purchased from a regular supplier at a Rs.50 per unit. The cost of placing an order is
Rs.60 per order and the annual carries cost is rs.5 per piece. What is the economic order
quantity (EOQ) for placing order?
2UP
Solution: EOQ =
S
U = Annual usage = 800  12 -= 96000 units
P = Cost of placing an order = Rs.60
S = Storage cost per unit = Rs. 5
2  9600  600 1152000
EOQ    230400  480 units.
5 5

59
Cost and Management
Accounting

Illustration 15:
A company manufactures 5,000 units of a product per month. The purchase price of raw
material is
Rs. 20 per kg. The re-order period is 4 to 8 weeks. The consumption of raw materials
varies from 200 kg to 600 kg per week. The cost of placing an order is Rs.100. The
carrying cost of inventory is 20% per annum. You are required to calculate:
(i) Re-order quantity;
(ii) Re-order level. (50 weeks in a year)
Sol. (i) Minimum consumption per week = 200 kg.
Maximum consumption per week = 600 kg.
Average consumption per week =
Minimum Consumption + Maximum Consumption
2
200kg+600kg
=
2
800 kg
=  400 kg.
2
No. of weeks in a year = 50
Annual consumption (A) = 400  50
, = 20,000 kg

Illustration -16 [B.Com. Delhi]

Find out the economic order quantity (EOQ) from the following information:
Quarterly Demand 1,200 units
Cost of placing an order Rs. 48
Cost per unit Rs. 24
Carrying cost as % of average inventory 12% p.a.
2UP
Solution: EOQ =
S
where U = Annual Demand = Rs.1,200  4 = 4,800 units
P = Buying cost per order = Rs. 48.
Cost per unit = Rs. 24
S = Carrying cost as percentage of average inventory = 12% p.a.
2  4,800  48 4, 60, 000
EOQ    1, 60, 000  400 units
24 12% 2.88

QUESTIONS

1. What do you mean by inventory control? State its objectives.

2. Explain some important requirements of every system of material control.
3. What do you understand by ABC analysis? What are its advantages?
4. What do you understand by economic ordering quantity? How are they calculated?
5. Write short notes on any three of the following:
60
 Account for Material
(Nature & Scope)

(i) Re-order quantity (ii) Reorder level (iii) Minimum level (iv) Maximum level

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

61
 BLOCK-2

Material and Labour

The present block produces the concepts of accounting for labour, overheads and
absorption for overheads. In this block the learners will learn about the concept,
relevance and types of labour and overheads. How is it treated in the Cost Sheet
of a business organisation? The present block refers the following unit;
Unit 4: Accounting for Labour

Unit 5: Accounting for Overheads

Unit 6: Absorption of Overheads

62
UNIT-4 ACCOUNTING FOR LABOUR

LEARNING OBJECTIVES

After studying this unit you should be able to understand

 Labour cost and Its purpose
 Components of Labour cost
 Control over labo ur cost
 Elements of Labour cost
 Accounting for idle time
 Labour Turnover
 Incentive plans

STRUCTURE

4.1 Introduction
4.2 Components of Labour cost
4.3 Control of Labour Cost
4.4 Elements of Labour cost
4.5 Accounting for Idle Time
4.6 Labour Turnover
4.7 Incentive Plans
4.8 Questions

4.1 INTRODUCTION

Labour cost is classified as direct and indirect. They form the labour cost which in turn
forms a significant percentage of the total cost of production in a manufacturing or
service organization and there is need to exercise maximum care to minimize these costs
minimizing cost does not mean reducing cost but means getting optional and efficient
productivity form the employees. Labour cost represents the human contribution to
production. It is an important cost factor requiring constant measurement, control and
analysis. Labour cost can be classified into (i) Direct Labour cost and (ii) Indirect labour
cost. The portion of wages and salaries cost unit is known as Direct labour cost and the
cost which cannot be directly related with the production of specific goods or services is
known as Indirect labour cost. Storekeeper, clerical staff etc. are examples of indirect
labour cost.

Purposes of labour cost :

The main purposes of labour cost are :

 To calculate the correct goods and net wages for each employees
 For financial accounting and management accounting purposes
 For reducing labour turnover purposes.
 For decision making and control purposes.
63
Cost and Management
Accounting

4.2 COMPONENTS OF LABOUR COST

Labour costs represents the various components of expenditure, which includes the
following:

(a) Monetary Benefits For example: (i) Basic Wages (ii) Dearness Allowance; (iii)
Employer's Contribution to Provident Fund ; (iv) Employer's Contribution to Employees'
State Insurance (ESI) Scheme; (v) Production Bonus; (vi) Profit Bonus ; (vii) Old age
Pension ; (viii) Retirement Gratuity.

(b) Fringe Benefits or Labour Related Costs for example: (i) Subsidised Food ; (ii)
Subsidised Housing ; (iii) Subsidised Education to the children- of the workers ; (iv)
Medical facilities; (v) Holidays Pay; (vi) Recreational facilities.

Notes: Fringe benefits are indirect forms of employee compensation. The total of these
benefits given to the employee should be sufficient enough to attract and retain the labour
force.

4.3 CONTROL OF LABOUR COSTS

Labour costs constitute a significant portion of the total cost of a product. Labour cost
may be excessive due to inefficiency of labour, more wastage of material by labour due
to lack of proper supervision, high labour turnover, idle time and unusual overtime work,
inclusion of bogus workers in the wages sheet and many other related factors. Therefore,
economic utilisation of labour is a need of the present day industry to reduce the cost of
production of the products manufactured or services rendered. Management is interested
in labour costs on account of the following two main reasons.

(a) to use direct labour cost as a basis for increasing the efficiency of workers; and

(b) to identify direct labour cost with products, orders, jobs or processes for
ascertaining the cost of every product, order, job or process ;

Therefore, control of labour costs is a important objective of management and the

realisation of this objective depends upon the cooperation of every member of the
supervisory force from the top executive to foreman. From functional point of view,
control of labour costs is effected in a large industrial concern by the co-ordinated efforts
of the following six departments :

(i) Personnel Department, (ii) Engineering Department, (iii) Rate or Time and Motion
Study Department, (iv) Time-keeping Department, (v) Cost Accounting Department, (vi)
Pay-roll Department.

64
 Accounting for
Labour

The functioning of some of these departments in relation to control of labour cost is given
below :

(i) Personnel department. This department is mainly concerned with the selection,
training, recruitment, placement, promotion etc. of workers in an organisation. It keeps
full details of each employee regarding date of employment, date of birth, particulars of
previous employment, wage rate, job specialisation medical history etc.

(ii) Engineering department. This department provides technical services and performs
the following functions:

(i) Preparation of job specifications. (ii) Conducting time study and motion study. (iii)
Looking after working conditions to. ensure safety of work force. (iv) Making job
analysis. (v) Supervising various production activities and exercising quality control.

4. Payroll department. The main task of the 'Payroll department is the preparation of the
payroll or the wage-sheets. In big enterprises this work is generally performed by a
separate 'Payroll department. Payroll accounting is that part of the main Accounting
department which is concerned with the computation and payment of wages and then
recording them in the books of accounts. Usually, following are the main functions of the
Payroll department:

 Workers or employees are authorised to attend to work by the Personnel

Department. But their work record is maintained by Payroll department.
 Payroll department receives the 'Time Cards', 'Piece Work Cards' or 'Job Cards'
etc. from factory foremen.

(iv) Time keeping department. The main function of this department is to keep a record
of workers' time. Recording of workers' time is needed not only for the purpose of
attendance of workers and calculation of their wages but also for the purpose of cost
analysis of the job and apportionment of labour cost over various jobs. The time keeping
department is an important part of a firm's system of accounting and control of labour
costs. Its two main functions are:

(i) Time keeping and (ii) Time booking.

Time keeping: A large factor, should have a separate time keeping office situated close
to the factory gate. The main function of this department is to maintain the exacted time
for which each worker has worked. It keep detailed records of any one of the following :

(i) Employees attendance in and out of factory gate.

(ii) Employee's attendance in and out of a particular department.

65
Cost and Management
Accounting

Time keeping will serve the following purposes

(i) Preparation of pay rolls.

(ii) Ascertainment of labour, cost of a job, work order or operation.
(iii) Meeting the legal requirements.
(iv) Determining productivity and labour cost through statistical analysis
(v) Apportionment of overhead costs e.g. wages paid or labour hours spent may be
taken as base in distribution of overhead cost.

Methods of time keeping

The various methods used for recording time may be classified into two groups:

(i) Manual methods. (ii) Mechanical methods.

(i) Manual methods : It includes both (a) Attendance Register method, and (b) Disc
method.

(a) Attendance Register Method : In this method an Attendance Register is kept at the
entrance gate and the workers' attendance in and out of the factory gate is being noted.

1. Disc Method : In this method each worker is assigned a number. A board with metal
discs bearing workers number booked. It is kept near factory main gate. At the time of
enteries into the factory, the worker remove their respective disc and place in a box on
empty tray.

(ii) Mechanical method: Big organisation use this method for recording workers time. it
includes:

(a) Deal time recorders and is card time recorders.

(b) Dial time recorders: A dial time recording has a dial around the clock with several
holes each of which bears a number corresponding to identification number of the
concerned workers. When a worker will enter into the man gate of the factory, he is to
press the appropriate name. Then the time recorder will automatically record the time.

(c) Card time recorder: In this method each worker is given a card called time card. It
contains the employees history like name, department, overtime, total time for all week
days etc. When a worker enter into the company he picks up his card from out of rack
and puoxes the time of his entry with the help of machines

Time -Booking : In addition to recording of worker's attendance in and out of the factory
or department, it is also necessary to record the time spent on each work order, Job or
operation as well as the particulars of work done. This is known as time booking. The
66
 Accounting for
Labour

purpose of time booking records is to ascertain the time taken by a worker, to complete a
job or an operation. Time booking records help in facilitating the ascertainment of labour
cost of every job and control over wastage of time. Large organisations keep time
recording clocks for maintaining records of time spent on each work, Job or operation. In
small organisation this may be done manually. The nature of documents maintained for
this purpose will vary depending upon the size of the organisation: The various methods
of time booking are as follows :

(i) Daily time sheet, (ii) Weekly time sheet, (iii) Job card, (iv) Combined time and Job
card, (v) Labour cost card and (vi) Piece work card.

1. Daily Time Sheet : Daily time sheet ie a daily record of the work done by a worker. It
shows the jobs on which he worked and the time spent on each job. The worker
completes the sheet everyday and hands it over to the foreman for signature. This method
is suitable in small organisations where the number of workers as well as number of jobs
handled by them are not many. This method is not very popular because there is too
much clerical work in this method.

2. Weekly Time Sheet : Weekly time sheet is similar to daily time sheet except that
weekly time sheets is prepared for a week in place of every day. The number of
documents to be prepared is considerably reduced. The weekly time sheet gives a ready
consolidation of the total hours shown in the clock cards. It is possible to have a better
supervision since worker's performance in a single work can be obtained readily.

3. Job Card : A Job card may be defined as a card containing the de-tails regarding the
time spent by a worker on a particular job. A job card is maintained for each job and is
allotted to the workers who work on that particular job. The purpose of "this card is, to
keep a close watch on time spent by a worker on each job and to calculate the labour cost
of each job. Job card travels along with the job from worker to worker and each worker
records time spent by him on it. It is useful when each job passes through different
workers of different grades.

4. Piece work card: Some time workers are paid wages on the piece work basis. In such
cases a piece work load is maintained for recording aspect and wages of each workers.

4.4 ELEMENTS OF LABOUR COST

Labour cost can either be direct or indirect. They include:

(i) Basic wages, (ii) Gross wages, (iii) Overtime premium, (iv) setup time and (v)
Labour turnover

(i) Basic wages: The definition of Basic Wages' has been defined under section
2(b) of the EPF and MP Act, 1952 as below.

67
Cost and Management
Accounting

Section 2(b), "Basic wages" means all emoluments which are earned by an employee
while on duty or on leave or on holidays with wages in either case in accordance with the
terms of the contract of employment and which are paid or payable in cash to him, but
does not include

 the cash value of any food concession.

 Only dearners allowance, house rent allowance, over time allowance, bonus,
commission etc.
 any present made by the employer.

(ii) Gross wages

The amount of gross wages is calculated by adding up wages at ordinary rates plus
overtime premium.

This may be put in the form of following formula:

Gross Wages = Ordinary wages + Overtime premium
Ordinary Wages = Total hours as shown by time card  Hourly Rate
Overtime premium  Overtime hours  Overtime premium rate

Example. A worker's time card shows that he has worked for 20 hours in the factory out
of which he has worked 4 hours overtime. The ordinary rate is Re. 1 per hour while the
overtime rate is to be at 1½ times of the ordinary rate.

The Gross Wages of the worker will be as follows:

Ordinary wages = 20 hours  Re. 1 = Rs. 20

Overtime premium = 4 hours  .50 P. = Rs. 2
= Rs. 22
The amount of overtime premium should be calculated separately since in most cases it is
charged as a works overhead item.

(iii) Overtime premium. Sometimes workers work for extra time over and above the
normal hours of work. According to the Indian Factories Act 1948, overtime is the time
worked for more than nine hours per day or 48 hours per week. Usually, workers are paid
at a higher rate for overtime than that for normal time. According to law, overtime has to
be paid at double the normal rate of payment. This coupled with the fact that overtime
comes at the end of the day when fatigue has set in, should make it clear that the jobs
done in overtime are rather costly. Overtime jobs are thus costly because of higher rate of
wage payment, low productivity of workers and additional expenses on lighting etc. The
Production Manager or some higher authority should authorise the overtirne because
there is a danger that workers may develop this as a habit.

68
 Accounting for
Labour

The following treatment should be given to overtime wages in the following cases:

 Overtime required because of some abnormal conditions like floods, earthquakes etc.
should be charged to Costing Profit & Loss A/c.
 Overtime when required or seasonal pressure should be taken as an item of factory
overheads,
 When overtime is direct i.e., it can be identified with individual jobs, it should be
charged entirely to that particular job or work order concerned.
 When overtime is required to make up for any shortfall in production due to some
fault of management or some unexpected development, it should be charged to
Costing Profit & Loss A/c.

(iv) Set-up time. In factories, it is absolutely normal that some time is lost or
consumed on the frequent setting up of the machines. This loss of time may be
because of changes from one job to another or because of break-downs etc. This
time means the time when the machines just lie idle. This is also called 'Making
machines ready time'. The cost of all such hours lost in setting up of the
machines (including wages of workers as well as other overheads) may be spread
over the jobs actually completed. Sometimes even separate rates (Machine hour
rate) are computed for running and this setting-up time. Through this method,
one can ensure the full absorption of the manufacturing overheads. Alternatively,
the cost of this setting-up time may be treated like 'Idle time' dividing the same
into normal setting up time and abnormal setting-up time.

(v) Idle time : Normally the time booked to different job is less than the gate time.
The, difference represents time lost which is termed as idle time. It is the time for
which the employer pays to the worker but does not get any output in return. For
example, if an employer pays to the worker for 8 hour's work but the job cost
shows that he has worker for 7 hours, then 1 hour is the idle time. Idle time
increases the labour cost component of a job. Hence, there is a need to control
idle time. To control idle time, it is necessary to know the causes of idle-time.

Causes of Idle Time

Idle time may arise because of the following causes :

I. Productive Causes which may be further classified as follows :

(i) Breakdown of plant and machinery., (ii) Power failures, (iii) Waiting for work, (iv)
Waiting for raw material, (v) Waiting for tools, (vi) Waiting for instructions.

II. Administrative Causes It arises out of administrative decisions, e.g., when there is a
surplus capacity of plant and machinery which the management decide not to work, there
may be some idle time. This is represented by idle facilities.

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Cost and Management
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III. Economic Causes e.g, stoppage of production due to non-availability of raw

materials, fall in demand, etc. Some of the causes mentioned above are controllable
internally while others are beyond the control of management. Therefore, idle time may
be of two types :

(i) controllable i.e., (idle time due to many of the productive causes is subject to control
internally.)
(ii) uncontrollable (idle time arising out of economic and administrative causes).
Idle time may be reduced by taking fallowing preventive measures :
(i) Proper planning of production in advance,
(ii) Careful supervision.
(iii) Proper maintenance of machines and power-systems,
(iv) Timely purchase of raw materials, tools and provisions.

Accounting for Idle time: Accounting for idle time in cost accounting to depends on
whether it is normal or abnormal idle time.

Normal idle time: This idle time arises out of normal process i.e. out of nature of human
labour. It is unavoidable, natural and anticipated. Therefore the cost of normal idle time
should be charged directly to production. It should be directly charged to costing profit
and loss account.

Abnormal Idle time: it is that kind of idle time which is not arises due to production or
work environment. Rather, it arises due to detective planning, inefficiency or accidents.
The cost of abnormal idle time is not the part of cost of production. It should be directly
charged to costing profit and loss account.

4.6 LABOUR TURNOVER

Refers to the rapidity with, which workforce in an organisation changes.. It is the rate of
change in the composition of the labour force in the organisation. Let us assume that in a
factory there were % employees on an average during the year 2015 and 100 persons left
100  100
the company during this period. So, the labour turnover will be  5%
2, 000
Generally, it is measured by the following formula :
No. of employees leaving during the period
100
Average number of employees employed during such period

Causes of Labour turnover : Various causes of labour turnover can be categorised as :

1. Personal causes, 2. Avoidable causes, 3. Unavoidable causes. Distinction between
avoidable and unavoidable causes is not always clear cut. Some causes may ba
unavoidable or uncontrollable for one organisation but avoidable or controllable for
another organisation.
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 Accounting for
Labour

1. Personal Causes: It includes: (i) Change for better job; (ii) death; (iii) retirement
because of old age; (iv) change for better working conditions, better environment; (v)
change for secured job; (vi) marriage especially of women workers; (vii) illness and
accident ' rendering the worker permanently incapable of doing and work; (viii) domestic
need and responsibility etc.

2. Avoidable Cause: It includes: (i) Lower Wages; (ii) unsatisfactory working

conditions, (iii) unsympathetic attitude of the management; (iv) lack of opportunities for
promotion; (v) lack of proper training; (vi) improper manpower planning; (vii) lack of
proper, incentives & long working hours; (viii) bitter relationship between management
and workers; (ix) lack of conveyance, accommodation, medical and educational facilities
and recreational amenities etc.

3. Unavoidable causes: Sometimes workers have to leave the organisation because of

management requirements and administrative actions. They also leave their employment
at their own will, that is, on personal reasons. In the latter case the management can do
nothing but remains a helpless onlooker. So, unavoidable causes may be administrative or
personal.

Effect of Labour turnover : Some labour turnover is inevitable, e.g. employees retire
every year, some may leave due to personal reasons, such as,, marriage, starting their
own business. However, excessive labour turnover is harmful and costly. It results in
increased cost of production due to the following reasons :

(i) With frequent changes in labour force production planning cannot be

properly executed as a result there is substantial loss in production,
(ii) Since the new workers have no previous experience in production there is
loss arising out of defective work, increased spoilage and wastage,
(iii) Newly recruited workers are likely to mishandle tools and equipment which
results in breakages.
(iv) The organisation has to incur extra cost for workers' training,
(v) Labour turnover causes increased replacement cost,
(vi) Labour cost increases due to lower productivity of newly recruited workers
as they do not possess the same expertise as the old workers who have left
the organisation.

Management of labour turnover

Labour turnover rate can be measured by the application of any one of the following
three methods :

(i) Separation method :

No. of employees, left (separation) during the period
100
Average number of workers during the period
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Cost and Management
Accounting

(ii) Replacement method :

No. of workers replaced during the period
100
Average number of workers during the period

(iii) Flux Method

No. of separation + No. of replacements
100
Average number of workers during the period

Equivalent annual rate of labour turnover

In case it is desire to relate the labour turnover rate for a months or a fraction of a month
to annual rate of turnover,. This may be done by calculations "Equivalent annual rate'
with the help of the following formula:
Turnover Rate  365
Equivalent Annual Rate = 100
No. of Days in the Relevant Period

Illustration 1: The following information relates to the personnel department of a factory

for the month of June 2015.
Number of Labourer on June 1 2015 000
Number of Labourer on June 1 2015 1100
Number of Labourer who got the company in June 10
Number of labourer discharge in June = 3.
Number of Labourer in June (including 120 on account of expansion scheme) = 140

Calculates the labour turnover rate and equivalent annual rate under the different method.

Solutions:
(1) Separation method
Number of Separation
Labour Turnover Rate = 100
Average Number of Workers
10  30
 100
1000  1100
2
40
  100  3.81%
1050
3.81 365
Equivalent annual turnover Rate =  46.36%
30
Replacement Method Labour Turnover Rate
Number of Replacements
= 100
Average Number of Workers
20
 100
1000  1100
2
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 Accounting for
Labour

20
  100  1.90%
1050
Equivalent annual turnover rate
1.90  365
  23.17%
30
(iii) Flux Rate Method
No. of Separation + No. of Replacament
Labour Turnover Rate = 100
Average Number of Workers
40  20
  10  5.71%
1050
5.71 365
Equivalent annual turnover rate =  69.52%
30

Illustration 2: From the following data, find out the Labour Turnover Rate by applying:
[B. Com
(Delhi)]
(i) Flux method;
(ii) Replacement method;
(iii) Separation method.
No. of workers on the payroll:
At the beginning of the month 500
At the end of the month 500

During the month, 5 workers left, 20 persons were discharged and 75 workers were
recruited. Of these, 10 workers were recruited in the vacancies of, while the rest were
engaged for and expansion scheme.

Solution:

Computation of Labour turnover:

No. of Separation + No. of Replacements
(i) Flux Method = 100
Average no. of workers
25  10
  100
550
= 6.36%
OR
No. of Separations + No. of Replacements
Flux Method = 2 100
Average no. of workers
25+10
17.5
 2  100   100  3.18%
550 550

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Cost and Management
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No. of Replacements
(ii) Replacement Method = 100
Average no. of workers
10
=  100 = 1.82%
550
No. of Separations
(iii) Separation Method :  100
Average No. of Workers
25
  100  4.55%
550
Cost of labour turnover. Cost of labour turnover is classified into the following two
categories:

1. Preventive costs. These are the costs which a company incurs to prevent the labour
from leaving the job. These costs are incurred in the form of giving more and more
benefits and incentives to workers like free medical facilities, transport facilities,
rent-free housing, education for children of workers etc.
2. Replacement costs. These costs are those which are incurred after the workers have
left the company.

Examples are:
 Cost of advertising the post.
 Cost of recruitment and selection of workers.
 Cost of accidents caused by new workers.
 Loss of materials wasted by new workers.
 Loss of production due to the delay in appointing new workers. ;
 Loss of production due to the slow work by new and untrained workers.

The cost of labour turnover is distributed between normal cost and abnormal cost. The
"normal cost will inflate the labour cost while any abnormal cost is transferred to Profit
and Loss A/c.

Illustration 3: From the following particulars, calculate the labour turnover rate and
labour flux rate.
Number of workers at the beginnign of the year = 4000
Number of workers at the end of the year = 4200

During the year 40 workers leave while 160 workers are discharged. 600 workers are
required during the year, of these 150 workers are recruited because of leavers and the
rest are engaged in accordance with an expansion scheme.

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 Accounting for
Labour

Solution .
4000  4, 00
Average number of workers during the year =  4100
2
Number of workers replaced during the year
Labour Turnover Rate = 100
Average number of workers during the year
50
=  100  3.66%
4100
Numer of additions + separations during the year
Labour Flux Rate : = 100
Average number of workers during the year
600  200
  100  19.51%
4100
Labour flux rate denotes total change in the composition of labour force due to additions
and separations of workers.

Illustration 4. From the following data provided to you find out the Labour Turnover
Rate by applying :
(a) Flux Method
(b) Replacement Method
(c) Separation Method
No. of workers on the payroll —
At the beginning of the month 500
At. the end of the month 600

During the month, 5 workers left, 20 persons were discharged and 75 workers were
recruited. Of these, 10 workers were recruited in the vacancies of those leaving, while the
rest were engaged for an expansion scheme.
(I.C.WA. Inter, June 1993)

Solution
(a) Labour Turnover Rate by Applying Flux Method
No. of additions + No. of separations
= 100
Average number of workers during a period
75  5  20 100
 100  100  18.2%
1 550
(500  600)
2
(b) Labour Turnover Rate by Applying Replacement Method
Number of workers replaced
 100
Average number of workers
10
 100  1.8%
1
(500  600)
2

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Cost and Management
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(c) Labour Turnover Rate by Separation Method

No. of separations
= 100
Average number of workers
5  20 25
 100   100  4.5%
1 550
(500  600)
2

Minimisation of Labour Turnover

We have already discussed that, as normal labour turnover is advantageous because it

allows injection of -fresh blood into the firm. But excessive labour turnover is not
desirable because it shows that labour force is not contended. Therefore, every effort
should be made to remove the avoidable causes which give rise to excessive labour
turnover. The following steps may be taken to reduce the labour turnover :

 A suitable personnel policy should be framed for employing the right man for the
right job and giving a fair and equal treatment to all workers.
 Good working conditions which may be conducive to health and efficiency should be
provided.
 Fair rates of pay and allowances and other monetary benefits should be introduced.
 Maximum non-monetary benefits (i.e., fringe benefits) should be introduced.
 Distinction should be made between efficient and inefficient workers by introducing
incentive plans whereby efficient workers may be rewarded more as compared to
inefficient workers.
 An employee suggestion box scheme should be introduced whereby workers who
suggest improvements in the method of production should be suitably rewarded.
 Men-management relationships should be improved by encouraging labour
participation in management.

In addition to the above point, the personnel department should prepare periodical reports
on the labour turnover listing out the various reasons due to which workers have left the
organisation. The report should be sent to the management with the necessary
recommendations so that corrective measures may be taken to reduce labour turnover.

4.7 INCENTIVE PLANS

Wages to workers is one of the most complex problems in a democratic country like
India. There is no single unique method of wage payment which is acceptable to both
parties i.e. employers and the workers. However before deciding the wages for employee
the employer should take in to account the following points.

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 Accounting for
Labour

Essential Features of a Good Wage System

A wage system will be treated as fair if it has the following features :

(i) The system should be fair both to the employer and the employee. It should be
based upon scientific time and motion study to ensure a standard output to the
employer India fair amount of wages to the workers.
(ii) The worker should be assured of a guaranteed minimum wage at satisfactory
level irrespective of the work done by him.
(iii) Workers should be paid according to their merits. Efficient workers should be
able to earn more wages as compared to the inefficient workers.
(iv) Skilled workers should be paid more as compared to the unskilled workers.
Skilled workers are to be compensated for the efforts put in by them to acquire
the skill.
(v) The system should ensure equal pay for equal work.
(vi) The system should be flexible to allow necessary changes which may arise.
(vii) The system should be such as to minimise labour turnover, absenteeism and late
attendance.

System of Wage Payment

There are two main wage system:

(i) Payment on the basis of time spent on the factory.

(ii) Payment on the basis of the work done irrespective of the time (Piece rate
system).
(iii) Premium and Bonus plan.

(i) Time Wage System: In this system, wages are paid to the worker on an hourly,
daily weekly and monthly basis. For example, a worker is paid at the rate Rs. 2
per hour and he has spent 250 hour during month of June. Therefore, his wages
for the month of June will be = 250 Hour  Rs.2 = Rs.500.

(ii) Piece Rate system: Under this system, wages are paid to worker on the basis of
pieces completed by the worker. For example, a worker is paid at the rate of Rs.
3 per unit and produce 10 units during the day, he will get Rs. 103 = R.s 30 on
that day.

(iii) Premium and Bonus Plan: The main object of a premium plan is to increase the
production by giving an incentive to the workers in the form of higher wages for
less time worked. Some of the important premium a plans are discussed here
below:

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Cost and Management
Accounting

Halsey premium plan:

It is a simple combination of time-speed basis of payment. The feature of the plans ara :
(a) Worker is paid at an hourly rate for the time for which he has worked.
(b) A standard time is determined and if a worker finishes a job before the time
fixed, he is paid a bonus for the time saved, besides the wages for the actual time
spent by him on the job.
(c) The amount of bonus is 50% of the time saved in case of Halsey Plan and 30% in
case of Halsey-Weir Plan and is allowed at the same hourly rate at which he is
paid for actual time worked.

Therefore, his total emoluments are the aggregate of guaranteed hourly wages for actual
time worked plus the amount of bonus. It can be expressed by way of a formula :
Total Earnings = T  R + (S  T)  R  50% (or 30%)
Where T = Time Taken
R = Hourly Rate
S = standard Time
Thus, total earnings are = Time taken  Hourly rate plus Time saved  Rate  50% (or
30%)

Illustration 5: Calculate from the following data Halsey Plan Incentive System.
Standard time fixed = 30 hours
Time Taken = 6 hours
Hourly Rate = Rs. 2 per hour
Solution:
The total earnings of the worker under Halsey Plan shall be computed as follows :
Minimum wage = Time taken  Hourly rate = 20  Rs.2 = Rs.40
Amount of Bonus = Time Saved x Rate x 50%
= (Standard time  Actual time)  Rate  50%
1 1
 (30  20)  2   10  2   Rs.10
2 2
Total Earning of Rs. 40 + Rs. 10 = Rs. 50.

(i) Rowan Plan. Under this method, the worker is again guaranteed wages at the ordinary
rate for the time taken by him to complete the job or operation. The difference between
the Halsey Premium Plan and the Rowan Premium Plan is only in the calculation of the
bonus. Under the Halsey Plan, bonus is a fixed percentage of the wages of the time saved
whereas under the Rowan Plan bonus is that proportion of the wages of the time taken
which the time saved bears to the standard time allowed. Thus, bonus under this system
will be calculated as :
ST
TR
S

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 Accounting for
Labour

ST
and the total earnings will be calculated as : T  R  TR
S
where T = Time taken (Actual Time)
S = Standard Time (Time Allowed)
R = Rate per hour.
Solution
S (Standard Time) = 20 hours
T (Time taken) = 15 hours
R (Rate) = Rs. 1.50 per hour
Total Earnings = T  R + 50% (S  T)R
50
 15  1.50  (20  15)  1.50
100
= 22.50 + 3.75 = Rs. 26-25
= Rs. 26-25
Total wages for 15 hours
Therefore, effective rate of earning per hour
Total Wages 26.25
=   Rs.1.75
Actual Time Taken 15
Note Percentage of bonus is to be taken 50% when it is not given.

Advantages of the Halsey Premium Plan

(i) It is simple to understand and relatively easy to operate.
(ii) It guarantees time wages to workers.
(iii) The wages of time saved are shared by both employers and workers, so it is (helpful
in reducing labour cost per unit.
(iv) It makes distinction between efficient and inefficient workers because it provides
increasing incentive to efficient workers.
(v) Fixed overhead cost per unit is reduced with increase in production.
(vi) The employer is able; to reduce cost of production by having reduction in labour cost
and fixed overhead cost per unit. So, he is induced to provide the best possible
equipments and working conditions. '

Disadvantages of the Halsey Premium Plan

 Quality of the work suffers because workers are in a hurry to save more and more
time to get more and more bonus.
 Workers criticise this method on the ground that the employer gets a share of
wages of the time saved.

Illustration 6. Mr. A is working by employing 10 skilled workers. He is considering the

introduction of some incentive scheme—either Halsey Scheme (with 50% bonus) or
Rowan Scheme—of wage payment for increasing the labour productivity to cope with
increased demand for the product by 25%. He feels that if the proposed incentive scheme
could bring about an average 20% increase over the present earnings of the workers, it

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Cost and Management
Accounting

could act as sufficient incentive for them to produce more and he has accordingly given
this assurance to the workers. As a result of this assurance, the increase in productivity
has been observed as revealed by the following figures for the current month.
Hourly rate of wages (guaranteed) Rs. 2
Average time for producing 1 piece by one workers at the
previous performance 2 hours
(This may be taken as time allowed)
No. of working days in the month 25
No. of working hours per day for each worker 8
Actual production during the month 1,250 units
You are Required : to (i) calculate effective rate of earnings per hour under Halsey
Scheme and Rowan Scheme
(ii) Calculate the savings to Mr. A in terms of direct labour cost per piece under the above
schemes.
(iii) Advise Mr. A about the selection of the scheme to fulfil his assurance. (I.C.WA.
Inter, Dec. 1993)

Solution
 Calculation of lime wages of 10 workers per month
= No. of working days in a month  No. of working hours per day each worker
 No. of
workers x Hourly rate of wages
= 25  8  10  Rs. 2 = Rs. 4,000
 Calculation of time saved per month
Time allowed per piece 2 hours
Time allowed for actual output of 1,250 units 2.500 hours
Less : Actual time taken by 10 workers working for 25
days @ 8 hours per day per worker (10 x 25 x 8) 2,000 hours
Time saved 500 hours
(c) Calculation of Bonus under Halsey Scheme
Bonus = 50% of time saved x hourly rate
50
=  500 (hours x Rs-2 = Rs.500
100
Total wages under Halsey Scheme = Time Wages + Bonus
= Rs. 4,000 + Rs. 500 = Rs. 4,500
 Calculation of Bonus under Rowan Scheme

Time saved
Bonus =  Time Wages
Time allowed
500 hours
=  Rs.4, 000  Rs.800
2,500 hours
Total wages to be paid to 10 workers under Rowan Scheme
= Time Wages + Bonus = Rs. 4,000 + Rs. 800 = Rs. 4,800
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 Accounting for
Labour

1. (I) Calculation of Effective Hourly Rate under Halsey Scheme

[Refer to Basic Calculations (a), (b) and (c)]
Time wages of 10 workers + Total Bonus under Halsey Scheme
=
Total hours actually worked
Rs. 4,000 + Rs. 500
=  Rs.2.25
2,000
(II) Calculation of Effective Hourly Rate under Rowan Scheme
Time wages of 10 workers + Total Bonus under Rowan Scheme
=
Total hours actually worked
Rs. 4.000 + Rs. 800
=  Rs.2.40
2,000
2. (I) Saving of Direct Labour Cost per Piece under Halsey Scheme
Labour cost per piece under time wage system = 2 hours @ Rs. 2 = Rs. 4
Labour cost per piece under Halsey Scheme
Total wages including bonus paid under Halsey Scheme
=
Total number of units produced
Rs. 4.500
=  Rs.3.60
1,250 units
Saving per piece - Rs. 4  Rs. 3-60 = Re. 0-40.
(II) Saving of Direct Labour Cost per Piece under Rowan Scheme
Rs.4,800
Labour cost per piece under Rowan Scheme =  Rs.3.84
1, 250 units
Saving per piece = Rs. 4  Rs. 3.84 = Re. 0.16.

Illustration 7. According to suggestion for scheme, an award equivalent to six. months'

saving in labour cost is granted to employees whose suggestions are accepted. Suggestion
of an employee to use a jig for a manufacturing operation of a component has been
accepted as it is found that the cost of a jig is only Rs. 600 (life one year) and that the
standard time can be reduced by three minutes.

Compute from the following data :

(a) the amount of the award,
(b) the estimated saving to the company per year,
(c) the revised estimated cost of the component.
(i) Number of pieces to be produced in one year — 12,000
(ii) Standard time per piece before use of jig—one hour
(iii) Raw materials required per piece—10 kgs. @ Re. 0.75 per kg.
(iv) Average rate of workmen Rs. 6 per day of 8 hours
(v) Average efficiency of workmen — 75%
 Standard time 
 Efficiency   100 
 Actual time 
(vi) Overhead charge—Rs. 6 per actual hour
(vii) Store handling expenses—2% of value of direct material. (I.C.WA. Inter)
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Cost and Management
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Solution
(a) Calculation of the Amount of the Award
Standard time 1hour 4
Actual time before use of the jig =   hr. or 80 minutes
Efficiency 75% 3
Saving in time by use of the jig = 3 minutes in standard time.
Therefore, standard time after use of the jig = 1 hour - 3 minutes = 57 minutes
Revised Standard time
Actual time per piece after use of the jig =
Efficiency
57 minutes
 76 minutes
75%
Saving in actual time per piece = 80 minutes - 76 minutes = 4 minutes
Time saved per year on 12,000 pieces @ 4 minutes = 48,000 minutes or 800 hours.
Saving in labour cost per annum = 800 hrs.  Average rate per hour.
6
 800   Rs.600
8
 Rs.6 
 Average rate per day of 8 hours = Rs. 6, Average rate per hour  8 
 
 Amount of the award = 6 months' saving in labour cost 
6
  Rs.600  Rs.300
12
(b) Calculation of the Estimated Saving to the Company per Year
Rs.
Saving in labour cost per year 600
Saving in overhead : Saving in time x Overhead rate per hour
800 hrs.  Rs.. 6 4,800
5,400
Less : Cost of the jig Rs. 600
Award to the workman Rs. 300 900
Net saving per year to the company , 4,500
(c) Calculation of the Revised Estimated Cost of the Component
Rs.
Material cost: 10 kgs. @ Re. 0.75 per kg. 7.50
Stock handling expenses @ 2% of material cost  
2
 Rs.7.50  0.15
 100 

per hour 
6 76 6
Labour cost for 76 minutes @ Rs.  Rs.  0.95
8  100 8
76
Overhead : hrs.  Rs.6 7.60
60
Rs.300
Award for suggestion : 0.025
12, 000 pieces
600
Cost of the jig : 0.050
12, 000 pieces
Cost per component 16.275
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 Accounting for
Labour

(iv) Bcdeaux Point Premium Plan. Under this plan, every operation or job is expressed
in terms of so many standard minutes, which are called "Bedeaux points" or Each B
representing one minute through time and motion study. Upto 100% performance i.e.,
upto standard B's, a worker is paid time wages without any premium for efficiency. If the
actual performance exceeds the standard performance in terms of B's, then 75% of the
wages of the time saved is paid to the worker as bonus and 25% is earned by the foremen.
For example, standard time required for a job is 20 hours i.e., 1200 B's in terms of
minutes (20 x 60) whereas a worker has taken 16 hours i.e., 960 B's (16 x 60) instead of
1,200 B's. The worker has saved 240 B's or 4 hours (4 x 60). Suppose time wage rate is
Rs. 2 per hour ; the time saved will be equal to Rs. 8 (4 hours @ Rs. 2). The worker will
get 75% of Rs. 8 as bonus. So, his total earnings will be as follows :
Rs.
Time wages for 16 hours - actual time taken @ Rs. 2 per hour 32
Bonus—75% of 4 hours wages  
75
 4  R.2  6
100 
Total earnings 38
This method ensures time wages to the workers and has the good feature of distributing
the wages of time saved among workers and foremen. It serves as a strong incentive for
workers for improving their performance above 100% of the standard. But workers
criticise this method as foremen are given a share of wages of the time saved. It is a
complicated method as the determination of standard time in terms of B's is not easily
understood by the workers.

Illustration 8. The cost accountant of Y Ltd has computed labour turnover rates for the
quarter ended 31 March 2012 as 10%, 5% and 3% under Flux method, Replacement
method and Separation method, respectively. If the number of workers replaced during
that quarter is 30, find out the number of (1) workers recruited and joined, and (2)
workers left and discharged

Solution
No. of replacements
Labour turnover rate =
Average No. of workers
5 30

100 Average No. of workers
100
Average No. of workers = 30  = 600.
5
(i) Calculation of workers recruited and joined
No. of separations + No. joined
Labour turnover rate (Flux method) =
Average No. of workers
10 18  No. joined

100 600
6, 000
No. joined =  18  42
100
Thus number of workers recruited and joined = 42
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2. *No. of workers left and discharged

No. of separations
Labour turnover rate (Separation method)  t
Average No. of workers
3 No. of separations

100 600
No. of separations = 18

Thus, the number of workers left and discharged = 18.

Illustrations 9. The worker is paid 50 paise per hour and the 5 days working week
contains 42 hours. The daily allowance for approved absence from his place of work,
maintenance of machine, etc., is 12 minutes and his job cards show that his time
chargeable during the week to various cost centres is as follows :
Job No. 305 20 hrs.
,, 310 10 hrs.
„ 320 8 hrs.
Time unaccounted for is caused by a power failure. Show how his wages for the week
would be dealt with in the cost accounts.
(B.Com. Hons. Delhi)

Solution
Total wages payable to the worker for the week = Rs. 21 (42 hours @ 50 P.)
Worker's wages are to be dealt with in the cost accounts as follows : Rs.
Wages chargeable to Job No. 305 (20 hours @ 50 paise) 10.00
Wages debited to Job No. 310 (10 hours @ 50 paise) 5.00
Wages debited to Job No. 320 (8 hours @ 50 paise) 4.00
Wages for approved absence for 5 days @ 12 minutes per day taken as normal
idle time to be recovered as factory overhead (1 hour wages @ 50 paise) 0.50
Wages for time wasted due to power failure taken as abnormal loss transferred
to Costing Profit and Loss Account (3 hours @ 50 paise) 1.50
21.00

Illustration 10. X Ltd. provides you the following information for its factory working 6
days in a week:
 Hours as per Time Card 48 hours
 Hours booked to jobs as per Job Card 36 hours
 Daily allowance for lunch, personal needs,
fatigue and maintenance of machine 40 minutes
 Wage Rate Rs. 20 per hour
 Time not booked was due to breakdown of machinery, power failure, waiting for jobs
materials and tools. [B.Com. (Pass), Delhi 2008]

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Solution :

(i) Time Wages paid 48 hrs.  20 = Rs. 960

(ii) Amount to be charged to Jobs as :
Direct Wages 36 x 20 = Rs. 720
240
Overheads  20 = Rs. 80
600
= Rs. 800
Amount to be charged to Costing P&L Account as : = Rs. 160
Abnormal Idle Time Cost Rs. 960

4.8 QUESTION

1. What are the advantages of time keeping and time booking system?
2. What is idle time? How would you treat normal and abnormal idle time wages in cost
account?
3. What do you mean by Labour turnover? What measures do you suggest to keep the
rate of labour turnover at low level?
4. Explain different methods for calculating labour turnover?
5. What is idle time? Give reasons for idle time. How do you treat idle time in cost
account.

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

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 UNIT-5 ACCOUNTING FOR OVERHEADS

LEARNING OBJECTIVES

After studying this unit you should be able to understand

 Meaning of Overhead
 Classification of overhead cost
 Segregation of Semi-Variable cost
 Overhead distribution
 Basis of apportionment and Re-apportionment of overhead
 Method of apportionment

STRUCTURE

5.1 Introduction
5.2 Meaning and definition of overhead
5.3 Classification of overhead costs
5.4 Segregation of Semi variable cost
5.5 Overhead distribution
5.6 Basis of Apportionment
5.7 Re-apportionment of Service
5.8 Method of Apportionment
5.9 Questions

5.1 INTRODUCTION

Overhead is those administrative expenses of a business that are required to operate

general corporate functions, and which cannot be definitely attributed to any revenue
generating activities or units of output. Overhead is necessary part of a business and must
be paid for even when ales levels are very low. The cost of overhead may be very
substantial. Therefore, a manager should closely monitor it. Some of the examples of
overheads may be administrative, salaries, insurance, legal expenses etc. The overhead
cost do not directly lead to the generation of profits. However, it provides a critical
support for the generation of profit making activities. In business overhead cost refers to
an ongoing expenses of operating a business. It may be also known as an operating
expenses. Overhead are the expenditure which cannot be conveniently traced to or
identified with any particular cost unit. Such expenses are incurred for output generally
and not for particular work order e.g. wages paid to watch man, heating and lighting
expense etc. Overheads includes a large number of types of indirect costs. Mainly
overhead includes i) Indirect material (ii) Indirect labour and (iii) indirect expenses.

(i) Indirect Material: All material which is used for proposes anciliary to the
business and which cannot be conveniently assigned to specific physical units is
known as Indirect material for example consumable stores, oil and wastage etc.

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(ii) Indirect labour: Labour employed for the purpose of carrying out tasks
incidental to goods or services provided is known as indirect labour. Such labour
does not directly participate in producing the product. For example, director fees,
salaries of sales man etc.

(iii) Indirect expenses: There are expenses which cannot be directly, conveniently
and wholly allocated to cost control and cost units. It means, cost which cannot
be traced to the finished products manufactured are termed as indirect expenses.

From the above discussion, it is clear that all kind of indirect expenses may be termed as
overhead. This implies overheads can only be apportioned to the finished products.

5.2 MEANING AND DEFINITION OF OVERHEADS

There are three elements of cost-material labour and expenses. These elements can
further be divided into direct and indirect. Direct materials, direct labour and direct
expenses constitute direct or prime cost while indirect materials, indirect labour and
indirect expenses constitute indirect cost or overhead.

Overhead = Indirect Material cost + Indirect labour cost + Indirect expenses.

In the terminology of Cost Accounting, overheads is defined as 'the aggregate of indirect

material cost, indirect wages and indirect expenses'. Overheads are not identifiable with
any particular product, process, operation, job. So, they are to be apportioned or allocated
to such cost centre on some equitable and fair basis.

According to CIMA, Overhead cost is expenditure on labour, materials or services that

cannot be economically identified with a specific saleable cost unit."

Importance of overhead cost: Management need to be aware of the level of expenditure

on overheads. If left uncontrolled, the amount spent can increase year on year, eroding
significant properties of goods profit and reducing competitiveness. Therefore, managers
need to know overhead expenditure per cost centre or department and overhead cost per
unit.

Classification of Overhead Costs

Overhead costs may be classified onto three categories.

(i) Element wise (ii) Function wise (iii) Behaviour wise

Let us discuss one by one :

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(i) Element Classification: Under it, the classification is done according to nature
and source of the expenditure. The expenses can be classified into three main
categories:

(a) Indirect material: Material costs which cannot be allocated but are
apportioned to cost units are known as indirect material. For example fuel
lubricants etc.
(b) Indirect wages : These wages cannot be allocated but are observed by cost
units are known as indirect wages, e.g. wages of sweeper, idle time wages
etc.
(c) Indirect expenses : Expenses which cannot be allocated but to be absorbed
by cost units are known as indirect expenses, such as depreciation, taxes, rent
and rates etc.

(2) Function-wise Classification:

(a) Production overhead: All indirect expenses incurred in connection with the
production are known as productions overhead. It is an aggregate of factory
indirect material, indirect wages and indirect expanses.
(b) Administration overhead: These expenses are of general nature and consist of
all costs incurred in the administration of an undertaking which are not related
directly to production or selling. They are known as office overhead.
(c) Selling and distribution overhead: Selling overhead is the expenses of seeking
for securing orders such as advertising, showroom expenses. Travelling
expenses, etc. Distribution expenses include the expenses incurred from the time
the product is completed in the factory till it reaches to the customers.
Distribution overhead is the cost of the process which begins with making the
packed product available for dispatched and ends with making the reconditioned
returned empty package available for re-use. It comprises all expenditure
incurred from the time the product completed in the factory until it reaches in the
hands of customers. It include cost of warehousing charges, cost of packing,
transportation etc.

3. Behaviour wise classification: Overheads cost can be classified into (i) fixed (ii)
variable and (iii) semi variable cost.

(i) Fixed overheads: Fixed methods may be defined as the overheads, which do not vary
with the volume of production within the installed capacity of plant. Fixed overhead
means the overhead which remains constant for all volumes of production within certain
limits. The examples of fixed overheads are rent of factory, salary of factory manager etc.

(ii) Variable Overheads: Variable overheads; maybe defined as the, overheads which
vary in direct proportion to the volume of production. There is positive correlation

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between the variable overhead and quantity of output. The examples of variable
overheads are power, repairs etc.

(iii) Semi-Variable Overheads: Semi-variable overheads are the overheads which

contain the elements of fixed and variable overheads. A part of these overheads is fixed
and part is variable and, therefore, known as semi-variables. Such costs do not vary
proportionately but simultaneously do not remain stationery at all times. For example,
telephone expenses consist of hire charges as well as the call expenses. Hire part is fixed
where are fee for calls is variable. Thus the total of two i.e., telephone expense becomes
semi-variable.

5.4 SEGREGATION OF SEMI-VARIABLE COSTS

The main aim of classifying overhead costs is divided into fixed and variable, as it will
help the management in making decision and in controlling the expenditure. The semi
variable costs are to be split up into fixed and variable expenditure. Methods of
Segregation: The various methods of segregation of semi-variable expenses are as under :
(i) Average Method, (ii) Scatter Diagram Method, (iii) High and low point Method and
(iv) Simultaneous Equation Method.

(1) Average Method : Under this method, the given data are divided into two parts and
then average of output and cost is separately computed for these two parts. Variable
expenses is calculated by the following method :
Difference in Average Costs
Variable expenses per unit =
difference in Average output

Illustration 1 : From the following information segregate the semi-variable cost into
fixed and variable expenses :
Month Output Semi-variable Costs
January 160 4400
February 80 3200
March 240 5600
April 320 6800
May 400 8000
June 280 6200

Solution.
I Average II Average
Semi-
Semi-variable
Units Units variable
expenses
expenses
Jan. Rs. 4400 April 320 6800
Feb. 3200 May 400 8000
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March 5600 June 280 6200

Average
480 13200 1000 21000

480/3 13200/3 1000/3 21000/3

= 160 = 4400 = 7000.
21000-13200 7800
Variable expenses Per unit =   15
1000-480 520

Fixed expenses in Jan. = 4400 - 2400 = 2000

Variable expenses in Jan. = 160 units x 15 = Rs. 2400
Note: In this way, it may be calculated for each month

(ii) Scatter Diagram Method

Under this method, the semi-variable costs are plotted on a graph. On its x-axis the
volume of production and on y-axis, the amount of expenditure is shown. After plotting
the points on graph, a straight line is drawn which represents an average of all the points.
If is known as line interacts the y-axis, marks the fixed cost. The difference between
semi-variable cost line and fixed cost line represents-variable cost.

The following graph is given with the help of data given in illustration No. 1.

(iii) High and Low point Method

Under this method, the highest and lowest output difference and the difference between
the corresponding costs are worked out. Then the variable cost per unit is calculated by
applying the following formula:
Difference in Semi - variable cost
Variable cost per unit =
Difference in output (units)

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Illustration 2 : From the following data, segregate the semi-variable cost into fixed cost
and variable cost:
Month Output (in units) Semi-variable cost
in (Rs.)
July 240 6600
August 120 4800
September 360 8400
October 480 10200
November 600 12000
December 420 9300

Solution.
(units) Highest Production 600 units in November
Lowest Production 120 units in August.
Difference = 480 units. (600  120)
Rs.
(Semi-variable cost) November = 12000
August = 4800
Difference = 7200
7200
Variable cost per unit = = Rs. 15 Per unit
480
Variable expenses in August = 120 units x 15 = Rs. 1800
Fixed expenses in August = Semi-variable - variables.
August = 4800  1800 = Rs. 3000.
Thus, Fixed cost in Aug.= Rs. 3000
Variable in Aug. = 1800
Total Semi-variable in Aug. = Rs. 4800

(iv) Simultaneous Equation Method

In this method, overhead costs are segregated by means of an equation which is as under:
y = mx + c
Where y = Total Semi-variable cost
m = Scope of variable cost line
x = Volume of output
c = Fixed cost

Illustration 3 : Take illustration No 1 and find out fixed and variable expenses with the
help of Equation :

Solution. Let us take January and February and make two equations.
y = rnx + c
for January : 4400 = 160 m + c — (i)

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for February : 3200 = 80 m + c — (ii)

Subtracting equation (ii) from (i) —
We get : 1200 = 80 m
m = 1200/80 = Rs. 15
Putting the value of m in equation (i) we get
4400 = 160 x 15 + c
4400 = 2400+ c
c = 4400  2400 = Rs. 2000/-
Thus fixed cost Rs. 2000
Variable cost Rs. 2400 (4400  2000)

5.5 OVERHEAD DISTRIBUTION

The various steps to be taken for distribution of overheads are as under :

(1) Classification and Collection of Overhead :

The overhead are classified into various categories. Production overheads should be
collected under standing order numbers. The main sources of collection of overheads are
as under :
(i) Stores requisitions-for indirect materials.
(ii) Journal entries-for adjustment entries and record.
(iii) Invoice— for collection of indirect expenses.
(iv) Wages Analysis Sheet-for collection of indirect wages.

(2) Allocation and Apportionment of overheads to Production Department:

Departmentalisation of overhead is the process of allocation of overheads to different

departments. These department are of two types as under : (a) Production Department (b)
Service Department

A Production department is one that is engaged in the actual manufacture of the product.
A service department, is one which is rendering a service to the production departments.

Allocation : Certain items of overhead costs can be directly identified with a particular
department. Allotment of such costs to department is known as allocation. Thus
allocation is charging to a cost centre those overheads that results solely for that cost
centre. Allocation can be made only when exact amount of expenses is defintely known.
Indirect materials can be easily allocated to various departments.

Apportionment : Certain overhead costs which cannot be directly charged to a

department is known as apportionment. Thus apportionment is the allotment of
proportions of items of cost to cost units. It is charging to a cost centre a fair share of an

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overhead. When any item is common to various cost centres, it is allocated to different
cost centres proportionately on such grounds.

Distinction between the two : Cost allocation means the allotment whole items of cost
to cost centre or cost units. Cost apportionment means and involves allotment or
proportion of items of cost centres or cost units. In other words, cost allocation deals with
whole items of cost. Further in allocation, costs are directly allocated- But apportionment
of cost needs a suitable basis for the sub-division of the costs to various cost units or cost
centres. Allocation is a direct process. But apportionment may be made indirectly on
suitable bases.

Allocation is a direct process and apportionment is an indirect Process for which suitable
bases are to be selected. Any item of cost can be allocated or apportioned does not
depend upon the nature of cost but upon its relation with the cost centre.

Principle of Apportionment: Apportionment of overheads to various production and

service departments is based on the following principle :
(1) Survey method : This method is useful for those overheads that are not directly
related to a particular department. For example lighting expenses may be apportioned on
the basis of a survey of the number of light points.
(2) Ability to pay Method : In overhead distribution, the departments having largest
income may be charged with the largest amount of overheads. But this method is not a
equitable method.
(3) Service Method : It is based on the theory that greater the amount of service received
by a department, the large should be the share of the expenses to be borne by that

5.6 BASIS OF APPORTIONMENT

The following are the common basis of apportionment of various overheads

Overhead Cost Basis of Apportionment

1. (i) Material handling Weight of material or value of materials.
(ii) Store overhead
2. Lighting expenses Number or light Points.
3. (i) Depreciation of Plant Capital values.
(ii) Insurance of Stock
(iii) Repairs and Maintenance of
Plant
4. (i) Compensation to workers Direct wages
(ii) ESI and PPF contributions
(iii) Holiday Pay
(iv) Fringe benefits
5. (i) Rent of Building Floor Area

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(iv) Fire service

(v) Air conditioning
(vi) Light and Heating
6. (i) Electric Power Horse power of machine or value or
(ii) Number of Machine hours machines.
7. (i) Power consumption Technical Estimates
(ii) Managerial service
(iii) Internal Transport
8. General overheads Direct Labour Hours or Direct Wages.
9. (i) Fringe benefits Number or Workers
(ii) Time keeping
(iii) Supervision
(in) Personal office
(v) Labour welfare expenses

5.7 RE-APPORTIONMENT OF SERVICE

Once the overheads have been apporioned to production and service departments, the
next step is to reapportion the service department costs to production Departments. The
cost of service Departments should be charged to production departments. It is called as
secondary distribution.

The important basis of apportionment of service department costs to production

departments are as under:

(i) Purchase Department Value of materials purchased

(ii) Personal Department Rate of Labour Turnover
(iii) Maintenance Department No. of hours worked in each
Department
(iv) Inspection Department Direct Labour hours
(v) Drawing Transport Service Man Hours Worked
(vi) Internal Transport Service Value or weight of goods
transported
(vii) Canteen Welfare and recreation Service Number of employees
(viii) Time keeping Department Number of employees
(ix) Store keeping Department Quantity of materials consumed.

5.8 METHODS OF APPORTIONMENT

The following methods of apportionment are given below:

1. Apportionment to production department only. Under this method, service

department costs are directly apportioned to various production departments only. This
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method does not take into account inter-departmental transfer of service i.e. service,
provided by one service department to other service departments.

2. Apportionment to production as well as service departments. This can either

be on non- reciprocal basis or on reciprocal basis.

Non-reciprocal basis. Under this method, the various service departments are first
arranged according to their serviceability. Serviceability may be either on the basis of
expenditure incurred in a service department or the number of departments served. The
most serviceable department is taken up first and its cost is distributed to other production
and service departments on a suitable basis. Its account is then closed. Then, the next
most serviceable department is taken up and its cost is apportioned to production and
service departments. This process goes on till the cost of last service department is
apportioned only to the production departments. This method is also called 'step method'.
If partly considers the service rendered by one service department to other service
departments.

Reciprocal basis. Inter-departmental services are taken into account on reciprocal basis.
The three methods which may be used for reciprocal distribution are:
(i) Simultaneous equation method
(ii) Repeated distribution method
(iii) Trial and error method.

(i) Simultaneous equation method. In this method, the true total overhead cost of
each service department is ascertained with the help of an algebric equation.
These are then redistributed to production departments on the basis of given
percentages.
(ii) Repeated distribution method. Under this method, the total overhead costs of
the service departments are distributed to other service and production
departments according to the given percentage till the expense of all service
departments are exhausted or become insignificant.
(iii) Trial and error method. Under this method, the cost of a service department is
apportioned to another service department. The cost of another service centre
plus apportioned cost from the first centre is apportioned back to the first service
centre. This process is repeated till the amount to be apportioned becomes
negligible.

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Illustration 1: The following information was available from the books of ABC Ltd. for
half year ending on 30th September 15. Prepare a overhead Departmental Distribution
Summary.
Particular Production Department Service Department
A B C X Y
Materials Rs. 6,000 5,000 4,000 3,000 2,000
Wages Rs. 14,000 12,000 10,000 2,000- 2,000
Electricity Kwt. 16,000 12,000 12,000 4,000 6,000
Assets values (Rs.) 100,000 6,000 40,000 20,000 20,000
Area occupied 1,600 1,200 1,200 400 400
(Sq. metre)
Light Points (No.) 20 30 30 10 10
Employees No. 800 600 600 200 200

The overhead for 6 month were as under :

Stores overhead Rs. 800 Repairs Rs. 2400
Electric lighting Rs. 400 Rent Rs. 1200
Labour Welfare Rs. 6000 Depreciation Rs. 12000
Motive Power Rs. 3000 General overheads Rs. 20000
Apportion the expenses of Deptt. X in ratio of 4 : 3 : 3 and that of Deptt. Y in proportion
to direct wages to Deptts. A, B and C respectively.,

Solution.
Overhead Distribution Summary
Items Basis of Total Production Deptt. Service Deptt.
Appor- Rs. A B C X Y
tionment Rs. Rs. Rs. Rs. Rs.
Materials 4,000 — — — 2,000 2,000
Wages 5,000 — — — 3,000 2,000
Stores- Materials 800 240 200 160 120 80
overheads
Motive- KWT. 3,000 960 720 720 240 360
Power
Lighting Points Nos. 400 80 120 120 40 40
Labour- No. of- 6,000 2,000 1,500 1,500 500 500
Welfare employees
Depreciation Asset Value 12,000 5,000 3,000 2,000 1,000 1,000
Repairs Asset Value 2,400 1,000 600 400 200 200
General- Wages 2,000 7,000 6,000 5,000 1,000 1,000
overheads
Rent Area 1,200 400 300 300 100 100
Total 54,800 16,680 12,440 10,200 8,200 7,280
Deptt. X 4:3:3 3,280 2,460 2,460 - —
8,200
Deptt. Y 7:6:5 2,832 2,426 2,022 — (-) 7,280
(Wages)
Total 54,800 22,720 17,326 14,682 — —
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Illustration 2. From the following information, work out the production hour rate of
recovery of overheads in departments X, Y and Z.
Production departments Service
departments
Particulars Total X Y Z A B
Rs. Rs. Rs. Rs. Rs. Rs.
Rent 1,000 200 400 150 150 100
Electricity 200 50 80 30 20 20
Fire insurance 400 80 160 60 60 40
Plant depreciation 4,000 1,000 1,500 1,000 300 200
Transport 400 50 50 50 100 150
Estimated — 1,000 2,500 1,800 — —
working hours

Expenses of service departments A and B are apportioned as under:

X Y Z A B
A 30% 40% 20% — 10%
B 10% 20% 50% 20% —

Apportion the expenses of service department according to

(i) Simultaneous equation method
(ii) Repeated distribution method
(iii) Trial and error method

Solution
Simultaneous equation method
Let x = Total expenses of department A to be apportioned
y = Total expenses of department B to be apportioned
x = 630 + 0.2y
y = 510 + 0.1x
or .
x  0.2y = 630 (i)
y  0.1x = 510 (ii)
Multiplying (i) by 5 and adding the two
5x  y  3150
0.1x  y  510
4.9x  3, 660
3, 660
x  747 (approx.)
4.9
Substituting this value in equation (i)
747  2y = 630
- 2y = 630  747
y = 585
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Service
Total
Production departments departments
Particulars Amount
X Y Z A B
(Rs.)
Rs. Rs. Rs. Rs. Rs.
1. Rent 1,000 200 400 150 150 100
2. Electricity 200 50 80 30 20 20
3. Fire insurance 400 80 160 60 60 40
4. Plant depreciation 4,000 1,000 1,500 1,000 300 200
5. Transport 400 50 50 50 100 150
Total departmental
expenses 6,000 1,380 2,190 1,290 630 510

Service Dept. A 224 299 149 747 75

(apportioned)
Service Dept. B  59 117 292 117 585
(apportioned) 6,000 1,663 2,606 1,731  
Total
1,000 2,500 1,800
Estimated working 1.66 1.04 96
hours
Overhead rate per
hour

Repeated distribution method

Overhead Distribution Summary

Total Production departments Service

departments
Partculars Amount X Y Z A B
Rs. Rs. Rs. Rs. Rs. Rs.
Rent 1,000 200 400 150 150 100
Electricity 200 50 80 30 20 20
Fire insurance 400 80 160 60 60 40
Plant depreciation 4,000 1,000 1,500 1,000 300 200
Transport 400 50 50 50 100 150
Total departmental
expenses 6,000 1,380 2,190 1,290 630 510
Service dept. A — 189 252 126 -630 63
Service dept. B — 57 115 286 115 -573
Service dept. A — 35 46 23 -115 11
Service dept. B — 1 2 6 2 -11
Service dept. A — 1 1 — (-)2 —
Total 6,000 1,663 2,606 1,731 — —
Working hours for
the department 1,000 2,500 1,800
Rate per hour (Rs.) 1.66 1.04 0.96

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Trail and error method

Service department
A B
Original apportioned amount Rs. Rs.
630 510
630 63(10% of 630) .
115(20% of 573) 11 (10% of 115)
2(20% of 11) (11)
Total positive figure 747 584
Note: After such apportionment is complete, the overhead cost of a production
department or cost centre will consist of:
 Expenses allocated to that department
 General overheads (common expenses) suitably apportioned to the department
 Share of the expenses of service department apportioned to the producing
departments.

Illustration 3. The New Enterprises Ltd. has production departments A, B and C and two
service departments D and E. The following figures are extracted from the records of the
company.
Rates and rates Rs. 5,000
General lighting Rs. 600
Indirect wages Rs. 1,500
Power Rs. 1,500
Depreciation of machinery Rs. 10,000
Sundries Rs. 10,000
The following further details are available:
Total A B C D E
Floor space (sq. ft.) 10,000 2,000 2,500 3,0'00 2,000 500
Light points 60 10 15 20 10 5
Direct wages (Rs.) 10,000 3,000 2,000 3,000 1,500 500
H.P. of machines 150 60 30 50 10 —
Value of machinery 2,50,000 60,000 80,000 1,00,000 5,000 5,000
(Rs.)
Working hours — 6,226 4,028 4,066 — 

The expenses of D and E are allocated as follows:

A B C D E
D 20% 30% 40% — 10%
E 40% 20% 30% 10% —
What is the total cost of article if its raw material cost is Rs. 50, labour cost Rs. 30, and it
passes through departments A, B, C for 4, 5, and 3 hours respectively.

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Solution
(i) Overheads Primary Distribution Summary
Items Basis of charge Total Production dept. Service dept.
Rs. A B C D E
Rs. Rs. Rs. Rs. Rs.
Direct wages Allocation 2,000 — — — 1,500 500
Rent and rates Re. 0.50 per
sq. ft. 5,000 1,000 1,250 1,500 1,000 250
General Re. 10 per
lighting point 600 100 150 200 100 50
Indirect 15% of direct
wages wages 1,500 450 300 450 225 75
Power Rs. 10 per H.P. 1,500 600 300 500 100 —
Depreciation 4% of the
of machinery value of ;
machinery 10,000 2,400 3,200 4,000 200 200
Sundries 100% of
direct wages 10,000 3,000 2,000 3,000 1,500 500
Total
departmental
overheads 30,600 7,550 7,200 9,650 4,625 1,575

(ii) Overheads Secondary Distribution Summary

(Repeated Distribution method)

Items z Production departments Service

A B C departments
D E
Rs. Rs. Rs. Rs. Rs.
Total overheads as per (i) 7,550 7,200 9,650 4,625 1,575
Dept. D overheads apportioned 925 1,387 1,850 (4,625) 463
Dept. E overheads apportioned
(1,575 + 463) 815 408 611 204 (2,038)
Dept. D overheads apportioned 41 61 82 (204) 20
Dept. E overheads apportioned 8 4 6 2 (20)
Dept. D overheads apportioned — 1 1 (2) —
Total 9,339 9,061 12,200
Working hours 6,226 4,028 4,066
Rate per hour 1.50 2.25 3.00

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Statement Showing the Total Cost of the Article

Amount (Rs.)
Direct Material 50.00
Direct labour 30.00
Prime Cost 80.00
Overheads :
Department A - 4 hours @ Rs. 1.50 per hour 6.00
Department B - 5 hours @ Rs. 2.25 per hour 11.25
Department C - 3 hours @ Rs. 3.00 per hour 9.00 26.25
Total Cost 106.25

Illustration 4. PH Ltd. is a manufacturing company having-three production departments

A, B and C and two service departments, X and Y. The following is the budget for
December 2015:
Total A B C D E
Rs. Rs. Rs. Rs. Rs. Rs.
Direct material 1,000 2,000 4,000 2,000 1,000
Direct wages 5,000 2,000 8,000 1,000 2,000
Factory rent 4,000
Power 2,500
Depreciation 1,000
Other overheads 9,000
Additional information:
Area (sq. ft.) 500 250 500 250 500
Capital value of
assets (Rs. lakhs) 20 40 20 10 10
Machine hours 9,000 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25

A technical assessment of the apportionment of expenses of service department is as

under:
A B C X Y
Service dept. X 45% 15% 30%  10%
Service dept. Y 60% 35%  5% 

Required:
1. A statement showing distribution of overheads to various department
2. A statement showing re-distribution of service department's expenses to
production departments.
3. Machine hour rates of the production departments A, B and C.

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Basis Total A B C X Y
Rs. Rs. Rs. Rs. Rs. Rs.
Direct material Direct — — — 2,000 1,000
Direct wages Direct — — — — 1,000. 2,000
Factory rent Area 4,000 1,000 500 1,000 500 1,000
Power H.PX
M/c hr. 2,500 500 800 800 150 250
Depreciation Cap. value 1,000 200 400 200 100 100
Other overheads M/c hr. 9,000 1,000 2,000 4,000 1,000 1,000
2,700 3,700 6,000 4,750 5,350

(ii) Re-distribution of Service Departments Expenses

A B C X Y
Rs. Rs. Rs. Rs. Rs.
Total overheads 2,700 3,700 6,000 4,750 5,350
Dept. X overhead apportioned
in the ratio (45:15:30:10) 2,138 712 1,425 -4,750 475
Dept. Y overhead apportioned
in the ratio (60:35:5) 3,495 2,039 — 291 - 5,825
Dept. X overhead apportioned
in the ratio (45:15:30:10) 131 44 87 -291 29
Dept. Y overhead apportioned
in the ratio (60:35:5) 17 10 — 2 -29
Dept. X overhead apportioned
in the ratio (45:15:30:30) 1  1 -2 —
Total 8,482 6,505 7,513 — —
(iii) Machine Hour Rate
A B .... C
Machine hours 1,000 2,000 4,000
Machine hour rate (Rs.) 8.48 3.25 1.88

Illustration 5. [B.Com. (Delhi)]. A factory is having three production departments A, B

and C, and two service departments Boiler-House and Pump-Room. The boiler-house has
to depend upon the pump-room for supply of water and pump-room in its turn is
dependent on the boiler-house for supply of power for driving the pump. The expenses
incurred by the production departments during a period are:
A-Rs. 8,00,000; B-Rs. 7,00,000; and C-Rs. 5,00,000. The expenses for boiler-house are
Rs. 2,34,000 and the pump-room are Rs. 3,00,000.

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The expenses of the boiler-house and pump-room are appointed to the production
departments on the following basis:
A B C B.H. P.R.
Expenses of boiler-house 20% 40% 30%  10%
Expenses of pump-room 40% 20% 20% 20% 

Show clearly as to how the expenses of boiler-house and pump-room would be appointed
to A, B and C departments. Use algebraically equation.

Solution. Suppose overheads of boiler-house = x

and overheads of pump-room = y
x = a + by
y = a + bx
x = 2,34,000 + 0.2y
y = 3,00,000 + 0.1x
Multiplying both the equations by 10 and then re-arranging
10x - 2y = 23,40,000 (i)
x + 10y = 30,00,000 (ii)
Multiplying (ii) by 10 and adding to (i), we get
10x  2y = 23,40,000
10x + 100y = 3,00,00,000
98y = 3,23,40,000  y = 3,30,000
(Pump-room) y = 3,30,000
Placing the value of y in (i), we get
(Boiler-house) x = 2,34,000 + 0.2(3,30,000)
= 2,34,000 + 66,000 = 3,00,000

Secondary distribution of overheads

Primary Total 8,00,000 7,00,000 5,00,000
B.H. (90% of 3,00,000) 60,000 1,20,000 90,000
P.R. (80% of 3,30,000) 1,32,000 66,000 66,000
Total 9,92,000 8,86,000 6,56,000

Illustration 6. [B.Com. (Delhi]. A factory has three Production Departments A, B and C

and two service Departments P and Q.
A Rs. 6,50,000 P Rs. 1,20,000
B Rs. 6,00,000 Q Rs. 1,00,000
C Rs. 5,00,000

The expenses of service Department are allotted on a percentage basis as under:

Production Service
A B C P
Q
Service Deptt. P 30% 40% 15% — 15%
Service Deptt. P 40% 30% 25% 5% —
Show how the expenses of two service Deptts. are to be charged to production Deptt.

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Solution.
Statement of overhead Distribution
Items Production Deptt. Service Deptt.
A B C P Q
Rs. Rs. Rs. Rs. Rs.
Total Expenses 6,50,000 6,00,000 5,00,000 1,20,000 1,00,000
Servicer Deptt. P 36,000 48,000 18,000 (-) 1,20,000 18,000
Servicer Deptt. Q 47,200 35,400 29,500 5,900 (-) 1,18,000
Servicer Deptt. P 1,770 2,360 885 (-) 5,900 885
Servicer Deptt. Q 354 266 221 44 -885
Servicer Deptt. P 13 18 7 (-44) 6
Servicer Deptt. Q 3 2 1 — (-)6

Illustration 7: From the data given below. Calculate the Machine Hour Rate:
Rs.
(i) Rent of the Deptt. (Space occupied 780
by machine of 1/5 deptt.)
(ii) Lighting (No. of men in the Deptt. 12 two 288
men are engaged on the machine)
(iii) Insurance 36
(iv) Cotton, waste oil etc. 60
(v) Salary of foreman (% time is occupied by this machine) 6000

The cost of the machine is Rs. 9,200 and it has an scrap value of Rs. 200.
(1) The machine will work for 1800 hours per annum.
(2) Expenses on repairs Rs. 1125.
(3) Power consumption 8 units per hour at cost of Re 1 Per unit.
(4) Working life of machinery 10 years.[Delhi B. Com.]

Solution.
Computation of Machine Hour Rate
Standing Charges : Rs. Rs.
- Rent (780 x % ) 156
- Lighting (780 x 1/5) 48
- Foreman's Salary (780 x 1/5 ) 1,500
- Insurance 36
- Cotton Waste 60
Total 1,800
Hourly Rate : 1,800/1800
Variable Expenses : '
1125 : 9200  200
- Depreciation 0.50
1800  100
- Repairs 10 1800 0.60
- Power 8 units @ Re 1/- 8.00
Machine Hour Rate 9.56

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5.9 QUESTIONS

1. What do you mean by overheads and explain various classification of overheads.

2. What are the basis of apportionment of overhead expenses among Departments.
Name the overhead for which each basis will be suitable.
3. Explain with examples the difference between the cost apportionment and cost
absorption.
4. Define a service department? Give illustration of service department.
5. Describe how service department cots are distributed to Production department.

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

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 UNIT-6 ABSORPTION OF OVERHEADS

LEARNING OBJECTIVES

After studying this unit you should be able to explain

 Meaning of absorption overhead
 Meaning of under and over absorption of overheads
 Methods of absorption of production overheads
 Treatment of special items of overheads
 Overhead absorption rate
 Method of absorption of factory overhead
 Machine hour Rate methods

STRUCTURE

6.1 Introduction
6.2 Under and over absorption of overheads
6.3 Methods of absorption of production overheads
6.4 Treatment of special items of overheads
6.5 Overhead absorption Rate
6.6 Methods of absorption of factory overheads
6.7 Machine hour Rate overheads
6.8 Questions

6.1 INTRODUCTION

The overheads expenses are ultimately to be charged or absorbed by the cost of

individual jobs, products and process. The amount of overheads allocated and
apportioned to the producing department is to be borne by all the cost units passing
through department. This is known as overhead absorption. This overhead is the
allotment of overheads to cost units. Further it is the process of allotting the total cost of
a cost centre to the products or series. Absorption of overhead is also known as levy,
recovery or application of overhead.

6.2 UNDER AND OVER-ABSORPTION OF OVERHEADS

Overheads may be charged to production on the basis of actual rates based on actual
output and actual overheads or on the basis of pre-determined rate. In practice, overheads
are charged to production at pre-determined rates. Since pre-determined rates are based
on estimates, actual overheads are found to be different from absorbed overheads. This
arises a difference between overhead absorbed and overhead incurred. Such a difference
is known as under-absorption or over- absorption of overheads.

Under-Absorption: When actual overheads incurred are more than the overheads
absorbed, it is known as under-absorption. Thus,
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Under-Absorption = Actual Overheads - Absorbed Overheads

Over-Absorption : When actual overheads incurred are less than the ' overheads
absorbed, it is known as over-absorption. Thus,
Over-Absorption = Absorbed Overheads - Actual Overheads.

Causes of under or Over-Absorption of Overheads

Over or under-absorption of overheads may arises due to one or more of the following
reasons :

1. Error in estimating the amount of overhead.

2. Error in estimating the level of production or hours to be worked.
3. Seasonal fluctuations in the overhead expenses, from time to time.
4. Changes in the methods or techniques of production.
5. Change in productive capacity.

Treatment of Over-Absorption or Under-Absorption of Overheads

Under-absorption has the effect of understating the cost while over-absorp-tion has the
effect of overstating the cost. Over-absorption or under-Absorption of overheads may be
disposed of in any one of the following ways: (i) Transfer to Costing Profit and Loss
Account, (ii) Carry forward to the next year, (iii) Use of supplementary rate.

(i) Transfer to Costing Profit and Loss Account: The amount of under-absorbed or
over-absorbed overheads is transferred (credited or debited) to Costing Profit and Loss
Account at the end of accounting period when
(i) The amount of under-absorbed or over-absorbed overheads is minor and insignificant.
Or
(ii) The under-absorption or over-absorption has caused by abnormal circumstances i.e.
the factors beyond the control of management,

(ii) Carry Forward to the Next year : The amount of under-absorbed or over-absorbed
overheads is carried over to subsequent years when management is sure that an over-
absorption in the current period will be more or loss neutralised by under-absorption in
the next period. Accordingly, the amount of the current period is transferred to a Reserve
Account or Suspense Account. This method has a limited application because it is against
the costing principle that overhead should be absorbed in a particular year in which it is
incurred. However, this method may be followed when:
(i) The industry is seasonal with fluctuating demand and fluctuation in production.
(ii) Normal business cycle extends beyond one year,
(iii) The project is new and output initially low but there will be more output in the next
year which will absorb more overheads,

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(iii) Use of Supplementary Rates : In case there is significant over or under absorption
due to anticipation about overheads cost or the basis not coming true, supplementary rate
may be used. It is calculated by dividing the amount of over-absorption or under-
absorption by the actual base. Thus.
Under-Absorption or Over-Absorption
Supplementary Overhead Rate =
Actual Base
Supplementary rates are of two types :
(i) Positive supplementary rates and
(ii) Negative supplementary rates. ,

The amount of under-absorbed overheads is, added through a positive supplementary rate
and the amount of over-absorbed overheads is deducted through a negative
supplementary rate. Overhead absorption is the apportionment of overheads of the cost
centres over cost units. There are two steps in the absorption overheads. (A) Computation
of these rates. and (B) Application of these rates.

(A) Computation of overhead Rates : Absorption rates are computed with the aim
of absorption of overheads in costs of the cost units. There are six methods of
determining absorption rates. In all these methods, the overhead rate is computed by
dividing the total amount of overheads by the number of units.
Total overhead
Thus, overhead absorption Rate =
Total units

(B) Application of Rates : The overhead rate is multiplied to the number of units in
the cost unit. Thus overhead absorbed = No. of units x overhead Rate

6.3 METHODS OF ABSORPTION OF PRODUCTION OVERHEADS

(1) Direct Material Cost percentage Rate

(2) Direct Labour Cost percentage Rate
(3) Prime Cost Percentage Rate
(4) Direct Labour hour Rate
(5) Machine Hour Rate
(6) Output Rate.

(1) Direct Material: It is computed by dividing the total overheads by the total cost
of direct materials Consumed in a particular department.
Production overhead
Formula :  100
Direct Materials

(2) Direct Labour cost Percentage Rate : It is computed by dividing the production
overhead by the direct labour cost.

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Production overhead
Formula :  100
Direct Labour Cost

(3) Prime Cost Percentage Rate: Overhead rate is calculated by dividing the
production overhead by Prime Cost.
Production overhead
Formula :  100
Prime Cost

(4) Direct Labour Hour Rate : It is calculated by dividing the total production
overhead by the total number of labour hours.
Production overhead
Formula :
Direct Labour Hours

(5) Machine Hour Rate : It is calculated by dividing the amount of factory

overhead apportioned to a machine by the number of machine hours for the
period.
Production overhead Formula
Formula:
No. of Machine Hours

(6) Output Rate Per Unit: It is determined by dividing the total overheads of
department by the number of units Produced.
Production overhead
Formula :
No. of units

Administration Overhead

All indirect expenses incurred in formulating the Policy, directing the organisation and
controlling the operations of an undertaking is known as administration overhead. They
have no direct connection with the production or sales. These are affected by any
fluctuations in the volume of production or sales.

For the absorption of these overheads, a single overhead rate is computed by any one of
the following methods :

(1) Percentage of Works Cost: It is absorbed as a percentage of works.

Administrative overhead
Formula :  100
Works Cost

(2) Percentage of Sales : This overheads may be absorbed as a percentage of sales.

Administrative overhead
Formula :  100
Total Sales

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(3) Percentage of Conversion Cost : It is the cost of converting raw material into
finished product.
Administrative overhead
Formula : 100
Total Conversion Cost

Selling and Distribution overhead

Selling Cost is the cost of seeking to create and stimulate demand and of securing orders.
Such as advertisement Show room expenses etc. Distribution cost is the cost of the
sequence of operations which begins with making the packed product available for
despatch.

Method of Absorption:

(1) Rate Per unit of Sales : This overhead are divided by the number of units sold.
(2) Percentage of Selling price :

A percentage of selling and distribution overheads to selling price is ascertained by the

following formula :
Selling and Distribution Expenses
Overhead Rate =  100
Sales

(3) Percentage of Works Cost:

In this method, a percentage of selling overheads to works cost is ascertained.

Selling and Distribution Expenses
Formula :  100
Total works cost

Treatment of Special items of Overheads

(1) Depreciation : Depreciation is the diminution in the value of a fixed asset due to
lose of time. In cost accounts, depreciation is charged to cost of production on the
following grounds :
(a) Depreciation represents a charge for usage of the capital resources.
(b) The invested amount has to be recovered over a number of years.

Methods of Calculating Depreciation :

(i) Straight line Method.
(ii) Diminishing Balance Method.
(iii) Annuity Method.
(iv) Depreciation fund Method.
(v) Insurance Method.
(vi) Revaluation Method.

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(2) Rent: Rent is an expenses to be taken into account as overhead. If any premises
is owned by the proprietor, and no rent is paid, in such a case, a charge in lieu of rent
should be made in cost accounts, so that the comparison of total cost may be made easily.

(3) Carriage Inwards : It is connected with the purchase of materials and is

included in the cost of material purchased being a direct cost.

(4) Royalties and Patent fees : Royalties payable is a direct expense and included in
prime cost. If Royalties are payable on the basis of sales, then it is a selling cost.

(5) Canteen Expenses: If Canteen is running on a subsidized basis, then it is a part

of overhead and is to be apportioned to various departments on number of workers basis.

(6) Director's fees and Salaries : Director's fees and salaries are to be apportioned
to production, administration and selling department on the basis of time devoted by the
directors.

(7) Research and Development:

(a) Expenses of current year is to be charged to revenue.
(b) When expenses is to be charged in number of years, then it is treated as
differed revenue expenditure.
(c) This expenditure is charged to Profit and loss Account.

(8) Market Research Cost: The expenses on market research is a matter of policy
costs and it is treated as selling overhead.

(9) After sales Service : This cost is a part of the selling overhead. Each case is
analysed and expenditure major repairs are treated as deferred charge and written
in Profit and loss account.

(10) Fringe Benefits: All the expenses of fringe benefits are apportioned on the basis
of quantum of benefits received by the employees,

(11) Cost of small Tools : It may be treated in any one of the following methods :
(a) They may be charged as an expense at the time of their purchase.
(b) If it is capitalised, it is debited to Small Tools A/c.
(c) It may be charged to Stores inventory.

(12) Cost Discount: It is a financial item and is not a part of Costs.

(13) Packing expenses :

(a) Primary Packing expenses are treated as direct material cost.
(6) Fancy packing is selling overheads.
(c) Packing facilitating transportation is treated as distribution expenses.
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(14) Drawing and Design office Costs: It may be treated as Direct Cost. If treated as
selling overheads. If it is related to service department, its costs to be apportioned
to production departments on the basis of technical estimates of service rendered.

(15) Expenses on Removal and Re-erection of Machinery : All expenses incurred

to dismantle and re-erection of any machine is treated as production overhead. If
this cost is a large one then it may be treated as deferred revenue expenditure. If
removal is done on account of faulty planning, it is charged to costing Profit and
loss account.

(16) Set-up Costs : The cost of set-up of time is charged to that particular Job for
which preparation is being made. It is frequent, it may be apporioned to all Jobs
equitably.

(17) Bonus to employees : Normal bonus is a part of wages and any bonus paid over
and above the minimum amount should be charged to Profit and Loss account.
Bonus may be treated as overhead and apportioned to various departments on the
basis of wages bill.

(18) Advertisement: Advertising expenses for promoting sales is a selling overhead.

If it is a common expenses, then it is apportioned on the basis of sales value of
product. Heavy advertising expenses are treated as deferred expenses and they
are catalyzed. If advertisement is not for sales promotion, it should be charged to
the department concerned.

(i) Interest on Capital. There are certain items of income, expenses and apportion
which are included in the financial accounts but do not find any place in the Cost
Accounts e.g., provision for taxation, debenture interest, income on investments,
fictitious assets written off, dividends paid etc. Similarly, some items belong to
Cost Accounts only. These items are mostly of notional character and are treated
by way of opportunity costs for purposes of managerial decision making. Interest
on Capital employed in the business is one such item. It may be included in cost
accounts through no payment for this Interest may have been made in actual.

(ii) Leave wages. There are always certain payments made to workers which are not
directly to production. These payments are : Leave Pay, HolidayPay, Stock pay,
Maternity Period Pay, Pension Scheme Payments, Employer's contribution
to the Provident Fund, Retirement cum Death Gratuity Payment, Medical
benefits etc. These are expenses besides wages and salaries, which the
management incurs by way of supplementary labour costs and these benefits are
enjoyed by the industrial labour. These costs are of such a nature that these can
not be allocated to cost units directly but may be allocated to the particular
departments or cost centres in which the workers are employed. Thus, it can be
said that the cost of fringe benefits are items of departmental overheads. In many
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cases, the cost of these benefits to labour is not incurred uniformly in each
accounting year. Therefore, benefits for the whole year are anticipated and a
proportionately uniform amount is charged to each accounting period. This helps
to avoid uneven charge of these costs over different accounting periods. So far as
pension benefits to workers are concerned, a reserve is usually created to meet
future payments. The amount of provision created is treated as an overhead.
Pension costs are usually allocated direct to a cost centre or apportionment may
be made on the basis of the number of employees or total wages paid.

(iii) Audit fees. It is just like any other normal item of expense and it is included as
an expense in the Cost Accounts as well as in the Financial Accounts In both the
accounts, it may be included as an expense on accrual basis even in it has not
been paid. This expense is part of the administration overheads and all these
office or general administration overheads are absorbed or charged to the product
cost at some or the other pre-determined rate.

(iv) Holiday with pay. Every worker is entitled to certain number of holiday during
the year for which he is paid. Holiday with pay is estimated in advantage for the
full year and is included in the cost. For direct workers, holiday will pay may be
treated as a direct cost by inflating the wage-rate. Alternatively, we may be
included in production overhead. For all indirect workers, holiday will pay is
treated as an overhead.

(v) Casual wages. Casual wages mean wages payable to casual workers. Casual
workers are those workers who are employed on daily basis and are not on the
regular payroll of the employer. Casual workers are mostly untrained and indirect
workers. Their wages therefore become a part of production overheads

(vi) Bad debts. There are different opinions on treatment of bad debts in Cost
Accounts. Some accountants exclude it as it is a financial loss. But some expert
say that bad debts should be included in Cost Accounts as selling overheads.
Only normal amount of bad debts should be included in Cost Accounts.
Abnormal amount of bad debts should not become a part of the cost but should
be transferred to Profit & Loss Account.

(vii) Expenses on staff welfare activities. These are also called 'Non-monetary'
benefits extended to the staff in the form of amenities or facilities These do not
offer, direct cash reward to the employees. However, these benefit or facilities
certainly go a long way in making the work-conditions quite lucrative as these
create a huge positive psychological effect upon the employees.

Some such benefits or facilities are given below:

(i) Good working conditions
(ii) Medical facilities for staff
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(iii) Education facilities for wards of staff

(iv) Subsidised canteens
(v) Recreational facilities like common room etc. and
(vi) Uniforms etc. for staff.

Expenses incurred by the employers on all such benefits or facilities are treated as part of
the factory overheads. These are apportioned over the different cost centres i.e., the
departments of the factory on the basis of number of employees employed by each
department. In this way, these costs are absorbed alongwith other items of the factory
overheads.

(viii) Wages paid for re-operation of defectives. Defective goods are that part of the
production which can be rectified with reasonable costs. Such rectification is not possible
in case of the 'Spoilage'. Spoilage is that part of the production which, like defectives,
does not come up to the standards of the normal output and it is as such rejected. Such
spoiled or damaged goods can not be brought back to the normal condition even after
repairs. Both of these i.e., spoilage and defectives can be controlled by classifying them
first into normal and abnormal. Reports on 'spoilage' and 'defectives' can go a long way in
this direction. effective steps should be taken to reduce the quantity of the abnormal
spoilage and defectives.

Defectives may arise because of reasons such as:

(i) defective material
(ii) poor workmanship
(iii) poor supervision
(iv) wrong design or planning and
(v) defective machines or tools.

Cost of rectification of the defectives can also be classified into normal and abnormal.
Normal cost is treated as part of the factory overheads whereas abnormal costs, if any, are
charged to 'Costing Profit & Loss Account.'

(ix) Research and Development expenses or costs.

'Research cost' includes expenses incurred on searching for new or improved products
or new or improved materials or methods. This expenditure usually comprises of the
wages and salaries of the research staff, materials and facilities provided in the laboratory
and research department, or payments to outside organisations. 'Development cost'
means expenses which are incurred on implementing the results of the research
programmes undertaken by the organisation. Usually, all these expenses incurred on
research and development activities are of the nature of pre-production costs as there is
always a considerable time lag between the incurring of such expenses and actual
realisation of their benefits. As there is no immediate production, therefore it may not be
possible to charge these costs as part of the factory overheads. Such expenses may be
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capitalised and then written off in future against actual production. However, if research
and development costs are of recurring or continuous nature, then the same may be treated
as part of the 'Factory overheads'. Similarly, if research and development costs are related
to any specific job then the same may be charged exclusively to that particular job.

6.5 OVERHEAD ABSORPTION RATE

Overhead absorption rates may be of two types (i) Actual rate and pre determined rate.

Actual rates are those which are based on actual cost while pre-determined rates are those
which are based on estimated or pre-determined cost.

Pre-determined overhead absorption rates. The computation and use of such pre-
determined overhead absorption rates is more practical and useful because in case of such
rates, the rates relating to a particular period are available for costing purposes well in
advance. This helps in preparation of cost estimates and fixing prices for sales or
quotation purposes etc. However, there is one limitation as well of such pre-determined
rates and this is that such rates when actually applied for absorption of the factory or
other overheads, generally result in over or under absorption of the factory overheads.

Purposes of overhead rates

The main objectives of fixation of overhead rate are:

1. Absorption of overhead to cost units on a logical and equitable basis.
2. Smoothing out of month-to-month fluctuations in the overhead cost per unit.
3. Prompt compilation of cost on completion of products.
4. Estimation of overhead cost in advance of production.
5. Prompt compilation of cost of work-in-progress.
6. Related to time factor as far as practicable.
7. Departmental rates are preferable to blanket rate.
8. Base for the rate should lay emphasis on the main production element of the firm.

Features of a satisfactory overhead rate

The main features of a satisfactory overhead rate are as under:

1. Simple, easy to operate, practical and accurate
2. Economic in application
3. Fairly stable so that cost from period to period is not distorted.

Pre-determined overhead absorption rates are preferred over actual rates because of the
following factors:
• Pre-determined rates help in the preparation of tenders and quotations.
• These help in controlling the cost.
• These are of greater practical utility.
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Various methods of absorption of factory overheads are as under:

6.6 METHODS OF ABSORPTION OF FACTORY OVERHEADS

The following methods are commonly used for absorption of factory overheads:
1. Percentage of direct material cost
2. Percentage of direct labour cost
3. Percentage of prime cost
4. Direct labour hour rate t
5. Machine hour rate (M.H.R.) »"•

These methods are being discussed in the following sections:.

Percentage of Direct Material Cost

Sometimes, the factory overheads are charged on the basis of materials consumed by
products. The overhead rate is calculated by dividing estimated factory overheads for the
period by the cost of direct material.

Overhead expenses
Percentage of direct material cost =  100
Total direct material cost

This method is simple but has only limited use because in most cases no logical
relationship exists between the direct material cost of a product and factory overheads
incurred. Again one product might be made for costly materials while another requires
less expensive materials. However, both might require the same manufacturing process
and thus incur approximately the same amount of factory overheads. If the material cost
basis is used to charge overhead, the product using costly material will be charged with
more than its share of overheads.

Percentage of Direct Labour Cost

(1) A percentage on direct wages. This is the oldest method and still appears to be the
most popular. The rate is calculated by dividing overheads cost by the amount of direct
labour. The overheads are applied by multiplying this percentage by the direct labour cost
of each job or cost unit.

For example: Production overheads = Rs. 10,000

Direct wages = Rs. 40,000

Now the percentage of overheads to direct wages is:

Overheads 10, 000
Rate = 100  10  25%
Direct wages 40, 000

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This method is usually applied where:

1. Labour is the most important factor of production.
2. The grades of labour, the rates of pay and basis of remuneration do not widely differ.
3 Where type of work performed by all the workers is uniform.

(III) Percentage of Prime cost: In this method, overhead rate is calculated by dividing
the factory overhead by prime cost.
Factory Overhead
Factory Overhead Rate =  100
Prime Cost

This is a simple method to apply, but as many overheads are related to time, and because
materials usually forms a large part of the total price costs it has no logical basis. It is
suitable only in case where one standard product made which uses a fixed quantity of
material at a constant price and time taken in production is constant. __

(IV) Direct Labour Hour Rate : Under this method, overheads is charged on the basis
of direct labour hours worked rather than direct wage paid. The overheads to be absorbed
are aggregated and rate cf overhead absorption is calculated by dividing the overhead
cost by the labour hours ex-pended.
Amount of Factory Overhead
Overhead Rate =  100
Total Direct Labour Hours
For example,
Labour = 4,000 hours
Factory Overheads = Rs. 10,000
10, 000
10,000 Factory Overhead Rate = = Rs. 2.50 per hour
4, 000

Thus, if 10 hours are spent on a job, factory overhead for that job will be Rs. 25.
This method gives full recognition to the time factor. It is easy to operate because labours
hours are readily available from the time sheet and job-cards etc. However, this method
does not take into consideration the factor of production other than labour and may lead
to faulty distribution of overhead to produce cost. It fails to take into consideration the
expenses which are not dependent on labour hours such as power, depreciation, fuel etc.

6.7 MACHINE HOUR RATE METHOD

It is one of the most scientific methods of absorption of overheads. Machine hour rate
means the cost of operating a machine for one hour. It is on the basis of this rate that a
charge is made to the jobs for the overheads depending upon the number of hours for
which a machine has worked on that job machine has rate is computed by the following
formula.
Overheads pertaining to each machine cost centre
Machine hour rate (M.H.R.) =
Number of effective machine-hours

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Effective machine hours = Normal working hours per year - loss of hours due to repairs
and maintenance and setting-up
etc.
Factory overheads
or Machine hours Rate =
Effective machine hours

Uses of Machine-hour rate:

1. It is a scientific method and is also a logically as well as theoretically sound method
of absorption of factory overheads.
2. It is specially useful in those departments of the factory where work is done mainly
by machines as compared to work done by labour.
3. It uses time as the basis of absorption of overheads.

Steps in calculation of machine Hour Rate :

1. While computing machine hour-rate, the first step is to determine effective machine
hours for the base period.

2. Overheads specific to machine are allocated to that machine. Such expenses may be
power, repairs, supervisor's salary etc. All other overheads are apportioned to each
machine on appropriate basis. For example, rent may be apportioned on the basis of
area occupied by the machines.

3. It is better to compute separate rate for fixed items and variable items, ience,
overhead costs are classified in following groups :
(a) Fixed or standing expenses.
(b) Variable or Machine Expenses.

Fixed or standing expenses are the expenses which are not affected by machine operation.
Such expenses include rent, rates, insurance, supervision etc. Variable or machine
expenses are the expenses which are affected by ma¬chine operation. Such expenses
include repairs, depreciation and power or fuel.

4. Sum total of standing charges or fixed charges is divided by total number of machine
hours. This will give us standing charges or fixed expenses per machine hour.

5. Per hour cost is calculated for each variable or machine expense.

6. Standing charges per hour and machine expenses per hour are added to obtain
machine hour rate.

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Advantages :

Some suitable basis for apportionment of departmental expenses which relate to more
than one machine. The bases which may be adopted for apportioning the different
expenses for computation of machine hour rate are given below.

An item of expenses Basis

Supervision According to the time spent
Rent Floor area occupied by the machines
Insurance on building Floor area
Insurance on machinery Value of machines
Repairs and maintenance Actual for each machine
Depreciation Value of the machines
Power Horse power of the motor x time operated
Consumable stores As per stores requisition slips
Lubricating oils As per stores requisition slips
Shop cleaners Time spent on each machine

Advantages
1. It is a scientific, practical and accurate method of recovery of overheads where work
is done mainly by machines.
2. It .provides useful data for estimating cost of production, setting standards and for
fixing selling prices for quotation.
3. Under absorption, if any, will reveal the extent to which the machines have been idle.
4. It takes into consideration the time factor completely.

Disadvantages
1. Estimation of machine hours becomes difficult, particularly when the production /
programme is not available in advance.
2. The maintenance of detailed records for the running hours of the machines and time

Illustration 1. The following expenses were incurred annually in respect of a factory

having 8 machines of similar nature:
Lighting for the factory Rs. 800
Supervision Rs. 900
Repairs Rs. 2,400
Rent and rates Rs. 4,000

Attendants: Two persons looking after Rs. 2,000

eight machines paid @ Rs. 60 per month Rs. 9,600
each Rs. 300
Interest paid on loan Rs. 240
Power consumed for the shop at 10 paise
per unit
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Depreciation per machine

Sundry supplies for factory
Each machine consumes 10 units of power
in an hour.

Calculate machine hour rate if a machine runs for 1,200 hours in a year.
(B.Com. (Pass) Delhi)

Calculation of Machine Hour Rate

Standing charges
Lighting 800
Supervision 900
Repairs 2,400
Rent and rates 4,000
Attendant's wages (2 x 60 x 12) 1,440
Sundry supplies 240
Total standing charges 9,780
Standing charges per machine (9,780  8) = Rs. 1,222.50
Standing charges per hour (1,222.50  1,200) 1.02
Machine expenses
Depreciation (300  1,200) 0.25
 9, 600  1.00
Power  
 8 1, 200 
Machine hour rate 2.27

Note: Interest paid on loan (being purely financial charge) has been ignored.

Illustration 2: From the following particulars compute machine hour rate:

Rs.
Cost of machine 1,14,800
Installation charges 5,400
Anticipated life of machine 10 years
Residual value at the end of 10 years 5,000
Rent and rates per annum 12,000
Insurance of the machine p.a. 3,000
Repairs and maintenance p.a. 8,640
Consumable stores p.a. 1,200
Total production services p.a. 1,080
Power cost is 5 units per working hour @ 40 paise per unit
Setting up time (Non-productive) 400 hours p.a.
There are 300 working days of eight hours in a year
B.Com. (Pass) Delhi, 1994

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Solution
Computation of Machine Hour Rated

Per year Per hour

Rs. Rs.
Standing charges „
Rent and rates 12,000
Insurance 3,000
Repairs and maintenance 8640
Consumable stores 1200
Production service 1080
Total 25920
Standing charges per hour (Rs. 25,920 + 2,000 hrs.) 12.96
 1,1 4, 800  5,400  5,000  5.76
Depreciation  
 10  2,000  2.00
Machine Hour Rate 20.72

Working note: Calculation of effective working hours

Annual hours (300 x 8) 2,400
Less Setting-up time 400
Effective hours 2,000

Illustration 3: From the following information, compute machine hour rate:

Cost of machine Rs. 44,000
Scrap value Rs. 4,000
Rent for the workshop Rs. 25,000 per annum
General lighting for the workshop Rs. 160 per month
Power consumption 20 units per hour @ Rs. 20 per every 100 units
Administrative expenses allocated to the machine Rs. 4,000 per annum
Repairs and maintenance 75% of depreciation
Workshop supervisor's salary Rs. 3,000 per month
Estimated working time per year 50 weeks of 40 hours each
Setting up time which is regarded as productive time 200 hours per year
Effective life of the machine 10 years
The machine occupies l/4th area of the workshop. The supervisor is expected to
devote
l/3rd of his time in supervising the machine. (B.Com. Delhi)

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Solution
Computation of Machine Hour Rate
(Machine hours: 50 x 40 = 2,000)
Particulars Per annum Per hour
Rs. Rs.
Standing or fixed charges
Rent for workshop (25,000  4) 6,250
160  12 
General lighting for the workshop  
480
 4 

Administrative expenses allocated to the machine 4,000

3, 000  12 
Workshop supervisor s salary  
 3  12,000
Total standing charges per annum 22,730
Standing charges per hour = 22,730  2,000 11.37
Machine expenses
 44, 000  4, 000  2.00
Depreciation  
 10  2, 000 
Repairs and maintenance (75% of depreciation) 1.50
 20  20 1,800  3.60
Power  
 100  2, 000 
Machine hour rate 18.47

Illustration 4: A manufacturing unit has added a new machine to its fleet of five existing
machines. The total cost of purchase and installation of the machine is Rs. 7,50,000. The
machine has an estimated life of 15 years and is expected to realise Rs. 30,000 as scrap at
the end of working life.

Other relevant data are as follows:

1. Budgeted working hours are 2,400 based on 8 hrs per day for 300 days. This includes
400 hrs for plant maintenance.
2. Electricity used by the machine is 15 units per hour at a cost of Rs. 2.00 per unit. No
current is drawn during maintenance.
3. The machine requires special oil for heating which is replaced once in every month at
a cost of Rs. 2,500 on each occasion.
4 Estimated cost of maintenance of the machine is Rs. 500 per week of 6 working days.
5. Three operators control the operations of the entire battery of six machines and the
average wages per person amounts to Rs. 450 per week plus 40% fringe benefits.
6. Departmental and general works overheads allocated to the operation during the last
year was Rs. 60,000. During the current year it is estimated that there will be an
increase of 12.5% of this amount. No incremental overhead is envisaged for the
installation of the new machine.

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You are required to compute the machine-hour rate for recovery of the running cost of
the machine. (I.C.W.A. Inter, June 1993)

Solution
Computation of Machine Hour Rate
Particulars Per annum Rs. Per hour Rs.

Standing charges
Operator's wages (450 x 3 x 50) 67,500
Add 40% fringe benefits 27,000

94,500
Departmental and general works overheads (60,000 +
12.5%) 67,500

Total standing charges for 6 machines 1,62,000

Cost per machine 1,62,000/6 = Rs. 27,000

13.50
Cost per machine hour = 27,000/2,000 = 13.50
Machine expenses

 7,50, 000  30, 000  24.00

Depreciation  
 2, 000  5 

Electricity @ Rs. 2 per unit 30.00

 2,500 12  15.00

Special Oil  
 2, 000 

 500  300  12.50

Maintenance  
 6  2, 000 

Machine hour rate 95.00

Working note: Effective machine working hours per annum:

No. of working days for the year 300
No. of working hours 300 x 8 2,400
Less Hours for machine maintenance 400
Effective hours 2,000

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Illustration 5. The following information relates to the activities of a production

department of a factory for a month.
Direct material consumed Rs. 1,80,000
Direct wages Rs. 1,50,000
Factory overheads chargeable to the department Rs. 1,26,000
Labour hours worked 12,000 hrs
Machine hours worked 10,000 hrs
The relevant data relating to one order carried out in the department during the period are
as given ahead:

Material consumed Rs. 30,000

Direct wages Rs. 24,750
Labour hours worked 1,650 hrs
Machine hours worked 1,200 hrs

Compute factory overhead rates of recovery and the amount of overhead chargeable to
the order by the following method:
(i) Direct material cost percentage;
(ii) Direct labour cost percentage;
(iii) Labour hour rate;
(iv) Machine hour rate.

Solution (i) Direct material cost percentage

Amount of factory overheads
=  100
Direct material
Rs. 1,26.000 x 100
 70 %
Rs. 1,80,000
Overheads chargeable = 70% of Rs. 30,000 = Rs. 21,000

(ii) Direct labour cost percentage

Amount of factory overheads
=  100
Direct Labour
Rs. 1,26.000 x 100
 84%
Rs. 1,50,000
Overheads chargeable = 84% of Rs. 24,750 = Rs. 20,790

(iii) Labour hour rate

Amount of factory overheads
=
Labour hours worked
Rs. 1.26.000
=  Rs.10.50
12,000
Overheads chargeable = l,650 hours x Rs. 10.50 = Rs. 17,325

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(iv) Machine hour rate

Amount of factory overheads
=
Machine hours worked
Rs. 1.26.000
=  Rs.12.60
10,000
Overheads chargeable = 1,200 hours  Rs. 12.60 = Rs. 15,120.

6.8 QUESTIONS

1. What is mean by absorption of overheads?" Explain briefly the different methods of

absorption of overheads.
2. What is machine hour rate: Rs. What procedure is followed for comparison of
comprehensive machine hour rate?
3. Why do we employ pre-determined overhead rate of absorption Rs. Under what
circumstances is direct labour cost percentage method to be employed.
4. Distinguish between allocation, appointment and absorption of overheads.
5. The following expenses were incurred annually in respect of a factory having 8
machines of similar nature :
Rs.
(i) Lighting for the Factory 800
(ii) Supervision 900
(iii) Repairs 2,400
(iv) Rent and Rates 4,000
(v) Attendants : Two persons looking after eight machines paid @ Rs. 60 per
month each
(vi) Interest paid on loan 2,000
(vii) Power consumed for the shop at 10 paise per unit 9,600
(viii) Depreciation per machine 300
(ix) Sundry supplies for factory 240
(x) Each machine consumes 10 units of power in an hour..

Calculate Machine Hour Rate if a machine runs for, 200 hours in a year.
[B. Com. (Pass) Delhi, 1988] [Ans. Rs. 2.27]

6. Calculate the Machine Hour Rate from the following details:

1. Bought off machinery Rs. 45,000
2. Installation charges Rs. 5,000
3. Life of machine 5 years
4. Working hours per year 2,500
5. Repair charges 75% of depreciation
6. Electric power consumed;
10 units per hour @ 15 paise per unit
7. Lubricant oilRs. 4 per day of 8 hours
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8. Consumable stores @ Rs. 10 per day of 8 hours.

9. Wages of machine operator @ Rs. 8 per day of 8 hours.
[B. Com. (Pass) Delhi, 1984] [Ans. Rs. 11.25]

7. From the following information compute machine hour rate in respect of 'Skylark'
machine for the month of May 2005:
Cost of the machine Rs. 3,00,000
Expenses on installation and freight charges 25,000
Estimated scrap value at the end 25,000
Insurance charges allocated to the machine Rs. 480 p.m.
Effective working life of the machine 24,000 hours
Hours worked during the month 240 hours
Repairs during the effective life of the machine Rs. 24,000

Power consumed by the machine is 20 units per hour at a cost of 25 paise per unit.
Additional charges at 5 paise per unit are payable on the total units consumed if the same
exceeds the basic consumption of 2,000 units per mr.ith. [B. Com. (Pass) Delhi, 1986,
adapted]

8. The following particulars relate to a new machine :

Rs.
Purchase price 4,00,000
Installation expenses 1,00,000
Rent per-quarter 3,750
General lighting for the total area 1,000 per month
Foreman's salary 30,000 per annum
Insurance premium for the machine 3,000 per annum
Estimated repairs for the machine 5,000 per annum
Consumable stores 4,000 per annum
Power-2 units per hour at Rs. 50 per 100 units.

The estimated life of the machine is 10 years and scrap value at the end of 10th year is
Rs. 1,00,000. The machine is expected to run 20,000 hours in its lifetime. The machine
occupies 25% of total area. The foreman devotes l/6th his time for the machine.
Calculate machine hour rate for the machine. [B.Com. (Pass) Delhi, 1996]
[Ans. Rs. 32.87]

9. Compute the machine hour rate from the following data :

Cost of machine 1,00,000
Installation charges 10,000
Estimated scrap value after the expiry of its life (15 years) 5,000
Rent and rates for the shop per month 200
General lighting for the shop per month 300
Insurance premium for the machine per annum 960
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Repairs and maintenance expenses per annum 1,000

Power consumption—10 units per hour
Rate of power per 100 units 20
Estimated working hours per annum—2,200
This includes setting up time of 200 hrs.
Shop supervisor's salary per month 600
The machine occupies 1/4 of the total area of the shop. The supervisor is expected to
devote 1/5 of his time for supervising the machine.
[Ans. 7.95.]
[Hint. (i) Presume setting up time as unproductive time.
(ii) No current consumed during setting up.]

10. Calculate the machine-hour-rate from the following details provided by a Production
Department A-B-C Ltd.:
(1) Bought of machineryRs. 4,50,000
(2) Installation charges Rs. 50,000
(3) Life of machine 5 years
(4) Working hourse per year 2,500
(5) Repairs charges 75% of depreciation
(6) Electric power consumed : 10 units per hour @ Rs. 3
(7) Lubricating oil Rs. 40 per day of 8 hours.
(8) Consumable stores @ Rs. 80 per day of 8 hours.
(9) Wages of machine operator @ Rs. 200 per day of 8 hours.
[B.Com. (Pass), Delhi 2012]
[Ans. Rs.140]

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

127
 BLOCK-3

Overheads

The present block refers to the concepts of various costing like single, output, job,
contract and process. The learners with learn about the process and steps of
calculating the costs of a business organisation. Further, they will have the
opportunities to enquire the specific knowledge about the single, output and job
costing. The present block refers the following unit;
Unit 7: Single or Output Costing

Unit 8: Job Batch and Contract Costing

Unit 9: Process Costing

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UNIT-7 SINGLE OR OUTPUT COSTING

LEARNING OBJECTIVES

After studying this lesson you will be able to explain

 Meaning and definition of single or output costing
 Method of determining unit cost
 Specimen of cost sheet
 Treatment of scrap in cost sheet
 Items to be excluded from cost sheet.
 Meaning of production account
 Price quotation

STRUCTURE

7.1 Introduction
7.2 Method of determining unit cost
7.3 specimen of cost sheet
7.4 Treatment of scrup
7.5 Items to be excluded from cost sheet
7.6 Production account
7.7 Question

7.1 INTRODUCTION

Unit or output costing is used in those industries or organizations where standard

products are produced from a common process and all the units produced are more or less
similar to each other. This method is also known as single costing method. SINGLE
UNIT AND OUTPUT COSTING is a method of costing adopted where large number of
identical units are produced. It is a form of process costing under which costs are
accumulated and analysed under various elements of cost and the cost per unit is
ascertained by dividing the total cost by the number of units produced.

According to Walter co Bigg, “unit costing method is a method of costing applied to

ascertain the cost per unit or production where standard and identical products are
manufactured.

Characteristics of Single or Output Costing: The following are the characteristics

features of the industries where the single or output costing is used:
 Production consists of a single product or a few products.
 Large number/quantity of identical units are produced with identical costs.
 Production is more or less of standard quality.
 Production is performed on a continuous basis.
 Cost units are physical and natural e.g. number of bricks, tones of cement, metres
of cloth, litres of milk.
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Some examples of industries where unit costing is used are:

(i) Cement, (ii) Steel, (iii) Floor mills and (iv) Bricks-making etc

Characteristics of unit production:

The important characteristics of unit production are;
(i) Production should be unit form or homogenous.
(ii) There should be identical products.
(iii) The cost unit should be physical or natural.
 The per unit cost should be determined for example per ton per meter etc.

Objectives of unit or output costing: the important objectives of unit or output costing
are discussed here below.
 The know the total cost of production
 To classify cost under related categories such as prime cost, work cost,
administration cost etc
 To determine the effect of each elements of cost.
 To determine proposed selling price to earn desired profit.
 To determine tender price on the basis of cost data and future prospects elements
of cost under unit or output costing: the main elements of cost under unit or
output costing are
(i) Material , (ii) Labor, (iii) Direct expenses and (iv) Overheads.

7.2 METHODS OF DETERMING UNIT COST:

Following are important method of determining unit cost

(i) Cost sheet, (ii) Statement of cost and (iii) Production account

Let us discussed one by one

(i) Cost sheet: A cost sheet is a statement showing various components of total cost
of output of a particular product or service produced during a particular period. It
may be prepared on actual basis or estimated basis. The cost sheet may be
prepared at convenient intervals such as weekly, monthly or a longer period.

FEATURE OF COST SHEET

Cost sheet has the following features:

 It relates to a particular period.
 It relates to cost incurred during a particular period, e.g. week, month, quarter,
year etc.
 It may show total cost as well as per unit cost.
 Cost sheet may be based on actual data or estimated data.

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 Single or Output
Costing

CONTENTS OF COST SHEET

A cost sheet shows-
(a) Different components od total cost (say prime cost. Factory cost, cost of good
produced)
(b) Total cost
(c) Cost per unit
(d) Previous year’s figures or standard figures to facilitate comparison if the
management so desires.

PURPOSES OF COST SHEET:

The cost sheet serves the following purpose:
(i) It helps in ascertaining the total cost, the different components of total cost,
and cost per unit of output
(ii) Break-up of cost in various cost groups and sub-group is highlighted.
(iii) It helps in fixing selling prices of quotations.
(iv) It facilitates the comparison of actual costs with the standard costs, of actual
costs of our period with that of another period.

7.3 SPECIMEN OF COST SHEET

Particular Details Amount

Rs Rs
Opening stock of raw material Xxx
Add purchases of raw material Xxx
Add purchase expenses Xxx
Less closing stock of raw material Xxx
Value of raw material consumed Xxx
Add direct labour Xxx
Add direct expenses Xxx
Prime cost Xxx
Add factory overheads:
Factory rent Xxx
Factory power Xxx
Indirect material Xxx
Indirect labor Xxx
Supervision salary Xxx
Factory insurance Xxx
Factory asset depreciation etc xxx
Work cost incurred Xxx
Add opening work-in-progress Xxx
Less closing work-in-progress xxx
Work cost xxx
Add office & administration overhead:

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Office rent Xxx

Office asset depreciation Xxx
General charges Xxx
Audit fees Xxx
Bank charges Xxx
Legal charges Xxx
Other office expenses Xxx
Cost of production Xxx
Add: opening stock of finished goods Xxx
Less: closing stock of finished goods Xxx
Cost of production goods sold Xxx
Add selling and distribution over head:
Salesman commission Xxx
Salesman salary Xxx
Travelling expenses Xxx
Advertisement bad debts Xxx
Were housing charges Xxx
Delivery man expenses Xxx
Sales tax Xxx
Cost of sales Xxx
Profit/loss Xxx
Sales-selling price Xxx

7.4 TREATMENT OF SCRAP

Scrape is the incidental residue from certain types of manufacture. It is generally, it is

generally, of small amount and low value, recoverable without further processing. Such
realizable value of scrap is deducted from the factory overheads or the factory cost.

TREATMENT OF SPOLAGE AND DEFECTIVES: Spoilage consist of goods that do

not meet production standards. Such goods are either sold for their salvage value or
discarded without further processing. The cost of normal spoilage will be borne by good
units. The cost of abnormal spoilage is transferred to costing profit and loss account.
Goods that do not meet production standards and must be processed further in order to be
salable as good units are known as defectives. Cost of rectification of normal defectives
is charged to good units including those rectified. The entire cost of abnormal defectives
is charged to costing profit and loss account.

SALES TAX, EXCISE DUTY AND ROYALITY: Sales tax: sales tax is levied on sales.
The firm has to deposite this amount with sales tax authorities. It is deducted from sales
to arrive at net sales to be shown in cost sheet / statement of cost. Excise duty: excise
duty is levied on production. It is treated as a direct charge to production and is included

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 Single or Output
Costing

in prime cost. Royalty: it is payment for the right to manufacture a product or the use of a
process. If royalties are paid on production, it treated as a direct charge to production and
included in prime cost. If royalties are paid on the number of units sold, the amount is
charged to selling overheads.

7.5 ITEMS TO BE EXCLUDED FROM COST SHEET

While preparing cost sheet, some broad categories of expenses are not to be included as
they are purely financial items not forming part of cost of production. These are the
following:

(i) Purely financial charges: It includes the followings:

(i) loss on sale of investment, fixed assets, etc
(ii) fines and penalties.
(iii) Interest on debentures, bank loans, fixed deposit, mortgages, etc.
(iv) Obsolescence loss, i.e. loss due to scrapping of a machinery before the
expiry of its life.
(v) Damages payable through a court of law.

(ii) Purely financial incomes

(i) Interest receive on bank deposits, (ii) Transfer fee received, (iii) Discount,
commission received, (iv) Rent/Interest/Dividend receivable (v) Profit on sale of
investments, fixed assets etc. (vi) Damages received through a court of law.

(iii) Appropriation of profits

(i) Writing-off, goodwill, preliminary expenses, capital raising expenses,
discount on the issue of shares and debentures, (ii) Income tax, (iii) Dividend on
shares, (iv) Charitable donations, (v) Appropriation to sinking fund, (vi) Transfer
to reserves and (vii) Excess provision for depreciation due to change in method
of charging depreciation etc.

(iv) Abnormal gains and losses: It includes the following: (i) Abnormal losses of
materials and (ii) Abnormal idle time of labour.

Illustration 1 . Find out the cost of raw materials purchased from the data given below:
Prime cost = 2,00,000
Closing cost of raw material = 20,000
Direct labor cost = 1,00,000
Expenses on purchases = 10,000
[B.Com. (Delhi)]

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Solution
Prime cost – direct labor cost = Raw material consumed
Rs. 2,00,000 – Rs. 1,00,000 = Rs. 1,00,000
Raw material consumed = opening stock + purchases +
expenses on purchase- closing
stock
Rs,1,00,000 = Nil + purchase + 10,000-20,000
Rs. 1,00,000 – 10,000 +20,000 = purchase of material
Purchase of raw material = Rs. 1,10,000

Some of the important transaction which are included in the couscous

administration cost and selling and distribution cost are discussed below.

(A) Works overheads: includes the generally the following items.

(i) Indirect materials
(ii) Leave wages
(iii) Fuel and power
(iv) Insurance
(v) Supervision
(vi) Canteen expenses
(vii) Haulage
(viii) Depreciation
(ix) Gas and Water
(x) Drawing factory salary
(xi) Laboratory expenses
(xii) Works telephone expenses
(xiii) Internal transport expenses
(xiv) Technical director expenses
(xv) Works expenses
(xvi) Works salaries
(xvii) Repairs
(xviii) Works stationary
(xix) Factory lighting
(xx) Rent and taxes
(xxi) Overtime premium
(xxii) Indirect wages

(B) Office and administrative overheads includes generally the followingimportant

items.
(i) Office salaries
(ii) Office rent and rates
(iii) Sundry office expenses
(iv) Office journals
(v) Establishment expenses
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 Single or Output
Costing

(vi) Postage
(vii) Audit fees
(viii) Depreciation of office equipment
(ix) Legal charges
(x) Director travelling expenses
(xi) Office lighting
(xii) Stationary and printing

(C) Director fees.

Selling and distribution overheads generally includes the following important
item
(i) Advertising
(ii) Bud debts
(iii) Packing expenses
(iv) Commission
(v) Catalogues
(vi) Collection charges
(vii) Cost of tenders
(viii) Cost of literature
(ix) Sales director fees
(x) Sales office expenses
(xi) Expenses of sales branches
(xii) Depreciation of delivery vans
(xiii) Counting house salaries
(xiv) Carriage outward
(xv) Salesman’s salaries
(xvi) Showroom expense

Illustration 2. From the following information calculate (1) prime cost (2) factory
cost (3) cost production (4) total cost (5) profit:-
Rs
Stock of materials – opening 3,76,000
Stock of materials – closing 4,00,000
Materials purchased 16,64,000
Direct wages paid 4,76,800
Indirect wages 32,000
Salaries to administrative staff 80,000
Freight-inward 64,000
Freight outward 40,000
Sales 31,59,600
Cash discount 28,000
Bad debts 37,600
Repairs of palnt 84,800
Rent factory 24,000
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Cost and Management
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Rent office 12,800

Travelling expenses 24,800
Salesman’s salary 67,200
Depreciation of machinery 57,800
Depreciation of furniture 4,800
Directors fees 48,000
Factory electric expenses 96,000
Fuel for boiler 1,28,000
Sale of scrap 1,000
General charges 49,600
Manager salary 96,000

The managers time is shared between the factory and the office in the ratio of 20:80.
Solution:
COST SHEET
PARTICULAR Rs Rs Rs
Opening stock of materials 3,76,000
Add: purchases 16,64,000
Freight inwards 64,000
21,04,000
Less: closing stock of materials 4,00,000
(1) Value of materials 17,04,000
Add: direct wages 4,76,800
(2) Prime cost 21,80,800
Factory overheads-
Indirect wages 32,000
Repairs of plant 84,800
Factory rent 24,000
Depreciation of plant 57,800
Electricity 96,000
Fuel 1,28,000
Manager salary
(96,000 * 20/100) 19,200 4,41,800
Less: sale of scrap 1,000 4,40,800
(3) Factory cost 26,21,600
Add: administrative cost
Salary to staff 80,000
Office rent 12,800
Depreciation of furniture 4,800
Director’s fees 48,000
General charges 49,600
Managers salary 96000*80/100 76,800 2,72,000
28,93,600

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Costing

(4) Cost of production

Add: selling and distribution overheads- 40,000
Freight outwards 24,800
Travelling expenses 67,200
Salesman salaries 37,600
Bad debts

Cost of sales 1,69,600

Profit Sales 30,63,200
96,400
31,59,600

Production account: production account also presents cost details like the cost sheet
with the difference that it is in the form of larger account. Production account is prepared
in T-form under costing. It shows output of the product during a given period, its total
cost and per unit cost, with cost components and profit and loss. It is prepared to suit the
needs of the organization. It may contain information regarding total cost only, or per unit
cost also, or even details regarding units of output. It may be divided in two, three or four
parts – the first part gives prime cost, the second part gives cost of goods manufactured or
production cost, the third part shows gross profit, and fourth shows the net profit formal
of production account is given below:

Particulars Rs Particulars Rs
To opening stock of raw materials XXX By closing stock of raw materials XXX
To direct materials purchases XXX By net value of normal XXX
To direct labour XXX scrap of raw materials XXX
To direct expenses XXX By prime cost c/d XXX

To prime cost b/d XXX XXX

XXX By closing stock of work in
To opening stock of work-in- XXX progress XXX
progress By factory cost c/d XXX
To factory overheads XXX
XXX By cost of goods XXX
To factory cost b/d XXX Produced c/d XXX
To office overheads XXX
XXX By closing stock of finished goods XXX
XXX By cost of goods sold c/d XXX
To opening stock of finished XXX
goods XXX
To cost of goods produced XXX By sales XXX
XXX
To cost of goods sold b/d XXX XXX
To selling &distribution
overheads
to profit
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Cost and Management
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In brief when cost sheet is prepared in T-shap account, it is known as production account.
in this account of debit side it shows the various items of cost, while its credit side shows
the sales of finished goods. Opening stock is written on debit side and closing stock on
credit side. The balance shows profit or loss.

Illustration 3.: prepare separate production account of coal and coke from the following
information:
Wages paid for coal 5,80,000 Salaries 36,000
Coal for colliery 45,000 coal sold (including colliery)
Timber used in coal 64,000 1,12,000 8,84,000
Ropes used in coal 12,000 wages of coke 50,000
Stores used in coal 76,000 stores for coke 37,000
Royalties paid 42,000 salaries for coke 8,000
General charges 70,000 coke sold (43,500 tons) 5,40,000

Coal stock at the beginning is 7000 tons valued at Rs. 5 per ton and at the end 15,000
tons valued at the same rate. The stock of coke in the beginning and at the end was 2,000
tons and 500 tons respectively at the rate of Rs. 10/-. The total production of colliery was
1,85,000 Tons of coal and 42,000 tons of coke. 65,000 tons of coal being used for coke
making [B.Com (Delhi)].
Solution:
COAL PRODUCTION ACCOUNT
Particular Rs Particular Rs
Rs
To wages 5,80,000 By cost of production 9,25,000
To coal for colliery 45,000
To timber 64,000
To ropes 12,000
To stores 76,000
To royal cities 42,000
General charges 70,000
To salaries 36,000
9,25,000 9,25,000
To opening stock By sales 8,84,000
7,000*5 35,000 “Coke Production .
A/c @5/- 3,25,000
To cost of production 9,25,000 (65,000*5)
To profit 3,24,000 By closing stock
15,000*5 75,000
12,84,000 12,84,000

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 Single or Output
Costing

COKE PRODUCTION A/C

PERTICULAR RS PARTICULAR RS
To coal consumed
65,000*5 3,25,000 By cost of production 4,20,000
To wages 50,000 42,000 tons @
To stores 37,000 Rs 10
To salaries 8,000
4,20,000 4,20,000
To opening stock
2000*10 20,000 43,500 ton 5,40,000
The cost of production 4,20,000 By closing stock
500*10 5,000
To profit 1,05,000
5,45,000 5,45,000

Illustration 4: M works can produce 60,000 units per annum at 100% capacity. The
estimated cost of production areas under:
Direct material Rs 3 per unit
Direct labor Rs 2 per unit.
Indirect expenses-
Fixed Rs 3, 00,000 per annum.
Variable Rs 5 per unit.
Semi variable: Rs 100,000 per annum up to 50% capacity and an extra
Rs 20,000 for every 25% increase in capacity or part thereof.
If management wishes to get Rs 2, 00,000 profit for the year as production programmed.
What will be the average selling price per unit:
First 3 months 50% of capacity.
Remaining 9 months 80% of capacity. [C.A.]
SOLUTION:
PRODUCTION STATEMENT (43500 OUTPUT UNITS)
Particular Rs Rs
Direct materials 43,500 units @ Rs. 3 per unit 1,30,500
Direct Labour 43,500 units @ Rs. 2per unit 87,000
Prime cost 2,17,500
Indirect expenses :
Fixed 3,00,000
Variable 43,000 units @ Rs. 5/ 2,17,500
Semi-variable
For first 3 at 50% Capacity
1,00,000* 3/12 25,000
For 9 months at 80%capacity
1,40,000*9/12 1,05,000
Cost of
production 6,47,000
Profit 8,65,000
sales prices 2,00,000
per unit sale price: 10,65,000/43,5000 units = Rs. 24.5 10,65,000
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Notes: output = 43,500 units

1 3
3 months at 50% capacity = 60, 000    7500 units.
100 12
80 9
9 months at 80% capacity = 60, 000    36000 units
100 12
Total = 7500 + 36000 = 43500 units.

Illustration 5: Prepare production account from the following information:

(B.Com. Delhi)

Particular Kg Rs

stock on 1st January

raw materials 4,000 4,000
Finished 1,000 3,500
Factory stores _ 14,500
Purchases
Raw material 3,20,000 3,60,000
Factory stores 48,500
Sales
Finished 3,06,100 18,36,000
Factory scrap 16,340
Factory wages 3,57,300
Power 60,800
Depreciation of machinery
Salaries: 36,000
Factory 1,44,440
Office 74,440
Selling 83,000
Expenses
Direct 37,000
Office 36,400
Selling 36,000
Closing stock on 31st December:
Raw materials 2,400
Finished 900
Factory stores _ 11,100

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Costing

The stock of finished goods at the end is to be valued at factory cost:

Solution:
Production Statement

Particular Quantity Amount

(Kg) Rs
Opening stock of raw material 4,000 4,000
Add: purchases 3,20,000 3,60,000
3,24,000 3,64,000
Less: closing stock of raw material 2,400 2,700
Material consumed: 3,21,600 3,61,300
Factory wages 3,57,300
Direct expenses 37,000
Prime cost 7,55,600
Factory overhead:
Factory stores 51,900
power 60,800
Depreciation of machinery 36,000
Factory salaries 1,44,440
10,48,740
Less: factory scrap sold 15,600 16,340
Works cost 3,06,000 10,32,400
Office salaries 74,440
Office expenses 36,400
Cost of production 3,06,000 11,43,240
Add: opening stock of finished goods 1,000 3,500
3,07,000 11,46,740
Less: closing of finished goods 900 3,036
Cost of production goods 3,06,100 11,43,704
Add: salaries of selling deptt. 83,000
Selling expenses 36,000
Cost of sales 12,62,704
Profit 5,73,296
sales 3,06,100 18,36,000

WORKING NOTES:
(1) closing stock of raw materials:
Rs. 3, 60,000
 2400 kg  Rs.2700
Rs. 3,20,000
(2) closing stock of finished goods:
Rs. 10,32,400
 900 kg  Rs.3, 036
3,06.000

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(3) quantity of factory scrap:

quantity of finished goods sold 3,06,100
add: closing stock 900
3,07,000
less: opening stock 1,000
3.06.000
scrap sold 15,600
,materials consumed 3,21,600

(4) factory stores consumed

(14,500 + 48,500 – 11,100) = Rs 51,900.

Illustration 3: Mohan furnishes the following data relation to the manufacture of a

standard product:
Raw material Rs 30,000
Direct labor Rs 18,000
Machine hours works 1,800
Machine hour rate Rs 5
Administrative expensive 20% of works cost
Selling overheads Rs 0.50 per unit
Unit produces 34,200
Unit sold 32,000 @ Rs 4 per unit
Prepare cost sheet showing total cost and profit.
[Banglore B.Com.]
Solution:
Cost Sheet
Output 34,200 unit
Particulars Rs Rs
Direct materials 30,000 0.877
Direct labour 18,000 0.526
Prime cost 48,000 1.403
Production overhead (1800hrs @ Rs5/-) 9,000 0.263
Works cost 57,000 1.666
Administrative overheads
@20% on works 11,400 0.334
Cost of production 68,400 2.000
Less: closing stock:
2,200 units @ Rs 2/-
4,400
Selling overheads @ o.50 per unit 64,000 2.000
for 32,000
Cost of sales 16,000 0.500
Profit 80,000 2.500
Sales (32,000 units) 48,000 1.500
1,28,000 4.000
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 Single or Output
Costing

Illustration 4: The following data were obtained from the record of a manufacturing
concern:
Rs
Purchases of raw materials 1,20,000
Direct wages 1,00,000
Rent and rates 40,000
Carriage inward 2,000
Opening stock-
Raw materials 20,000
Finished goods 16,000
Closing stock-
Raw materials 22,000
Finished goods –
Work in progress-opening 4,800
Work in progress-closing 16,000
Cost of factory supervision 8,000
Sales of finished goods 3,00,000

Advertising @ 0.40 per ton sold. 64,000 tons of the commodities were produced.
Prepare cost sheet.
[Delhi B. Com.]
Solution:
Cost Sheet
Particular Per ton Total
Rs Rs
Opening stock raw material 20,000
Add: purchase 1,20,000
1,40,000
Less: closing stock 22,000
Material consumed 1,18,000
Direct wages 1,00,000
Prime cost 2,18,000
Factory overheads:
Rent and rates 40,000
Carriage inwards 2,000
Factory supervision 8,000 50,000
2,68,000
Add: opening work in progress 4,800
2,72,800
Less: closing work in progress 16,000
Cost of production 4.01 2,56,800
Add: opening finished goods 16,000
2,72,800
Less: closing finished goods
(4,000*4.0125) 32,100
Cost of goods sold 2,40,700
Selling overheads (4,000+64,000-8,000)
=60,000 ton @ 0.40 0.40 24,000
Cost of sales 4.41 2,64,700
Profit 0.59 35,300
5.00 3,00,000

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ILLUSTRATION 5: Usha Co. manufactured and sold 2,000 machines in 2015.

Following are the details of cost [B.Com. Bangalore]
Rs
Cost of materials 1,60,000
Wages paid 2,40,000
Manufacturing expenses 1,00,000
Salaries of staff 1,20,000
Rent and rates 20,000
Selling expenses 60,000
General expenses 40,000
Sales. 8,00,000

The company plans to manufacture 2400 machines in 2016. Prepare a statement in which
the company will show a profit of 10% on selling price.

Additional Information:
(1) the price of materials will be rise by 20%
(2) wages rate will rise by 5%
(3) manufacturing expenses per unit will rise in proportion to the combined cost of
material and wages
(4) selling expenses per unit will remain unchanged.
(5) Other expenses will remain unaffected by the rise in output.

Solution:
Statement of Cost
Output 2,400units

Particulars Rs Rs
Materials (80+20%) = 96 2,30,400 96.00
Direct wages (120+5%) = 126 3,02,400 126.00
Prime cost 5,32,800 222.00
Manufacturing expenses 1,33,200 55.50
Work cost 6,66,000 277.50
Administrative expenses
Rent and rate 20,000 8.33
Staff salaries 1,20,000 50.00
General expenses 40,000 16.67
8,46,000 352.50
Selling expenses 72,000 30.00
Cost of sales 9,18,000 382.50
Profit – 10% on selling price {10/90} 1,02,000 42.50
Selling price 10,20,000 425.00

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 Single or Output
Costing

ILLUSTRATION 6: The following particulars are available of a factory:

Rs
Cost of materials 12,00,000
Wages 10,00,000
Factory expenses 6,00,000
Administrative expenses 6,72,000
Selling expenses 4,48,000
Distribution expenses 2,80,000
Profit 8,40,000

A work order has been received and the estimated expenses are as under-
Materials 16,000 wages Rs 10,000.
Assuming that the rate of factory expenses has gone up by 20%, distribution charges have
gone down by 10% and selling and administration charges have gone each up by 15%. At
what price should the product be sold as to earn the same rate of profit as before. Factory
expenses are based on wages, and administrative, selling and distribution expenses
are based on factory cost.
[Banglore B.Com.]
Solution:
COST SHEET
Particular Rs
Direct materials 12,00,000
Wages 10,00,000
Prime cost 22,00,000
Factory expenses: 60% of wages 6,00,000
Factory cost 28,00,000
Administrative expenses 24% of factory cost 6,72,000
Cost of production 34,72,000
Selling expenses (16% of factory cost) 4,48,000
Distribution expenses (10% of factory cost) 2,80,000
Cost of sales 42,00,000
Profit 20% on total cost 8,40,000
sales 50,40,000

COST OF WORK ORDER

PERTICULAR RS
Materials 16,000 16,000
Wages 10,000
Prime cost 26,000
Factory expenses (60% of Wages increased
By 20% i.e. 72%) 7,200
Factory cost 33,200
Administrative expenses:
(24% of factory cost increased by
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Cost and Management
Accounting

15% i.e. 27.6%) 9,162

Cost of production 42,362
Selling expenses (16% of factory cost
Increased by 15% i.e. 18.4%) 6,108
48,470
Distribution expenses-
(10% of factory cost decreased by
10% i.e. 9%) 2,988
Cost of sales 51,458
Profit 20% on cost of sales 10,292
Quotation price 61,750

7.8 QUESTIONS

1. What do you mean by single unit or output costing

2. Explain briefly in which in district unit costing technique are applied.
3. What is a cost sheet? In what respect does it differ from a worming of production
account
4. Calculate the tender price of 1,400 sewing machine from the following information:
Raw material for one machine Rs. 120
Direct wages for one machine Rs. 130
Factory overheads 30% on direct wages
Administrative overheads 10% on work cost
Selling expenses Rs. 5 per machine
Profit 25% on cost of sales
(B.Com. (pass) Delhi)
Ans. Rs 5,65,075.
5. Total production in 1992: 5,000 tonnes
Rs
Cost of raw materials 20,00,000
Carriage inwards 2,00,000
Direct wages 20,00,000
Indirect wages (in factory) 1,00,000
Office expenses 10,00,000
Public relation expenses 50,000
Expenses on testing lab 60,000
Selling overheads 10,00,000
Salary of managing director 50,000
Payment of income tax 3,00,000
Notes:
(i) A profit margin of 50% on cost is provided.
(ii) The government grants a special exports subsidy of Rs. 1,00,000 per ton.
Prepare a cost sheet showing the price to be quoted.

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 Single or Output
Costing

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

147
 UNIT-8 JOB BATCH AND CONTRACT COSTING

LEARNING OBJECTIVES

After studying this unit you should be able to understand

 Meaning of Job Costing
 Meaning of Batch costing
 Meaning of Contract Costing
 Main Aspect of Contract Costing
 Treatment of Profit and Loss on Contract Costing

STRUCTURE

8.1 Introduction
8.2 Meaning of Job Costing
8.3 Meaning of Batch Costing
8.4 Meaning of Contract Costing
8.5 Main aspect of contract costing
8.6 Treatment of Profit and Loss on Contract Costing
8.7 Questions

8.1 MEANING OF JOB COSTING

The job cost record will report the direct materials and direct labour actually used plus
the manufacturing overhead assigned to each job. An example of an industry where job
order costing is used is the building construction industry. Job costing involves the
accumulation of th3e cost of material, labour and overhead for a specific job. This
approaches is an excellent techniques for tracing specific costs to individual jobs and also
examining them to see if the costs can be reduced in later job. It is applied where each job
may be different from the next and consumers different resources.

Steps in Job costing: Some of the important steps in job costing are discussed below
(i) Identify the job that is chosen cost object.
(ii) Identity the direct cost of the job i.e. direct material and direct labour.
(iii) Select the cost allocation base to use for allocating indirect costs to the job.
(iv) Match indirect cost to their respective cost allocation best.
(v) Calculate an overhead allocation rate by applies the following formula.
- Budgeted overhead costs
- Budgeted overhead allocation base.
- Actual overhead cost
- Actual overhead allocation base.
(vi) Allocate overhead costs to the job overhead allocation rate  Actual base activity
for the job.
(vii) Compute total job costs by adding all direct and indirect costs together.

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 Job Batch and
Contract Costing

Features of Job Costing :

The main features of Job costing are ;
 Each job is treated as a cost unit.
 All costs are accumulated and ascertained for each job.
 Each job is unique. Each job is assigned a specific job order number.
 Each job is executed as per customer's specification.
 Jobs are generally costed after the completion of jobs.
 Estimated job cost sheet can be prepared for submitting tenders for each jobs.

Applicability of Job Costing

Job costing is used by organisations whose products or services can readily, identified by
individual units or batches. Each receives varying inputs of indirect materials, direct
labour and factory overhead. Industries that use job order methods include construction,
printing, aircraft, furniture and machinery.

Non-manufacturing organisations that use job costing include auto repair, auditing,
consulting engagements, hospital cases, social welfare cases am research projects.

Objectives of Job Costing

The main objectives of costing are :

 It aims at computing the cost of each job and Profit or Loss execution of different
jobs.
 It facilitates estimation of cost of similar job to the undertaken future.

Advantages of Job Costing

 Use of materials, labour cost and overheads for different department and jobs can be
ascertained.
 Cost of each job is ascertained.
 Job cost sheets can be used to attain efficiency and estimate future
 It provides a basis for making comparison of cost of one job with that of the other.
 Profitability each job can be ascertained easily.

Illustration: 1 A factory uses job costing. The following data are obtained front the
books
Rs. Rs.
Direct materials 180,000 Selling and distributive 105,000
expenses
Direct wages 150,000 Administrative expenses 84,000
Profit 121,000 Factory overheads 90,000

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Cost and Management
Accounting

(1) Prepare a cost sheet.

(2) The factory receives an order and it is estimated that direct materials required
will be Rs. 240,000 and direct labour will cost Rs. 150,000.

If selling and distirbution overheads have gone up by 15%. The factory intends to earn
the - same rate of profits on sales. The factory recovers factory overhead on direct
wages and administrative and selling expenses on works cost. Find out the selling price
of the order received. (CA Inter)

Solution :
Production Statement
Direct Material 180,000
Direct Wages 150,000
Prime cost 330,000
Factory overheads 90,000
Works cost 420,000
Administrative overheads 84,000
Cost of Production 50,4000
Selling and Distributive expenses 105,000
Cost of sales 609000
Profit (given) 121,800
Sales price 7,30,800

Job Cost Sheet

Direct Material 240,000
Direct Wages 150,000
Prime cost 390,000
Factory overheads (60% of wages) 90,000
 90, 000  480,000
 100  60%  Works cost
 150, 000 
Administrative overheads : 20% of works cost 96,000
 84, 000 
 100  20%  Cost of Production 5,76,000
 42, 000 
Selling and distribution overheads 28.75% of work
13,8000
cost.
Total Cost 7,14,000
121800
Profit (1/5 of cost)  100  16.67% or1/ r of sales
730,800
or 1/5 of total cost 1,42,800
Sales price 8,56,800

150
 Job Batch and
Contract Costing

MEANING OF BATCH COSTING

A batch is a cost unit consisting a group of identical items. Batch costing applies, when
production consist of limited repetition work and a definite number of goods are
manufactured in each batch for sale to the customers. Batch costing is applied in the
production of toys, readymade garments, cars parts radios, watches and shoes etc.

Procedure : Each batch is given a batch number. In Batch cost card, direct materials,
direct labour and direct expenses are recorded, overheads are absorbed on the basis of
certain criterion. When batch is completed the total cost of the batch is divided by the
quantity produced and per unit cost is arrived at.
Illustration 2. A component of a machine is made entirely in cost centre. Material cost is
12 paisa per component and each component takes 10 minutes to produce. The machine
operator is paid Rs 1.44 per hour and the machine hour rate is Rs 3,00. the setting up of
the machine to produce the component takes 2 hours 20 minutes. Prepare a comparative
cost sheet showing the production cost of a batch of (i) 10 components (ii) 100
components and (iii) 1000 components. (CA Inter).
Solution :
Comparative cost sheet
Component
Batch sizes of components
Units 10 100 1000

Setting up cost :
Labour 2 hours 20 minutes
Rs.
at Rs 1.44 per hour 3.36
overheads 2 hours 20 minutes at
Rs 3.00 per machine 10.36 10.36 10.36
hour: 7.00
Production cost : 1.20 12.00 120.00
Materials @ 12 paise per component 2.40  
wages @ Rs. 1.44 per hours :
  
For 10 components 1 hour 40 minutes
 24.00 
For 100 components, 16 hrs 40 minutes
240.00
For 1000 components, 166 hrs 40 minutes,
overheads : @ Rs. 3.00 per
Machine hour
For 10 components : 1 hrs 40 minutes 15.00  
For 100 components : 16 hrs 40 minutes 50.00
For 1000 components : 166 hrs 40 minutes   500.00
Total cost 18.96 96.36 870.36
Cost per units 1.88 0.96 0.8703

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Economic Batch quality [EBQ]: In the industries, setting up cost is a fixed nature,
which remains unchanged with the increase or decrease in the batch size. Thus if the
number of units in a batch is larger, the setting up cost per unit will be lower. Hence in
the industries, the optimum quantity in a batch is determined, at which cost per unit may
be minimum. This is known as Economic Batch Quantity. While determining economic
batch Quantity, the following two types of costs are to be considered. Such as (i) Setting
up cost and (ii) Carrying cost

(i) Setting up cost: It is the cost of setting the machine and tools used for production.
This is of a fixed nature. When the size of the batch increase, setting up cost per article
becomes lower.

(ii) carrying cost: It includes the cost of storage, interest on capital etc. When the size
any batch is larger the carrying cost will also be higher and vice-versa.

Main consideration:

In determining the economic batch quantity, the main consideration are as under: (i) -
Cost and time taken in setting up
(i) Cost and time taken in manufacturing
(ii) Cost of storage
(iii) Rate of consumption
(iv) Interest on capital invested Formula:
Formula :
2AS
EBQ =
C
Where : EBQ = Economic Batch Quantity
A = No. of units to be produced
S = Set up costs per batch
C = carrying cost per unit

Illustration 3 : A manufacturer has to supply 10,000 unit per day to a mill. He finds that
when he starts production he can produce 50,000 units per day. The cost of holding on
unit in stock for one year is 4 paisa and the setting up cost of production run is Rs 36.
How frequently should production runs be made ? [I C. W.A Inter]
Solution :
2AS
EBQ =
C
A = 10,000 x 365 days = 365,000
S = Setting up cost per unit = Rs 36
C = Carrying cost per unit = 0.04
2AS
Thus EBQ =
C

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 Job Batch and
Contract Costing

2  36,5000  36
 = 81,056 units
0.04
81, 056
Frequency of production =  8days
20, 000 units per day

Illustration 4: The following direct costs were incurred on a job of standard Ratio
company :
Materials Rs. 12,020
Wages :
Deptt X : 120 hrs @ Rs 30 per hour
Y : 80 hours @ RS. 20 per hour
Z : 40 hours @ RS. 50 per hour

Overhead costs:
Variable overheads
Deptt. X : Rs. 30,000 for 3,000 labour hours.
Y : Rs. 8,000 for 400 labour hours.
Z : Rs. 24,000 for 600 labour hours.

Fixed overheads:
Rs. 80,000 for 4000 normal working hours,
Charge profit 25% on selling price.

Calculate the cost of job.

Solution :
Job cost sheet
Rs. Rs.
Direct materials 12,020
Wages-Deptt. X 120 hrs X Rs 30 3,600
Y80hrsXRs20 1,600
Z 40hrsXRs50 2,000
Overheads variables : 7,200
X 120 hrs @ Rs 10 1,200
Y 80 hrs @ Rs 20 1,600
Z 40 hrs @ Rs 40 1,600 4,400
Fixed overheads 240 hrs @ B 20 per hrs. 4,800
28,400
Profit 25% on sales or 1/3 of total cost 9,473
Selling price. 37,893
Rs.80, 000
Working Notes : Fixed overheads :  Rs.20 per hour
4000 hrs
Total hours Worked : 120 + 80 + 40 = 240 hours.
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Cost and Management
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Meaning of Contract Costing

Contract costing is that methods of costing in cost according which is used to collect and
identity all the expenses relating to a specific contract. For this purpose, a contractor has
to maintain contract ledger in which he has a show contract account. Every clause in a
contract, regardless of whether if applies to economic or non-economic issues, can have
cost implications. However, the importance of contract costing depends on the share of a
company's total costs on labour. Therefore, contract costing is a special type of job
costing where the unit of cost is a single contract. According to ICMA terminology,
contract costing is that term of specific order costing which applies where work is
undertakes to customer's special requirements and each order is of long duration. The
work is usually of construction nature. Contract costing is also known as terminal
costing

Basic Features of Contract Costing :

(i) Each contract is treated as cost unit.
(ii) Costs are accumulated for each contract, which is regarded as a separate activity
for cost determination and control,
(iii) A separate Contract Account is prepared for each contract and is assigned a
certain number by which the contract is identified,
(iv) In contract costing, most of the expenses incurred are of the nature of direct
expenses,
(v) Indirect expenses usually constitute a small portion of the total cost of the
contract.
(vi) All direct cost, i.e., cost of materials, cost of labour, cost of special plant and
equipment and architects' fee etc. are debited to contract account.
(vii) Contract Account is credited with amount of work certified and uncertified.
(viii) The different between debit and credit side of Contract Account shows notional
Profit or Loss.

Contract Costing is frequently used by companies engaged in building constructions, civil

engineering works, shipbuilding, and similar activities.

Main aspect of contract costing

Some of the important aspect of contract costing are discussed here below:
(1) Material: It includes the following items.
Cost of material – It includes material purchased for the contract and materials issued
from stores. The cost of both these materials is derived to the contract account.
(2) Material returned to store: Materials which are returned back to store are credited to
contract account.

Materials at site: When any material is lying unused at site, that material will be credited
to contract account.
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 Job Batch and
Contract Costing

(3) Labour: All wages of workers engaged on a contract are charged to the contract
account.

Plant and Machinery : Following methods are often used for charging the contract for
use of Plant and Machinery.
 If machinery is used at contract site for along period of time, the particular
contract may be debited with the value of plant (original cost or written down
value) at the beginning and credited with the depreciated value at the end of the
accounting period. If plant and machinery is returned to head office before the
accounting period, the depreciated value of plant and machinery on that
particular date is credited to contract account.
 Total depreciation during a period is calculated for each plant and concerned
contract account is debited with depreciation of plant and machinery.
 When plant is sent to contract for short period contract account is debited by the
account of depreciation.
 When a plant is hired for a contract, the hire charges are debited to contract
Account.

(iv) Indirect expenses: When a contractor has a number of contract-in-process, he

may have a common office and common supervision staff for all contract. The
expenses of the office and the salaries of such staff will be considered as indirect
expenses. This cost will be apportioned among different contract.

(v) Work Certified: It is that part of work-in-progress which has been approved or
certified or authenticated and valued by the experts called certifier known as
work certified. It is a part of work actually done and it is generally value at a
contract price.

(vi) Work uncertified: The work done but not certified by the surveyor or Architect
is termed as work uncertified . It is valued at cost and credited to contract account
and debited to work-in-progress account. Both work certified and uncertified are
a part of work-in-progress and are credited to contract account.

(vii) Work-ion-progress: It includes the amount of work certified and the amount of
work uncertified. The work in progress account will appear on the asset side of
the Balance-sheet. The amount of cash received from the contractor and reserve
for contingencies will be deducted out of this amount.

Treatment of Profit and Loss on Contract Account

The accounting treatment of profit or loss of contracts on the following stages.

(a) Profit or loss on incomplete contracts.
(b) Profit or loss on completed contracts.

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Cost and Management
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(a) Profit or loss on incomplete contracts

To calculate the profits to be taken to profit and loss account, on the case of
incomplete contracts, the following situation may be arised.
(i) Completion of contract is less than 25% - In this case no profit should be
taken to profit and loss account.
(ii) Completion of contract is upto 25% or more but less than 50%. In this case
1/3 of the notional profit should be transferred to profit and less account. It
can be expressed as:
1 Cash received
 Notional Profit 
3 Work certified

(b) Completion of contract is upto 50% or more but less than 90% = In this case 2/3 rd of
the notional profit should be transformed to profit and loss account. It can be
expressed as
2 Cash received
 Notional Profit 
3 Work certified

(c) Completion of contract is upto 90% or more than 90% i.e. Near completion contract
When contract is near completion, then the estimated profit should be calculated on the
whole contract. The proportion of estimated profit to be transferred to Profit and Loss
Account is computed by any one of the following formulas:
Work certified
 Estimated profit 
Contract price
Work certified Cash received
 Estimated profit  
Contact price Work certified
Cost of work to date
 Estimated profit
Estimated total cost of work
Cost of work to date Cash received
 Estimated profit  
Estimated total cost of work Work certified

(d) Loss on Uncompleted contract : In the event of a loss on uncompleted contract. This
should be transferred in full to the profit and loss account.

Notional Profit: Notional profit is the difference between the value of work-in-progress
certified and the cost of work-in-progress certified. Notional profit = Value of work
certified + Cost of work not yet certified  Cost of work to date.

Estimated profit: It represents the excess of the contract price over the estimated total
cost of the contract. Estimated profit = contract price  total cost already incurred 
estimated additional costs to complete the contract.
 Retention Money: Fuller amount of work certified is never paid to the contractor.
contract may pay a fixed percentage of the work certified and it is known as cost
ratio. The balance amount which is not paid is known as Retention money. This
156
 Job Batch and
Contract Costing

retention money is treated as security money and may be utilised for any defective
work done or found during the contract work. The retention money may be adjusted
against any penalties imposed, if any contract is not completed within the stipulated
time.
 Extra Work:- Sometimes, the contractor is required to do some extra work is
addition to the work originally assigned to him. For such extra work the contractor
will charge extra money which will be credited in the contract account and whatever
cost of such extra work is made, it will the debited to contract account.
 Esclation De-Esclation class: This clause is generally provided in long term contract
with a view to protecting both the contractor and the contractee against fluctuations
in the price of inputs to the contract, mainly material and labour. The clause provides
for changes in the price of contract to cover jphanges in the price of raw materials
and labour. The contract price is revised in an agreed proportion to the changes in the
price of inputs.

Edelation clause aims at safeguarding the interest of the contractor against unexpected
rise in cost. On the other-hand dc-esclation clause provides for a decrease in the contract
price due to a decrease in the price of inputs so that the benefit of price decrease is passed
on the contractee.
 Cost plus Contract: These contracts provide for the payment by the contractee of
the actual cost of manufacturing plus a stipulated profit. The profit to be added to the
cost may be a fixed amount or it may be a stipulated percentage of cost.

Illustration 5: Vikram Constructions Ltd. have obtained a contract for construction of a

bridge. The value of the contract is Rs. 12 lakhs and the work commenced on 1st Jan.
2015. The following details are shown in their books for the year ended 31st December,
2015.

Plant purchased Rs. 60,000; Materials issued to site Rs. 3,36,000; Wages paid Rs.
3,40,000; Direct expenses Rs. 8,000; General overheads apportioned Rs. 32,000; Wages
accrued due as on 31.12.15 Rs. 2,800; Materials at site as on 31.12.2015, Rs. 4,000;
Direct expenses accrued as On 31.12. 2015 Rs. 1,200; Work not yet certified at cost Rs.
14,000; Cash received being 80% of work certified Rs. 6,00,000. Life of plant purchased
is 5 years and scrap value is nil. Prepare the contract account for .the year ended
31.12.2015 and show the amount of profit which you consider might be fairly taken on
the contract. Show complete calculations. (B,.Com, Delhi)

Contract Account for .the year ending 31st Dec., 2015

Materials issued 3,36,000 Work in progress at the end
Wages paid 3,40,000 : 7,50,000
Wages accrued 2,800 Work certified
Direct expenses 8,000 (60,00,000  100/80) 14,000
Direct expenses accrued 1;200 Work uncertified 4,000
Plant purchased 60,000 Materials at site at the end 45,000
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Cost and Management
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General overheads 32,000

Notional Profit c/d 36,000 Plant on hand at the end
8,16,000 8,16,000
Profit credited to P&L A/c 19,2000, 36,000
Reserve on WIP (36,000 - 16,800
19,200) 36,000 Notional Profit b/d 36,000

Working Notes:
Cash received 2
Profit to be taken = Notional Profit  
Work certified 3
6, 00, 000 2
 36, 000    Rs.19, 200
7,50, 000 3
Plant at site = Cost less depreciation = 60,000  20% of 60,000 = Rs. 48,000.

Illustration 6: Surya Construction Ltd. started business with a paid up capital of Rs. 50
lakhs. On 1st April, 2015, it undertook a contract to construct a building for Rs. 60 lakhs.
Cash received on account of the contract upto 31st March, 2015 was Rs. 18 lakhs (being
90% of work certified). Work uncertified as on 31st March, 2015 was estimated at
Rs.1,00,000. As on 31st March, 2015, the cost of materials at site was Rs.30,000 and
outstanding wages were Rs.5,000. Of the plant and machinery charged to the contract,
machinery costing Rs.2,00,000 was returned to stores on 31st March, 2015. Plant and
machinery charged to the contract is to be depreciated at 5%. The following were the
ledger balances as per the trial balance as on 31st March, 2015.

Rs.
Land and building 23,00,000
Plant and machinery (60% at site) 25,00,000
Furniture 60,000
Materials 14,00,000
Fuel and Power 1,25,000
Site expenses 5,000
Office expenses 12,000
Rates and taxes 15,000
Cash'at bank 1,33,000
Wages 2,50,000

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 Job Batch and
Contract Costing

Prepare Contract Account and Balance Sheet for the year ending 31st March, 2016
Contract Account for the year ended 31st March, 2016.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To Materials 14,00,000 By Materials at site 30,000
To Wages By Plant returned
2,50,000
Add : Outstanding 5,000 2,55,000 (2,00,000 - 5% of 2,00,000) 1,90,000
To Plant and Machinery at site By Plant at site
(60% of Rs. 25,00,000) 15,00,000 [(15,00,000 - 2,00,000)
To Fuel and Power 1,25,000 -5% of 13,00,000] 12,35,000
To Site expenses 5,000 By Work-in-progress

Work certified 10, 00, 000 

100 
To Office expenses' 12,000  20,00,000
 90 
To Rates & taxes 15,000 Work uncertified 1,00,000
To Notional Profit c/d 2,43,000
35,55,000 35,55,000

To Profit & Loss Account 72,900 By Notional Profit b/d 2,43,000

To Reserve (Balancing Figure) 1,70,100
2,43,000 2,43,000

Balance Sheet as on 31.3.2016.

Liabilities Amount Assets Amount
Share Capital 50,00,000 Land and Building 23,00,000
Wages Outstanding 5,000 Plant in store
Profit & Loss Account 72,900 (10,00,000 + 1,90,000) 11,90,000
Plant at site 12,35,000
Furniture 60,000
Materials at site 30,000
Cash at Bank 1,33,000
Work-in-Progress
Work certified 20,00,000
Work uncertified 1,00,000
21,00,000
Less : Cash received 18,00,000
3,00,000
Less : Reserve 1,70,100 1,29,900
50,77,900 50,77,900

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Accounting

Working Notes
(1) . Contract price = Rs. 60,00,000
Work certified = Rs. 20,00,000
20, 00, 000 1
Percentage of work certified to the contract price =  100  33 %
1
Since percentage of work certified to the contract price is 33 % , 3the profit to be
60, 00, 000
3
transferred to the Profit & Loss Account would be calculated as follows :
Cash Received
Notional Profit =
1 18,00,000
i.e. 2'43'000 Work

Certified
 Rs.72,900
3 20,00,000
Illustration 7: The following information is available to a building contract for Rs.
20,00,000 for two years. (Delhi, B.Com.)
I year II Year
Rs Rs.
Materials 6,00,000 1,68,000
Direct Wages 4,60,000 2,10,000
Direct expenses 44,000 20,000
Indirect expenses 12,000 2,800
Work certified 15,00,000 20,00,000
Work uncertified 1,600 —
Materials at site 1,000 14,000
Plant issued 28,000 4,000
Cash received 12,00,000 20,00,000

The value of plant at the end of the year was

Rs 14,000 and Rs. 10,000 respectively.
Prepare contract A/C and contract account for two year.
Solution :
Contract Account
Rs. Rs.
To Materials 6,00,000 By Work in Progress
To Direct Wages 4,60,000 Work certified 1500,000
To Direct expenses 44,000 Work uncertified 16,000
To Indirect expenses 12,000 15,16,000
To Depreciation on plant By Materials at site 10000
(28000-14000) 14,000
To Balance c/d. 2,96,000
15,26,000 15,26,000
To P/1A/C:- By Balance b/d
3,96,000
1200000
396000  2 = 2,11200
1500000
To Work in Progress A/c: (Reserve)
184800
396000 396000

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 Job Batch and
Contract Costing

Contracte's A/C
Rs.
Rs.
T Balance c/d 1200000 By Cost
1200,000
12,00,000
12,00,000
Contract Account
Rs. Rs.
To Work in progress :- By Contrect A/C 20,00,000
Certified 15,00,000 By Materials at site 14,000
uncertified 16,000
Less: Reserve 1,84,800 13,31,200
To Materials at site 10,000
To Materials issued 1,68,000
To Direct Wages 2,10,000
To Direct expenses 20,000
To Indirect expense 2,800
To Depreciation on plant 8,000
(28,000 + 4,000 - 14,000 - 10,000)
To P/LA/C 2,64,000
20,14,000 20,14,000

Contracted A/C
By Balanceb/d 12,00,000
To Contract 20,00,000 By Cash (Balance) 800,000
20,00,000 20,00,000

Illustration 8: The Balance sheet of Ashoka Company showed information : the

following
Rs. Rs.
Capital 2,00,000 Land & Building 60,000
Cash received 80% of Machinery (75% at site) 80,000
Work certified 2,40,000 Bank Materials at site 8,000
Direct Labour 80,000
Expenses at sites 1,10,000
Lories 4,000
Furniture 60,000
Office Equipment 2,000
Postage and telegraph 20,000
Office expenses 1,000
Rent and taxes 4,000
Fuel and power 6,000
5,000
4,40,000 4,40,000

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Cost and Management
Accounting

The contract price is Rs 6,00,000 and work certified was Rs. 30,000. the work uncertified
being Rs 2,000. Machinery costing Rs 4,000 was returned to store at the end of the year.
Stock of materials at site on 31st December was rs 10,000. Wages outstanding were Rs
400. Depreciate machinery at 10% Prepare contract Account and Balance sheet.
[Delhi B. Com. (Hons)]
Solution :
Contract Account
Rs. Rs.
To Materials 80,000 By Work in Progress 3,00,000
To Direct Wages 1,10,000 capital in 2,000
To expenses 4,000 certified
To Wages outstanding 400 10,000
To Fuel and power 5,000 By Materials at site 50,400
To Machinery 60,000 By Machinery at site 3,600
To Balance c/d 1,06,600 By Mac binary returned

3,66,000 3,66,000
To P/L A/C By Balance b/d 106,600
1,06,600x2/380% 56,854
To Reserve 49,746

1,06,600 1,06,600

Balance Sheet
Liabilities Rs. Assets Rs.
Work in progress 300,000
Certified 2000
Uncertified
Less : Cash
Received

Less : Reserve
302000
240000
62000
49746
12254
Illustration 9: A contract was commenced on 1st April. The following information is
available of a contract on 31st December:
Rs.
Material 5,16,200
Labour 11,21,000
Formen's Salary 15,86,000

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Contract Costing

Plant costing Rs. 5,20,000 had been on site for 146 days. The scrap value being Rs
30,000 and working life 7 years. A supervisor salary Rs 8,000 Plant and Machinery has
devoted 3/4 of his to this contract. The administrative expenses being Rs. 2,80,000.
Materials at site Rs. 50,500. Materials costing Rs. 9,000 was sold for Rs. 8,000 and a
plant costing Rs. 11,000 found unsuitable and was sold at a profit Rs. 2,000.

The contract price was RS 44,00,000 but is was accepted for Rs 40,00,000.2/3 of the
contract was completed and work certified was 50% of contract price and Rs 15,00,000
was received in cost.

Prepare contract Account and Balance sheet as on 31st Decemeber. [CA. Inter]
Solution:
Contract Account
Rs. Rs
.
To Materials Wages 5,16,200 By Materials at site 50,800
To Wages 11,21,000 By Materials sold 8,000
To Formens salary 1,58,600 By Loss on sale of 1,000
To Supervisor salary By materials Work in
3 54,000 progress
3 8,000  9
4
To Depreciation of Certified 20,00,000
plant 2,80,000
146 (Balance Amount) 5,24,500
(5, 20, 000  30, 000)t
7  365 incertified

To Ad. Expenses 2,80,000

To Balance c/d 4,26,500

25,84,300 25,84,300
To P/LA/C By Balance b/d 2,26,500
150000 2,13,250
426500  2 / 3 
2000000

To Reserve 2,13,250
4,26,500 4,26,500
Work uncertified:
Contract completed 2/3, work certified 50%
1
Work uncertified = 2/3   1/ 6
2

Total cost: 5,16,200 + 11,21,000 + 1,58,600 + 54,000 + 28,000 + 2,80,000

 (50,800 + 8,000 + 1,000) = 20,98,000
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2/3 of contract = 20,98,000

2
 Cost of complete contract; 20,98,000 = 31,47,700
3
Work uncertified : 31,47,000  1/6 = 5,24,500

Contractee Account
Rs. Rs.
To Balance 15,00,000 15,00,000
By Cash c/d

Balance Sheet
Liabilities Rs. Assets Rs.
Profit & Loss A/c Material at sit 50,800
Profit on contract 2,13,250 Plant at site 4,81,000
Add: Profit on Work in progress
Work certified
20,00,000

8,11,250
1000 work uncertified
Sale of plant
214,250 5,24,500
Less : Loss on 25,24,500
Add of 1000
Materials
213,250
Less Reserve
2,13,250
23,11,250
Less cash
15,00,000

Illustration 10: [B.Com., (Delhi)]

December, 2015 General plant in use :
Materials Written down value 1,00,000
Direct purchases 50,000 Depreciation thereon 10,000
Issued from store 10,000 Direct expenses 3,500
Wages for labour 45,000 Materials on hand 1,000
Share of overhead 2,000 Salvage value of material lost 150

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 Job Batch and
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Materials lost by fire 500 Value of work certified 1,59,000

Wages accrued due 5,000 Cost of work uncertified 4,500
Direct expenses accrued due 500

The value of the contract is Rs. 2,15,000 and it is the practice of the contractee to retain
10% of work certified. From the above, prepare a Contract Account and show how the
various items would appear in the Balance Sheet.

Contract Account for the year ending 31st Dec., 2015

Particulars Rs. Particulars Rs.
Materials : Work certified 1,59,000
Direct purchases 50,000 Work uncertified 4,500
Issued from store 10,000 Materials on hand at the end 1,000
Wages 45,000 Plant on hand at the end 90,000
Wages accrued due 5,000 (1,00,000 - 10,000)
Direct expenses 3,500 Costing P & L A/c : 500
Expenses accrued due 500 (Loss of materials)
Share of overheads 2,000
Plant 1,00,000
Notional profit c/d 39,000 • - .. -.
2,55,000 . 2,55,000
Profit credited to P & L A/c
 3 90  23,400 Notional profit b/d . 39,000
 39,000   
 3 100 
Reserve on work-in-progress
(39,000-23,400) 15,600
39,000 39,000

Balance Sheet (extract) as on 31st Dec., 2015

Liabilities Rs. Assets Rs.
Reserve and Surplus : Fixed Assets :
Profit on contract Plant
1,00,000
23,400 Less : Depreciation 90,000
10,000
Less : Loss by fire 23,050 Current Assets :
(Rss.500150) 350 Materials on hand 1,000
Work-in-progress :
Current Liabilities Work certified
5,000
Wages accrue, Work uncertified 1,59,000
500
Direct expenses accrued 4,500
1,63,500

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Illustration 11 : X contractor has undertaken the following two contracts on 1st

January 2015:
Contract A Rs. Contract B Rs.
Material 1,70,698 1,46,534
Labour 1,48,750 1,37,046
Plant 30,000 25,000
Direct Expenses 6,334 5,718
Establishment charges 8,252 7,704
Materials returned to stores 1,098 1,264
Work certified 3,90,000 2,90,000
Uncertified work 9,000 6,000
Closing materials 3,766 3,472
Wages accrued 4,800 4,200
Direct Expenses accrued 480 360
Closing plant 22,000 19,000
contract price 5,00,000 4,00,000
Cash Received 3,60,000 2,80,000
Prepare Accounts.
Solution :
Contract Account

Rs.
A B A B
To Materials 1,70,698 1,46,534 By Materials 1,098 1,264
To Labour 1,48,750 1,37,046 By Materials in hand 3,472
3,766
To Plant 30,000 25,000 By Plant in 22,000 19,000
hand
To Direct expenses 6,334 5,718 work
certified
To Establishment exp. 8,252 7,704 Work 3,90,000 2,90,000
certified
To Wages accrued 4,800 4,200 By Balance loss
to

To Direct expenses
accured 480 360 P/L A/C — 6,826
To Balance c/d 56,550 —.
42,58,864 3,26,562 42,58,864 3,26,562
To P/L /A/C By Balance b/d 56,550 —
2 360000 34,800 —
56550  
3 395000

To Reserve 21,750
56,550 — 56,550

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 Job Batch and
Contract Costing

Contractee's Account
A B A• B

To Balance c/d 3,60,000 2,80,000 By Cash 36,000 2,80,00

0
3,60,000 2,80,000 By Balanceb/d 36,000 2,80,00
0

Balance Sheet as on 31st December 2015

Liabilities Rs. Assets Rs.
Wages Accrued 4,800 Plant less Depreciation
4,200 9,000 55,000 - 14,000 41,000
Materials on hand 7,238
840 Contract A
Work certified
3,90,000
27,974 Work uncertified
9,000 1,81,250

17,250

16,000
Direct expenses Accrued
480 + 360
Profit: Contract A : 34,800
Less: Loss of
Contract B 6,826
3,99,000
Less : Reserve
2,17,750

3,77,25
0
Less : Cash Received
3,60,000
Contract B :
Work certified:
2,90,000
Work uncertified
6,000

2,96,000
Less Cash Received
2,80,000

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Cost and Management
Accounting

Illustration 12: [B.Com. (Delhi)]

Rs.
Material sent to site 85,349
Labour 74,375
Plant 15,000
Direct expenses 3,167
Establishment charges 4,126
Material returned to store 549
Work certified J ,95,000
Work not certified 4,500
Material in hand at the end of the year 1,883
Wages Accrued 2,400
Direct Expenditure accrued 240
Value of plant at the end of the year 11,000
Contract price 2,50,000
Cash received 1,80,000

You are required to prepare :

(i) Contract A/c showing profit transferred to Profit & Loss A/c «tad
(ii) ContracteeA/c

Solution: Contract Account

Particulars Rs. Particulars " Rs.
To Materials sent to site 85,349 By Work-in-progress :
To Labour 74375 Work certified 1,95,000
Add : Accrued 2400 76,775 Work uncertified 4,500 1,99,500
To Plant 15,000 By Material return to store 549
To Direct Expenses 3167 By Material in hand at the end of 1,883
Add : Accrued 240 3407 the year
To Establishment Charges 4,126 By Plant at the end 11,000
To National Profit b/d 28,275
2,12,932 2,12,932
To Profit credited to Profit & By National Profit b/d 28,275
Loss A/c
 2 180000  17,400
 28275  3  195000 
 
To Reserve on fwork-in-progress
(28275 - 17400) 10,875
28,275 28,275

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 Job Batch and
Contract Costing

Contractee A/c
Particulars Rs. Particulars " Rs.
By Ban A/c 80,000
To Contractee A/c 195000 By Balance A/c 15000
195000 195000

Illustration 13: Two contracts, commenced on 1st January and 1st July, 2025
respectively, were undertaken by a contractor and their accounts on 31st December
2015 showed the following position:
Contract Contract
I II
Contract price 4,00,000 2,70,000
Expenditure: Materials 72,000 58,000
Wages paid 1,10,000 1,12,000
General charges 4,000 2,800
Plant installed 20,000 16,000
Materials on hand 4,000 4,000
Wages accrued Work 4,000 4,000
certified 2,00,000 1,60,000
Cash received in 1,50,000 1,20,000
Work uncertified 6,000 8,000

Additional Information: The plant was installed on the date of commencement of each
contract; depreciation thereon is to be taken at 10% per annum. Prepare the Contract
Accounts in the tabular form and ascertain the profit or loss to be taken to Profit & Loss
Account.

Solution
Contract Account
Particulars Contact Contact Particulars Contact Contact II
1 (Rs.) II (Rs.) 1 (Rs.) (Rs.)
Materials 72,000 58,000 Materials in hand 4,000 4,000
Wages. 1,10,000 1,12,00 Plant at site 18,000 15,200
Wages accrued 4,000 4,000 Work-in-progress
General charges 4,000 2,800 - Certified 2,00,000 1,60,000
Plant installed 20,000 16,000 - Uncertified 6,000 8,000
To National profit 18,000  By Loss transferred to
Profit & Loss A/c  5,600

By Notional Profit
2,28,000 .1,92,800 2,28,000 1,92,800

9,000 18,000
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Cost and Management
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9,000
18,000 18,000

Working notes:
- Contract II was undertaken on 01.07.15
- Depreciation has been charged for six months
- In Contract I, transfer to Profit & Loss Account is calculated as under:
2 1,50, 000
Rs.18, 000    Rs.9, 000
3 2, 00, 000

8.7 QUESTIONS

1. What is the difference between job costing and contract Costing Rs. Explain the
objectives and procedure of job costing system.
2. What do you understand by Batch Costing Rs. In which industries is applied ?
3. Explain briefly the distinguishing features of contract costing.
4. Write short notes on : (i) Escalation Clause, (ii) Cost Plus Contracts. (iii) Features of
Job Costing.
5. Mayur Engineering, engaged in job work, has completed all jobs in hand on 30th
December, 2006 except Job No. 447. The cost sheet on 30th December showed direct
materials and direct labour costs of Rs. 40,000 and Rs. 30,000 respectively as having
been incurred on Job No. 447.

The costs incurred by the business on 31st December, 2015, the last day of the accounting
year, were as follows:
Direct Materials (Job 447) Rs. 2,000
Direct Labour (Job 447) Rs. 8,000
Indirect Labour Rs. 2,000
Miscellaneous Factory Overheads Rs. 3,000

It is the practice of business to make the jobs absorb factory overheads on the basis of
120 per cent of direct labour cost.

Calculate the value of Work-in-progress of Job No. 447 on 31st December 2015.
[AnsRs.1,25,600]

6. From the following particulars relating to four jobs of a manufacturer, ascertain the
total cost each job :
Job Job Job Job
No. 1 No. 2 No: 3 No. 4
Direct Materials 800 1,000 1,200 1,400
Direct Wages 400 500 600 700
Direct Expenses 80 100 120 140
Works overhead is 45% on prime cost, and office overhead is 15% on works cost.
170
 Job Batch and
Contract Costing

(Calicut Univ., B. Com.)

[Ans. (1) Rs. 2,134.40; (2) Rs. 2,668; (3) Rs. 3,201.60; (4) Rs. 3,735.20.]

7. How much profit will be credited to profit and loss account in the following case :
Contract price Rs. 20,00,000
Cost incurred Rs. 1 1,20,000
Cost received (90% of work certified) Rs. 10,80,000
Work not certified Rs. 1 ,20,000
[IB. Com. Delhi] [Ans.Rs. 1,20,000]

8. The following expenditure was incurred for the contract on construction of the
building of 12,00,000 for the year ending 31-12-2011 :
Materials 2,40,000
Wages 3,28,000
Plant 40,000
Overheads 17,200

Cash received on account of the contract to 31 st Dec. 2011 was Rs. 4,80,000, being 80%
of the work certified. The value of materials in hand was ^ 20,000. The plant had
undergone 20% depreciation. Prepare Contract Account.[B.Com. (Pass), Delhi, 2012]
[Ans. Profit to P&L A/c Rs. 14,293; Work-in-Progress A/c Rs. 12,507]

9. Following amounts have been spent on a contract still unfinished on 31st December,
2006 :
Materials Rs. 80,000
Wages Rs. 70,000
Direct Charges Rs. 50,000

Rs. 2,00,000 have been received from the contractee being 80% of the work certified.
Calculate profit to be credited to Profit and Loss Account, uncertified work in progress
being Rs. 10,000. Total value of the Contract is Rs. 4,00,000.
[Ans. Profit to P.& L. A/c Rs. 32,000, Balance being Reserve Rs. 28,000.]

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.
171
 UNIT-9 PROCESS COSTING

LEARNING OBJECTIVES

After studying this unit you should be able to explain

 Meaning of process costing
 Procedure of process of costing
 Advantages of process costing
 Accounting for losses and gains in process costing

STRUCTURE

9.1 Introduction
9.2 Procedure of Process Costing
9.3 Accounting for Losses and Gains in Process costing
9.4 Process Losses and Wastages
9.5 Questions

9.1 INTRODUCTION

The method of cost accounting used by processing firms is called process costing system.
For each process function, product costs includes direct materials, direct labour and
factory overhead system. Process costing is a special branch of costing used by the
manufacturing industries; who are involved in converting the raw materials into the
finished product. Such work of conversion is done step by step. Each step is called as a
process. Process costing is a method of allocating manufacturing cost to products to
determine an average cost per unit. Process costing is a form of operation costing used
where production follows a series of sequential process. Under this method of costing all
costs are accumulated for each stage of production also called process of production) and
the cost per unit of product is ascertained at each stage of production by dividing the total
cost of each process by the normal output of that process.

Accordign to CIMA, London, process costing as "that form of operation costing which
applies where standardised goods are produced."

Features : The following are the most common features in the process costing systems:
 The production is continuous and homogeneous.
 The processes are standardised.
 The output of one process becomes the input of another process.
 The output of the last, process is transferred to Finished Stock Account.
 Costs are collected process-wise. Process cost centres are clearly defined and all
costs are accumulated by the cost centres.
 Cost per unit, is calculated at the end of period by dividing the total process cost
by the normal output produced.

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 Process Costing

Applicability : Process costing is used in those industries where manufacturing activity

is carried on continuously by means of two or more processes and the output of one
process becomes the input of the following process till completion. It is generally applied
in (a) Paper Industries, (b) Chemicals Industries, (c) Textiles Industries, (d) Sugar
Industries, (e) Crude oil Refineries and (f) Milk daires, etc.

Distinction between Job Costing and Process Costing

Job Costing Process Costing
 Job is performed to meet specific order.  Production is continuous.
 Each job is different from the other.  Product is homogeneous and
 Job a cost centre. standardised.
 Costs are collected and ascertained for  Each process is a separate cost centre.
each job separately.  Cost are collected and ascertained for
 Cost of job is determined on its each process separately.
completion.  Process cost are calculated at the end of
 There may or may not be work-in each period.
process.  There is always some work in process
 Higher degree of control is required jobs because of continuous production.
are different from each other.  Lower degree of control is required
 There are usually no transfers from one because of homogeneous products and
job to another unless there is some standardised process.
surplus work.  The output of one process is transferred
 There is no question of by products and to ar. other process as input.
Joint products.  Many time process costing involves
problems o by products and Join
products.

9.2 PROCEDURE OF PROCESS COSTING

The procedure of process costing are given below:

 The production is divided into a number of processes and an account is maintain

separately for each process.
 Each process account is debited with material, labour, overheads and other expenses.
 The output of one process is transferred to the next process in the sequence.
 Finished product of one process becomes the input of another process
 The finished output of last process is transferred to the finished goods accounts.

Advantages of Process Costing

Main advantages of Process costing are given below:

(i) Cost of individual processes as well as finished products can be ascertained at short
intervals.

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Cost and Management
Accounting

(ii) Effectiveness of each process is decided on the basis of cost incurred at individual
process.
(iii) Cost data are available process-wise for exercising managerial control.
(iv) Since output at each process is homogeneous average "cost per unit can be easily
computed.
(v) Make or buy decision for different processes can be taken in the light of costs at
different process.
(vi) Valuation of inventory of work-in-progress at different processes and finished
products in facilated by process accounts.
(vii) It helps the management in determining or fixing up price quotations. -

9.3 ACCOUNTING FOR LOSSES AND GAINS IN PROCESS

COSTING

Particulars Unit Amount (Rs.) Particulars Unit Amount

(Rs.)
To Unit XXX XXX By Normal loss XXX XXX
Introduced account (scrap value)
(Input)
To Material XXX By Abnormal loss XXX XXX
account
To Wages XXX By Unit transferred to XXX XXX
next process account
To Production XXX
overheads
To Other XXX
expenses
To Abnormal XXX XXX
gain account
XXX XXX XXX XXX

Illustration 1. A product passes through three distinct processes in completion. 100 units
are produced. The following information is available :
Process A Process B Process/C
Rs Rs Rs
Materials 13000 6,000 4,000
Labour 10,000 8,000 10,000
Direct expenses 3000 1400 2,000

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 Process Costing

The indirect expenses are Rs. 5,600 to be apportioned on the basis of labour
Prepare process accounts Solution:

Process A Account
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To Materials 13000 By Process B 28000
To Labour 10,000
To Direct expenses 3000
To Indirect expenses 2,000
28000 28000

Process B Account
Particulars Rs. Particulars Rs.
To Process A 2000 By Process C 59400
To Material 6,000
To Labour 8,000
To Direct expenses 1400
To Indirect expenses 16.,000
59400 59400

Process C Account
Particulars Rs. Particulars Rs.
To Process B 59400 By Finished stock 79400
To Materials 4,000
To Labour 10,000
;
To Direct expenses 2,000
To Indirect expenses 2,000

77,400 77,400

Finished Stock A/c

Particulars Rs. Particulars Rs.
To Process C 60,000

Note : Labour Ratio = 10,000 : 8,000 : 10,000 or 5 : 4 : 5

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Cost and Management
Accounting

9.4 PROCESS LOSSES AND WASTAGES

In most of the industries a certain amount of loss occurs at various stages of production.
This loss might be due to chemical reaction. Proper record is to be maintained of such
type of losses. This loss may be of two types as under:

(i) Normal loss and (ii) Abnormal loss

(i) Normal loss : When a loss cannot be avoided on account of the nature of
material or its process, it is known as normal loss e.g., Goods taken as sample or
evaporation of material etc.
(ii) Abnormal loss: This types of loss occurs on account of carelessness, use of
defective material, breakdown of machine etc.

ACCOUNTING TREATMENT OF LOSSES

(A) Normal loss: Normal loss is a part of cost of production. It is determined as a

percentage of input. Sometimes, this loss may be due to loss of weight etc. When such
loss is physically present in the form of scrap, it may have some value. Whenever
scrapped material has any values, the process account is credited by that amount

Illustration 2. The following information is available in respect of a Process X.

Material 200 kg C Rs 6 per kg
Labour Rs 10,000
Direct expenses Rs 2,000
Indirect expenses Rs. 4000
Normal wastage 10% of input

Scrap value Rs I/- per unit.

Prepare Process X Account.
Solution :
Process X Account
Particulars Kg Amount Particulars Kg Amount
(Rs.) (Rs.)
To Materials 2,000 12,000 By Normal loss
To Labour 10,000 10% 200 200
To Direct exp. 2,000 By Transfer to 18,00 27800
To indirect exp. 4000
2000 28,000 2000 28000

Proforma of Normal Loss Account

Particulars Unit Amount Particulars Unit Amount
( Rs.) (Rs.)
To Process Account XXX XXX By Sale proceeds XXX XXX
(@ Scrap Value) (Cash account)
By Abnormal Gain XXX XXX
(@ Scrap value)
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 Process Costing

XXX XXX XXX XXX

Abnormal loss account:

Abnormal loss is an avoidable loss which occurs due to abnormal reasons like sub
standard materials, carelessness of work. Machinery breakdown, unplanned operations
etc. Such losses are in excess of pre-determined normal losses. Such losses can not be
estimated in advance. Thus, abnormal losses arise when actual losses are more than
expected losses.

Accounting Treatment of Abnormal Loss

(a) The cost of abnormal loss is not treated as part of production.
(b) The cost of abnormal loss is not absorbed by the good units produced.
(c) It is charged (debited) 'to Costing Profit and loss Account.

Its value is credited to the concerned Process Account and debited to Costing Profit and
Loss Account.

Calculation of cost of Abnormal loss :

Cost of abnormal loss is calculated as follows :
Total Cost incurred - Scrap Value of Normal Loss
  Units of Abnormal Loss
Inpout  Normal Loss

Specimen of Abnormal Loss Account

Abnormal Loss Account

Particulars Units Amount Particulars Units Amount

(Rs. ) (Rs.)
To Process A/c XXX XXX By sales proceeding XXX XXX
By Costing P & L A/c XXX

XXX XXX XXX XXX

Illustration 2. The following data have been collected from the Ledger Accounts :
Input - Materials - 1000 tonnes Rs 150 per tonne
Wages Rs. 20,000
Overheads Rs. 10,000
Normal wastage @ 5% which can be sold at Rs. 5 per tonne. Actual production is 900
tonnes.
Compute the value of abnormal loss and show the relevant accounts.

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Cost and Management
Accounting

Solution. Abnormal Loss = Actual loss - Normal loss

= 100 - 50 = 50 tonnes.
Particulars Qty. Amount Particulars Qty. Amount
(Rs. ) (Rs. )
To Materials 1000 150,000 By Normal Loss 50 250
To Wages 20,000 By Abnormal Loss 50 9460
To Overhead 10,000 By Good Production
Transferred to Next
Process 900 170289
1000 180,000 1000 189,000

Calculation of Value of Abnormal Loss

Total Cost = Rs. 180,000
Less : Amount realised from normal loss 250
Value of normal units of 950 179,750
Rs.179, 750  50
So, Value of Abnormal Loss =  Rs.9460
950
Abnormal Loss Account
Particulars Amount Particulars Amount
(Rs. ) ( Rs. )
To Process A/c 4,197 By Scrap Sales Account (50 x Rs. 250
5) 4947
By Costing Profit & Loss A/c
4,197 4,197

Abnormal Gain or Effectiveness: Abnormal Gain arises when the actual loss is smaller
than estimated loss.
Abnormal Gain = Normal Loss  Actual Loss

Accounting Treatment of Abnormal Gain

The value of abnormal gain is calculated at the rate at which the effective output would
have been valued of normal wastage had taken place according to expectation.
Total Cost incurred - Scrap value of Normal Loss
  Units of Abnormal Gain
Input - Normal Loss
(i) Process Account is debited with the value of Abnormal Gain and Abnormal
Gain A/c is credited,
(ii) Debit 'Abnormal Gain account and credit 'Normal Loss account with the
units and realizable value of abnormal gains.
(iii) Close the 'Abnormal Gain Account by transferring its balance to the 'Costing
Profit & Loss Account'. It should be noted that :
 Cost of abnormal gains is not treated as recovery of cost of Production.
 Cost of good units is not reduced by the cost of abnormal gains.
 It is credited to Costing Profit & Loss Account.

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 Process Costing

Specimen of Abnormal Gain Account

Cr.
Particulars Units Amount Particulars Units Amount
(Rs. ) (Rs. )
To Normal Loss A/c -------- -------- By Process A/c ------- ------
To Costing P & L --------- --------
A/c
-------- -------- -------- --------

Illustration 3. The product of Company A passes through two processes A and B and
then to finished Stock Account. In each process 5% of the total weight is lost and 10% is
scrap which realises from process A Rs. 80 per tonne and Process B Rs. 200 per tonne
respectively.
The following are the figure relating to both the processes :
Process A Process
B
Materials (tonnes) 1,000 70
Cost of material per tonne ( Rs. ) 125
200
Wages ( Rs. ) 28,000 10,000
Expenses ( Rs. ) 8,000 5,250
Output (tonnes) 830 780

Prepare Process Accounts, Abnormal Loss Account and Abnormal Gain Account.
Solution.

Dr. Process A Account Cr.

Particulars Tonnes Amount Particulars Tonnes Amount
(Rs.) (Rs.)
To Materials 1,000 1,25,000 By Loss in Weight 50 -
To Wages 28,000 By Normal. Loss 100 8,000
To Expenses 8,000 By Abnormal Loss 20 3,600
By transfer to
1,000 1,61,000 Process 830
1,000 1,49,400
1,61,000
B@ Rs. 180 per
Working Notes : tonne
Rs.l,61,00  Rs.8,000
Cost of Abnormal Loss =  20
850
= Rs. 80 x 20 = Rs. 3,600

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Cost and Management
Accounting

Dr. Process B Account Cr.

Particulars Tonnes Amount Particulars Tonnes Amount
Rs. Rs.
To transfer from By Loss-in Weight 45 —
Process A 830 1,49,400 By Normal Loss 90 18,000
To Material 70 14,000 By -transfer to
To Wages 10,000 Finished Stock
To Expenses 5,250 @ Rs. 210 per tonne 780 1,63,800
To Abnormal Effectives ,
(GainA/c) 15 3,150
915 1,81,000 915 1,81,000

Working Notes:
Normal Gain
Value of Abnormal Gain =  Units of Abnormal Gain
650  Rs.18, 000
Rs.1, 78,Output
Normal
  15
 45  90
900650
Rs.1, 60,
  15  Rs.3,150
765
Dr. Abnormal Loss Account Cr.
Particulars Tonnes Amount Particulars Tonnes Amount
Rs. Rs.
To Process A 20 3,600 By Cash/ Bank A/c 20 1,600
By Costing 2,000
20 3,600 P&LA/c 20 3,600

Dr. Abnormal Gain Account Cr.

Particulars Tonnes Amount Particulars Tonnes Amount
Rs. Rs.
To Normal Loss 15 3000 By Process Bank 15 3150
To Costing Profit &
Loss Account (Gain) 150
15 3150 15 3150

Illustration 4: A product is completed in two process A and B. During a particularly

month, the input to process A of the basic raw-material was 5000 units at Rs. 2 per unit.
Other Information for the month is as follows:
Particulars Process A Process B
Output (Units) 4700 4300
Normal Loss (1% of input) 5 10
Scrap value per Unit ( Rs. ) 1 5
Direct wages ( Rs. ) 3000 5000
Direct expenses ( Rs. ) 9750 9910
Total overheads, Rs. 16,000 were recovered as percentage of direct wages. There were
no Opening or Closing Work-in-progress Stocks.

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 Process Costing

Prepare Process A and Process B Accounts.

Solution
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Units 5,000 10,000 By Normal Loss 250 250
To Direct Wages 3,000 (5% of 50,000@ Re.
1)
To Direct Expenses 9,750 By Abnormal Loss 50 300
.To Overheads (3/8 x 6,000 By Process B 4,700 28,200
16,000)
5,000 28,750 5,000 28,750

28, 750  250 28,500

Value of abnormal Loss =  50   50  Rs.300
5, 000  250 4, 750

Process B Account
Particulars Units Amount Particulars Units Amount
( Rs.) (Rs.)
To Process A 4,700 28,200 By Normal Loss 470 2,350
To Direct Wages 5,000 (10% of 4,700
To Direct Expanses 9,910 @Rs.5p.u.)
To overheads (5/8 x 16,000) 10,000 By Finished Stock 4,300 51,600
To Abnormal Gain 70 840
4,770 53,950 4,770 53,950

53,110  2,350 50, 760

Value of abnormal Gain =  70   70  Rs.840
4, 700  470 4, 230

Illustration 5. The output of Process X was 5,000 units. Normal loss allowed was 10%
of input. Abnormal loss was 400 units. The following further information is obtained :
Material @ Rs. 5 per unit
Labour Rs. 8,000
Overheads Rs. 6,700
Wastage realized Rs. 2.50 per unit
Prepare Process X account and Abnormal Loss account.
5
Solution. (a) Let the input be x units
Normal loss = 10% of input
10 x
 x  units
100 10
Abnormal loss = 400 units
Output = 5,000 units
Now Input = Output + Abnormal loss + Normal loss
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Cost and Management
Accounting

x
x = 5,000 + 400 +
10
x
x = 5,400 +
10
10 x= 54,000 + x
9x = 54,000
x = 6,000
Units introduced = 6,000
Process 'X' Account
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Materials 6,000 30,000 By Normal loss 600 1,500
@ Rs. 5 per unit @ Rs. 2.50 per unit
To Labour 8,000 By Abnormal loss 400 3,200
To overheads 6,700 By output 5,000 40,000
transferred
to process Y a/c:
@ Rs. 8 per unit
6,000 44,700 6,000 44,700
Working Notes:
Calculation of Normal Loss:
10  6000
Normal loss = 10% of 6,000 = = 600 Units.
100
Calculation of Value of abnormal loss
Total cost – Value of Normal Loss
=  Units of Abnormal Loss
 1500– Units of Normal Loss
Total Input
44700
  400  Rs.3200
600  600
Abnormal Loss Account
Particulars Units Amount Particulars Unit Amount
(Rs.) (Rs.)
To Process 400 3200 By Sale of Scrap @250 per unit 400 1000
A/c
By Costing Profit & Loss A/c - 2200
400 3200 400 3200

Illustration 6: In a factory, the product passes through two processes, A and B. Loss of
5% is allowed in Process A and 2% in Process B. Nothing being realized by disposal of
the wastage. During April, 2015, 10,000 units of material costing Rs, 6 each were
introduced in Process A. The other costs were as follows :
Process A Process B
Rs. Rs.
Materials - 6,140
Labour 10,000 6,000
Overheads 6,000 4,600
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 Process Costing

The output was 9,300 units from Process A. The output of Process B was 9,200 units,
8,000 units of the finished product were sold.
Prepare Process Accounts and Abnormal Loss/Gain Accounts.

Rs.
Raw materials 6,000
Direct wages 5,000
Factory overheads 2,400
Opening stock of finished goods 800 [200 kg]
Closing stock of finished goods [400 kg]
Sale of finished product 20,000 [3,000 kg]
Advertising and Selling expenses 1,475
Profit desired is 30% on sales.

Solution:
Process 'A' Account
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Units introduced - @ 10,000 60,000 By Normal Loss 500 -
Rs. 6 per unit By Abnormal Loss 200 1600
To Labour 10,000 By Transfer to 9,300 74,400
To Overheads 6,000 Process 'B' A/c
10,000 76,000 10,000 76,000

Process 'B' Account

Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Process 'A' A/c 9,300 74,400 By Normal loss 186 -
To Material 6,140 By transfer
To Labour 6,000 to finished
To Overhead Rs. 4,600 stock A/c 9,200 92,000
To Abnormal gain 86 860
9,386 92,000 9,386 92,000

Abnormal Loss Account

Particulars Amount Particular Amount
Rs.
To Process 'A' A/c 1,600 By Costing P and L A/c 1,600
(200 units)
1,600 1,600

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Abnormal Gain Account

Particulars Amount Particulars • Amount
Rs. Rs.
To Costing P &; L A/c 860 By Process ''B' A/c (86 Units) 860
860 860
Working Notes
1. Value of Abnormal Loss
Total cost  Value of Normal loss
  Units of Abnormal Loss
Input  Units of Normal Loss
75, 000  0
 200  Rs.1, 600
10, 000  500
2. Value of Abnormal gain
Total cost  Value of Normal Loss
  Units of Abnormal gain
Input  Units of Normal Loss
91,140  0
  86  Rs.860
9300  186

Illustration 7: A product passes through two distinct processes A and B and then to
finished stock. The output of A passes direct to B and that of B passes to finished
product. From the following information you are required to, prepare Process Account.
Process A (Rs.) Process B (Rs.)
Material consumed. 12,000 6,000
Direct Labour 14,000 8,000
Manufacturing Expenses 4,000 4,000
Input in Process A (Units) 10000 units
Input in Process A (Value) 10,000
Output (Units) 9400 units 8300 units
Normal wastage . 5% 1 0% _
.(percentage of input)
Value of normal wastage 8 10
(per 100 units)

No opening or closing stoc is held in process.

Process A Account
Particulars Units Rs. Particulars Units Rs.
To Input . 10,000 10,000 By Normal Wastage 500 40
To Material Consumers 12,000 By Abnormal Loss A/c 100 421
To Direct Labour 14,000 By Process B (Output 9,400 39,539
To Manufacturing 4000 transfer to next process)
Expenses
10,000 40,000 10,000 40,000
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 Process Costing

Process B Account
Particulars Units Rs. Particulars Units Rs.
To Process A Account 9,400 39,539 By Normal Wastage 940 94
To Material 6,000 By Abnormal Loss 160 1,086
To Direct Labour 8,000 By Finished Stock A/c 8,300 56,359
To Manufacturing 4,000 transfer to next process)
Expenses
9,400 57,539 9,400 57,539
Working Notes:
Rs.57539  Rs.94
Cost of Abnormal Loss =  160
9400  940

Illustration 8. D. Ltd. introduced 5,000 units in a process at a cost of Rs. 10,000. .'he
wages and overheads incurred are Rs. 10,000 and Rs. 8,000 respectively. It is expected
that 10% of the output is likely to be defective. Actual output of goods is 4,400 units. The
rectification of defective units costs Rs. 4 per unit. Calculate the cost per\unit and show
how will you deal with the cost of rectification of abnormal defective units.
Process Account
Units Amount Units Amount
(Rs.) (Rs.)
To Units introduced 5,000 10,000 By Abnormal Loss 100 600
To. Wages 10,000 By Finished Stock A/c
To Overheads 8,000 @ Rs. 6 4900 29,400
To Cost of Rectification — 2,000
(500 units @ Rs. 4)
5,000 30,000 5,000 30,000

Working Notes:
1 Rectification of normal defective units is an item of factory overheads. Hence 10% of
5,000 units, i.e., 500 units multiplied by Rs. 4, i.e., Rs. 2,000 has been added to the
cost.
2. Total Output = Actual output + Rectified units = 4,400 + 500 = 4,900 units
3. There is no normal loss
Normal Cost 30, 000
Cost per unit =   Rs.6
Normal Output 5, 000
Normal Cost = Total cost  Scrap Value of Normal Loss
= 30,000  0 = Rs. 30,000
Normal Output = Units introduced - Units of normal loss
= 5,000 - 0 = 5,000
4 Units of Abnormal loss = 5,000  4,900 = 100 units
Value of Abnormal Loss = Units of abnormal loss  Cost per unit
= 100  6 = Rs. 600
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Accounting

5 Cost of rectification of abnormal defective units is debited tp the Costing Profit & Loss
Account.

Illustration 9 : A product passes through two process A and B. The normal wastage for
each process is as follows:
Process A = 3 Percent and Process B = 5 percent
Wastage of process A was sold at 25 paise per unit and that of process B of 50 paise per
unit. 10,000 units were introduced in process A @ Re 1 per unit.
Other expenses were :
Process A Process B
Material 1000 1500
Labour 5000 8000
Direct expenses 1050 1188
Actual output 9500 9100
Prepare (1) Process Account (ii) Normal Loss A/c, (iii) Abnormal Loss
A/c and (iv) Abnormal Gain A/c
Process A account
Amount Amount
Particulars Units (Rs.) Particulars Units (Rs.)
To Units introduced 10,000 10,000 By Normal Loss A/c
(10,000 units @ Re.l (Normal wastage)
Per unit) (3% of 10,000)
To Material 1,000 Units sold at 300 75
To Labour 5,000 25 paise per unit)
To Direct Expenses 1,050 By Abnormal Loss A/c 200 350
(Abnormal wastage)
By Process B (Output
transferred) 9,500 46,625
10,000 17,050 10,000 17,050

Rs.17, 050  Rs.75

Note : Abnormal Loss =  200
10, 000  300
Process B Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.)
To Transfer from Process By Normal Loss A/c
A 9,500 16,625 (Normal wastage)
To Material 1,500 [5% of 9500 units sold 475 238
To Labour 8,000 at 50 paise per unit)
To Direct Expenses 1,188 By Finished Stock A/c 9,100 27,300
To Abnormal 75 225 (Output)
Effectiveness (Gain) A/c
9,575 27,538 9,575 27,538

Note : Calculation of Abnormal Effectiveness (Gain)

186
 Process Costing

Rs.27, 075
  75  Rs.225
9025
Abnormal Loss A/c
Amount Amount
Particulars Units (Rs.) Particulars Units (Rs.)
To Process A 200 350 By Sale wasted units :
Process A @ 25 paise 200 50
per unit
By costing profit 300
/ & loss A/c
200 350 200 350

Normal Loss Account

Amount Amount
Particulars Units (Rs.) Particulars Units (Rs.)
To Process A 300 75 By Sale Process of
Wasted Units
To Process b 475 238 A 300 75
B 400 200
By Abnormal Gain A/c 75 38
(Effectiveness)
775 313 775 313

Abnormal Gain Account

Amount Amount
Particulars Units (Rs.) Particulars Units (Rs.)
To Normal Loss A/c 75 38 By Process B 75 225
To Costing Profit & Loss 187
A/c
75 225 200 350

Illustration 10: The product XYZ of a company passes through three distinct processes
before completion. From the past experience it is ascertained that wastage is incurred in
each process as under:
Process A 2%; Process B 5%; Process C 10%.

The wastage of Processes A and B is sold at Rs. 10 per unit and that of Process C at Rs.
80 per 100 units. The following is the information regarding the production as on 31"
March 2015 :
Process A Process B Process C
Materials 12,000 8,000 4,000
Direct Labour 16,000 12,000 6,000
Machine Expenses 2,000 2,000 3,000
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Cost and Management
Accounting

Other factory expenses 3,500 3,800 4,200

20,000 units have been issued to Process A at a cost Rs. 20,000. The output of each
process has been as under:
Process A—19,500 units , B-18,800 units and C—16,000 units
There was no stock of work-in-progress in any process in the beginning and at the end of
31st March 2015. Prepare Process Accounts.
Sol. Process 'A' Account
Particulars Units Amount Particulars Units Amount
(Rs) ( Rs. )
To Input 20,000 20,000 By Normal Loss 400 4,000
To Materials 12,000 By Abnormal Loss 100 252
To Direct Labour 16,000 By Transfer to Process
To Machine Expenses 2,000 'B' Account @
To Other Factory Expenses .3,500 Rs. 2.52 per unit 19,500 49,248
20,000 53,500 20,000 53,500

Working Notes for Process 'A'

2  20, 000
 2% of 20,000 =  400
100
 400  Rs. 10 = Rs. 4,000
 Abnormal loss (in units) = Input – Output + Normal Loss)
o = 20,000  (19,500 + 400) = 100
Normal cost
 Value of Abnormal Loss =  Units of Abnormal Loss
Normal Output
Total Cost  Scrap Value of Normal Loss
  Units of Abnormal Loss
Input Units  Units of Normal Loss
53,500-4,000
  100 = Rs, 252 (app.)
20,000-400 5
49,248
 = Rs. 2.52(app.)
19,500
Process 'B' Account
Particulars Units Amount Particulars Units Amount
To Transfer from
Process 'A' Account 19,500 49,248 By Normal Loss 975 9,750
To Materials 8,000 By Transfer to Process
To Direct Labour 12,000 'C Account®
To Machine Expenses 2,000 Rs. 3~52 per unit 18,800 66,267
To Other Factory 3,800
Expenses
To Abnormal Gain 275 969 -
19,775 76,017 19,775 76,017

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 Process Costing

Working Notes for Process 'B'

5  19,500
 5% of 19,500 =  975
100
 975  Rs. 10= Rs. 9,750
 Abnormal Gain = (Output + Normal Loss)  Input = 18,800 + 975  19,500 = 275
units
Normal Cost
 Value of Abnormal Gain   Units of Abnormal Gain
Normal Output
Total Cost - Scrap Value of Normal Loss
  Units of Abnormal Gain
Input Units - Units of Normal Loss
(49, 248 + 8, 000 + 12, 000 +2,000 + 3, 800)  9,750
  275
19,500  975
75,048  9,750 65, 298
  275   275  Rs.959(app.)
18,525 18,525
66, 267
  Rs.3.52 (app.)
18,800
Process 'C' Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.)
To Transfer from
Process 'B' Account 18,800 66,267 By Normal Loss 1880 1504
To Materials 4,000 By Abnormal Loss 920 4,457
To Direct Labour 6,000 By Transfer to
finished
To Machine Expenses 3,000 Stock Account @
To Other Factory 4,200 Rs. 4.84 per unit 16,000 77,506
Expenses
18,800 83,467 18,800 83,467

Working Notes for Process 'C'

10  18,800
 10% of 18,800= = 1,880
100
 Sale value of\00xunits = Rs. 80
 80 
 Sale value of 1,880 units = Rs.   1,880   Rs.1,504
 100 
 Abnormal Loss (in units)
= Input  (Output + Normal Loss)
= 18,800-(16,000+ 1,880)
= 18,800 -17,880 = 920 units
 Value of Abnormal Loss

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Accounting

Normal Cost
=  Units of Abnormal Loss
Normal Output
Total Cost - Scrap Value of Normal Loss
=  Units of Abnormal Loss
input Units - Units of Normal Loss
83,467  1,504 81,963
=  9209   920
18,800-1,880 16,920
= Rs. 4,457 (app.)
77,506
  Rs.4.84 (app.)
16,000

Illustration 11. The output from Process A transferred to Process B was 2,500 units.
Normal Loss being 10% of input in Process A was 300 units. 200 units were reported to
be as abnormal loss. Material introduced @ Rs.5 per unit, labour cost Rs. 4,000 and
overheads Rs. 3,350 and normal loss realised Rs.2.50 per unit.

You are required to prepare: (i) Process Account A and (ii) Abnormal Loss Account
Solution: Input = Output + Normal Loss + Abnormal Loss
= 2,500 + 300 + 200 = 3,000 units '
OR
Normal Loss = 10% of input
= 300 units
300
Input = = 3,000 units
10%
Process 'A' Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.)
To Materials 3,000 By Normal Loss 300 750
@ 5 per unit 15,000 By Abnormal Loss 200 1600
To Labour Cost 4,000 By Transfer to Process 'B' 20,0003
To Overheads 3,350 Account 2,500
— — @Rs.8 per unit
3,000 22,350 3,000 22,350

WORKING NOTES FOR PROCESS'A'

 300  Rs. 2.50 = Rs. 700
Normal Cost
 Value of Abnormal Loss =  Units of Abnormal Loss
Normal Output
Total Cost - Scrap Value of Normal Loss
=  Units of Abnormal Loss
Input Units-Units of Normal Loss
22,350  750
=  200= Rs. 1,600
3,000  300

190
 Process Costing

20,000
  Rs.8
2,500

Abnormal Loss Account

Particulars Units Amount Particulars Units Amount
( Rs. ) ( Rs. )
To Process 'A' Account 200 1,600 By Sale of scrap @ 2.50 per ,
unit
By Costing Profit 200 500
& Loss A/c 1,100
200 1,600 200 1600

Illustration 12: 600 units were introduced in Process X at Rs. 20 per unit. 500 units
were completed and transferred to process Y. The normal process loss was 20% of the
input and the scrap is sold at Rs. 3 per unit. The labour and overhead expenditure
incurred in the process amounted to Rs.600. You are required to show the Process
Account, Normal Loss Account and Abnormal Gain Account.
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.) (Rs.) (Rs.)
To Units introduced 600 12,000 By .Normal loss 120, 360
By Transfer to process
To labour and overhead 'Y' Account @ Rs.
expenditure . 600 25.50
To Abnormal Gain 20 510 per unit 500 12,750 ,
620 13,110 620 13,110

Input in Process 'X'= 600 units

Normal loss = 20% of 600 = 120 units
Output = 500 units
Actual loss= Input  Output
= 600-500 = 100 units
Since, Normal loss is greater than actual loss, there is abnormal gain.
Abnormal Gain = Normal Loss  Actual Loss
= 120 -100 = 20 units
Normal Cost
Value of Abnormal Gain =  Units of Abnormal Gain
Normal Output
Total Cost - Scrap value of Normal Loss
  Units of Abnormal Gain
Units Introduced - Units of Normal Loss

12,000+ 600  360

=  20 = Rs. 510.
600  120
Normal Loss Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.) (Rs.) (Rs.)
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Cost and Management
Accounting

To Process 'X' Account 120 360 By Cash : Sale of .scrap 100 300
By Abnormal Gain 20 60
120 360 Account 120 360

Illustration 13. product passes through two processes A and B. Normal loss in process A
is 10% of the input and in process B it is 7.5% of the input. The scrap value in the process
A is 5 paisa per unit and in process B it is 10 paisa per unit. Other information is as
follows:
Process .
A B
Materials 5,000 2,500
Wages 5,000 3,000
Other expenses 2,500 1,073
l,000 units were introduced into process A at a cost of Rs. 5,000.
The outputs were : Process A — 8,400 units
Process B — 7,300 units
Prepare process cost accounts.
Solution: Process 'A' Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.) (Rs.) (Rs.)
To units introduced 10,000 5,000 By Normal loss 1,000 50
To Materials 5,000 (10% of 10,000)
To Wages 5,000 By Abnormal loss 600 1,200
To Other expenses 2,500 By Transfer to Process
'B' Account 8,400 16,800
@ Rs. 2 per unit
10,000 18,050 10,000 18,050

Working Notes for Process 'A'

Input = 10,000 units
Normal Loss = 1,000 units (10% of 10,000)
Output = 8,400 units.
Actual Loss = Input - Output
= 10,000 - 8,400
= 1,600 units
Since actual loss is greater than normal loss, there is abnormal loss,
Abnormal Loss = Actual Loss - Normal Loss
= 1,600 - 1,000 = 600 units
Normal Cost
Value of Abnormal Loss = x Units of Abnormal
Normal Output
Loss
Total Cost - Scrap value of Normal Loss
=  Units of Abnormal Loss
Units introduced - Units of Normal Loss
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 Process Costing

18,050  50
=  600
10,000  1,000
18,000
  600 = Rs. 1,200
9,000
Process 'B' Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.) (Rs.) (Rs.)
T6 Transfer from By Normal loss 630 63
Process 'A' Account 8,400 16,800 (7.5% of 8,400)
To Materials 2,500 By Abnormal loss 470 1,410
To Wages 3,000 By Transfer to Finished
To Other Expenses 1,073 Stock Account @ Rs. 7,300 21,900
3
per unit
8,400 23,373 8,400 ^23,373

Working Notes for Process 'B"

Input = 8,400 units
Normal Loss = 630 units (7.5% of 8,400)
Output = 7,300 units
Actual Loss = Input - output
= 8,400 - 7,300 = 1,100 units
Since actual loss is greater than normal loss, there is abnormal loss.
Abnormal Loss = Actual Loss  Normal Loss
= 1,100 - 630 = 470 units
Normal Cost
Value of Abnormal Loss =  Units of Abnormal
Normal Output
Loss
Total Cost - Scrap Value of Normal Loss
=  Units of Abnormal Loss
Units introduced - Units of Normal Loss
23373  63 23310
=  470   470  1410
8400  630 7770

Illustration 14: From the following information relating to Process A, prepare Process A
Account, Abnormal Gain Account and Normal Loss Account.
Units introduced 840
Cost per unit Rs. 40
Material Introduced Rs. 5,924
Direct wages Rs. 8,000
Overheads Rs. 8,000
Actual output 750 units
Normal loss 15% of input
Value of scrap Rs. 10 per unit.
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Cost and Management
Accounting

Solution: Units Introduced = 840

15
Normal Loss = 15% of 840 = 840  = 126 units
100
Actual Output = 750 units
Actual Loss = Units introduced  Actual Output
= 840 - 750 = 90 units
Since Actual Loss is less than Normal Loss, there is Abnormal Gain.
Abnormal Gain = Nromal Loss  Actual Loss
= 126 - 90 = 36 units

Process 'A' Account

Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.) (Rs.) (Rs.)
To Units introduced 840 33,600 By Normal Loss 126 1,260
(840 x 40) (12610)
By Transfer to Process
'B'
To Material added 5,924 Account@ Rs. 76 .
To Direct Wages 36 8,000 per unit 750 57,000
To Overheads 8,000
To Abnormal Gain 2,736
876 58,260 876 58,260

Normal Cost
 Value of Abnormal Gain =  Units of Abnormal Gain
Normal Output
Total Cost - Scrap Value of Normal Loss
=  Units of Abnormal Gain
Units introduced - Units of Normal Loss

(33, 600  5,924  8, 000  8, 000)  1, 260

=  36
840  126
55,524-1,260 54,264
=  36   36  Rs.2, 736 ..
714 714
Normal Loss Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.)
To Process 'A' Account 126 1,260 By Cash : Sale of Scrap 90 900
By Abnormal Gain 36 360
Account

194
 Process Costing

126 1,260 126 1,260

Since actual loss is only 90 units, only 90 units could be sold as scrap. Abnormal Gain
Account
Particulars Units Amt. Particulars Units Amt.

To Normal Loss 36 360 By Process 'A' Account 36 2,736

Account 2,376
To Account
Costing Profit & Loss
36 2,736 36 2,736

Illustration 15. The product of a manufacturing concern passes through two processes —
A and B. The normal losses and abnormal losses are defective units having a scrap value
of Rs. 2 and Rs. 5 per unit in processes A and B respectively. The following
information relates to the month ending 31-03-2010:
Process A Process B
Raw materials issued @ 3000 units -
Rs. 5 10% of input 5% of input
Normal loss 2800 units 2600 units
Output Rs.1,000 Rs. 780
Additional components Rs.4,000 Rs. 3,000
Direct wages Rs. 10,000 Rs. 14,000
Direct expenses 75% 125%
Production overheads
(as a percentage of direct
wages)

There was no opening or closing work in progress but opening and closing stocks of
finished goods were Rs. 20,000 and Rs.23,000 respectively. Prepare Process Accounts,
Finished Stock A/c, Normal Loss A/c, Abnormal Loss A/c and Abnormal Gain A/c.
Solution Process A Account
Particulars Units Ami. ( Rs. Particulars Units Amt. ( Rs.
) )
To Raw Materials 3000 15,000 By Normal Loss 300 600
To Additional 1,000 By transfer to Process B 2,800 33,600
Components 4,000 @ Rs. 12
To Direct Wages 10,000
To Direct Expenses 3,000
To Production 33,000
Overheads 1,200
100
3,100 34,200 3,100 34200
To Abnormal Gain
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Cost and Management
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Working note:
Rs.33, 000  600 Rs.32, 400
Cost per unit =   Rs.12
3000  300 units 2, 700 units
Process B Account
Particulars Units Amount Particulars Units Amount
(Rs.) (Rs.)
To Transfer from 2,800 33,600 By Normal Loss 140 700
Process A By Abnormal Loss @
To Additional Rs. 20.46* 60 1,228
Components 780 By transfer to Finished 2,600 53,202
To Direct Wages 3,000 Stock A/c
To Direct Expenses 14,000
To Production
Overheads 3,750
2,800 55,130 2,800 55,130

Working note:
Rs.55,130  700 Rs.54, 430
Cost per unit =   Rs.20.46
2800  140 units 2, 660 units
Finished Stock Account
Particulars Rs. Particulars Rs.
To Balance b/d 20,000 By Cost of Sales By 50,202
To Process B A/c 53,202 Balance b/d 23,000
73,202 73,202

Normal Loss Account

Particulars Units Amt. (Rs) Particulars Units Amt. (Rs)
To Process A A/c 300 600 By Cash 200 400
To Process B A/c 140 700 By Abnormal Gain 100 200
By Cash (B) 140 700
440 1,300 440 1,300

Abnormal Gain Account

Particulars Units Amt. (Rs) Particulars Units Amt. (Rs)
To Normal Loss A/c 100 200 By Process A A/c 100 1,200
To P & L A/c 1,000
100 1,200 100 1,200

Abnormal Loss Account

196
 Process Costing

Particulars Units Amt. (Rs) Particulars Units Amt. (Rs)

To Process B A/c 60 1228 By Cash A/c 60 300
By P&L A/c 928
60 1,228 60 1,228

9.5 QUESTIONS

1. Distinguish between :
(i) Normal loss and abnormal
(ii) Job Costing andProcess
(iii) Abnormal Loss & Abnormal
2. Explain normal wastage and abnormal wastage and state how they should be
dealt with in Process Cost Accounts.
3. Calculate the cost of each process and the total cost where production per month
was 480 radios :
Process A Process B Process C
Materials 750 250 100
Wages 400 1,000 300
Factory Overheads 130 360 125
Indirect costs 7 425 should be apportioned on the basis of wages.
[B.Com. (Pass) Delhi, 1982, 1983, 1984 adapted]
[Ans. Cost Process A 7 1,380. Process B 7 3,240, Process C 7 3,840]
4. In a factory, a product passes through two processes. A and B. During the month
of March 2012, certain number of units costing 7 10 per unit were introduced in
process A. The other costs were 7 2850. 855 units were completed and
transferred to process B at the end of the month and nothing was in process
Assuming that a normal loss of 10% of input is allowed in process A and realises
7 4 per unit; and assuming that there was no abnormal loss or gain in the process.
(i) State the number of units introduced in the beginning of the process, and
(ii) Complete Process^ Account, [B.Com. (Pass) Delhi]
[Ans. 950 units, Cost of output transferred 7 11,970]
5. Find out the number of units initially introduced in Process /when Normal
Wastage is 10%, 5% and 8% of the input respectively. There are 3,933 units of
Finished Stock. There was no Abnormal Loss of Effectives in any of the
processes. [B.Com. (Pass), Delhi, 1997]
[Ans. 5,000 units]
6. 600 kg of material was charged to process A @ Rs. 4 per kg. The direct labour
accounted for Rs. 200 and the other departmental expenses to Rs. 760. The
normal loss is 10% of input and the net production was 500 kg. Assuming that
the process scrap itself is saleable at Rs. 2 per kg, prepare Process A Account
clearly showing the value of normal and abnormal loss. Also prepare normal and
abnormal loss account. [B.Com. (Pass), Delhi, 2009]
197
Cost and Management
Accounting

[Ans. Normal Loss Rs. 120; Abnormal Loss Rs. 240]

Process I Process II
Rs. Rs.
Indirect Material 10.000 13,000
Direct Labour 10,000 13,100
Production overheads 20,000 10,000
% Normal Loss (of input) 5 5
Scrap Value per unit 5 5
Output (Units) 19.000 18,800
20,000 units costing Rs. 60,000 are introduced in Process I.
[B. Com. (P'ass), Delhi, 1997]
[Ans. Cost of Process I 19,000 units of Rs. 95,000; Cost of Process II 18,800
units of
Rs. 1,31,600 Cost of Abnormal Effectives 750 units of Rs. 5,250.]
8. The output from process X transferred to process Y was 2,500 units. Normal
Loss was 10% of input in process A"and was 200 units were reported to be as
abnormal loss. The other information is given below :
Materials introduced @ Rs. 5 per unit. Labour Cost Rs. 4,000 and Overheads
Rs. 3,350 and normal loss realised Rs. 2.50 per unit.
You are required to prepare :
(i) Process A' Account
(ii) Abnormal Loss Account.
[B. Com. (Pass) Delhi, 1986 & 1987, adapted]
[Ans. (i) 2,500 units of Rs. 20.000; (ii) Net Abnormal Loss Rs. 1,100].
9. The output of Process A" was 2,500 units. Normal loss allowed was 10% of
input. Abnormal loss was 200 units.
Material @ Rs. 5 per unit
Labour Rs. 4,000
Overheads Rs. 3,350
Wastage realised Rs. 2.50 per unit
You are required to prepare Process X Account and Abnormal Loss Account.
[B. Com. (Pass) Delhi, 1996]
[Ans. Cost of Process A Rs. 2,500 units of Rs. 20,000 Net Abnormal Loss Rs.
1,100]
10. 2,000 units costing Rs. 4 per unit were introduced to Process /. Labour Costs
and other expenses were Rs. 1,080 and Rs. 120 respectively. Its output was 1,900
units. The Normal Scrap was 10% of the input and had a realisable value of Re. 1
per unit.
Prepare Process / Account, Normal Loss Account and Abnormal Gain Account.
[B.Com. (Pass) Delhi, 1994]
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 Process Costing

[Ans. Cost of Process I 1,900 units of Rs. 9,500 Net Abnormal Gain Rs. 400]

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

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 BLOCK-4

Methods of Costing

The present block refers to the details concepts of operating as well as service
costing and reconciliation of cost and financial accounts. Further, the learner will
have the opportunity to learn about the basic of budgetary control. How the
budgets of an organisation prepared and managed. The present block refers the
following unit;
Unit 10: Operating or Service Costing

Unit 11: Reconciliation of Cost and Financial Accounts

Unit 12: Budgeting and Budgetary Control

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UNIT-10 OPERATING OR SERVICE COSTING

LEARNING OBJECTIVES

After studying this unit you should be able to understand

 Meaning of Operating Costing
 Application of operating costing
 Transport costing
 Operating cost sheet
 Classification of Operating cost

STRUCTURE

10.1 Introduction
10.2 Application of operating costing
10.3 Transport costing
10.4 Operating cost sheet
10.5 Classification of Operating Cost
10.6 Questions

10.1 INTRODUCTION

Operating costing is a method of costing applied by undertaking which provides service

rather than production of commodities. Like unit costing and process costing, operating
costing is thus a term of operation costing. The emphasis under this costing is on the
ascertainment of cost of rendering service and rather than on the cost of manufacturing a
product. It is applied by transport companies, gas and water users, electric supply
companies canteens, hospitals, etc Operating costing offers better scope for control. It
facilitates the compensation of unit operation cost at the end of each operating dividing
the total operation cost by total input units.

Definitions

According to ICWA, "Operating cost is, "the cost incurred in conditions a business
activity. Operating cost 5refers to the cost of undertakings which do not manufacture any
product but which provide services.

CIMA London, defines Operating Costing as "that form of operation costing which
applies where standardised services are rendered either by an undertaking or by a service
cost centre within an undertaking."

The costs incurred in providing a service are called 'Operating costs' and the method used
for computing such costs is called 'Operating Costing'.

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Cost and Management
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Basic Features of Operating Costing

(i) It deals with determination of cost of repetitive services, not tangible products.
(ii) It resembles with unit costing in that the total cost incurred during a period in a
service divided by the total number cost units of the service gives cost per unit of
service,
(iii) Services are standardised.
(iv) Investment in fixed assets is high and in working capital is low.
(v) Major portion of the total cost is fixed cost. Hence, the cost per unit of service
rendered is affected by the economies and scale of operations,
(vi) Various costs in providing services may be categorised as :
(i) Standing changes and Maintenance charges.

10.2 APPLICATION OF OPERATING COSTING

Operating Costing is applied in those undertakings which are engaged in providing services
rather than manufacturing of tangible products. It is generally applied in : (a) Road
Transport, Railways, Airlines, (b) Hotels, (c) Hospitals, (d) Electricity Supply Companies,
(e) Water Supply Companies, (f) Gas Supply Companies, (g) Cinema, (h) Canteen

10.3 TRANSPORT COSTING

Method of ascertaining cost in transport undertaking is known as transport costing. It

relates to determining cost per ser-vice unit for Air, Water, and Road traffic — both
goods and passengers, e.g. cost of plying a passenger for 200 km; cost of air-lifting one
ton of goods for 100km; cost of shipping 100 tons per 100 km, cost per km for a taxi, cost
per passenger— km in case of a bus.

Objectives : The objectives of Transport Costing may be summarised as follows :

• To ascertain the operating cost of running a vehicle per kilometre.
• To fix the rates of cartage of goods and passengers on the basis of operating cost.
• To determine the hire charges where vehicles are given on hire.
• To compare the cost of maintaining one of group of vehicles with another groups.
• To provide cost comparison between own transport and alternative e.g. hiring.
• To determine what should be charged against department using the service.

Cost unit: There are large varieties of services and therefore, there are different cost
units for different services. The unit for which the operating cost is to be computed
should be decided after considering all the technical and other factors affecting the
operating cost. The cost unit may be of two types as follows :

(i) Simple cost unit: A cost unit is said to be simple cost unit when it involves one
characteristic, for example :
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 Operating or
Service Costing

Undertaking Cost Unit

 Transport per kilometre .
 Canteen per item, per meal
 Water per 1000 litres

(ii) Composite cost unit : A cost unit is said to be the composite cost unit when it reflect
two or more characteristic, for example :
Undertaking Cost Unit
 Passenger Transport per passenger-km
 Goods Transport per tonne-km
 Hotel per room per day
 Hospital per bed per day
 Electricity per kilowatt hour

Transport Costing Procedure

The procedure of ascertaining costs in transport undertaking is to prepare an operating
cost sheet the following steps are taking in preparing operating cost sheet.

1. Selection of Cost unit : A basic problem in transport costing is the selection of a

suitable cost unit. Cost unit in transport costing may be of the following two
types:
(i) Simple cost unit, e.g. per kilometre or per mile, i.e., ascertaining the cost of
running a vehicle per km. or per mile.
(ii) Composite cost unit, e.g., per passenger kilometre or per tonne kilometre, i.e.,
cost of tansporting a passenger or a tonne of goods for one kilometre.

2. Compilation of costs : In transport costing, cost are classified and complied in

an operating cost sheet as follows :
A. Standing or fixed charges: They are: Salary of operating manager, supervisor,
etc. Insurance. Motor Vehicle Tax., Licence Fees, Garage Rent, General
supervision, Interest on capital.
B. Maintenance charges: Semi-variable expends are included in this group, viz.;
Tyres and tubes, Repairs and paintings, Overhauls, etc.
C. Operating and running charges: These will include - Petrol, oil, grease, etc.,
Wages of driver, conductor, attendant, etc. Depreciation.

In short, all the variable charges for running the vehicle are included in this group.
Normally, the life of a vehicle is given in terms of mileage to be run. Accordingly,
depreciation is to be allocated on the basis of mileage run and hence should be treated as
'variable expense'. A clear-cut classification of the various items of costs into the above
three groups should not attempted to be made as a matter of rule. It should be, rather,
based upon. circumstances of each case. For example, the wages payable to a driver by a
private owner on a 'no work no pay' basis should be always treated as an item of

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Cost and Management
Accounting

'operating or variable expenses'. But in case of employees of, say, a State Transport
Corporation, who are employed on a permanent basis, same item of cost should be treated
as part of standing or fixed charges'.

3. Ascertainment of costs : Total fixed, maintenance and operating costs are collected
under respective heads and these are then divided by total units e.g. ton-miles or
passenger miles to arive at average unit cost. A performa of cost sheet is given below :

XYZ Transport Company Ltd.

Cost Sheet for the Month of December 2015
Expenses Vehicle No. 8216 9255 3193 Total
Capacity 5 4 6
(tons)
1. Fixed Costs :
Garage Rent
Insurance
Motor Vechile Tax
Licence Fees
General supervision
Interest on
Capital
Total
Grand Total (1 + 2+ 3)
2. Maintenance Costs :
Tyres and Tubes
Repairs
Paintings
Overheads
Total
3. Operating Costs
Petrol
Engine Oil
Lubricating oil, grease, etc.
Wages of operators
Depreciation Total
4. Mileage run
Load carried (tons)
Days on road
% utilization
Ton-miles run
Cost per ton-mile:
Fixed
Operating
Maintenance
Total

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 Operating or
Service Costing

Classification of Operating Cost

Costs are classified into the following three heads :

1. Standing or Fixed Charges. These charges are incurred in spite of the kilometres
run e.g. salary of operating manager and supervisors etc., insurance, motor
vehicle tax, licence fee, garage rent, general supervision and interest on capital.
2. Maintenance Charges. Semi-variable expenses are included in this group e.g
tyres and tubes, repairs and paintings, overhauls etc.
3. Operating and Running Charges. These charges vary more or less in direct
proportion to kilometres and include, petrol, oil, grease etc., wages of driver,
conductor, attendant etc. if payment is related to time or distance of trips,
commission of taking, if any, and depreciation. Normally the life of a vehicle is
given in terms of mileage to be run. Accordingly depreciation is to be allocated
on the basis of kilometres run and hence should be treated as an item of variable
charge.

The classification of various items of costs into the above three groups should not be
attempted as a matter of rule. It depends basically on the circumstances of each case. For
example, the wages payable to a driver by a private owner on a no work no pay basis
should be treated as an item of operating or variable expenses. But in case of employees
of State Transport Corporation and employed on permanent basis, the same item of cost
should be treated as pan of standing or fixed charges.

Illustration 1: From the following information calculate total kilometer and total
passengers kilometers
No. of Buses = 6
Days operated ion the month = 25
Trips By Each Bus = 4
Distance of rate 20 kms one way.
Capacity of Bus = 40 passengers
Normal passenger travelling 90% of the capacity.

Solution: Total passenger kilometers covered = Run  Load

Load = Maximum capacity used capacity
= 40  90% = 36
Total passengers kilometers covered = 2400  36 = 864000 kilometers
Note :
Absolute (Weighted average) tonnes kms = Absolute tonnes kms, are the sum total of
tonens kilometers arrived at by multiplying various distances by respective load
quantities and carried.

Commercial (simple average) tonnes kms – commercial tonnes kms are arrived at by
multiplying total distances kilometers by average load quantity.

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Cost and Management
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Illustration 2: A lorry starts with a load of 30 tonnes of goods from Station A. It unloads
8 tonnees at station B and rest of goods at station C. It reaches back directly to station A
after getting reloaded with 16 tonnes of goods at station C. The distance between A to B,
B to C and then from C to A are 100 kms, 120 kms and 160 kms, respectively. Compute
Absolute tonnes kms and commercial tonnes kms.

Solution: Absolute tonnes kms = 30 tonnes  100 kms + 12 tonnes  120 kms + 16
tonnees  160 kms = 7000 tonnees kms.
Commercial tonnees kms = Average load  Total Kilo metres travelled
 30  12  16) 
  tonnes  380 kms
 3 
58 22040
  380   7346 tonnes kms.
3 3

Illustration 3: From the following data, calculate the cost per kilometer of a vehicle.
Value of Vehicle = Rs. 15,00,000
Road licence fee per year = 500
Insurance charges per year = 100
Garage rent per year = 600
Driver wages per month = 200
Cost of petrol per litre 3.60
Kilometers per litre 8
Proportionate charges for tyre and maintenance per km.
Estimated life 1,50,000 km.
Estimated annual kilometreage— 6,000 km.
Ignore interest on capital

Solution: Operating Cost Sheet of a Vehicle

Particulars Per Year Per Km
Standing Charges :
Road Licence Fee 500.00
Insurance charges 100.00
Garage Rent 600.00
Driver's wages 2,400.00
(200x12) Total 3,600.00
Standing Charges
Standing Charges per km. : 0.60
(3,600+6,000)
Variable Charges :
Depreciation : 0.10
 15, 000 
 
 1,50, 000  0.45
Petrol 
3.60 

 8  0.20
Tyre and Maintenance
Cost per Kilometer 1.35

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 Operating or
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Illustration 4: Mr. Sharma is running a taxi for which the following information is given.
You are required to compute the rate per kilometre to be charged to earn a profit of 20% cash:

Cost of vehicle 5,00,000

Road licence (annual) 7,500
Insurance (annual) 7,000
Garage rent (annual) 6,000
Supervision and salaries 12,000
Driver's wages per hour 30
Cost of fuel per litre 30
Repairs and maintenance per km 1.75
Tyre allocation per km 0.70
Estimated life of vehicle in kms 1,00,000
Kms run (annual) 10,000
Kms run per litre 20 kms
Charge interest at 5% per annum on cost of vehicle. The vehicle runs 10 kms per hour on
an average.

Solution:
Particulars Per Annum Per km
Standing charges :
Road Licence 7,500
Insurance 7,000
Garage Rent 6,000
Supervision and Salaries 12,000

 5 
Interest  5,00,000  
 100 
25,000
Total Standing Changes
47,500
Standing Charges per km.
 47,500 
 
 10, 000  4.75
Variable Charges :
 5, 00, 000 
Depreciation  
 10, 000  5.00
Repairs and Maintenance 1.75

Cost of fuel  
30
 20  1.50
Tyre allocation 0.70

Driver's wages  
30 3.00
 10 
Operating cost per km. 17.70
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Cost and Management
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Working note:
Profit (20% on cost)
Operating cost per km = Rs. 17.70
Profit (20% on cost) = Rs. 3.54
Rate to be charged = Rs. 21.24
Profit (20% on rate / fare)
Operating cost per km= Rs. 17.70
Profit (20% on Rate or 25% on cost) = 4.43
Rate to be charged 22.13

Illustration 5. Ganeev Transport Service Company Ltd. is running 4 buses between two
towns which are 50 km apart. Seating capacity of each bus is 40 passengers. The
following particulars were obtained from their books as on 31" March 2015:

Wages of drivers, conductors and cleaners 2,40,000

Salaries of office and supervisory staff 1,00,000
Diesel oil and other oils 4,00,000
Repairs and Maintenance 80,000
Taxation, Insurance etc. 1,60,000
Depreciation 2,60,000
Interest and other charges 2,00,000
14,40,000

Actual passengers carried were 75% of the seating capacity. All the four buses ran on all
the days of the Month (30 days). Each bus made one round trip per day. Find out the cost
per passenger km.

Solution:
Number of passenger kilometers
= Number of buses x Distance x capacity of each bus x Actual capacity
utilised x Round trip x Number of days
= 4x 50 x 40 x 75% x 2 x 30
75
= 4 x 50 x 40 x x 2 x 30 = 3,60,000
100

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 Operating or
Service Costing

Sanjeev Transport Service Company Ltd.

Operating Cost Sheet
for the year ending 31st March, 2015
Particulars Amount Amount
(Rs.) (Rs.)
Standing Charges
Wages of drivers, conductors and cleaners 2,40,000
Salaries of office and supervisory staff 1,00,000
Taxation, Insurance etc. 1,60,000
Interest and other charges 2,00,000 7,00,000
Variable Charges
Diesel oil and other oils 4,00,000
Repairs and Maintenance 80,000
Depreciation 2,60,000 7,40,000
Total Cost 14,40,000

Illustration 6: Ahuja runs a tempo service in Delhi. He furnishes the following

particulars of his vehicle A
Rs.
Cost of vehicle 25,000
Road License for per year 750
Supervisor's salary per year 1,800
Driver wages per hour 4
Cost of fuel per litre ; 1.50
Repair per mile 1.50
Garage rent per annum 1,600
Insurance premium per annum 850
Miles run per litre 6
Milage run during the year 15,000 miles
Estimated life of vehicle 1,00,000 miles
Charge interest @ 10% P. A. on the cost of vehicle. The vehicle runs 20 miles per hour
on an average.
You are required to calculate cost per running mile.
Operating Cost sheet
A. Standing or Fixed Expenses (per annum) Rs.
Road License 750
Supervisior Salary 1,800
Garage rent 1,600
Insurance Premium 850
Interest @ 10% p.a. on cost 2500
[Rs. 25000 x 10/100] 7500
Total
Mileage run per annum 15,000
:. Fixed Exp. per mile [Rs. 7500/15,000] 0.50
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Cost and Management
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B. Running or variable expenses per mile

Driver's wage 4  20 0.20
Fuel Cost 1.50  6 0.25
Rs.25, 000
Depreciation =
1, 00, 000 0.25
Repair 1.50
Operating cost per mile (A + B) (0.50 + 2.20) 2.20
2.70

Illustration 7: Varun Ltd. is running four buses between Delhi and Alwar, covering a
distance of 100 kms. The seating capacity of each bus is 40 passengers. The following
particulars are obtained from its Books for the month of Oct. 15 :
Rs.
Wages of drivers, conductors 9,600
Salaries of office staff 3,000
Honorarium of accountant 1,000
Diesel, oil etc. 16,000
Repairs and maintenance 3,200
Road tax and insurance 6,400
Depreciation 10,400
Interest and other charges 8,000
Actual passengers carried were 75% of the seating capacity. All the buses ran for 30
days. Each bus made one round trip per day. Find-out the fare the company should charge
per passenger/km, if it wants a profit of 20% on the taking.
75
Solution: Effective Passenger kms per bus = 2  100  30  40 
100
= 1,80,000 passengers kms
Operating Cost Sheet for Four Buses for Delhi-Alwar
Particulars Rs.
Fixed Costs:
Wages of drivers, conductors 9,600
Salaries of office staff 3,000
Honorarium of accountant 1,000
Repairs and maintenance 3,200
Road tax and Insurance 6,400
Depreciation 10,400
Interest and other charges 8,000
Total Fixed cost for 4 buses 41,600
Variable Costs :
Diesel, Oil etc. for 4 buses 16000
Total Cost for 4 buses 57600
Profit 20% of taking i.e. 25% of cost 1,4400
Total fair collection from 4 buses 72000
72, 000
Total fair from one bus Rs.  Rs.18, 000
4
Fair per passenger km = Rs. 18,000 = 1,80,000 = 10 paise.
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 Operating or
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Illustration 8: The Madras Transport Company which keeps a fleet of lorries, shows the
following information :
Kilometres run for April 2015—30,000
Rs.
Wages for April 2015 2,000
Petrol, oil, etc, for April 2015 4,000
Original cost of vehicles 1,00,000
Repairs for April 2015 6,000
Garage rent etc. for April 2015 1,000
Licence, insurance etc. for the year 2015 6,000

Depreciation is to be allowed @ 25% per annum on original cost. Prepare a statement for
April 2015 showing the cost per running kilometre.
Solution:
Madras Transport Company
Operating Cost statement for the month of April, 2015
Kilometers run = 30,000
Particulars Per Month (Rs.) Per Km.
(Rs.)
Rs.
Fixed Costs
Wages Garage Rent 2,000
Licence, insurance etc. 1,000
(6000 + 12) 500 3,500 0.117
Variable or Running Charges :
Petrol, oil etc. 4,000
Repairs 6,000
Depreciation 2,083
 25 1 
 1, 00, 000    12,083 0.403
 100 12 
15,583 0.520

Illustration 9: Union Transport Company supplies the following details in respect of a

truck of 5 tonnes capacity :
Cost of truck Rs. 90,000
Estimated life 10 years
Diesel, oil Rs. 15 per trip each way
Repairs and maintenance Rs. 500 per month
Cleaner's wages Rs. 250 per month
Driver's wages Rs. 250 per month
Insurance Rs, 4,800 per year
Tax Rs, 2,400 per year
General supervision charges Rs. 4,800 per year
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Cost and Management
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The truck carries goods to and from city covering a distance of 50 miles each way. While
going to the city, freight is available to the extent of full capacity and on return 20% of
capacity.
Assuming that the truck runs on an average 25 days a month, work out: Operating cost
per tonne mile.

Solution: Operating Cost Statement

Tonne Miles: 7,500
Particulars Per Month Per Tonne
(Rs.) Mile (Rs.)
Rs.
Fixed Costs
Driver's wages 500
Cleaner's Wages 250
Insurance (Rs. 4,800  12) 400
Tax (Rs. 2,400  12) 200
General Supervision (Rs. 4,800/12) 400 1,750 0.233
Variable or Running Charges :
Diesel oil (15 x 2 x 25) 750
Repairs and Maintenance 500

Depreciation  90, 000   

1 1 750 2,000 0.267
 10 12 
3,750 0.500
Tonne Miles :
Load while -going to the city = 5 tonnes
Load while coming from the city
= 20% of 5 tonnes = 1 tonne
Total load = 5 + 1 = 6 tonnes
 Tonne Miles = Total load x distance x No. of days
= 6 x 50 x 25 = 7,500
Operating Cost per tonne mile = Re 0.50

Illustration 10. A transport operator runs 4 buses between 2 cities, the distance between
the two being 100 kms. Each bus has a seating capacity of 50 and actual passengers
carried were 75% of the capacity. Each business takes 1 round trip every day and 30 days
in the month. Other details of the month:
Wages of drivers, conductors, cleaners Rs. 36,000
Salaries of office staff Rs. 14,000
Diesel, oil etc. Rs. 56,000
Repairs and maintenance Rs. 10,000
Road-tax and insurance Rs. 21,000
Cost of each bus Rs. 3,50,000
(charge depreciation @ 20% p.a.)
Interest and other charges Rs. 28,000
Calculate cost per passenger km.
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 Operating or
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Solution: 4 buses of 50 seating capacity = 200 passengers.

Actual passengers carried = 75% of 200 = 150
In a month of 30 days, passengers carried = 150 x 30 = 4,500
Distance being 100 kms, one round trip - 100 x 2 = 200
Thus, total passenger - kms in a month = 4,500 x 200 = 9,00,000

Operating Cost Sheet Details

Amount
Rs. Rs.
Monthly Operating and Maintenance charges
Diesel, oil etc. 56,000
Repairs & maintenance 10,000
Depreciation [Rs. 14,00,000 x 20/100x1/12] 23,333
Total operating and Maintenance charges 89,333

Monthly Fixed charges

Wages of drivers, conductors, cleaners 36,000
Salary of office staff 14,000
Road-tax and insurance 21,000
Interest & other charges 28,000
Total fixed charge 99,000
Total Monthly Operating Cost 1,88,333
Total passenger-Kilometers
9,00,000
Cost per passenger - Km = Rs. 1,88,333  9,00,000 = Re. 0.20

Illustration 11. A person owns a bus which runs between Delhi and Chandigarh and
back, for 10 days in a month. The distance from Delhi Chandigarh is 240 kms. The bus
completes the trip from Delhi to Chandigarh and back in the same day. The bus goes
another 10 days month to Agra and the distance covered being 200 kms. The trip also
completed in the same day. For the rest of 4 days it runs in the Delhi city. Daily distance
covered in local city is 60 kms. Calculate the amount person should charge from
passenger when he wants to earn profit of 33% on his takings. The other particulars are
given be:
Cost of bus Rs. 2,00,000.
Depreciation 20% per annum.
Salary of driver Rs. 1,600 per month.
Salary of conductor Rs. 1,500 per month.
Salary of part time accountant Rs. 400 per month.
Insurance Rs. 2,000 per annum.
Diesel consumption : 6 kms. per litre costing Rs. 4.00 per litre.

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Token tax Rs. 600 per annum.

Repairs Rs. 1,000 per month.
Normal capacity 50 passengers.

The bus is generally occupied 90% of the capacity when it goes to Chandigarh and 80%
when it goes to Agra. It is always full when it runs within the city.

Solution:

Delhi to Chandigarh
Selling Capacity = 50 passengers
Actual passengers carried = 50 x 90% = 45
Actual passengers carried for 10 days = 45 x 10 = 450 ,

Actual passenger kms. = 450 x 240 x 2 = 2,16,000

Delhi to Agra
Actual passengers carried = 50 x 80% = 40
Actual passenger for 10 days = 40 x 10 = 400
Actual passenger kms. = 400 x 200 x 2 = 1,60,000

Local City
Actual passenger carried = 50
Actual passenger for 4 days = 50 x 4 = 200
Actual passenger kms. = 200 x 600 = 12,000
Total passenger kms. = 2,16,000 + 1,60,000 +
12,000
= 3,88,000
Total Kms. travelled in a month
Delhi to Chandigarh (240 x 2 x 10) = 4,800 kms
Delhi to Agra (200 x 2 x 10) = 4,000 kms
Local (60x4) = 240 kms = 9, 040 kms

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 Operating or
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Operating Cost Sheet

for the month
Per month Amount
(Rs.)
Rs.
Standing Charges :
Salary of Driver 1,600
Salary of Conductor 1,500
Salary of part time Accountant 400
Insurance 2,000  12 167
Token tax 600 + 12 50 3,717
Variable Costs : 3,333
Depreciation (Rs. 40,000  12) 1,000
Repairs
6,027 10,360
Diesel consumption:
14,077
4
9,040  - .
6
0.0363
Total Cost
0.0181
Cost per passenger km.
(14,077 + 3,88,000) 0.0544
Profit (1/3 of takings or 1/2 of cost)
Rate per passenger km.

Rate per passenger to be charged

(i) Delhi to Chandigarh= 240 kms. @ Re. 0.0544 = Rs. 13.06
(ii) Delhi to Agra = 200 km. @ Re. 0.0544 = Rs. 10.88

Illustration 12. Union Transport Company supplies the following details in respect of a
truck of 5-tonne capacity
Cost of truck Rs. 90,000
Estimated life 10 years
Diesel, oil, grease Rs. 15 per trip each way
Repairs and maintenance Rs. 500 per month
Driver's wages Rs. 500 per month
Cleaner's wages Rs. 250 per month
Insurance Rs. 4,800 per year
Tax Rs. 2,400 per year
General supervision charges Rs. 4,800 per year

The truck carries goods to and from city covering a distance of 50 miles each way.
While going to the city, freight is available to the extent of full capacity and on return
20% of capacity.
Assuming that the truck runs on an average 25 days a month, work out-
(i) Operating cost per tonne-mile, and
(ii) Rate per tonne per trip that the company should charge if profit of
50% on freightage is to be earned.
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Cost and Management
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Operating Cost Sheet

Per month Per tonne-mile
Rs. Rs.
 Fixed Costs
Driver's wages 500
Cleaner's wage 250
Insurance 400
Taxes 200
General supervision 400 1,750 0.223
 Running Costs :
Diesel oil, etc. 750
Repairs & maintenance 500
Depreciation 750 2,000 0.267
Total 3,750 0.500

Cost per tonne-mile = Cost per month/7,500 tonne miles

(ii) Calculation of Freight rate
Cost per tonne-mile Re.. 0.50
Profit per tonne-mile (50% of freightage or
100% of Cost) Re. 0.50
Freight rate per tonne-mile Re. 1.00
Freight rate per tonne per trip (both ways)= Re. 1 x 300 = Rs. 300.
Note: Tonne mile = 50  5 + 50  1 = 300 per trip
tonne mile for the month = 300  25 = 75 00 tonne

Illustration 13: A toy manutacturer earns an average net profit of Rs. 3 per piece at a
selling price of Rs. 15 by producing and selling 60,000 pieces at 60% of capacity.
Composition of his cost of sales is :
Rs. per Piece
Direct Material 4.00
Direct Wages 1.00
Work Overheads 6.00 (50% fixed)
Sales Overheads 1.00 (25% varying)

During the current year he intend to produce the same number but anticipated that: (a) his
fixed charges will go up by 10%; (b) rates of direct labour will increase by 20%; (c) rates
of direct material will increase by 5%; (d) selling price cannot be increased.

Under these circumstances he obtains an order for a further 20% of his capacity. What
minimum price will you recommend for accepting the order to ensure the manufacturer
an overall profit of Rs. 1,80,500 Rs.

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 Operating or
Service Costing

Solution
Operating Cost Statement
(Annual mileage 6,000 miles)
Annual Cost, Cost per mile
Rs. Rs.
Fixed or Standing Charges :
Road licence fee 500
Insurance charge 100
Garage rent 600
Driver's wages per year 2,400
Total/per mile fixed cost 3,600
Variable or Running Charges : 0.60

15,000  6,000 600 0.10

Depreciation-
1,50,000
Cost of petrol per mile 8-8 6,000 1.00
Cost of tyres and maintenance per mile 1,200 0.20
Total/per mile variable cost 7.800 1.30
Total cost and Cost of running the
vehicle per mile 11.400 1.90

Statement of Cost and Profit

Output : 60,000 Toys

Budget for
Particulars Previous Year Current rear
Per Piece Amount Per Piece Amount
Rs. Rs.
Sales (A) 15.00 9,00,000 15.00 9,00,000
Less : Marginal Cost Direct 4.00 2,40,000 4.20 2,52,000
material
Direct Wages 1.00 60,000 1.20 72,000
Variable Works Overheads 3.00 1,80,000 3.00 1,80,000
Variable Sales Overheads 0.25 15,000 0.25 15,000
Total Marginal Cost (B) 8.25 4,95,000 8.65 5,19,000
Contribution (A - B) 6.75 4,05,000 6.35 3,81,000
Less : Fixed Costs
Works Overheads 80,000 1,98,000
Sales Overheads 45,000 2,25,000 49,500 2,47,500
Profit 1,80,000 1,33,500
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Cost and Management
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Minimum price of additional 20,000 toys i.e., 20% of capacity :

Rs.
Marginal Cost of additional 20,000 toys @ Rs. 8.65 1,73,000
Increased profit or contribution expected (Rs. 1,80,500  1,33,500) 47,000
2,20,060
Rs.2, 20, 000
Minimum Selling Price to be accepted = = Rs. 11 per toy.
20, 000

Illustration 14: [B.Com. (Delhi) Vehicle A Vehicle B

Km. run (annual) 15,000 6,000
Cost of vehicle (Rs.) 25,000 15,000
Road licence (annual) (Rs.) 750 750
Insurance (annual) (Rs.) 700 400
Garage rent (annual) (Rs.) 600 500
Supervision and salaries (annual) (Rs.) 1,200 1,200
Drivers' wages per hour (Rs.) 3 3
Cost of fuel per gallon (Rs.) 3 3
Km. run per gallon (Rs.) 20 15
Repairs & maintenance per km. (Rs.) 1.65 2.00
Tyre allocation per km. (Rs.) 0.80 0.60
Estimated life of vehicles 1,00,000 Km. 75,000 Km.

Charge interest at 5% per annum on cost of vehicles. The vehicles run 20 Km. per hour
on an average.
Operating Cost Sheet
Particulars Vehicle A Rs. Vehicle B
Rs.
A. Fixed Cost per annum :
Road licence 750 750
Insurance 700 400
Garage rent 600 500
Supervisory salaries 1,200 1,200
Interest 1,250 750
Total Fixed Cost 4,500 3,600,
Km. run per annum 15,000 6,000
Fixed cost per Km. 0.30 0.60
B. Variable Cost per Km.
Drivers' wages (Rs. 3 per hour for (20 Km.) 0.15 0.15
Fuel cost per Km. 0.15 0.20
Repairs & maintenance 1.65 2.00
Tyre allocation 0.80 0.60
Depreciation (cost + estimated life) 0.25 0.20
Variable cost per km. 3.00 3.15
Total Cost per Running Km. (A+B) 3.30 3.75
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 Operating or
Service Costing

Illustration 15. SR Airlines has been permitted to operate three flights per week,
between A and B cities (both sides). The Airline operates a single aircraft of 160 seating
capacity. The normal occupancy is estimated at 60% throughout the year of 52 weeks.
The one way fare is Rs. 7,200. The cost of operation of flights are:

Variable Cost: Rs. 76,000 per flight

Fuel Cost Rs. 24,000 per flight
Crew charges
Food served on board
(on non-chargeable basis) Rs. 125 per passenger
Commission 5% of the fare applicable for all bookings
Fixed Costs:
Aircraft Lease 3,50,000 per flight
Landing charges 72,000 per flight
Required:
(i) Calculate Operating Cost per passenger per flight.
(ii) Calculate net operating income per flight.
(iii) The airlines expects that its occupancy will increase to 120 passengers per flight
if the fare is reduced to Rs. 6,500. Find operating cost per passenger per flight
and net operating income per flight if this proposal is implemented.

Solution: Operating Cost Statement

(Rs.)
fixed Costs: Per flight
Aircraft lease 3,50,000
Landing charges 72,000
Total (A) 1422,000
Variable Costs:
Fuel Cost 76,000;
Crew charges . 24,000
Food served on board (Rs. 125  96 passengers) 12,000
Commission (Rs. 7200  5%  96 passengers) 34,560
Total (B) 1,46,560
Total Operating Cost (A + B) 5,68,560
Gross Sales (Rs. 7,200 x 96 passengers) 6,91,220
Net Income (Gross Sales - Total Cost) 1,22,640
Operating Cost per passenger per flight
Total operating cost Rs.5, 68,560 Rs.
= 
No. of passengers 96 5922.50
Note. * No. of passengers = 160 x 60% = 96 passengers

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Cost and Management
Accounting

(iii) Operating Cost Statement (When number of passengers is 120)

Rs.
fixed Costs: . Per flight
As per Statement (z) — (A) 4,22,000
Variable Cost:
Fuel Cost 76,000
Crew charges 24,000
Food served (Rs. 125  120) 15,000
Commission (Rs. 6,500  5%  120) 39,000
Total (B) 1,54,000
Total Operating Cost (A + B) 5,76,000
Gross Sales (Rs. 6,500 x 120) 7,80,000
Net Operating Income (Gross Sales  Total Cost) 2,04,000
Rs.5, 76, 000 Rs.4,800
Operating Cost per passenger per flight =
120

Illustration 16. A Transport Co. charges Rs. 120 per ton for a 5 tons lorry load from A
station to B station. The charges for return trip are Rs. 110 per ton. In the month of July,
2015, a truck has made 10 outward journeys with full load out of which 3 tons were
unloaded twice at C station on the way. It returned without any load once only from C
station to A station. The expenses incurred were :
Annual fixed charges : Rs. 38,400
Annual maintenance : Rs. 19,200
Monthly running charges : Rs. 2,404

You are required to find the cost per ton-kilometre (absolute) and the profit are the month
of July, 2015, assuming that no concession is made for delivery t the intermediate
stations. Distance from A station to B station is 210 kms, and from A to C station 120 ms.
The truck carried a load of 8 tons 5 times in the month while returning on B station but
was once caught by the police and was fined Rs. 2,000.
Solution:
(i) Calculation of tonne km
Outward Journey Tonne Rs.
A to C (120 km x 5 tons x 2 times) 1,200

C to B (210 - 120) i.e. (90 kms x 2 tons x 2 times) 360

A to B (210 km x 5 tons x 8 times) 8,400
9 960
Return Journey
B to C (90 km x 5 tons x 1 time) 450
B to A (210 km x 5 tons x 4 times) 4,200
B to A (210 km x 8 tons x 5 times) 8,400
Total 23,010

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 Operating or
Service Costing

Income Rs.
Outwards (10 trips x 5 tons x Rs. 120) 6,000
Return (5 trips x 8 tons x Rs. 110) 4,400
Return (5 trips x 5 tons x Rs. 110) 2,750
Total 13,150
Less: Fine 2,000
Net Receipts 11,150
Cost
Per annun
Rs.
Fixed charges 38,400
Maintenance 19,200
Total 57,600
Charges per months (57,600/12 months) 4,800
Running charges 2,404
Total 7,204
Cost per ton km Rs. 7,204/23,010 0.31
Total Receipts for the month of July 11,150
Less: Cost for the month of July 7,204
Profit 3,946

Illustration 17. A. transport company has been given a 20 km long route to run a bus.
The bus costs Rs. 50,000 and has been insured @ 6% p.a. while annual taxes amount to
Rs. 2,000. Garage rent is Rs. 100 p.m. Yearly repairs will be Rs. 2,000, • and the bus is
likely to last for 5 years. The driver's salary will be Rs. 3,000 p.a. and that of conductor's
Rs. 1,800 p.a. is in addition to 10% of the takings as commission (to be shared by the
driver and the conductor equally). Cost of stationery will be Rs. 600 p.a., Manager's
salary is Rs. 400 p.m. who also looks after accounts.

Diesel and oil will be Rs.25 per 100 km. The bus will make 3 round trips arriving on the
average 40 passengers on each trip. Assume 25% profit, calculate the bus fare to be
charged from each passenger. The bus runs on an average 25 days in a month.
Solution:
Operating Cost Statement
Standing Charges: (per Annum)
Taxes 2,000
Insurance (6% of 7 50,000) 3,000
Garage rent (Rs. 100 x 12) 1,200
Repairs 2,000
Salary of driver 3,000
Salary of conductor 1,800
Stationery 600
Salary of Manager (Rs. 400 x 12) 4,800
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Cost and Management
Accounting

Total 18,400
Standing Charges p.m. (Rs. 18,400/12) 1,533.33
Depreciation 833.34
Diesel and Oil 750.00
Total Cost before Commission 3,116.67
Commission 10% of Takings 479.48
Total Cost 3596.15
Profit (25% of Takings) 1198.72
Takings 4,794.87
Rs.4, 7947
Fare per passenger =  20 km  Rs.0.80 (approx.)
1,20,000

Working note
50, 000
Depreciation   Rs.833.34
5 years 12 months
25
Diesel and Oil = 20 km  3  2 trips  25 days   Rs.750
100
Calculation of Commission and Profit:
Suppose Takings = x
10x 25x
Commission  ; and Profit 
100 100
10x 25x 10x 25x
x  3116.67   or x   3116.67
100 100 100 100
65 100
or x  3116.67  or x(Takings)  3116.67   4, 794.87
100 65
x(Takings)  4,794.87
Total kms travelled by passengers = 20  3  2  25  40 = 1,20,000 kms

Illustration 18. Global Transport Ltd. charges Rs. 90 per tonne for its 6 tonnes lorry load
from city 'A' to city 'B'. The charges for the return journey are Rs. 84 per tonne. No
concession or reduction in these rates is made for any delivery of goods at the
intermediate station 'C'. In January 2015, the truck made 12 outward journeys for city 'B'
with full load out of which 2 tonnes were unloaded twice in the way at city 'C. The truck
carried a load of 8 tonnes in its return journey for 5 times but was once caught by the
police and Rs. 1,200 was paid as fine. For the remaining trips the truck carried full load
out of which all the goods on load were unloaded once at city 'C'. The distance from city
'A' to city 'C' and city 'B' are 140 kms and 300 kms respectively. Annual fixed costs and
maintenance charges are Rs. 60,000 and Rs. 12,000 respectively. Running charges spent
during January 2015 are Rs. 2,944. You are required to find out the cost per absolute
tonne-km and the profit for January 2015.

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 Operating or
Service Costing

Operating Cost Sheet

Rs.
Fixed Cost per month (Rs. 60,000 + 12) 5,000
Maintenance charges per month (Rs.12,000 1,000
Running charges 2944
Total Cost 8,944
Total Cost Units = 44,720 tonne km.
Cost per absolute tonne-km. = Rs. 8,944/44,720 = 20 paise
Calculation of Profit: Rs.
Total Revenue 12,168
Less: Total Cost 8,944
Net Profit 3,224
Working Notes
Calculation on tonne-kms
Onward A to B (300 x 6 x 10) 18,000
A to C (140 x 6 x 2) 1,680
C to B (160 x 4 x 2) 1,280
Return - B to A (300 x 8 x 5) 12,000
B to A (300 x 6 x 6) 10,800
B to C (160 x 6 x 1) 960
Calculation of revenue Rs.
A to B (12 x 6 x Rs. 90) 6,480
B to A (6 x 6 x Rs. 84) 3,024
B to A (5 x 8 x Rs. 84) 3,360
B to C (1 < 6 x Rs. 84) 504
13,368
.-. Net Revenue = Rs. 13,368  Fine Rs. 1,200 = Rs. 12,168

Illustration 19. [B.Com. (Delhi)]: A city municipality arranges for the removal of its
gabrage by means oif motor vehicle transport. The following vehicles are maintained:
No. of Vehicles Specification
30 5 tonne lorries
40 3 tonne lorries
50 2 tonne lorries
20 4 tonne lorries

On an average each lorry makes 5 trips a day and each trip covrs an average distance of 6
kms. Each lorry carries garbage of 50% of its capacity. On an annual average, 10% of the
lorries are laid up for repairs every day. he conservancy work is carried out daily.
Calculate tonne-ms per month
Solution: (a) Tonne Capacity
30 Vehicles  5 tonnes 150
40 Vehicles  3 tonnes 120
50 Vehicles  2 tonnes 100
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20 Vehicles  4 tonnes 80
450
Calculate of tonnee kms
50 90
 450  5  6    30  1,82, 250 tonne kms
100 100

10.6 QUESTIONS

1. What is operating cost Rs. Describe its essential characteristics?

2. What do you mean by comprise unit in service costing.

3. The more kilometer you travel with your own veicle, the cheaper it becomes.
Comment.

4. A bus started from Delhi for Mussoorie with 50 passengers on board. 20 passengers
got off at Dehradun and the bus proceeded with the remaining passengers. In the
evening the same bus left Mussoorie with 50 passengers, 10 passengers got off at
Dehradun and the bus resumed its journey with remaining passengers for Delhi. The
distance between Delhi and Dehradun is 280 km. and between Dehradun to Mussoori
it is 20 km. Compute the cost per passenger km., if the total cost of running the bus
comes out to be Rs. 5,000.
[B. Com. (Hons.) Delhi] [Ans. Cost per passenger km. : 19 paise]

5. A transport operator runs 4 buses between 2 cities, the distance between the two
being 100 kms. Each bus has a seating capacity of 50 and actual passengers carried
were 75% of the capacity. Each bus makes 1 round trip every day and 30 days in the
month. Other details for the month :
Wages of drivers, conductors, cleaners Rs. 36,000
Salaries of office staff Rs. 14,000
Diesel, oil etc. Rs. 56,000
Repairs and maintenance Rs. 10,000
Road-tax and insurance Rs. 21,000
Cost of each bus Rs. 3,50,000
(charge depreciation @ 20% p.a.)
Interest and other charges Rs. 28,000
Calculate cost per passenger km. [B.Com. Delhi] [Ans. Rs. 0.21]

6. The Madras Transport Company which keeps a fleet of lorries, shows the following
information : Kilometres run for April 2008-30.000.
Wages for Apr! 12008 2,000
Petrol, oil, etc. for April 2008 4,000
Original cost of vehicles 1,00,000

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 Operating or
Service Costing

Repairs for April 2008 6,000

Garage rent etc. for April 2008 1,000
Licence, insurance etc. for the year 2008 6,000
Depreciation is to be allowed (a) 25% per annum on original cost. Prepare a
statement for April 2008 showing the cost per running kilometre. [B.Com. Delhi]
[Ans. Kms. : 30,000, Cost per km. Re. 0.52]

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

225
 UNIT-11 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

LEARNING OBJECTIVES

After studying this unit you should be able to understand

 Meaning of reconciliation
 Integrated system of accounts
 Need of reconciliation
 Reasons for the difference between cost and financial accounts
 Method of reconciliation

STRUCTURE

11.1. Introduction
11.2. integrated system of accounts
11.3 need for reconciliation
11.4 Reason for the difference between cost and financial accounts
11.5 Method of reconciliation
11.6 Questions

11.1 INTRODUCTION

A manufacturing concern may adopt either integrated accounting system or non-integral

accounting system. Under integrated accounting system only one set of books is
maintained to record both costing and financial transaction, therefore, under this system,
both financial and cost accounts will give similar results. However, in non-integral
accounting system, separate bonus are maintained for costing and financial transaction.
Therefore, different result may exhibit i.e. profit or loss. In other words, when cost
accounts and financial accounts are maintained independently by business enterprise, the
profit or loss shown by the cost accounts may not agree with the profit or loss shown by
the financial accounts. In this situation. It is necessary to reconcile the profit or losses
shown differently in cost accounts and financial accounts. This can be done by preparing
a statement which is popularly called as reconciliation statement. Reconciliation
statement is a statement which reconcile the profit or loss as per cost accounts with the
profit or loss as per financial accounts. A cost reconciliation statement is a statement
where the causen responsible for the difference in net profit ot loss between cost and
financial accounts are established and suitable adjustments are made to remove them. In
other words, cost reconciliation statement is prepared for the purpose of reconciling or
agreeing the results of financial accounts with the results of cosat accounts by making
suitable adjustments for the items responsible for the disagreement. In brief, it is the
statement through which reconciliation or agreement between the results of cost accounts
and financial accounts is affected. There are two systems of keeping accounts such as
non-integrated systems of accounting and integrated system of accounting.

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 Reconciliation of
Cost and Financial
Accounts

NON-INTEGRATED ACCOUNTING: Under this system, cost accounts and financial

accounts are separately maintained. Profit or loss under the two systems may differ, and
therefore, there may arise a need for reconciliation.

11.2 INTEGRATED ACCOUNTING

Under this accounting system, both the cost accounts as well as financial accounts are
maintained in one and the same set of books. It means ‘the merger or integration of both
financial and cost accounts’, thus maintaining only one integrated ledger containing both
financial as well as costing records. Otherwise, in non-integrated accounting system, cost
accounts and financial accounts are kept separately. Under this system, however, certain
inter-locking accounts may be maintained so as to ensure integration. This is know as
‘interlocking’ of the two accounts.

Under integrated accounting method, there is no need to recouncile the results of cost
accounts with those of the financial accounts. It is so because in case of ‘integrated
accounting system; both accounts are treated as part of a single comprehensive
accounting method.

Advantages of the integrated accounting system are:

 No need of preparation of any ‘Reconcilation statement’.
 No duplication of work because only one set of accounts is maintained.
 It saved cost.
 More efficient control over accounting process.
 Timely reporting of information at the end of the year without delay.

11.3 NEED FOR RECONCILATION

If financial and cost records have been integrated into a single set of there would not be
any need to reconcile them because there will be only profit loss figure. There are so
many transitions and data will be similar in both the sets but there will be differences due
to the differences in objectives and assumptions. Hence there is need of reconciliation of
profit under financial and cost accounting.

Need for Reconciliation:-

Cost and financial profits need to be reconciled due to following reasons:
 To ascertain the reason for difference in cost and financial profit or loss.
 To check mathematical accuracy of cost and financial profit/loss.
 To facilitate cost ascertainment and cost control.
 To facilitate formation of policies regarding stock valuation, depreciation and
overheads.
 To promote coordination between and financial accounting departments.
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Cost and Management
Accounting

 Management is enable to know the reasons for the difference in results of both
cost and financial accounts.
 Reconciliation explains reasons for difference which facilitate internal control.
 Reconciliation ensure the reliability of cost data.
 Reconciliation ensurn management leeside meaning.

11.4 REASON FOR THE DIFFERENCE BETWEEN COST ACCOUNTS

& AND FINANCIAL ACCOUNTS

The various reasons which create difference between cost and financial profit or loss
shown by the two set of books may be listed under the following heads.
(i) Items included in financial accounts and not in cost accounts.
(ii) Items shown only in cost accounts.
(iii) Absorption of over head.
(iv) Method of stock valuation.
(v) Method of depreciation.

Differences in cost and financial accounts arise because of the following reasons:

(a) Items included in financial accounts and not in cost accounts.

There are a number of items which are included in financial accounts but find no place in
cost accounts. All such items of expenditure will reduce the financial profit for the year
while any item of income will increase the financial profit. Under this head the following
items are included:

(1) Purely financial charges:

(i) Loss on investments & fixed assets, (ii) Fines and penalties, (iii) Preliminary
expenses written off, (iv) Stamp duty and expenses on transfer of capital, stock, shares,
bonds etc., (v) Discount on debentures, (vi) Interest on bank loans etc., and (vii) Dividend
paid
(2) Purely financial incomes:
(i) Profit on sale of fixed assets, (ii) Rent received, brokerage and commission
received, (iii) Dividend received on investment, (iv) Interest received on bank deposits
and investment, (v) Fees received on transfer of shares and (vi) Promotion on use of
share.
(3) Appropriation of profits:
Items which appear in profit &loss appropriation account:
(i) Dividend paid, (ii) Taxes paid, (iii) Transfers to reserves, (iv) Goodwill
written off and (v) Transfers to sinking fund etc.

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 Reconciliation of
Cost and Financial
Accounts

(b) Items included in cost accounts only:

There are certain items which are included in cost accounts but not in financial accounts.
All expenditures incurred, whether for cash or credit pass through financial accounting
system, so the type of entry, which can appear only in cost accounts, is a normal charge.
The following two items are examples of this type:
(i) Interest on capital: only that part of the interest in charged which is not
actually paid but charged in cost accounts.
(ii) Charge in lieu of Rent: in case premises are owned by the firm, a nominee
charge in lieu of rent is made in cost accounts but not in financial accounts.

(c) Under and over-recovery of overheads

Overheads are recovered on the base of pre-determined rates i.e., estimates like
percentage on direct materials, percentage on direct wages etc so that the amount
recovered and the amount actually incurred will invariably disagree. If overheads are not
fully recovered which means that the amount of overheads absorbed (in cost accounts), is
less than the actual amount, the shortfall is called as under-recovery. On the other hand, if
overhead expenses recovered in cost accounts are more than actual, it is called as over
recovery. Thus, over or under-recovery of overheads leads to difference in cost accounts
and financial accounts.

(d) Different methods of valuation of stock:

Basis of stock valuation in cost accounts and financial accounts and financial accounts
may be different leading to a difference in the profits. In cost accounts, stock will be
valued at FIFO, LIFO or average stock etc. but in financial accounts the principle is cost
or market price, whichever is less. However, sometimes in both sets of books different
bases of depreciation may be followed.

(e) Basis of depreciation:

Different methods of providing depreciation adopted in two sets of books may also lead
to some difference in the profit or loss figures. For example in cost accounts machine-
hour rate method, or replacement cost method may be used whereas in financial accounts
straight line method or diminishing balance method may be used. This will lead to a
difference in profits.

(f) Abnormal loss and gain:

Different items of abnormal wastages, losses or gain which are included in financial
accounts but are not included in cost accounts. Thus, the figure of abnormal losses and
gains may affect the result of financial accounts.
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Cost and Management
Accounting

Methods of reconciliation:

For reconciling the profit or loss as disclosed by the financial accounting with that shown
by the cost accounting, a reconciliation statement or memorandum of reconciliation
account is prepared. The following steps have to be taken for preparation of
reconciliation statement.

Process of preparing reconciliation statement:

the following steps should be adopted for reconciling profit /loss as per cost and
financial books.
Step 1: take the profit/loss as per cost accounts/ financial accounts as the starting point.
Step 2: Add the items having the affect of higher profit as per other set of books.
Step 3: Deduct the items having the effect of lower profit as per other set of books.
Step 4: calculate the profit/loss as per other set of books.

Preparation of Reconciliation statement

Step I: start with the profits as per cost accounts.
Step II: Add, items having the effect of higher profit in financial accounts:
(i) Items of income included in financial accounts but not in cost accounts
(profit increased in financial accounts) XXX
(ii) Item of expenditure included in cost accounts but not in financial
accounts (profit in financial accounts increased). XXX
(iii) Over absorption of overheads in cost accounts (profit increases)
(iv) Amounts by which items of income have been shown in excess in financial
accounts as compared to corresponding antries in cost in cost
accounts. XXX
(v) Amounts by which items of expenditure have been shown in excess in
cost accounts as compared to the corresponding entries in financial
accounts XXX
(vi) Over valuation of closing stock in financial accounts XXX
(vii) Under valuation of closing stock in financial accounts XXX
XXX
Step II: Deduct, items having the effect of lower profit in financial accounts:
(i) Items of income included in cost accounts but not
Included in financial accounts XXX
(ii) Items of expenditure included in financial accounts
But not in cost accounts XXX
(iii) Under-absorption of overheads in cost accounts XXX
(iv) The amount by which the closing stock of inventory
Is under valued in financial accounts XXX
(v) The amount by which the items of expenditure have
Been shown in excess in financial accounts over the
Corresponding items of expenditure in cost accounts XXX
(vi) The amount by which the opening stock of inventory is
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 Reconciliation of
Cost and Financial
Accounts

Under valued in cost accounts XXX

(vii) Amount by which the items of expenditure have been
Shown in excess in financial accounts over the
corresponding items in financial accounts XXX
XXX
profit as per financial accounts XXX

The following table will also help to prepared the reconciliation of cost and financial
accounts treatment of cause for differences
Serial Reason for difference Suitable Suitable
No adjustment adjustment
Base is base is
costing profit financial
or financial profit or
loss(+) or (-) costing loss
(+) or (-)
1 Over absorption of overhead in cost account Add (+) Less (-)
2 Over valuation of closing stock in financial Add (+) Less (-)
account
3 Over valuation of opening stock in cost Add (+) Less (-)
account
4 Excess provision for depreciation of building, Add (+) Less (-)
plants & machinery etc
Charged in cost account
5 Items of expenses charged in cost account but Add (+) Less (-)
not in financial accounts (Interest on capital,
Rent in premises etc)
6 Items of income recorded in financial Add (+) Less (-)
accounts but not in cost account
7 Under absorption of overhead in financial Less (-) Add (+)
account
8 Over valuation of openings stock in financial Less (-) Add (+)
account
9 Over valuation of closing stock in cost Less (-) Add (+)
account
10 Item of income tax, dividend paid, Less (-) Add (+)
preliminary expenses written off,
underwriting commission and debenture
discount written off and any appropriation of
profit included in financial account any

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Accounting

Preparation of memorandum reconciliation account: the memorandum reconciliation

account can be prepared on the same lines as a reconciliation statement, the only
difference is that in the firmer ‘Dr’ denotes ‘-‘ while ‘Cr’ denote ‘+’.

This is an alternative to reconciliation statement. The only difference is that the

information shown above in the pro forma reconciliation statement is shown in the form
of an account. The profit as per cost accounts is the starting point and is shown on the
credit side of this account. All items which are added to costing profit for reconciliation
are also shown on credit side. The items to be ‘deducted’ from costing profit for
reconciliation are also shown on the debit side. The balance figure is the profit as per
financial accounts.

It is only a memorandum account and does not form part of the double entry books of
account.

Pro forma of Memorandum Reconciliation Account

Rs Rs
To (Item to be deducted) ……. By profit as per cost account ……..
To (Item to be deducted) ……. By (Item to be deducted) .,……
To (Item to be deducted) ……. By (Item to be deducted) ……..
To (Item to be deducted) ……. By (Item to be deducted) ……..
To (Item to be deducted) ……. By (Item to be deducted) ……..
To profit as per financial ……. By (Item to be deducted) ……..
accounts

Pro forma of reconciliation statement

Profit as per cost accounts Rs Rs
Add: 1. Over-absorption of overheads
2. financial incomes not recorded in cost books
3. items charged only in cost accounts
(national rent and interest on capital, etc.)
4. over-valuation of opening stock in cost books
5. under-valuation of closing stock in cost books
Less: 1. Under absorption of overheads
2. purely financial charges
3. under valuation of opening stock in cost books
4. over-valuation of closing stock in cost books
Profit as per financial accounts

Types of problems:
You are required to prepare a reconciliation of cost of cost and financial account from the
following structures.
(i) When profit or loss of financial account and cost account are given

232
 Reconciliation of
Cost and Financial
Accounts

(ii) When profit or loss of financial account is given

(iii) When profit or loss of cost account is given
(iv) When profit and loss account and additional information are given

Illustration 1: from the following figures. Prepare a reconciliation statement.

Cost books financial books
Rs Rs
Profit 50,000 ?
Marketing overheads 8,000 8,000
Provisions for bad debts - 5,000
Factory overheads 8,500 7,000
Directors fees - 2,000
Income tax paid 15,000
Rent of owned -
Premises 6,000 -
Depreciation 11,250 12,000
Share transfer fee (Cr.) - 1,000
Administrative overheads 5,000 8,000
Solution:
Particular Rs (+) Rs (+)
Profit as per cost books 50,000
Less: provision for bad debt made in financial books 5,000
Add: factory overheads recovered in cost books 1,500
Less: directors fees charged in financial books 2,000
Less: income tax paid charged in financial books 15,000
Add: rent on owned premises charged in cost books 6,000
Less: depreciation under9charged in cost books 750
Add: share transfer fees credit in financial books 1,000
Less: administration overheads under-recovered in cost
books . 3,000
58,500 25,750
Profit as per financial books 32,750

Illustration 2: MS Rana trader maintain separate cost bonus which discloser a profit Rs.
60,228 for the year ending March 31, 2014. The net profits disclosed by financial
accounts amounted to Rs. 39,520. Upon enquiry, it is found that:
(i) The company made a provision of Rs. 1,200 for bad debts.
(ii) Overheads charged to production in cost books were Rs. 15,000, whereas
actual overhead expenses amounted to Rs. 13,864.
(iii) Directors were paid fee amounting to Rs. 1,500.
(iv) Installation of a new plant involved an expenditure of Rs. 24,000 but in had
not gone into production as yet. Depreciation @ 5% was provided on the cost
of the plant.
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Cost and Management
Accounting

(v) The company received interest on bank deposit amounting to Rs. 56.
(vi) It paid income tax Rs. 18,000.

Prepare a reconciliation statement, explaining the difference between the profits

revealed by the cost and financial books.
Reconciliation statement
Particular Rs Rs
Profit as per cost accounts 60,228
Add: over-absorption of overheads (Rs.15,000-
Rs.13,864) 1,136
Interest on bank deposites 56 1,192
61,420
Less: provision for bad debts 12,00
Directors fees 1,500
Depreciation 1,200
Income tax 18,000 21,900
Profit as per financial accounts 39,520

Illustration 3: the following figures are available from financial accounts for the
year ended 31st March, 2015:
Rs
Direct material consumption 2,50,000
Direct wages 1,00,000
Factory overheads 3,80,000
Administration overheads 2,50,000
Selling and distribution overheads 4,80,000
Bad debts 20,000
Preliminary expenses (written off) 10,000
Legal charges 5,000
Dividend received 50,000
Interest on deposit received 10,000
Sales 1,20,000 units 7,00,000
Closing stock:
Finished stock- 40,000 units 1,20,000
Work-in-progress 80,000
The cost accounts reveal:
Direct material consumption: Rs, 4,80,000.
Factory overhead recovered at 20% on prime cost.
Administration overhead at Rs. 3 per unit of production.
Selling and distribution overhead at Rs. 4 per unit sold.
Required: prepare
(i) Cost sheet.
(ii) Financial profit and loss account,
(iii) Statement reconciling the profits disclosed by the costing
234
 Reconciliation of
Cost and Financial
Accounts

Profit and loss account and financial profit and loss account.
Cost sheet
Particular Rs
Direct material consumption 2,80.000
Direct wages 1,00,000

Prime cost 3,80,000

+factory overheads[20% of Rs.3,80,000] 76,000
4,56,000
-stock of W.I.P 80,000
Work cost 3,76,000

-office & administration over heads(1,60,000Rs. 3) 4,80,000

Cost of production 8,56,000
-closing stock of finished goods

8,56,000 2,14,000
 40,000
1,60,000
Cost of goods sold 6,42,000
+selling & distribution-overhead(1,20,000 x Rs.4) 4,80,000

Cost of sales 11,22,000

Loss(balancing figure) 4,22,000
sales 7,00,000

Working Notes:
*Units product = No. of unit sold + No. of units in closing Stock
= 1,20,000+40,000 = 1,60,000 units

Dr. Trading and profit & loss account Cr.

Particular Rs Particular Rs
Direct material used 2,50,000 Sales 7,00,000
Direct wages 1,00,000 Closing stock
Factory overhead 3,80,000 Finished stock 1,20,000
Administration over head 2,50,000 -40000 units
Selling and distribution Work in progress 80,000
Over heads 4,80,000 Dividend receives 50,000
Bed debts 20,000 Interest on deposite 10,000
Preliminary expenses received
235
Cost and Management
Accounting

(written off) 10,000 Net loss(bal.fig) 5,35,000

Legal charges 5,000
14,95,000 14,95,000

Illustration 4: the following profit and loss account for the year ending 31st March
2015 has been extracted from the bonus of A Ltd

Profit & Loss Account

Particular Rs Particular Rs
To direct material 10,000 By sales 50,000
To direct labor 20,000 Direct labor 600
To factory expenses 9500 Direct material 400
To administrative expenses 5200 Faction expenses 300 1300
To selling expenses 3800 By finished stock in hard
To interest on capital 1000 2700
To good will written off 1500
To net profit 3000
54,000 54,000

Additional information
Cost account manual states that the factory overheads are to be recovered at 50% of
direct wages, administration overheads of 10% of work cost and selling and
distribution overheads @ Re.l per unit sold
The units of product sold and stock in hand were 4,000 and 257 respectively.
Prepare:
(i) Statement of cost and profit as per cost accounts
(ii) Reconciliation statement.

Solution
Statement of cost and profit as per cost accounts
Particulars Rs
Direct material 10,000
Direct labor or direct wages 20,000
Prime cost 30,000
Add: factory overheads50%of direct wages 10,000
Work 40,000
Less: closing work in progress
Direct labor 600
Direct material 400
Factory expenses 300 1,300
Factory cost or work cost 38,700
Add: administration overheads 10% of work 3,870
cost 42,570
Total cost of production
236
 Reconciliation of
Cost and Financial
Accounts

2,570
Less: cost off finished goods 42,570x257/4,257*
40,000
Total cost of production of goods sold 4,000
Add: selling and distribution overheads
@Re.1per unit sold(i.e4,000x1) 44,000
Cost of sales 6,000
Add :profit (balancing figure)
50,000
sales
Solution
Reconciliation statement
Particulars Rs +
Profit as per cost account 6,000
Add: over-absorption of factory overheads
(10,000 – 9,500) 500
Closing stock overvalued in financial accounts 130
(2,700 – 2,570)
Over-absorption of selling expenses
(4,000 – 3,800) 200
Less: under-absorption of administrative overheads. 1330
[5,200 – 3,870] 1000
Interest on capital 1500
Goodwill written off
6,830 3830
Profit as per financial account (6,830 – 3830) 3,000

Illustration 5: A manufacturing company disclosed a net loss of Rs. 3,47,000 as per

their cost accounts for the year ending March 31st 2015. The financial accounts
however disclosed a net loss of Rs. 5,10,000 for the same period. The following
information was revealed as a result of scrutiny of the figures of both the sets of
accounts:

Rs.
(1) Factory overheads under-absorbed 40,000
(2) Administration overheads over absorbed 60,000
(3) Depreciation charged in financial accounts 3,25,000
(4) Depreciation charged in cost accounts 2,75,000
(5) Interest on investment not included in cost accounts 96,000
(6) Income tax provided 54,000
(7) Interest on loan funds in financial accounts 2,45,000
(8) Transfer fees (credit in financial books) 24,000
(9) Stores adjustment (credit in financial books) 14,000
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Cost and Management
Accounting

(10) Dividend received 32,000

a. Prepare a reconciliation statement 10
Reconciliation statement
Particular Rs Rs
Net loss as per cost accounts 3,47,000
Add: factory overheads underabsorbed 40,000
Income tax provided 54,000
Depreciation under charged
(Rs 3,25,000 – Rs 2,75,000) 50,000
Interest on loan funds in financial accounts 2,45,000 3,89,000
7,36,000
Less: administration overheads overabsorbed 60,000
Interest on investment not
Included in cost accounts 96,000
Transfer fee (credit in financial books) 24,000
Store adjustment (credit in financial books) 14,000
Dividend received 32,000 2,26,000
Net loss as per financial accounts 5,10,000

Illustration 6: A manufacturing company disclosed a net loss of Rs. 3,47,000 as per

their cost accounts for the year ended March 31st 2015. The financial accounts
however disclosed a net loss of Rs. 5,10,000 for the same period. The following
information was revealed as a result of scrutiny of the figures of both the sets of
accounts:
Rs Rs
Factory overheads under-absorbed 40,000
Administration overheads overabsorbed 60,000
Depreciation charged in financial accounts 3,25,000
Depreciation recovered in cost accounts 2,75,000
Interest on investments not included in cost accounts 96,000
Income tax provided 54,000
Interest on loan funds in financial accounts 2,45,000
Transfer fee (credit in financial books) 24,000
Stores adjustment 14000
(credit in financial books)
Dividend received 32,000

Prepare a statement showing reconciliation between the figure of net loss as per cost
accounts and the figure of net loss shown in the financial books.

238
 Reconciliation of
Cost and Financial
Accounts

Solution: Reconciliation statement

Particular Rs Rs
Net loss as per cost accounts 3,47,000
Add: factory overheads underabsorbed 40,000
Income tax provided 54,000
Depreciation under charged
(Rs 3,25,000 – Rs 2,75,000) 50,000
Interest on loan funds in financial accounts 2,45,000 3,89,000
7,36,000
Less: administration overheads overabsorbed 60,000
Interest on investment not
Included in cost accounts 96,000
Transfer fee (credit in financial books) 24,000
Store adjustment (credit in financial books) 14,000
Dividend received 32,000 2,26,000
Net loss as per financial accounts 5,10,000

Illustration 7: from the following informations, reconcile the profit as per cost
accounts and find out the profit as per financial accounts:
Reconciliation statement
Particular Cost A/c Financial
Rs A/c Rs
Profit 86,250
Opening stock:
Material 10,500 10,300
Work in progress 8,500 8,000
Closing stock: material 14,200 15,000
Work in progress 6,000 5,600
Dividend received 600
Loss on sale of investment 1,000
Goodwill written off 2,500
Preliminary exp. Written off 3,000
Overhead incurred 40,000
Overhead absorbed in cost accounts 38,500 -

Solution: Reconciliation statement

Particulars Rs Rs
Profit as per cost accounts 86,250
Add: 1. Over valuation of opening
Stock of materials in cost
Accounts Rs. (10,500 – 10,300) 200
2. over-valuation of opening stock of
Work in progress in cost accounts
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Cost and Management
Accounting

Rs. (8,500 – 8,000) 500

3. under-valuation of closing stock of
Material Rs (15,000 – 14,200) 800
4. dividend and interest received 600 2,100
88,350
Less: 1. Over valuation of closing stock of
Work in progress rs. (6,000 – 5,600) 400
2. goodwill written off 2,500
3. preliminary expenses written off 3,000
4. loss on sale of investments 1,000
5. overheads under-absorbed
Rs. (40,000 – 38,500) 1,500 8,400
Profit as per financial accounts 79,950

Illustration 8: from the following figures prepare a reconciliation statement:

Rs
Profit as per costing records 5,000
Factory overheads under-recovered in costing 3,000
Selling and administration overheads over recovered in costing 2,000
Bank interest credit in financial books 500
Preliminary expenses written off in financial books 6,500
Opening stock value:
In cost books 5,000
In financial books 4,000
Closing stock value:
In cost books 12,000
In financial books 10,000
Reconciliation statement
Particulars Rs Amount
Rs
Profit as per costing records 5,000
Add: selling and administration over-heads over-recorded in
costing 2,000
Bank interest credited in financial books 500
Opening stock over-valued in cost books
(Rs 5,000 – Rs 4,000) 1,000
8,500
Rs
Less:factory overheads under-recovered in costing 3,000
Preliminary expenses written off in financial books 6,500
Closing stock over-values in cost books
(Rs 12,000 – Rs 10,000) 2,000 11,500
Profit as per financial records -3,000

240
 Reconciliation of
Cost and Financial
Accounts

Illustration 9: the net profit of manufacturing company stood at Rs 5,000 as per

financial records for the year ended 31st March 2015. The cost books, however,
showed a net loss of Rs 4,200 for the same period. A careful analysis of the figures
from the both sets of books revealed the following:
Rs
Income tax provided in financial books 4,000
Bank interest in credit in financial books 2,500
Works overheads under recovered in cost books 2,550
Depreciation charged in financial books 6,000
Depreciation charges in cost books 8,000
Administrative overhead over recovered 1,850
Loss due to obsolescence charged in financial accounts 1,800
Interest on investments not included in cost account 12,400
Stores adjustment (credit in financial books) 300
Loss due to depreciation in stock values charged in financial books 1,500
You are required to prepare a reconciliation statements as on 31st March 2015.
Solution: Reconciliation statement
Particulars Rs Rs
Net profit as per cost accounts -4,200
Add: bank interest not recorded in cost accounts 2,500
Depreciation over charged in cost accounts
(Rs 8,000 – Rs 6,000) 20,000
Administrative overheads over recovered in
Cost accounts 1,850
Interest om investment not included in cost
Accounts 12,400
Stock adjustment not included in cost account 300 19,050
14,850
Less: income tax not included in cost accounts 4,000
Works overhead under-recovered in cost
Accounts 2,550
Loss due to absolescence not included in cost
Accounts 1,800
Loss due to depreciation in stock values not
Included in cost accounts 1,500 9,850
Profit as per financial accounts 5,000

Illustration 10:
(b)from the information given below ,prepare:
(i) a statement showing costing profit or loss and (ii)another statement
reconciling the costing profit with those shown by financial account:
Trading and profit & Loss account

241
Cost and Management
Accounting

Particulars Amount Particulars Amount

Rs Rs
Materials consumed 1,50,000 Sales (1,50,000 units)
Direct wages 75,000 3,00,000
Indirect factory expenses 45,000
Office expenses 13,500
Selling and distribution
Expenses 9,000
Net profit 7,500
3,00,000 3,00,000

The normal output of the factory is Rs2,25000 units. Factory expenses of a

fixed nature are Rs 27,000 office expenses are for all practial purposes
constant selling and distribution expenses are constant to the extent of Rs
3000 and the balance varies with sales.
Solution
Statement of profit/Loss as per cost accounts
Particulars Amount
Material consumed 1,50,000
Direct wages 75,000
Prime cost 2,25,000
Factory overheads
Fixed 18,000
Variable 18,000 36,000
Factory cost 2,61,000
Office overheads (fixed) 9,000
Cost of production 2,70,000
Selling and distribution overheads
Fixed 2,000
Variable 6,000 8,000
Cost of sales 2,78,000
Profit (balancing figure) 22,000
sales 3,00,000

Working notes:

1. Total factory overheads are Rs 45,000 out of which Rs 27,000 are fixed. Thus Rs
18,000 are available overheads. In cost accounts, fixed factory overheads must
have been determined on the basis of normal output of 2,25,000 units. Thus, the
fixed factory overheads recovered in cost accounts would be Rs 18,000
{27,000/2,25,000 * 1,50,000}. Variable overheads woulds would be Rs 18,000 in
cost account.

242
 Reconciliation of
Cost and Financial
Accounts

2. On the same basis, Rs 9000 {13,500/2,25,000 * 1,50,000} by way of fixed office

overheads and Rs 2,000 {3,000/2,25,000 * 1,50,000} by way of fixed selling and
distribution overheads must have been charged in cosat accounts.

Reconciliation statement
Particulars Amount Amount
Rs Rs
Profit as per cost accounts 22,000
Less: factory overheads under absorbed in
Cost accounts Rs (45,000 – 36,000) 9,000
Office overheads under absorbed in
Cost accounts Rs (13,500 – 9,000) 4,500
Selling and distribution overheads under-
Absorbed in cost accounts Rs (9,000 – 8,000)
Profit as per financial accounts 1,000 14,500
7,500

11.6 QUESTIONS

1. Describe the reasons which are responsible for the differences in profits as revealed
by cost accountings and financial accounting
2. Indicate the reasons why it is necessary for the cost and financial accounts of an
organization to be reconciles?
3. Write a note on the items excluded from cost accounts
4. Differentiate between reconciliation statement and reconciliation account
5. The net profit of a business house according to financial accounts was Rs 84,377
while profit shown by cost accounts was Rs 1,06,200 for the same year. Prepare
reconciliation statement to reconcile both the profits from the following information:
(i) Depreciation charged in financial accounts Rs 5,600, while recovered in
cost accounts Rs 6,250.
(ii) Works overheads under-absorbed in cost accounts Rs 1,560 while office
overheads over-recovered in cost accounts Rs 850.
(iii) Interest on loan not included in cost Rs4,000.
(iv) Loss due to obsolescence charged in financial accounts Rs 2,580.
(v) Bank interest and dividend deceived Rs 375.
(vi) Income-tax paid Rs 20,150.
(vii) Loss due to depreciation in inventories charged in financial accounts Rs
3,375.
(viii) Stores adjustment (credited in financial accounts) Rs 237.
[B.Com. (Pass) Delhi]
[Ans. Profit as per financial accounts Rs 76,377]
6. Prepare cost sheet from the following data provided by M/s. R.S. Ltd. For the year
ending 31st March, 2012:
243
Cost and Management
Accounting

Rs Rs
Raw materials 15,000 production 17,100
Direct labor 9,000 sales 16,000
Machine hours 900 selling price per unit 4
Machine hour rate 5 selling overhead per unit 50 paise

office overheads are 20% of works cost.

Also prepare a reconciliation statement, if factory, office and selling expenses are
Rs.5,000, Rs 5,000
And Rs 10,000 respectively, while closing stock is valued at Rs, 2,500 in
financial books.
[B.Com.(Pass)Delhi, 1997, adapted]
[Ans. Profit as per cost accounts Rs 24,000, profit as per financial accounts Rs
22,500.]
7. From the following information prepare:
a. P & l account
b. Cost sheet
c. Reconciliation statement
Rs. Units
Sales 2,50,000 20,000
Material 1,00,000
Wages 50,000
Factory overheads 45,000
Office overheads 26,000
Selling and distribution overheads 18,000
Closing stock finished goods 15,000 1,230
Work in progress:
Materials 3,000
Wages 2,000
Factory overheads 2,000
Goodwill written off 20,000
Interest on capital 2,000

In costing books, factory overheads in charged at 100% on wages, administration

overheads at 10 % of factory cost and selling and distribution overheads at the rate of Rs.
1 per unit sold
[B.Com. (pass) Delhi, 1996]
[Ans. Profit as per cost accounts Rs 30,000 profit as per financial accounts Rs 11,000].

244
 Reconciliation of
Cost and Financial
Accounts

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

245
 UNIT-12 BUDGETING AND BUDGETARY CONTROL

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Explain budgeting and budgetary control
 Understand objectives, merits and limitations of budgeting
 Describe Budget Administration
 Understand budgeting procedure, budget committee, budget period and budget
control
 Explain various types of budget
 Understand zero base budgeting

STRUCTURE

12.1 Introduction
12.2 Advantages of Budgeting
12.3 Budgetary Control
12.4 Advantages and Limitation of Budgeting Control
12.5 Organisation and Administration
12.6 Sales Budget
12.7 Production Budgets
12.8 Material and Labour Budget
12.9 Factory overhead Budget
12.10 Selling overhead Budget
12.11 Cash Budgets
12.12 Performance Budgeting
12.13 Zero Base Budgeting

12.1 INTRODUCTION

The word budget is derived from a French word BOUGETTE, PURSE. It generally refers
to a list of all planned expenses and revenue. The main objective of the management
accounting is to provide information to management for proper planning and control.
Budgeting can act as an important tool of both planning and controlling. It is an
estimation of the revenue and expenses over a specified future period of time. A budget
can be made for a person, family, business, government, country, multinational
organization etc. 'No risk no gain' is the slogan of business. The higher the risk, the
higher is the profit. In order to maintain the profitability and solvency of any business, a
plan has to be formulated in relation to future financial requirements. This plan is known
as Budget. Thus, Budgeting is related to various methods of planning and preparation of
budget plans. It is an act of preparing the budgets. Hence budget is a statement of the
estimated revenue and expenditure of the government.

246
 Budgeting and
Budgetary Control

12.2 ADVANTAGES OF BUDGETING

(i) It ascertains the responsibilities of employees.

(ii) It throws light on capabilities of deficiencies of business and helps in taking
measures for improvement
(iii) It develops amongst members the habit of giving timely and serious thoughts to all
the factors.
(iv) It increases the profits of organisation because budget expenses are controlled.
(v) It facilitates maximum utilisation of labour, material, capital and other resources,

12.3 BUDGETARY CONTROL

The primary objectives of every business firms is to maximise the profits and to minimize
the cost. This can be possible if an organisation have good budgetary system. Budgetary
control system is quite helpful in reducing cost of a product in business. This is a
controlling technique in which the actual state of affairs is compared with the budget and
if there is any deviation, a necessary action will be taken by the management to remove
the deviation.

 CIMA London : "Budgetary control is the establishment of budget relating to the

responsibilities of executives of a policy and continous comparison of the actual with
the budgeted results, either to secure jjy individual actioathe objective of the policy
or to provide a basis for its reservations.

Objectives of Budgetary Control

(i) The main objective of budgetary control is to control the production and other
costs with maximum output.
(ii) It establishes coordination amongst various department.
(iii) Various activities are controlled through budgetary control for the attainment of
budget estimates.
(iv) Budgetary control helps administrations in smooth running of the business. It can
be used in production, administration, sales and in estimating financial
requirements.
(v) Targets for various departments are ascertained through budgetary control.
Proper steps can be taken against those persons who are not in a position to attain
their targets.
(vi) Business policies are determined through budgetary control, which shows the
path for the future growth of the organisation.

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Cost and Management
Accounting

12.4 ADVANTAGE'S OF BUDGETARY CONTROL

The main advantages of Budgetary control are discussed below:

(i) It becomes simple to control cost by application of budgetary control. Standards
are fixed in budget and efforts are made to control them. Every department tries
to control waste expenditure and to complete the work in budgeted amount,
(ii) Budgetary control establishes coordination amongst various department and the
work becomes very simple.
(iii) Budgetary control is helpful in ascertainment of various policies of the
organisation,
(iv) Budgetary control brings maximum utilisation of resources and they provide
maximum profits to the organisation,
(v) Targets are fixed for-every department and efforts are made to achieve those
targets. It increases the efficiency of every department and of every person
(vi) The amount and kind of work to be done by each department is ascertained
through budget If any work is performed according to the pre-determined plan,
expenses will be controlled,

Limitations of Budgetary Control

Some of the main limitation of budgetary control are as under:

(i) Sources of budget depends upon the accuracy of forecasting. But it has been
observed that forecast made for future are not correct and the success of budgets
becomes doubtful.
(ii) Budgetary control gives birth to rigidity in control. Sometimes achievements of
these forecast becomes uncontrollable and the manager has to face so many
difficulties.
(iii) It has been observed that undue weightage is given to the paper work and the
main purpose of preparing the budget is not achieved.
(iv) Experienced persons are appointed in this system and it becomes very expensive
which is not possible to adopt it by the small concerns.

12.5 ORGANISATION & ADMINISTRATION

The success of effective budget is dependent on strong organisation of the concern. In

this connection, the following points are to be considered :
 Budget centres: When the organisation of business enterprises are divided into
different departments. These departments are known as budget centres.
 Budget committee: Responsibility of preparation of budget is assigned to a
committee known as budget committee. Chief manager is the chairman of this
committee and accountant works as budget officer. The committee may makes
amendments and coordinates all the budgets and then master budget is prepared.

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 Budgeting and
Budgetary Control

 Budget period : Every budget is prepared for a definite time period, few budgets
are prepared for long term period and some short term budgets are also prepared.
 Budget key factor : It is a factor which affects the level of activity. There can be
more than one key factor in any business organisation. Key factors are applicable
in raw material, management and working capital etc. 0\
 Organisation chart: Budget chart should be prepared for budgetary control. In
this chart, rights of each officer are specified. The outline of budget chart
depends upon the nature and size of the business.
 Budget Manual: It is a written document in which directions for the preparation
of budget are given and the method to be adopted is also described in it.
 Level of activity : Level of activity can be fixed on the basis of past results or on
the basis of optimum capacity. The best level would be if the level is fixed on the
basis of general capacity keeping in mind the present conditions.
 Budget controller: There should be a man controlling the budget, known as
budget controller. The main function of budget controller is to look into
preparation of budget and establishment of coordination. This officer may help in
removing obstacles in many departments.

Types of Budgets

The main types of Budgets are as under:

(i) Sales Budget, (ii) Production Budget, (ii) Production cost Budget, (iii) Raw material
Budget/Purchase budget, (iv) Labour Budget, (v) Factory overhead Budget, (vi) Sales
overhead Budget, (vii) Cash Budget (viii) Fixed and Flexible Budget (ix) Master Budget,
(x) Performance budget and (xi) Zero Base Budget
Let us discues each of the Budget one by one:

12.6 SALES BUDGET

The success of any business firms depends upon the quick turnover of its production.
Every company wants to increase its sales and also market share. Thus, every effors are
made to achieve the sales targets. Sales budgeting is a key function of sales management.
Sales budget is the most important budget based on which all other budgets are built up.
This budget is a forecast of quantities and values of sales to be achieved in a budget
period. Every company may have sales projection, which will be made as a periodic basis
and the sales budget will be prepared accordingly. In brief, a sales budget is an estimate a
future sales expressed in quantity and money. Every effort should be made to ensure that
its figures are as accurate as possible. Because this budget is starting budget and it will
have impact on other budget also. Here the sales manager should be made directly
responsible for the preparation and of the budget. However, before preparing this budget,
the sales manager should be taken in to account the following factors.

(i) Previous years sale figure and its trend, (ii) Estimates given by sales man, (iii)
Available plant capacity, (iv) Availability of raw materials and other necessary supplies,
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(v) General economic trend of the country, (vi) Seasonal fluctuations in sales, (vii)
Available of finance, (viii) Nature and degree of competition in the market (ix) Planned
advertising and product promotion and (x) Political and legal environment.

Illustrated 1. M/s Aradhna Ltd. manufacturer's two types of toys:

Raja and Rani sells them in Mumbai and Delhi markets. The following information
is made available for the current year 2015.
Market Budgeted Sales Actual Sales
Mumbai :
Raja 800 at Rs. 9 each 1000 at Rs. 9 each 400 at Rs.
Rani 600 at Rs. 21 each 21 each
Delhi:
Raja 1200 at Rs. 9 each 1400 at Rs. 9 each 800 at Rs.
Rani 1000 at Rs. 21 each 21 each

Market studies reveal that —

(1) Raja is popular and its price is increased by Re 1 per unit.
(2) Rani is over priced and its selling price be reduced to Rs. 20 per unit.
Percentage increase in sales over current budget is as under:
Mumbai Delhi
Raja +10% +5%
Rani +20% +10%
With intensive advertisement, the following additional sales are possible:
Mumbai Delhi
Raja 60 units 70 units
Rani 40 units 50 units
Prepare a sales budget for the current year 2015
Solution: Sales Budget
Budget for current Actual sales Budget for the
year future
Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.
Mumba Raja 800 9 7,200 1,000 9 9,000 940 10 9,400
i
Rani 600 21 12,600 400 21 8,400 760 20 15,200
Total 1,400 19,800 1,400 17,400 1,700 24,600
Delhi Raja 1,200 9 10,800 1,400 9 12,600 1,330 10 13,300
Rani 1,000 21 21,000 800 21 16,800 1,150 20 23,000
Total 2,200 31,800 2,200 29,400 2,480 36,300
Grand Raja 2,000 9 18,000 2,400 9 21,600 2,270 10 22,700
Total Rani 1,600 21 33,600 1,200 21 25,200 1,910 20 38,200
3,600 51,600 3,600 46,800 4,180 60,900

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Working Notes: Budget Estimates:

Mumbai Delhi Mumbai Delhi
Raja 800 1,200 Rani 600 1,000
+10% 80 +5% 60 20% 120 10% 10
880 1,260 720 1,100
+ 60 70 40 50
Total 940 1,330 760 1,150

12.7 PRODUCTION BUDGET

Production budget involves planning the level of production which in turn involves the
answer to the following four questions.
(i) What is to be produced? (ii) When to be produced? (iii) Where to be produced? and
(iv) How to be produced?

Production budget is an important part of master budget. It establishes the level of

production for budgeted period. It fixes the target for the future period. This budget
attempts to estimate the number of units of each product which a company plans to
producee during a year. There should be sufficient quantity of goods which may be
available at the time of sales. A portion of these goods may already available in the form
of opening stocks. Before preparing this budget the production manager should be taken
in to account following factors.

(i) Opening and closing, (ii) quantity required to meet projected sales, (iii) Availability of
storage facility, (iv) Amount of investment (finance) required (v) Policy of management
regarding procurement of goods and (v) Time taken in production process.

Formula
Total units to be produced =
Expected units of sales XXX
(+) Desired units in closing stock xxx
xxx
(-) Estimated units is opening stock xxx
Units to be produced xxx

Illustration 2. Aditya Ltd. plans to prepare a production budget for 3 products. The sales
forecasts of these products are 166400 units, 145600 units and 176800 units respectively.
The estimated requirements of inventory both at the beginning and at the end of the
budget period are shown in the following schedule:
A B C
Opening (Units) 32,000 24,000 40,000
Closing (Units) 41,600 22,320 55,200

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Prepare production budget.

Solution: Production Budget (in units)
A B C
Expected Units of Sales 1,66,400 1,45,600 1,76,800
(+) Closing stock 41,600 22320 55,200
2,08,000 1,67,920 2,32,000
(Less) Opening Finished 32,000 24,000 40,000
Stock
1,76,000 1,43,920 1,92,000
Production required
Production Cost Budget

This budget is an estimate of cost of output planned for a budgeted period. Further it
shows a summary of different items of cost to be incurred for the budgeted output. This
budget may be classified into material cost budget, labour cost budget and overhead cost
budget, because cost of production includes material, labour and factory overhead.

Illustrations 3: (B.Com (Hons), Delhi)

The following information has been made available from the records of incharge, Sunil
Tools limited for the last six months of 2014 and of only the sales of January 2015 in
respect of product X:
(i) The units to be sold in different months are:
July 2014 1,100 November 2014 2,500
August 2014 1,100 December 2014 2,300
September 2014 1,700 January, 2015 2,000
October 2014 1,900
(ii) There will be no work-in-progress at the end of any month.
(iii) Finished units equal to half the sales for the next month will be in stock at the
end of every month (including June, 2014)
(iv) Budgeted production and production cost for the year ending 31st December
2014 are as thus: Production (units) 22,000
Direct Materials per unit Rs. 10.00
Direct Wages per unit Rs. 4.00
Total Factory overheads apportioned to Product Rs. 88,000

It is required to prepare:
(a) a Production Budget for each of the last six months of 2014, and
(b) a Summarized Production Cost Budget for the same period.

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Solution (a) Production Budget for the six months ending 31-12-2014
July Aug. Sept. Oct. Nov. Dec. Total
Sales (in units) 1,100 1,100 1,700 1,900 2,500 2,300 10600
Add: Closing Stock 550 850 950 1,250 1,150 1,000 5750
1,650 1,950 2,650 3150 3,650 3,300 16350
Less: Opening Stock 550 550 850 950 1,250 1,150 5300
Production units 1,100 1,400 1,800 2,200 2,400 2,150 11050

(b) Production Cost Budget

Production for six months (July to Dec.) (in units) 11,050
Direct Material Cost @Rs. 10 per unit (11,050 x Rs. 10) 1,10,500
Direct Wages @Rs. 4 per unit (11,050 x Rs. 4) 44,200
Factory overheads @ Rs. 4 per unit (11,050 x Rs. 4) 44,200
Total Production Cost 1,98,900

Working Notes:
(1) Calculation of Closing Stock
1100 2500
July   550 unit October   1250 unit
2 2
1700 2300
August   850 unit November   1150 unit
2 2
1900 2300
September   900 unit December   1150 unit
2 2

12.8 MATERIAL BUDGET

Material budget is prepared with a view to ensure regular supply of raw materials
according to the requirements of production schedule. A schedule of materials
requirements is prepared. The quantity of material required for production and the
required inventory will indicate the quantity of each material, which should be made
available. The inventory of raw materials at the beginning of the budget period is
deducted and the balance quantity is produced during the budget period. Materials budget
checks wastage of raw material and at the same time helps in the determination of
economic order quantity. In brief this budget provides information about the material to
be a purchased from the market during the current period.

Formula : Material budget = Estimated Sales.

Add : Closing stock require Less : Opening stock

Illustration 6. Draw a material requirement budget from the following information :

Estimated sales of a product: 80,000 units.
Each unit requires 3 units of material A and 5 units of Material B.

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Estimated opening Balances of the beginning of the next year :

Finished Product Units
Material X 10,000
Material Y 24,000
Material on order:
Material X 14,000
Material Y 22,000

The desirable closing balances at the end of the next year :

The desirable closing balances at the end of the next year :
Finished Product Unit
Material X 14,000
Material Y 30,000
Material on order : 50,000
Material X 16,000
Material Y 20,000
Solution : Material Requirement Budget
X Y
Material required 2,52,000 4,20,000
Add : Closing stock required 30,000 50,000
Material on order 16,000 46.000 20.000 70,000
2,98,000 4,90,000
Less : Opening Stock :
Opening stock 24,000 40,000
Material on order 14,000 38,000 22,000 62,000
Units to be Procurred : 2,60,000 4,28,000

Notes: Units of Material required Units

Estimated sales Add: 80,000
Closing Add: Closing 14,000
stock 94,000
Less: Opening stock 10,000
Production in units 84,000

Material required :
X = 84,000  3 = 2,52,000 and Y = 84,000  5 = 4,20,000

Direct Labour Budget

This budget shows the total direct labour cost and number of direct labour hours needed
for production. It helps the management to plan its labour force requirements. Direct
labour budget is a component of master budget. It is prepared after the preparation of
sales and production budget. This budget is either presented monthly or quarterly format.
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Formula
Planned production in units x Direct Labour hour required per units = Budgeted labour
hours required.
Budgeted Direct Labour Cost =
Budgeted Labour hours required x cost per Direct Labour hours.

Illustration 5
Aradhya Ltd. manufactures two products using one grade of labour. Shown below is an
extract from the company's working paper for the next period's budget:
Particular Product Product
Budgeted Production (Units) 3500 4500
Standard hours allowed per product 5 4
Budgeted wage Rate Rs. 10 per hour.

Overtime premium is 50% and is payable, if a worker works for more than 40 hours a
week. There are 100 direct workers. The target productivity ratio for the productive hours
worked by the direct workers in actually manufacturing the production is 80%; is
addition the non-productive downtime is budgeted at 20% of the Productive hour worked.
There are twelve 5 days week in the budgeted period.

Calculate the wages/labour budget for direct workers showing hours required and wages
paid.

Solution
Particulars Product x Product x Total
Budgeted Production in units 3500 4500
Standard hours for budget 17500 18000 35,500
(3500 units (4500 units
x 5 hours x 5 hours)
Standard hours for budgeted production at
target efficiency ratio of product x = 35500 hours  100 44375
80
8350
Add Normal Production down time to (x) 44375x20%
Total
= labour hours required 53250
Less Normal labour hours 48000
= (100 workers  12 weeks  5 days  8 hours) =
Difference (i.e. overtime) 5250
Wages for normal hours 48000  Rs. 10 480000
Overtime wages (5250  Rs. 15) 78750
Total Wages 558750

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12.9 FACTORY OVERHEADS BUDGET

The factory overhead budget shown all the planned/manufacturing expenses which are
needed to produce the budgeted production level of a period other than direct costs which
are already covered under direct material and direct labour .budget. In this budgets all
manufacturing expenses are classified as fixed, variable and sermvariable expenses. In
preparing the budget, fixed expenses can be estimated on the basis of past information
after taking into consideration the expected changes which may occur during the budget
period. Variable expenses are estimated on the basis of output.

Illustration 6: Prepare a factory overhead budget and calculate factory overhead rates at
50% and 70% capacity. The following particulars are given at 60% capacity.

Variable overheads: Rs.

Indirect Materials 6000
Indirect Labour 18,000

Semivariable overheads:
Power (40% fixed) 30,000
Repairs and maintenance
(20% variable) 3,000

Fixed Overheads:
Depreciation 17,000
Insurance 4,000
Salaries 20,000
Estimated Direct Labour hours 186,000 hours

Solution
Manufacturing/Factory overhead budget
Particulars 50% 60% 70%
capacity capacity capacity
Rs. Rs. Rs.
Variable Overheads:
Indirect Materials 5,000 6,000 7,000
Indirect Labour . 15,000 18,000 21,000
Semi Variable Overheads
Semi variable overheads 12,000 12,000 12,000

Power Fixed
Variable 15,000 18,000 21,000
Repairs maintenance Fixed 2400 2400 2400
Variable 500 600 700
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Fixed overhead 17000 17000 17000

Depreciation
Insurance 4000 4000 4000
Salaries 20,000 20,000 20,000
Total overheads
90900 80,000 105,100

Estimated direct labour hours 155,000 186,000 217,100

Overhead Rate
Rs. 0.586 Rs. 0.430 Rs. 0.484

Working Notes:
(1) Power
40
At 60% capacity power cost is Rs. 30,000 of which Rs. 12000 (ie. 30,000 ) is fixed
100
for all
capacity and Rs. 18000 is variable.
The variable portion of the power cost
18000
at 50% capacity =  50  Rs.15000
60
18000
and for 70% capacity =  70  Rs.2100
60

(ii) Repair and Maintenance

At 60% capacity repair and maintenance cost is Rs. 3000 of which Rs. 3000 x 80/100 =
Rs. 2400 is fixed for all capacity and Rs. 600 (Rs. 3000 x 20/100) is variable
The variable portion at 50% capacity
600
  50  Rs. 500 and
60
600
for 70% capacity   70  Rs. 700
60

12.10 SELLING AND DISTRIBUTION OVERHEAD BUDGET

The selling and distribution overhead budget is the forecast of the cost of selling and
distribution for budget period and it is clearly related to sales Budget. This budget is
comprised of the budgets of all non-manufactures departments such as the sales,
marketing, advertising, ware housing etc. It is a component of master budget and is
prepared by all types of business.

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Illustration 7: From the following information, prepare a sales overheads budget:

Rs.
Salaries to sales department 10,000
Salesman's Dearness allowance 12,000
Advertisement 5,000
Other expenses of sales Department 3,000
Counter salesman commission 1% on sales. Travelling salesman commission at 10% on
sales and their sales expenses at 5% of sales.

The sales record was as under:

Counter Sales Travelling Salesman
Rs. Rs.
1,60,000 20,000
2,40,000 30,000
2,80,000 40,000
Solution : Sales Overheads Budget
Estimated sales 1,80,000 2,70,000 3,20,000
Fixed overheads—
Salaries of sales Department 10,000 10,000 10,000
Salesman Dearness allowance 12,000 12,000 12,000
Advertisement 5,000 5,000 5,000
Other expenses 3,000 3,000 3,000
30,000 30,000 30,000
Variable overheads—
Commission to counter salesman 1,600 2,400 2,800
Traveller salesman commission 2,000 3,000 4,000
Expenses 1,000 1,500 2,000
4,600 6,900 8,800
Total Expenses 34,600 36,900 38,800

12.11 CASH BUDGET

Cash budget is a forecast related to cash for a certain period. Under it flow of cash is
controlled by estimating cash receipts and payments for a definite period. Cash should be
available in sufficient quantity in future. Cash is received from the sale, rent, interest,
dividend and sale of assets etc. Cash is paid for creditors, purchases, salaries, rent, taxes
and capital expenditures etc.

Importance of Cash Budget

(i) Amount of cash can be controlled through cash budget,
(ii) Surplus or deficiency of cash can be calculated easily.
(iii) Effect of seasonal changes on cash can be ascertained with the help of cash
budget,
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(iv) Other budgets can be regularised on the basis of cash budget,

(v) Information about other conditions can be obtained easily.
(vi) It becomes easier to formulate strong dividend policy on the basis of availability
of cash through the cash budget.
(vii) Cash budget prepares solid base for getting further loans.
(viii) Coordination of cash can be established with the working capital, sales, loans,
investment etc.

Methods of Preparation of Cash Budget

(i) Receipt and Payment Method: Under this method, a statement is prepared
under which all receipts from various sources and all payments to various items
are recorded. The difference of both the side is known as cash balance and cash is
forecasted.
(ii) Projected Balance Sheet Method: Under it, efforts are made to forecast cash
position at special points. At the end of the budget period, a projected Balance
sheet is prepared in which forecasts are made for all the assets and liabilities, but
it excludes cash and bank balance or overdraft. These items are projected in
Balance Sheet and the balance is known as cash in hand or balance at Bank.
.
(iii) Cash Flow Method: In this method, it is assumed that cash comes into the
organisation from Debtors, Stock, Bills Receivables and there is no increase or
decrease in fixed assets. In case of changes made, proper adjustments are made
and recorded. Few adjustments are to be made while preparing cash forecasts.
Cash balance is adjusted with changes in current assets and current liabilities etc
and then with the help of all adjustments cash balances are drawn, and
forecasted.
(iv) Adjusted Profit and Loss Method: The profit forecast for the budget period is
adjusted for non-cash items and for expected changes in assets and liabilities.
Thus net estimated profit is increased by the amount of non-cash transactions
which in turn is added by capital receipts, reduction in assets and increase in
liabilities to form total cash receipt. It is reduced by payments made and the
balance will be cash available.

Sources of cash receipts

(i) Opening cash balance, (ii) Collection from debtor, (iii) Interest received on loan, (iv)
Issue of shares and debenture, (v) Sale proceeds of capital asset, (vi) Cash sales, (vii)
Collection from Bills receivable, (viii) Dividend received, (ix) Government assistance
and Govt. loans (xi) Other Receipts.

Items of Cash Payments

(i) Cash purchases, (ii) Salaries and wage (iii) Payment of tax liabilities, (iv) Purchase
of capital asset (v) Redemption of debentures, (vi) Payment to creditors and Bills payable
(vii) Manufacturing, administrative, sales and distribution expenses, (viii) Payment of

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interest and dividend (ix) Redemption of Preference share capital (x) Repayment of
loans, (xi) Other expenditures.

(c) Cash Balances : After recording all cash receipts and cash payments, cash balance is
ascertained. If total of cash receipts is greater than total of payments the balance is treated
as cash balance and if the total of payment is greater than the total of cash receipts, then
the balance is known as overdraft or credit balance of cash.

Illustration 8. Prepare a cash budget for 4 months from April 2015 to July 2015
from the following information:
Month Sales Credit Wages Manufactures Distribution &
Purchase Administration Selling expense
Overhead
April 30,000 30,000 6,000 1,000 600
May 33,000 21,000 7,000 1,100 700
June 36,000 20,000 8,000 1,100 700
July 39,000 18,000 9,000 1,200 800
August 42,000 17,000 10,000 1,300 800

Additional Information
(1) Cash balance on 1st April was Rs. 17,500.
(2) 50% of sales are on credit which are realised in subsequent month.
(3) Suppliers are paid in the month following the month of supply.
(4) Delay in payment of wages and overheads is 30 days.
(5) Dividends on investment Rs. 5,000 may be received in April, June and July.
(6) Machinery purchased for Rs. 30,000, payment made in there equal instalments in
April, June and July.
Solution: Cash Budget
Rs.
April May June July
(A) Balance b/d. 17,500 27,500 21,400 16,100
(B) Receipts:
Cash sales 50% 15,000 16,500 18,000 19,500
Debtors  15,000 16,500 18,000
Dividends 5,000   5,000
Total (A + B) 37,500 59,000 55,900 58,600
;
(C) Payments
Creditors  30,000 21,000 20,000
Wages  6,000 7,000 8,000
Administration overheads  1,000 1,100 1,100
Distribution expenses  600 700 700
Machine 10,000  10,000 10,000
Total C 10,000 37,600 39,800 39,800
Closing Balance (A + B-C) 27,500 21,400 16,100 18,800
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12.12 PERFORMANCE BUDGETING

It was introduced in USA in 1949 by Hoover Commission. According to him budget

should be in accordance with the functions, programmes, activities and policies of any
organisation. In India performance budgeting was first introduced in the year 1967 on the
recommendation of administrative Reform Commission. It is an important technique of
management accounting which is prepared in accordance with the activities of the
organisation. Valuation of various activities are carried out for making the policies more
effective. The deficiencies of traditional budgeting are removed under it. Both public and
private sectors are free to use this technique. According to this concept, budget is
prepared by giving due consideration to activities and functions of various departments. It
is a special technique of financial control.

Nature of Performance Budgeting

Performance budgeting is a programme of activities to be performed by any organisation
and it is prepared according to cost and objectives. Under it the following points are to be
studied and considered :
(i) The objectives are ascertained and efforts are made to achieve these objectives.
(ii) Comparison with actual are made and efforts are made to remove variations.
(iii) Steps for improvements are taken.
(iv) It is similar to responsibility accounting in which responsibilities are defined at
various managerial levels.
(v) It is valued and prepared in context to entire organisational objectives and efforts
are made to remove the deficiencies.

Objectives of Performance Budgeting

 Defining responsibilities and accountability of officers and employees.
 Achievements of short term and long term strategies.
 Attainment of targets.
 Establishment of an effective valuation system in an organisation.
 Valuation of progress of all the activities of the concern.

Steps taken in Performance Budgeting

(i) All budgetary objectives are to be defined.
(ii) Short term and long term strategies are to be planned,
(iii) Establishment of different agencies for proper implementation of activities,
(iv) Special attention towards arrangements of resources.
(v) Finding out variations and to take necessary steps in it.
(vi) Issue of clear and special directions to officers and employees.
(vii) Activities of organisation are to be classified in accordance with the main
objectives of the organisation.
(viii) Analysis and identification of identified alternate activities from the point of
view of cost and benefits.
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(ix) Issue of reports by related authorities, so that variation are detected

(x) Performance budget measures every work effort and establishes relationship
between programmes and financial resources.

Limitations of Performance Budgeting

(i) It can be used only for such programmes, where evaluation can be done in a
precise manner.
(ii) Well organised departments is necessary for the use of performance budgeting,
which is very rare to find.
(iii) Only a limited number of organisation can be benefitted by this approach of
budgeting.
(iv) It evaluates only quantitative and financial variables,
(v) It lacks quantitative approach to the evaluation of the programme.

12.13 ZERO-BASE BUDGETING

In business zero-base budgeting was introduced by Peter Payal of USA in 1969. But in
military it was in use since 1960. It helps the manager in implementation and formation
of various managerial activities. Under this system, every item is checked independently
before the preparation of the budget, so that its utility can be ascertained in real life.
Under conventional budget amendments are made to previous budget, whereas in zero
Budget every activity and item is tested and then budget is prepared accordingly for the
future.

Features of Zero base Budgeting

— Each item is analysed from the beginning.
— Proposals are prepared and then they are evaluated and afterwards are presented
for decision.
— For each decision package, a responsible officer is appointed to take care of it.
— Resources are allocated for each decision package.
— Justification is presented for each item of expenditure.
— For each programme cost benefit analysis is made.
— Each activity is selected for proper decision making.
— Relationship is maintained between decision package and targets.
— Priorities are identified and decision are taken accordingly.

Drawbacks of Conventional Budgets

There are various deficiencies in conventional budget and they are as under : —
(i) The people working in conventional budget do not take interest and they feel the
work quite monotonous.
(ii) Due to lack of analysis, the decision derived are affected and wrong conclusions
are drawn on it.
(iii) Under conventional system, items are not analysed properly consequently it
increases cost due to lack of identification.
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(iv) Irrelevant items are not detected easily and it increases the cost unnecessary.
(v) Proper accountability is not defined and due to it the targets of the organisation
are affected.

Advantages of Zero-Base Budgeting

(i) Under it the various budget are allocated in proper manner, which increases the
efficiency in management.
(ii) It emphises an optimum utilisation of resources and a proper control on
unnecessary expenditure. Due to detailed study and analysis of allotted amount
control is made on expenditure.
(iii) Evaluation of every activity is possible under zero base budgeting system. Proper
provision is made in the budget for it.
(iv) Under it old and new proposals are evaluated without any unfair influence.
Therefore resources are allocated properly.
(v) Under this system, past records of expenses are not taken into account and every
expenditure is studied in isolation.
(vi) Zero base budgeting emphasises on preparation of different alternative plans,
which are helpful in the selection of profitable channels.
(vii) Proper coordination is established between top level management and various
managerial decision making units.

Limitations of Zero-Base Budgeting

(i) Due to lack of skills of managers and employees, it is not possible to evaluate the
budget properly and it increases the unnecessary expenditure of the organisation.
(ii) Since the budgeting process is quite different with the conventional process, the
managers feel its difficult to accept the changed process.
(iii) In the absence of actual facts proper analysis and evaluation of zero base
budgeting is difficult.
(iv) Detailed analysis of every work is done which in turn increases the paper work.
(v) Increase in costs : Zero base budgeting emphasises on research work and it
increases the cost at every level of working.

 Fixed Budget:- This is defined as budget which is designed to remain unchanged

irrespective of the volume of output or turnover attained. This budget will be useful
only when the actual level of activity corresponds to the budgeted level of activity.

 Flexible Budget: Flexible budget is a budget which, by recognising the difference

between fixed, semi variable and variable costs is designed to change in relation to
the level of activity attained. A flexible budget is a series of cost budget which
prepared for a different level of capacity. It is a statement of low costs change with
changes in the activity level. Flexible budgets do not distinguish between variable
and fixed overhead.

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Flexible budgeting can be incorporated in two ways —

(i) Step budgets : Budgets are developed for different levels of operation.
(ii) Variable budget: Where budgets are prepared on a variable cost basis.

Business executives prefer the technique of flexible budgeting, as it can be easily

understood by the supervisors at all levels. The main significance of flexible budgeting is
that it provides completely realistic budget amounts. There are less chances for variances
which can be the result of inefficient control in operating conditions.

Method for preparation of flexible budget: Fixed, variable and semi-variable costs are
kept into mind while preparing flexible budget. Fixed expenses do not change and
variable expenses change at every level of activity. Semi-variable expenses change at
every level of activity. There are some semi-variable expenses which remain fixed at
different level of activities and some of them change at different levels. The following
points are to be kept into mind:
(i) Fixed expenses are always remain fixed at each level of production.
(ii) Variable expenses per unit remains the same. The total variable expenses
increases with the increase in production and vice-versa.
(iii) Some part of semi-variable is variable and other part is of fixed nature.
(iv) There may be changes in the rates of sales for different level of production.

Illustration 9: [B.Com (Hons), Delhi]

A Department of Tech mahindra company attains sale of Rs. 600,000 at 80% on its
normal capacity and its expenses are given below:
Administration cost:
Office salaries Rs. 90,000
General expenses 2% of sales
Depreciation Rs. 7,500
Rates and Taxes Rs. 8750
Distribution cost :-
Wages 15,000
Rent 1% of sales
Other expenses 4% of sales
Setting cost :-
Salaries 8% of sales
Travelling expenses 2% of sales
Sales office expenses 1% of sales
General expenses 2% of sales
Draw up flexible administration, selling and distribution cost budget, operating at 90%,
100% and 110% of normal capacity.

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Solution:-
Flexible Budget for Administration, Selling and Distribution Cost
Particulars 90% 100% 110%
Rs. Rs. Rs.
Sales Rs. 675,000 Rs. 750,000 Rs. 825,000
Administration Cost
Office salaries 90,000 90,000 90,000
General expenses 13,500 15,000 16,500
Depreciation 7,500 7,500 7,500
Rates and Taxes 8,750 8,750 8,750
Total Administration Cost (A) 119750 121250 122750
Distribution cost
Wages 15000 15000 15000
Rent 6750 7500 8250
Other expenses 27000 30,000 33,000
Total Distribution Cost (B) 48750 52500 56250
Selling cost
Salaries 54,000 60,000 66,000
Travelling exp 13,500 15,000 16,500
Sales office expenses 6750 7500 8250
General expenses 13500 15000 16500
Total Selling cost (C) 87,750 97,500 10,7250
Total Cost (A+B+C) 2,56,250 2,712,50 2,86,250
Profit (Sales-Total Cost) 4,18,750 4,78,750 5,38,750
Distinction between fixed Budget and Flexible Budget
Fixed Flexible
Budget Budget
1. Flexibility This budget is inflexible and This budget is flexible and can
does not change with the actual
be suitably recasted quickly
volume of output achieved. according to the level of
activity achieved.
2. Condition Fixed budget assumes that Flexible budget is designed to
conditions would remain change according to changed
static i.e. unchanged. conditions.
3. Classification In this Budget costs are not In this budget costs are class-
classified according to their ified according to the nature
variability i.e. fixed and of their variability.
variable.
4. Comparison Very difficult to compare Comparison can be made
performance if the volume of easily.
output is different.
5. Forecast It does not help in fore- It help in fore casting.

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casting
6. Application It has limited application It has wider application
7. Tool for cost control It cannot be applied as a It can be applied as a tool for
tool for cost control. cost control.

Master Budget
The master budget is expressed in financial terms and set out plan for the operations and
resources of the firm. It is a summary of the budget schedules high lighting the budget
period. The master-budget called the comprehensive budget is the complex blueprint of
the planned operations of the firm. Master budget is an overall budget of the firm, which
includes all other small departmental budgets. It is a network consisting of many separate
budgets. It coordinates various activities of the business. It contains consolidated
summary of all the budgets prepared. Such budget is of no use for the departmental
executives. It draws the attention to those issues which provide immediate attention.
CIMA defines this budget as "the summary budget incorporating its component
functional budget and which is finally approved, adopted and employed." This master
budget is a summary of all functional budget is capsule form available in one report.
Preparation of master budget is a complex process. It includes all preparation of a
projected profit and loss account and balance sheet. Preparation of master budget
involves the following steps :

(i) Preparation of Sales Budget, (ii) Cost Budget, (iii) Projected Profit and loss Account,
(iv) Production cost Budget, (v) Cash budget, (vi) Projected Balance Sheet.
Difference between Budget and forecast
Budget Forecast
 Meaning It means plan of action It means prediction
 Preparation of budget only the authorised Any body can make a fore
management of a company cast about a company's
can prepare budget performance
 Expressed It is expressed in terms of
rupees or quality It is not always expressed
in terms of rupees or
quantitative.

Illustration 10: B.Com (Hons) Delhi

The following are the estimated sales of Philips company for eight months ending 30-10-
2015:
April 2015 12,000 units
May 2015 13,000 units
June 2015 9,000 units
July 2015 8,000 units
August 2015 10,000 units
September 2015 12,000 units
October 2015 14,000 units
November 2015 12,000 units

As a matter of policy, the company maintains the closing balance of finished goods and
raw materials as follows:

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Budgetary Control

(i) Finished goods — closing stock of a month will be 50% of the estimated sales
for the next months.
(ii) Raw materials — closing stock of a month will be equal to estimated
consumption for the next month.

Each unit of production consumes 2 kg of raw material costing Rs. 6 per kg.
Prepare the following budgets for the half year ending 30-9-2015:
(i) Production budget (monthwise is units)
(ii) Raw material purchase budget (monthwise in units and cost).

Solution
Production Budget for the half year ending 30-9-15
April May June July Aug. Sep. Total
Sales (units) 12,000 13,000 9,000 8,000 10,000 12,000 64000
Add: Closing stock 6,500 4,500 4,000 5,000 6,000 7,000 33000
Less: Opening stock (6,000) (6,500) (4,500) (4,000) (5,000) (6,000) 32000
Estimated Production 12,500 11,000 8,500 9,000 11,000 13,000 65000

Raw material purchase budget for half year ending 30-9-08

April May June July Aug. Sep. Total
Material @ 2 kg per
unit of Production
(kg-) 25,000 22,000 17,000 18,000 22,000 26,000
Add: Closing stock 22,000 17,000 18,000 22,000 26,000 26,000
Less: Opening stock (25,000) (22,000) (17,000) (18,000) (22,000) (26,000)
Purchases 22,000 17,000 18,000 22,000 26,000 26,000
Cost @ Rs. 6 per kg 1,32,000 1,02,000 1,08,00 1,32,00 1,56,000 1,56,000 7,86,000
(Rs.) 0 0

Illustration 11: B.Com (Hons) Delhi

You are requested to prepare a sales overhead Budget from the estimates given below
Advertisement = Rs. 2500
Salaries of the sales department = Rs. 5000
Expenses of sales Department = Rs. 1500
Counter sales man's salaries and dearness allowance = Rs. 6000
Commission to counter salesmen at 1% on sales. Travelling sales men's commission at
10% on their sales and expenses at 5% on their sales.
The sales during the period were estimated as follows:
Counter sales Travelling salesman's sale
80,000 10,000
120,000 15,000
140,000 20,000

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Solution Sales Overhead Budget

Particular Estimated Sales
Rs. Rs. Rs.
90,000 1,35,000 1,60,000
Fixed overheads
Advertisement 2,500 2,500 2,500
Salaries of Sales Department 5,000 5,000 5,000
Expenses of Sales Department 1,500 1,500 1,500
Salaries of Counter Salesmen and their Dear 6,000 6,000 6,000
ness allowance
Total Fixed Overhead 15,000 15,000 15,000
Variable overheads
Commission of Counter Salesman (1% of
Counter Sales) 800 1,200 1,400
Commission of Travelling
Salesmen (1% of their sales) 1,000 1,500 2,000
Expenses of Travelling
Salesmen (5% of their Sales) 500 750 1,000
B 2,300 3,450 4,400
Total Sales overheads (A+B) 17,300 18,450 19,400
Total Sales 90,000 1,35,000 1,60,000
% of Sales overheads of Sales 19.22% 13.67% 12.13%

Working Notes: Estimated

Sales
Counter Sales 80,000 120,000 140,000
Travelling Salesman 10,000 15,000 20,000
Total Sales 90,000 135,000 160,000

Illustration 12: B.Com (P) Delhi 2006, Correspondence

Prepare a flexible budget for production at 80% and 100% activity on the basis of the
following information:
Production at 50% capacity = 5000 units.
Raw materials = Rs. 80 per units
Direct Labour = Rs. 50 per units
Direct Expenses = Rs. 15 per units
Factory Expenses = Rs. 50000 (50% fixed)
Administration expenses Rs. 60,000 (60% variable)

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Budgetary Control

Solution
Flexible Budget

Cost 80% 100%

8,000 units 10,000 units
Per unit Total Per unit Total
Rs. Rs. Rs. Rs.
Raw materials 80.00 6,40,000 80.00 8,00,000

Direct Labour 50.00 4,00,000 50.00 5,00,000

Direct Labour 50.00 1,20,000 50.00 1,50,000

Prime Cost 145.00 11,60,000 145.00 14,50,000

Add: Factory expenses :

Variable 5.00 40,000 5.00 50,000

Fixed 3,125 25,000 2.50 25,000

Work Cost 153.125 12,25,000 152.50 15,25,000

Add: Administration :

Variable 7.20 57,600 7.20 72,000

Fixed 3.00 24,000 2.40 24,000

Total Cost 163.325 13,06,600 162.10 16,21,000

Illustration 13: B.Com (P) Delhi

From the following information Regular a Cash Budget for the month of May and
June, 2015

Month Sales Purchase Wages

April 62,000 38,000 8,000
May 64,000 33,000 10,000
June 58,000 39,000 8,500

(a) Cash balance a.4 on 1st May, 2015 was Rs. 8,000.
(b) 75% of the sales are realised in the same month and rest in the following month.
(c) Period of ere/flit from suppliers is one month.
(d) Time Lag in payment of wages is one month
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Solution
Cash Budget
for the month of May and June, 2015
Particulars May Rs. June Rs.
Opening balance 8,000 25,000
Receipts :
Cash Sales 48,000 43,500
Collection from Debtors 15,500 16,000
A. Total Receipts
Cash Payments :
71,500 85,000

Payment to Creditors 38,000 33,000

Wages 8,000 10,000
B. Total Payments
C. Closing Balance (A - B)
46,000 43,000

25,500 42,000

Working Notes:
(1) Calculation of cash sale
75 75
May  64000   Rs.15,500 June  58000   Rs.16, 000
100 100
(2) Calculation of Collection from Debtors
25 75
May  62000   Rs.15,500 June  64000   Rs.16, 000
100 100

Illustration 14: B.Com Delhi

The monthly budgets for factory overhead for two levels of activity were given below.
Budgeted 60% 100%
Production (units) 600 1000
Rs. Rs.
Wages 1200 2000
Consumable Stores 900 1500
Maintenance 1100 1500
Power & Fuel 1600 2000
Depreciation 4000 4000
Insurance 1000 1000
Total 9800 12000

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 Budgeting and
Budgetary Control

You are required to prepare a budget for 80% capacity.

Solution
Budget for 80% Capacity
Particulars Nature Costs .
Wages Variable 1,600
Consumable Stores Variable 1,200
Maintenance Semi-variable
Variable 800
Fixed 500
Power & Fuel Semi-variable
Variable 800
Fixed 1,000 1,800
Depreciation Fixed 4,000
Insurance Fixed 1,000
Total 10,900
Working Notes
Classification of Cost according to the variability :
(i) Wages : Rs. 2 per unit (Variable Cost)
(ii) Consumable Stores : Rs. 1.50 per unit (Variable cost)
(iii) Maintenance Cost
Variable Cost Per unit = Change in cost / Change in output
Variable Cost Per unit = Rs. 400/400 = Rs. 1 per unit
At 600 units variable Maintenance cost are = 600 x Re. 1 = Rs. 600
At 600 units Maintenance Fixed costs are = Rs. 1100 - Rs. 600 = Rs. 500
At 100 units the fixed maintenance costs are = Rs. 1,500 - Rs. 1,000 = Rs. 500
Hence, maintenance cost is a semi-variable cost.
(iv) Power and Fuel Cost per unit
Variable cost per unit = Change in cost/Change in output
= 400/400 = Re. 1
At 600 units Fixed Power & Fuel costs are = Rs. 1,600 - Rs. 600 = Rs. 1,000
At 1000 units Fixe dpowers & Fuel costs are = Rs. 2,000 - Rs. 1,000 = Rs. 1,000
Thus, power and fule is a semi-variable cost
(v) Depreciation remains constant at both levels of activity and there fore, it is fixed
cost,
(vi) Insurance remains constant at both levels of activity and, therefore it is fixed cost.

QUESTIONS

Theoretical Questions:

1. Define budgeting and explain the main features of budgeting system.

2. What is budgeting? Mention the various types of budget.

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3. "For planning, the manager wants information about the future, for control about
the past." Comment upon this statement.
4. What is flexible budget? State its importance and limitations.
5. Mention the utility of sales budget. What factors are to be taken into
consideration before preparing sales budgets.
6. What is business budget ? State the procedure for preparation of a budget.
7. Explain Budgetary control and describe the advantages of a good budgetary
control.
8. Explain Flexible Budget and mention the advantages and limitation of a flexible
budget.
9. Describe production Budget and discuss its purposes. ;
10. Write short notes on:
(i) Master budget, (») Sales budget
(iii) Labour budget, (iv) Cash budget
11. What is cash budget ? How it is prepared ? Mention its utility.
12. Define cash budget and discuss its advantages and limitations.
13. Explains briefly zero base budgeting.
14. Ravi Ltd. plans to prepare production budget for its 3 products X, Y and Z, the
sales forecasts for their product is 80,000 units, 100,000 units and 1,40,000 units
respectively. The estimated requirements of inventory at the beginning and as the
end are as under:
A B C
1st January (units) 10,000 12,000 14,000
31st December (units) 8,000 6,000 4,000

Prepare a production budget. [Ans. A: 78,000 units, B: 94,000 units, C: 1,30,000 units]
(i) Finished units equal to half the sales for the next month will be in stock at the
end of each month including September 2014.
(ii) Product cost for 31st March 2015 are as under:
Production (units) 80,000
Material per unit Rs. 6
Labour per unit Rs. 3
Total Factory overheads Rs. 45,000
15. Prepare a sales overhead budget from the following information:
Rs.
Salaries of sales Deptt. 2,000
Advertisement 1,000
Expenses of sales deptt. 600
Salesman salaries 2,400

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Budgetary Control

Commission to salesman 1 % on their sales. Travelling salesman commission at 10% on

their sales and expenses at 5% on their sales. Sales have been budgeted as under :
Salesman sales Travelling salesman (sales)
A 32,000 4,000
B 48,000 6,000
C 56,000 8,000
[Ans. Total sales overheads: A Rs. 6,920, B Rs. 7,380, C Rs. 7,760]
16. The following data relates to the working of a factory for the year 2015:
Capacity at 50%
Rs.
Fixed cost:
Rent and Rates 1,12,000
Depreciation 1,40,000
Salaries 1,68,000
Other Ad. Expenses 1,60,000
Total 5,80,000

Variable cost: 4,80,000

Material 5,12,000
Wages 76,000
Other Expenses 10,68,000

Proposed sales at various level of workings are :

60% Rs. 19,00,000
75% Rs. 23,00,000
90% 27,50,000
100% 30,50,000
Prepare a flexible budget and show the forecast at profit at 60%, 75%, 90% and 100%.
[Ans. Profits : at 60% Rs. 38,400 at 75% Rs. 1,18,000 at 90%
Rs. 2,47,600 at 100% Rs. 3,34,000]
17. Prepare a flexible budget from the following information and show the profits at
60%, 70%, 90% and 100% capacity : -
Capacity worked 50%
Rs.
Fixed Expenses 80,000
Rent 1,00,000
Salaries 1,20,000
Depreciation 1,40,000
Administration Exp. 4,40,000
Variable Expenses:
Material 4,00,000
Labour 5,00,000
Others 80,000

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Semi-variable expenses 9,80,000

Repairs 2,00,000
Indirect labour 3,00,000
Others 1,80,000
6,80,000
Semi-variable expenses do not move when capacity ranges between 45% and 65% and it
rises by 10% when production goes beyond 65% but not more than 75% and further rise
by 5% if production is more than 75% and thereafter there is no change upto 100% of
capacity. Sales were as under:
Sales (Rs.)
at 60% 22,00,000
at 75% 26,00,000
at 90% 30,00,000
at 100% 34,00,000
[Ans. Profit: at 60% Loss Rs. 96,000 at 75% Profit Rs. 40,000 at 90%, Profit Rs. 14,000
at 100% Profit Rs. 2,18,000]

SUGGESTED REFERENCE

 Mittal & Maheswari, Elements of Cost Accounting, Shree Mahavir Book Depot
(Publishers) 2015.
 Varshney J.C., Principles and Practice of Cost Accounting, Wisdom Publication
House (2009).
 Mittal & Maheswari, Management Accounting, Mahavir Publication, 2015.
 Arora M.N. Cost Accounting, Vikas Publishing House Pvt. Ltd. 2013.
 Jain & Narang, Cost Accounting, Kalyani Publishers 1998.
 Arora M.N., Management Accounting, Himalaya Publishing House, 2006.

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 BLOCK-5

Management and Responsibility Accounting

The present block refers to the concepts of management accounting. In this block
the learners will learn about the financial statements analysis, accounting ration,
cash flow statement as well as the operational part of the budgeting that how the
financial activities of a business is managed. The present block refers the
following unit;
Unit 13: Financial Statement Analysis

Unit 14: Accounting Ratios

Unit 15: Budgeting-I

Unit 15: Budgeting-II

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UNIT-13 FINANCIAL STATEMENT ANALYSIS

CONTENTS
13.0 Objectives
13.1 Introduction
13.2 Techniques of financial analysis
13.3 Common size statement analysis
13.4 Comparative statement analysis
13.5 Objective of comparative statement financial statement
13.5.1 Performance analysis
13.5.2 Strength analysis
13.5.3 Planning and forecasting
13.6 Comparative income statement
13.7 Comparative balance sheet
13.8 Trend analysis
13.9 Statement of changes in fund
13.10 Ratio analysis
13.11 Check your progress

13.0 OBJECTIVES

 Discuss the various techniques of analysis of financial statement.

 Use of common size statement for financial statement analysis
 Objective and usage of comparative statement analysis as financial tool for analysis
of financial statement by the investors before investment
 Usage of trend analysis by the investors

13.1 INTRODUCTION

Every organization prepares financial statement at the end of every period. The users of
accounting information derive information from these financial statements in accordance
with their objectives. Financial Statements are divided in three parts, namely, Balance
Sheet, Profit & Loss Accounts and Cash Flow Statements. Balance Sheet shows the
financial strength of the business, profit & loss states the operation status of the company.
Cash flow statements are prepared to examine the change the changes in cash position of
the organization. Users of financial statement can get better idea about financial strengths
and weakness of the enterprises if they properly analyze information reported in these
statements. Financial analysis is the starting point for making plans before using any
sophisticated forecasting and planning procedures. Understanding the past is a
prerequisite for anticipation of futures.

13.2 TECHNIQUES OF FINANCIAL ANALYSIS

Financial analysis is the process of identifying the financial strength and weakness of the
enterprises by properly establishing the relationship between Balance Sheet, Profit &
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Analysis

Loss accounts and cash flow statement. The analysis may be done by the management or
by the outsider of the business. The nature of analysis depends upon the objectives of the
analyst or user.

Following are the techniques used for financial analysis:

1. Common size statement analysis
2. Comparative Statement Analysis
3. Trend analysis
4. Statement of changes in funds (Fund Flow Statement)
5. Ratio analysis

Now we discuss all above analysis techniques in details in the following sections.

13.3 COMMON SIZE STATEMENT ANALYSIS

Common size statements are those statements which are prepared by assuming a common
base. For instances, in case of profit & loss accounts, sales are consider 100% and
expenditures are calculated as percentage of sales. Similarly for Balance Sheet, items are
expressed as percentage of total assets or total funds.

Such comparisons can be done only where all the accounting policies of the firm are
same as in the previous year. If there is any change in the accounting policies, then the
analysis will not fulfill objective of the firm.

This technique is very useful when we compare our business with the other business of
the same nature. This technique may also be used when we compare our business with
the same nature of industry. Usually industry data are published in this form.

The above technique can be better understood from the following example:

Income Statement of ABC Ltd

Particulars 2006-07 2007-08
Rs. Rs.
(Lacs) (Lacs)
A. Sales (Net) 2000.00 2500.00
B. Cost of goods sold 1650.00 2055.00
C. Gross Profit (A-B) 350.00 445.00
D. Selling and Distribution expenses 204.00 232.00
E. Operating Income (C-D) 146.00 213.00
F. Other Income 14.00 25.00
G. Earning Before Interest and
Tax (E+F) 160.00 238.00
H. Interest paid 52.00 110.00
I. Profit before Tax (G-H) 108.00 128.00
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J. Taxes 36.00 42.00

K. Profit after tax (I-J) 72.00 114.00

If we apply the technique of common size statement, then the above Income statement
shall be presented as given below.

Common Size Income Statement of ABC Ltd

Particulars 2007-08 2006-07
A. Sales (Net) 100.00 100.00
B. Cost of goods sold 82.50 82.20
C. Gross Profit (A-B) 17.50 17.80
D. Selling and Distribution expenses 10.20 9.28
E. Operating Income (C-D) 7.30 8.52
F. Other Income 0.70 1.00
G. Earning Before Interest and Tax (E+F) 8.00 9.52
H. Interest paid 2.60 4.40
I. Profit before Tax (G-H) 5.40 5.12
J. Taxes 1.80 1.68
K. Profit after tax (I-J) 3.60 4.56

The above common size statement shows that in 2007-08, Cost of goods sold is 82.50%
of the sales whereas in 2006-07 is 82.20. Similarly Gross profit has been decreased in
2007-08 from 2006-07 and so on.

The common size statement is very simple to understand and it may be used for
comparison instead of to read typical financial statement.

The common size statement can be prepared for position statement also. It is illustrated
through the following example.

Balance Sheet of ABC Ltd

2006-07 2006-07
Rs. (Lacs) Rs. (Lacs)
SOURCES OF FUNDS
Share Capital 25.00 21.00
Reserve & Surplus 17.00 15.00
Total Shareholders fund 42.00 36.00
Secured Loans 35.00 27.00
Unsecured Loans 15.00 13.00
Total Debt 50.00 40.00
Total Liabilities 92.00 76.00

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Analysis

APPLICATION OF FUNDS
Gross Block 78.00 72.00
Less: Acc. Depreciation 27.00 24.00
Net Block 51.00 48.00
Capital Work in Progress 9.00 4.00
Investments 15.00 12.00
CURRENT ASSETS, LOANS & ADVANCES
Inventories 18.00 14.00
Sundry Debtors 14.00 16.00
Cash and Bank 8.00 7.00
Loans and advances 8.00 8.00
Less: Current Liabilities and Provisions
Sundry Creditors 24.00 22.00
Provisions 9.00 13.00
Net Current Assets 15.00 10.00
Miscellaneous Expenditures 2.00 2.00
Total Assets 92.00 76.00

The above Balance Sheet can be presented in common size as below.

Common Size Balance Sheet of ABC Ltd

2006-07 2006-07

SOURCES OF FUNDS
Share Capital 27.17 27.63
Reserve & Surplus 18.48 19.74
Total Shareholders fund 45.65 47.37
Secured Loans 38.04 35.53
Unsecured Loans 16.30 17.11
Total Debt 54.35 52.63
Total Liabilities 100.00 100.00

APPLICATION OF FUNDS
Gross Block 84.78 94.74
Less: Acc. Depreciation 29.35 31.58
Net Block 55.43 63.16
Capital Work in Progress 9.78 5.26
Investments 16.30 15.79

CURRENT ASSETS, LOANS & ADVANCES

Inventories 19.56 18.42
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Sundry Debtors 15.21 21.05

Cash and Bank 8.70 9.21
Loans and advances 8.70 10.52
Less: Current Liabilities and Provisions
Sundry Creditors 26.09 28.95
Provisions 9.78 17.10
Net Current Assets 16.30 13.15
Miscellaneous Expenditures 2.19 2.63
Total Assets 100.00 100.00

The above common size balance sheet shows all the assets in percentage form on the
basis of total asset and percentage composition of shareholders fund and long term debt
of the total liability.

Common size statement are classified in two category, namely,

1. Vertical Analysis
2. Horizontal Analysis

When we prepare common size statement for one period by measuring the percentage,
known as vertical analysis whereas when compare these figures from other period, it
becomes horizontal analysis. For example, if we prepare common size statement only for
2007-08 of the above company. It is known as vertical analysis of common size
statement. However when we compare these figure from 2006-07, it becomes the
horizontal analysis of common size statement.

13.4 COMPARATIVE STATEMENT ANALYSIS

Comparative statement may be defined as comparison of financial information from the

existing information with the other period information. That period may be weekly,
monthly, quarterly or yearly. Comparative analysis makes the financial information easy
to understand. However comparative statement may prepared only from those financial
statement which are presented and prepared on uniform basis. One may know from this
analysis that what has been change during particular period and how much.

Comparative analysis is different from common size statement. Comparative analysis

shows the change in particular figure during particular period whereas common size
statement shows comparison on the basis of base for the year. In common size statement,
changes are known by measuring the expenditure in respect of sales. However in
comparative statement, we measure the change in sales or other revenue and
expenditures.

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13.5 OBJECTIVES OF COMPARATIVE FINANCIAL STATEMENTS

13.5.1 Performance analysis

Comparative analysis shows the changes in financial performances and financial position
of the enterprises. From financial analysis point of view, it gives the measurement of
changes.

13.5.2 Strength analysis

This statement shows the financial strength of the firm. In other words, it shows
weakness, soundness about profitability and liquidity of firm.

13.5.3 Planning and forecasting

The analysis of comparative statements helps in planning and forecasting of enterprises.
Comparative analyses are broadly classified in two parts, namely, comparative income
statements and comparative balance sheet.

13.6 COMPARATIVE INCOME STATEMENT

Comparative income statement shows the operating results of the enterprises for any
number of accounting periods. It shows the change in terms of values and percentage on
the basis of base year.

The comparative income statement shows the following of enterprises,

 Increase or decrease in Gross and Net sales.
 Increase or decrease in Cost of Goods Sold.
 Increase or decrease in Gross profit and reasons thereof.
 Increase or decrease in operating expenses and operating profit.
 Increase or decrease in non-operating incomes and non-operating expenses of the
company.
 Increase or decrease in net profit and tax thereon.

The aforesaid points may be better understand from the following given example.

Example-1
Prepare comparative Income Statement of Aslam Ltd with the help of following
information
Particulars 31.03.2006 31.03.2007
Rs. Rs.
Sales 5,00,000 8,00,000
Cost of goods sold 3,00,000 5,00,000
Direct expenses 40,000 20,000
Indirect Expenses 30,000 40,000
Income Tax 40% 50%
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Solution
Comparative Income Statement of Aslam Ltd

Particulars 2006 2007 Change Change

Rs. Rs. Rs. (%)
Sales 5,00,000 8,00,000 3,00,000 60
Less: Cost of goods sold 3,00,000 5,00,000 2,00,000 66.67
Gross Profit 2,00,000 3,00,000 1,00,000 (50)
Less: Indirect expenses 30,000 40,000 10,000 33.34
Net Profit Before Income Tax 1,70,000 2,60,000 90,000 52.94
Less: Income Tax 68,000 1,30,000 62,000 91.17
Net Profit after tax 1,02,000 1,30,000 28,000 27.45

Example-2
Income Statement of ABC Ltd
Particulars 2006 2005
Rs. Rs.
Sales (Net) 1265000.00 870000.00
Cost of goods sold 910800.00 643800.00
Gross Profit 354200.00 226200.00
Administrative Expenses 101200.00 78300.00
Selling and Distribution expenses 164450.00 95700.00
Operating Income 88550.00 52200.00
Other Income 125000.00 115000.00
Earning Before Interest and Tax 213550.00 167200.00
Interest paid 65000.00 74000.00
Profit before Tax 148550.00 93200.00
Taxes 42000.00 27000.00
Profit after tax 106550.00 66200.00

Solution
Comparative Income Statement of ABC Ltd
Particulars 2006 2005 Change Change
Rs. Rs. Rs. (%)
Sales (Net) 1265000.00 870000.00 395000.00 45.40
Cost of goods sold 910800.00 643800.00 267000.00 41.47
Gross Profit 354200.00 226200.00 128000.00 56.59
Administrative Expenses 101200.00 78300.00 22900.00 29.25
Selling and Distribution
Expenses 164450.00 95700.00 68750.00 71.84
Operating Income 88550.00 52200.00 36350.00 69.54
Other Income 125000.00 115000.00 10000.00 8.70
Earning Before Interest
and Tax 213550.00 167200.00 46350.00 27.72
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Interest paid 65000.00 74000.00 (9000.00) (12.16)

Profit before Tax 148550.00 93200.00 55350.00 59.39
Taxes 42000.00 27000.00 15000.00 55.56
Profit after tax 106550.00 66200.00 40350.00 60.95

Analysis and interpretations

The above comparative income statement shows that sales has been increased by Rs.
395000.00 i.e. 45.40% in comparison with 2005. Since sales is increasing by 45.40%, but
cost of goods sold has been increased by 41.47% only. The reasons may be that the firm
got quantity discounts, reduction in freight inward or reduction in wages paid to the
employees. Because of these effects gross profit on sales has been increased by Rs.
128000.00 i.e. 56.59%. However there is decline trend in amount paid for interest. Net
profit of the company has been increased by 60.95%, which shows that the firm has
adequate profit to meet his operating expenses.

Overall analysis of this statement shows favorable position.

13.7 COMPARATIVE BALANCE SHEET

Comparative balance sheets are used to compare assets, liabilities and capital at two or
more different dates. Such analyses are used to examine the progress of the enterprises
during particular period.

According to Foulka “Comparative balance sheet analysis is the study of trend of the
same items, group of items and computed items in two or more balance sheets of the
same business enterprises on different dates.”

The above definition explains that it is a analysis of trends for the group of items of the
balances sheet of any company. It may for the same year at two different dates or for two
different accounting periods.

Advantages of comparative balance sheets

1. Comparative balance sheet shows the figure for two different periods, which are
used to examine the increase or decrease in particular group of items.
2. In particular year of balance sheet, we evaluate the present status of assets and
liabilities. However, in comparative balance sheet, we evaluate the changes
occurred in groups of item of balance sheet.
3. Comparative balance sheet shows the progress trend of business and it is used for
financial planning and analysis.

Example-1
Prepare Comparative Balance Sheet of ABC Ltd from the following

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BALANCE SHEET OF ABC LTD

2006 2005
Rs. Rs.
SOURCES OF FUNDS
Share Capital 230000.00 190000.00
Reserve & Surplus 165400.00 149700.00
Secured Loans 340000.00 380000.00
Unsecured Loans 135000.00 154500.00
Current Liabilities 244200.00 285600.00
TOTAL 1114600.00 1159800.00

APPLICATION OF FUNDS
Net Fixed Assets 435000.00 387000.00
Investments 340000.00 390000.00
Current Assets 339600.00 382800.00
TOTAL 1114600.00 1159800.00

Solution
COMPARATIVE BALANCE SHEET OF ABC LTD

2006 2005 Change Change

Rs. Rs. Rs. (%)
SOURCES OF FUNDS
Share Capital 230000.00 190000.00 40000.00 21.05
Reserve & Surplus 165400.00 149700.00 15700.00 10.49
Secured Loans 340000.00 380000.00 (40000.00) (10.53)
Unsecured Loans 135000.00 154500.00 (19500.00) (12.62)
Current Liabilities 244200.00 285600.00 (41400.00) (14.50)

TOTAL 1114600.00 1159800.00 (45200.00) (3.90)

APPLICATION OF FUNDS
Net Fixed Assets 435000.00 387000.00 48000.00 12.40
Investments 340000.00 390000.00 (50000.00) (12.82)
Current Assets 339600.00 382800.00 (43200.00) (11.29)

TOTAL 1114600.00 1159800.00 (45200.00) (3.90)

Analysis and interpretation

The above comparative balance sheet shows that overall reduction in the net worth of the
company is 3.90% in comparison of the last year. This overall reduction consists of
reduction in long term debt and current liabilities and increase in shareholders fund for

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sources of funds. The company has issued share capital during the year for the
redemption of long term borrowings.

From the application of funds point of view, company has sold his investment for the
payment of debt and making the investments in his fixed assets. Company’s current
assets are decreasing more than decrease in current liabilities.

Overall analysis of balance sheet shows that, financial position of the company is not
favorable.

Example-2
From the following information, prepare a Comparative Balance Sheet of Z Ltd:

Particulars 31.03.2005 31.05.2006

Rs. Rs.
Equity Share Capital 25,00,000 25,00,000
Fixed Assets 30,00,000 36,00,000
Reserve and Surplus 5,00,000 6,00,000
Investments 5,00,000 5,00,000
Long term loans 15,00,000 15,00,000
Current Assets 15,00,000 10,50,000
Current Liabilities 5,00,000 5,50,000

Solution
COMPARATIVE BALANCE SHEET OF Z LTD

2005 2006 Change Change

Rs. Rs. Rs. (%)
SOURCES OF FUNDS
Equity Share Capital 25,00,000 25,00,000 - -
Reserve & Surplus 5,00,000 6,00,000 1,00,000 20
Long term Loans 15,00,000 15,00,000 - -
Current Liabilities 5,00,000 5,50,000 50,000 10

TOTAL 50,00,000 50,00,000 1,50,000 3

APPLICATION OF FUNDS
Fixed assets 30,00,000 36,00,000 6,00,000 20
Investments 5,00,000 5,00,000 - -
Current Assets 15,00,000 10,50,000 (4,50,000) (30)

TOTAL 50,00,000 51,50,000 1,50,000 3

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13.8 TREND ANALYSIS

Trend analysis is a concept which is used by the financial analysts to examine the
increase or decrease in the value of assets, liabilities, expenses and revenues. This method
is used by the banking industry, usually, to examine and control over the fund disbursed
to the parties. This method is also used for analysis of financial position after a certain
period of time on the basis of past data of accounting.

Trend analysis is conducted for revenue and expenditure nature items of the business.
However, now a days, it is also used for critically evaluation of the net worth of
organization also.

Trend method may be used in the light of two factors, the rate of fixed growth and
general price level. To get a true growth of revenue, such as sales, it should be adjusted
with the true rate of general price level. If the general pricing level is not considered
while analyzing trend of growth, it can mislead management.

TREND ANALYSIS
ABC LTD
2008 2009 2010
Sales 100 120.00 155.90
Earning before interest & tax 100 147.70 156.75
Profit after tax 100 135.80 145.76
Current assets 100 160.00 175.00
Current liabilities 100 135.54 145.86
Gross fixed assets 100 134.40 152.80
Net assets 100 127.96 142.00
Total assets 100 185.65 190.34
Net worth 100 164.54 175.24
Dividend 100 115.00 145.00

For trend analysis, the procedures followed shall be 100 for the base year and on the basis
of this we measure the changes in the following relational year. In the above example, the
base year is 2008.

Following are some examples or indicator which has different meaning as per trend
analysis.

i. Increase in current debt

Where the financial statement shows increase in debt without any increase in assets, it is
very dangerous for the business. It should be critically examined. It is will increase
financial risk of business by increasing the burden of interest.

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ii. Major gap between Gross sales and Net sales

A gap between gross sales and net sales are acceptable to some extent. This gap ration
depends upon the nature of business. However the gap should not be high. If such ratio is
high, there may be possible that the organization showing dummy sales.

iii. Decreasing cash position

Cash may be decreased because of low collection of funds from the debtors, higher cash
expenditure and financing of capital assets.

iv. Slowdown in receivable collection

Receivable collection may be slow because of lengthy period of credit, high defaulter’s
rate and so on.

v. Rising Inventories
This may be because of slow moving items included in stock, inflated value of closing
stock, purchase invoice entered but goods not received etc.

vi. Increase in debt to capital

This indicates that company has borrowed funds for his project, decrease in capita due to
loss in business, financing of short term assets by long term funds etc.

vii. Change in cost of goods sold

This may be because of change in sales position, increased/decrease in trade discount and
other operating expenses.

viii. Changes in profit with respect to sales

This may be because of poor cost controls, poor management of business and fail to shift
cost to other business organization.

13.9 STATEMENT OF CHANGES IN FUND

The balance sheet discloses the financial position of the firm on a specific date. It will be
different from the opening date balance sheet. However, closing balance sheet does not
reflect the changes occurred during that particular period. Therefore the analysts prepare
details of change in those figures of balance sheet between two different dates. This
statement is known as change in funds statement or fund flow statement. In other words,
funds flow statement is a statement that shows details of changes in funds of the
organization between two particular periods. It has been discussed in details of this paper
earlier.

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13.10 RATIO ANALYSIS

Ratio analysis is an arithmetical expression of relationship between two related variables

or group of items. However, these variables must have cause and effect relationship.
According to J. Betty, “the term accounting ratio is used to describe significant
relationships which exist between figures shown in balance sheet, in a profit & loss
account, in a budgetary control system or in any part of the accounting organization.”
The above definition shows that ratio analysis shows the cause and effect relationship
between two related variable of financial statement or budgetary control. Ratio analysis
may also be used to analyze financial statement in the form of ratio instead of in terms of
value or money. We may also prepare comparative analysis statement through ratio
analysis for analysis of financial statement, financial planning budgetary control and
forecasting. It has been discussed in details in the next unit of this module.

13.11 CHECK YOUR PREOGRESS

1. List all the techniques for financial analysis.

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………
2. Define common size income statement technique for financial analysis and
discuss its importance.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………
3. List the advantages of Comparative Statement techniques for financial
analysis.
…………………………………………………………………............................................
................................................................................................................................................
..................
4. Prepare Common size statement from the following financial statement of
XYZ Ltd for the year:

Income Statement of XYZ Ltd.

Particulars 2008 2007

Rs. Rs.
(Lacs) (Lacs)
A. Sales (Net) 3600.00 3350.00
B. Cost of goods sold 2495.00 2486.00
C. Gross Profit (A-B) 1105.00 864.00

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D. Selling and Distribution expenses 310.00 167.00

E. Operating Income (C-D) 795.00 697.00
F. Other Income 105.00 125.00
G. Earning Before Interest and Tax (E+F) 900.00 822.00
H. Interest paid 176.00 196.00
I. Profit before Tax (G-H) 724.00 626.00
J. Taxes 215.00 183.00
K. Profit after tax (I-J) 509.00 443.00

Balance Sheet of XYZ Ltd

2008 2007
Rs. (Lacs) Rs. (Lacs)
SOURCES OF FUNDS
Share Capital 35.00 27.00
Reserve & Surplus 17.00 19.00
Total Shareholders fund 52.00 46.00
Secured Loans 45.00 30.00
Unsecured Loans 25.00 18.00
Total Debt 70.00 48.00
Total Liabilities 122.00 96.00

APPLICATION OF FUNDS
Gross Block 96.00 82.00
Less: Acc. Depreciation 39.00 37.00
Net Block 57.00 45.00
Capital Work in Progress 12.00 14.00
Investments 16.00 12.00

CURRENT ASSETS, LOANS & ADVANCES

Inventories 19.00 14.00
Sundry Debtors 28.00 16.00
Cash and Bank 13.00 11.00
Loans and advances 12.00 12.00
Less: Current Liabilities and Provisions
Sundry Creditors 28.00 24.00
Provisions 12.00 10.00
Net Current Assets 32.00 19.00
Miscellaneous Expenditures 5.00 6.00

Total Assets 122.00 96.00

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5 From the following information, prepare Comparative Income Statement.

Particulars 2004 2005
Rs. Rs.
Sales 4,00,000 5,00,000
Cost of goods sold 2,00,000 3,00,000
Administrative and Selling expenses 40,000 1,00,000
Other Income 20,000 30,000
Income tax 60,000 70,000

6. From the following summarized Balance Sheet of Red Ltd, Prepare

Comparative Balance Sheet.

Figures in lacs
Particular 2006 2007
Rs. Rs.
Equity Share Capital 120.00 120.00
Preference Share Capital 30.00 30.00
Reserve and Surplus 30.00 36.00
Fixed Assets 180.00 216.00
Investments 30.00 30.00
Current Assets 90.00 63.00
Secured Loans 60.00 54.00
Unsecured Loans 30.00 36.00
Current Liabilities 24.00 26.40
Provisions 6.00 6.60

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UNIT-14 ACCOUNTING RATIOS

LEARNING OBJECTIVES

Contents
14.1 Introduction
14.2 Importance of Ratio Analysis
14.3 Types of Ratios
14.4 Liquidity Ratios
14.4.1 Current Ratio
14.4.2 Acid Test Ratio
14.4.3 Cash Ratio
14.5 Leverage Ratios
14.5.1 Debt Equity Ratio
14.5.2 Total Debt Ratio
14.5.3 Proprietary Ratio
14.5.4 Fixed Assets to Net worth Ratio
14.5.5 Debt Service Ratio
14.6 Activity Ratios
14.6.1 Inventory Turnover Ratio
14.6.2 Debtors Turnover Ratio
14.6.3 Creditors Turnover Ratio
14.6.4 Assets Turnover Ratio
14.6.3.1 Total Assets Turnover Ratio
14.6.3.2 Net Assets Turnover Ratio
14.6.3.3 Fixed Assets Turnover Ratio
14.6.3.4 Current Assets Turnover Ratio
14.6.3.5Net Working Capital Turnover Ratio
14.7 Profitability Ratios
14.7.1 Gross Profit Ratio
14.7.2 Net Profit Ratio
14.7.3 Operating Profit Ratio
14.7.4 Operating Ratio
14.7.5 Expenses Ratio
14.8 Investment Ratios
14.8.1 Return on Gross Capital Employed Ratio
14.8.2 Return on Net Capital Employed Ratio
14.8.3 Return on Share Capital Employed Ratio
14.8.4 Return on Equity Capital Employed Ratio
14.9 Check Your Progress

14.1 INTRODUCTION

Ratio Analysis is a best technique of analysis of financial statement. It expressed the

relationship between two variables, connected with each other. Ratio Analysis shows the

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various ratios between the related items of financial statements in the summarized form
instead of the heavy figures of amounts of the financial statement. Ratio Analysis is
summarized and comprehensive financial information derived from financial statement. It
helps in judging the financial operation and financial position of the enterprises.

14.2 IMPORTANCE OF RATIO ANALYSIS

i. Helpful in evaluation of performance:

With the help of ratio analysis conclusion can be drawn regarding several aspects such as
financial health, profitability and operational efficiency of the firm. Ratio points out the
operating efficiency of the firm i.e. whether the management has utilized the firm’s assets
efficiently and effectively, to increase the investor’s wealth. It ensures a fair return to its
owners and secures optimum utilization of firm’s assets.

ii. Helps in inter-firm comparison:

Ratio analysis helps in inter-firm comparison by providing necessary data. An inter-firm
comparison indicates relative position. It provides the relevant data for the comparison of
the performance of different departments. If comparison shows a variance, the possible
reasons of variations may be identified and if results are negative, the action may be
initiated immediately to bring them in line.

iii. Simplifies financial statement:

The information given in the basic financial statements serves no useful Purpose unless
its interpreted and analyzed in some comparable terms. The ratio analysis is one of the
tools in the hands of those who want to know something more from the financial
statements in the simplified manner.

iv. Helpful in evaluation of financial position

Ratio analysis facilitates the management to know whether the firms financial position is
improving or deteriorating or is constant over the years by setting a trend with the help of
ratios. The analysis with the help of ratio analysis can know the direction of the trend of
strategic. Ratio may help the management in the task of planning, forecasting and
controlling.

v. Helpful in budgeting and forecasting:

Accounting ratios provide a reliable data, which can be compared, studied and analyzed.
These ratios provide sound footing for future prospectus. The ratios also serve as a basis
for preparing budgeting future line of action.

vi. Liquidity position

With help of ratio analysis, conclusions can be drawn regarding the Liquidity position of
a firm. The liquidity position of a firm would be satisfactory, if it is able to meet its
current obligation as and when they become due. The ability to meet short term liabilities
is reflected in the liquidity ratio of a firm.
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vii. Long term solvency

Ratio analysis helps equally in assessing the long term financial ability of the Firm. The
long term solvency is measured by the leverage or capital structure and profitability ratio.
This shows the earning power and operating efficiency. Solvency ratio shows relationship
between total liability and total assets.

viii. Operating efficiency:

This is another dimension of ratio analysis, relevant from the management point of view,
as it throws light on the degree efficiency through the various activity ratios of the firm.
This shows the operational efficiency of the firm.

14.3 TYPES OF RATIOS

As discussed in the previous modules that the information required for analysis of
financial statement depends upon the information required by finance manager for
decision making. Therefore, the finance manager will need various ratios for financial
planning and decision. However, some of the ratios have been classified on the basis of
their common features. Ratios for analysis of financial statement have been classified in
the following categories.
1. Liquidity Ratios
2. Leverage or Solvency Ratios
3. Activity Ratios
4. Profitability Ratios

14.4 LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its short-term financial obligations when
and as they fall due. The main concern of liquidity ratio is to measure the ability of the
firms to meet their short-term maturing obligations. The failure to meet obligations on
due time may result in bad credit image, loss of creditors confidence, and even in legal
proceedings against the firm. The greater the coverage of liquid assets to short-term
liabilities the better, as it is a clear signal that a company can pay its debts that are
coming due in the near future and still have fund for its ongoing operations. On the other
hand, a company with a low coverage rate should raise a red flag for investors as it may
be a sign that the company will have difficulty in running its operations, as well as
meeting its obligations. However very high degree of liquidity is also not desirable since
it would imply that funds are idle and earn nothing. Therefore it is necessary to strike a
proper balance between liquidity and lack of liquidity.

The liquidity ratios are also known as Balance Sheet ratios because the information used
for measurement of liquidity ratios are taken from the Balance Sheet only.
Ratios that explain about the liquidity of the firm are given below.
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1. Current Ratio
2. Acid Test Ratio or Quick Ratio
3. Cash Ratio

14.4.1 Current Ratio

Meaning
The current ratio measures the short-term solvency of the firm. It establishes the
relationship between current assets and current liabilities. In other words, the number of
times the short term assets can cover the short term debts of the firm.

Measurement
It is measured by dividing the current assets by current liabilities. This ratio is shown in
times. Symbolically,

Current Asset
Current Ratio =
Current Liabilities

Current asset are those which can be converted into cash within a short period of time,
normally not exceeding one year. Current assets include cash and bank balances,
marketable securities, inventory, and debtors excluding provisions for bad debts and
doubtful debtors, bills receivables and prepaid expenses.

Current liabilities are those liabilities which become payable within a period of one year.
It includes accounts payable, short term notes payable, short-term loans, current
maturities of long term debt, accrued income taxes and other accrued expenses.

Analysis
The analysis and comparison of Ratio depends upon the Industry ratio of the firm.
Generally, a Current Ratio of 2 times or 2:1 is considered to be satisfactory, though this is
not applicable in all types of business. Higher the current ratio, the better is the liquidity
of firm. However, too high ratio reflects an in-efficient use of resources and too low ratio
leads to insolvency.

14.4.2 Acid Test Ratio / Quick Ratio

Meaning
It is an important indicator of the firm’s liquidity position and is used as a complementary
ratio to the current ratio. It indicates the ability to meet short term payments using the
most liquid assets. It is often referred to as quick ratio because it is a measurement of
firm’s ability to convert its current assets quickly into cash in order to meet its current
liabilities.

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This ratio is more conservative than the current ratio because it excludes inventory and
other current assets, which are more difficult to turn into cash or cash equivalents
immediately. It establishes the relationship between quick assets and current liabilities.

Measurement
It is measured by dividing the quick assets by the current liabilities.
Quick Assets
Quick Ratio =
Current liabilities

Quick assets are those parts of current assets, which may be converted into cash or cash
equivalents immediately or within reasonable short time without a loss in value of assets.
These include cash and bank balances, sundry debtors, bill’s receivables and short-term
marketable securities. Symbolically,

Quick Assets = Current Assets – Inventories – Prepaid Expenses

Analysis
The standard of quick ratio is 1:1. i.e. the liquid or quick assets should be equal to the
current liabilities of the firm. Another beneficial use of quick ratio is to compare the
quick ratio with the current ratio. If the current ratio is significantly higher than quick
ratio, then it shows that the firm have invested heavy amount in the Inventories.

14.4.3 Absolute Liquid Ration / Cash Ratio

Meaning
It shows the relationship between absolute liquid or super quick current assets and current
liabilities. This ratio only considers the absolute liquid assets of the firm.

Measurement
It is measured by dividing the absolute liquid assets by current liabilities. This ratio is
also shown in times. Symbolically,
Absolute liquid assets
Absolute Liquid Ratio =
Current liabilities

Absolute liquid assets include cash, bank balances and short term marketable securities.

Analysis
The cash Ratio of magnitude up to 1:2 may be satisfactory and a firm need not maintain
too much of highly/super liquid assets. If the super liquid assets are too much in relation
to the current liabilities then it may affect the profitability of the firm as these funds
would be idle.

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14.5 LEVERAGE OR SOLVENCY RATIOS

These ratios indicate the degree to which the activities of a firm are supported by long
term creditors’ funds as opposed to owner’s funds. These ratios are measured to know the
ability of firm with regard to periodic payment of interest during the period and loan
repayment of principal on maturity or in predetermined installments at due dates of the
long term creditors.

Thus, there are two aspects of the long-term solvency of a firm.

i. Ability to repay the principal amount when due
ii. Regular payment of the interest.

The ratio is based on the relationship between borrowed funds and owner’s capital.
Therefore first part is computed from the balance sheet and the second part is calculated
from the profit and loss a/c.

Solvency ratios have been classified in the following categories.

1. Debt equity ratio
2. Total debt ratio
3. Proprietary (Equity) ratio
4. Fixed assets to net worth ratio
5. Debt service (Interest coverage) ratio

14.5.1 Debt Equity Ratio

Meaning
Debt equity ratio shows the relative claims of creditors (Outsiders) and owners (Interest)
against the assets of the firm. Thus this ratio indicates the relative proportions of debt and
equity in financing the firm’s assets. Debt Equity Ratio is based on the assumption that
the extent to which a firm should employ the debt should be viewed in terms of the size
of cushion provided by the shareholders.

Measurement
It is calculated by dividing the total long term funds (Debt) by shareholder funds (Equity)
or Net Worth. Symbolically,
Long term Debts (Debts)
Debt equity ratio =
Shareholder Funds or Equity

Long Term Debts may be defined as the debts which are payable after one year.
Generally, Debentures, Term Deposits and Public Deposits are long term debts for the
Company.

The shareholder funds include equity share capital, preference share capital and reserves
& surplus including accumulated profits. However fictitious assets like accumulated
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deferred expenses, preliminary expenses, to the extent not written off, etc should be
deducted from the total of these items to achieve shareholder funds. The shareholder
funds so calculated are also known as net worth of the business.

Analysis
The Debt Equity Ratio of a firm should be compared with the industry average. The
reason is being that every industry has its own characteristics relating to capital
requirements. For example, in case of basic and heavy industries the Debt Equity Ratio
will be higher as compared to general manufacturing concerns.

Usually, a lower ratio is always safer, however too low ratio reflects an in-efficient use of
equity. Too high ratio reflects either there is a debt to a great extent or the equity base is
too small.

14.5.2 Total Debt ratio

Meaning
This compares a company’s total debt to its total assets, which is used to gain a general
idea as to the amount of leverage being used by a company. This reflects the proportion
of capital employed which has been funded by debt. A larger debt financing implies that
larger are the claims of the creditors against the assets of the firm.

Measurement
The total debt ratio compares the total debts (long term debts as well as Short term debts)
with the total assets. Symbolically,
Total Debts
Total Debt ratio =
Total Assets

Long Term Debts + Current Liabilities

=
Total Debts + Net Worth

Analysis
The higher the Total Debt Ratio, more risky is the situation because all liabilities are to
be repaying sooner or later. In other words, higher liabilities imply greater financial risk
also. On the other hand, a low Debt Equity ratio implies a low risk to lenders and
creditors of the firm.

14.5.3 Proprietary (Equity) Ratio

Meaning
This ratio indicates the proportion of total assets financed by owners. This ratio is
particular importance to the creditors who can ascertain the proportion of shareholders
funds in the total assets employed in the firm. A high equity ratio shows a strong
financial structure of the company. A relatively low equity ratio reflects a more
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speculative situation because of the effect of high leverage and the greater possibility of
financial difficulty arising from excessive debt burden.

Measurement
It is computed by dividing proprietor’s (Shareholder’s) funds by total assets of the firm.
Proprietor’s Funds or Shareholder’s Funds
Proprietary Ratio =
Total Assets – Fictitious Assets

The shareholder’s funds include equity share capital, preference share capital, reserves
and surplus including accumulated profits. However fictitious assets like accumulated
deferred expenses, preliminary expenses, to the extent not written off, etc should be
deducted from the total of these items to derive shareholder’s funds. The shareholder
funds so calculated are also known as net worth of the business.

Analysis
A higher ratio indicates adequate safety for the creditors of business. However, a very
high ratio indicates improper mix of debt and equity of the business. It affects the
profitability of firm and consequently low return on investment. The mixing of debt and
equity shall be depends upon the Return on Investment of the firm.

14.5.4 Fixed Assets to Net Worth Ratio

Meaning
This ratio establishes the relationship between fixed assets and shareholder funds. This
ratio indicates that how much part of fixed assets is financed by the shareholder’s funds.
This ratio has equal importance as proprietary ratio among the creditors.

Measurement
It is computed by dividing fixed assets by shareholder’s funds. This ratio is indicated in
percentage form.
Total Fixed Assets
Fixed Assets to Net Worth ratio = x 100
Net Worth

Fixed Assets shall be considered after depreciation for the year.

14.5.5 Debt Service (Interest Coverage) Ratio

Meaning
This ratio shows the number of times the earnings of the firm are able to cover the fixed
interest liability of the firm. This ratio, therefore, is also known as Interest coverage or
time interest earned ratio.

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Measurement
It is computed by dividing the earnings before interest and tax (EBIT) by interest charges
on long term borrowings. This ratio is shown in times.
Earning Before Interest and Tax (EBIT)

Debt Service Ratio =

Interest Charges on long term debts

It is to be noted that EBIT is the operating profit of the firm, therefore, the Debt Service
Ratio measures as to how many time the interest liability of the firm is covered with the
operating profits of the firm. For the purpose of Debt Service Ratio, accrual system of
accounting shall be applied instead of cash basis.

Analysis
Higher the ratio, better is the performance of business in payment of interest to the
lenders and creditors. The lower the ratio, the more the company is burdened by debt
expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to
meet interest expenses may be questionable.

14.6 ACTIVITY RATIO OR TURNOVER RATIO

Turnover ratios are also known as activity ratios or efficiency ratios or performance ratios
with which a firm manages its current assets. These ratios look at how well a company
turns its assets into revenue as well as how efficiently a company converts its sales into
cash, i.e how efficiently and effectively a company is using its resources to generate sales
and enhancing Shareholder’s value. The better these ratios, the better it is for
shareholders of the business.

The following turnover ratios may be computed to judge the effectiveness of usage of
assets of the firm.
1. Inventory Turnover Ratio
2. Debtor Turnover Ratio
3. Creditor Turnover Ratio
4. Assets Turnover Ratio

14.6.1 Inventory Turnover Ratio

Meaning-
This ratio indicates the number of times the inventory has been converted into sales
during the period. In other words, It measures the stock in relation to turnover in order to
determine how often the stock turns over in the business. It indicates the efficiency of the
firm in selling its product. Thus it evaluates the efficiency of the firm in managing its
inventory.

Measurement It is calculated by dividing the cost of goods sold by average inventory.

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Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory

Cost of Goods Sold = Opening Stock + Net Purchase – Closing Stock

= Net Sales – Gross Profit

The average inventory is the simple average of the opening and closing balance of
inventory during the year i.e. (Opening inventory + Closing inventory) / 2. In certain
circumstances opening balance of the inventory may not be known then closing balance
of inventory may be considered as average inventory of the firm.

Analysis
Inventory Turnover Ratio is a test of efficient inventory management. There is no ideal
standard for evaluating an Inventory Turnover Ratio of a firm so it should be compared
with the Inventory Turnover Ratio of the other firm or past Inventory Turnover Ratio of
the same firm. if the Inventory Turnover Ratio for a year below the range, it may signal
inactive stock. While the Inventory turnover ratio beyond the range may indicate
insufficient inventory signaling a risk of stock outs.

14.6.1 Inventory Holding Period

Inventory Turnover Ratio shows the times of conversion of goods or stock in to sales. It
does not show the period for which stock is in the warehouse of the company or firm. It
can be measured by the Inventory Holding Period. This is also an important ratio for
financing decision. It is measured by the following formula.
360 days / 365 days / 52 weeks / 12 months
Days of Inventory
Holding (DIH) = Inventory Turnover Ratio

Higher the Days of Inventory Holding Period, Higher would be investments in the stocks
of the Company. This ratio would also affect the current ratio of the company.

14.6.2 Debtor Turnover Ratio

Meaning
This indicates the number of times average debtors have been converted into cash or cash
equivalents during a year. It indicates the efficiency of staff entrusted with collection of
amounts due from debtors. This ratio also shows the collection and credit policies of the firm.
If the firm has lineal credit policies, its debtor’s turnover ratio shall be high and vice versa.

Measurement
It is determined by dividing the net credit sales by average debtors. Symbolically,
Annual Net Credit Sales
Debtors Turnover Ratio =
Average Receivables
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It is important to note that while calculating the Debtors turnover ratio, we do not deduct
provision for doubtful debtors and provision for discount on debtors from the book value
of debtors. Because the purpose of measurement is to know the conversion times of
debtors from sales instead of amount to be received from debtors.

Net credit sales consist of gross credit sales minus sales return. Trade debtor includes
sundry debtors and bill’s receivables. Average trade debtors shall be (Opening and
Closing balances of debtors and bills receivable / 2)

When the information about credit sales, opening and closing balances of trade debtors is
not available then the ratio can be calculated by dividing total sales by closing balances
of trade debtor.

Analysis
A higher ratio is better since it would indicate that debts are being collected more
promptly. If the organization collecting funds promptly, it may be invested else where for
other use. For measurement and comparison, the firm should obtain the DTR from
industry or other firm of the same industry. A ratio lower than the standard shows that
inefficiency in collection and higher investment in debtors.

Average Collection Period

The average collection period measures the quality of debtors since it indicates the speed
of their collection. It is measured by following.

360 days / 365 days / 52 weeks / 12 months

Average Collection Period =
Debtors Turnover Ratio

The shorter the average collection period, the better the quality of debtors, as a short
collection period implies the prompt payment by debtors. An excessively long collection
period implies a very liberal and inefficient credit and collection performance and
policies. The delay in collection of cash impairs the firm’s liquidity. On the other hand,
too low collection period is not necessarily favorable, rather it may indicate a very
restrictive credit and collection policy which may curtail sales and hence adversely affect
profit.

14.6.3 Creditor Turnover Ratio

Meaning
It indicates the number of times sundry creditors have been paid during a year. In other
words, the Creditors Turnover Ratio shows the velocity of debt payment of the firm. It is
calculated to judge the requirements of cash for paying sundry creditors. It is calculated
on the same line as debtor’s turnover ratio.

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Measurement
It is computed by dividing the net credit purchases by average creditors of the business.
As given below,
Net Credit Purchase
Creditor Turnover Ratio =
Average Trade Creditors

Net credit purchases consist of gross credit purchases minus purchase return during the
year.

When the information about credit purchases not give in question, then the ratio is
calculated by dividing total purchases by the closing balance of trade creditors.

Analysis
A high turnover ratio shows the less availability of credit period or early payments. It also
indicates that the firm is not availing full credit period. A very low or lower turnover ratio
shows the availability of more credit period or delayed payments. This ratio also affects
current ratio of the firm. A lower ratio shows higher liquidity toward the firm and vice
versa.

14.6.4 Assets Turnover Ratio

This ratio indicates the efficiency with which the firm uses all its assets to generate sales.
The relationship between assets and sales is known as assets turnover ratio. Several
assets turnover ratios may be computed as depending upon the groups of assets, as
discussed below, which are related to sales.
i. Total asset turnover.
ii. Net asset turnover
iii. Fixed asset turnover
iv. Current asset turnover
v. Net working capital turnover ratio

14.6.3.1 Total Asset Turnover

This ratio shows the firms ability to generate sales from all financial resources to total
assets. It is computed by dividing sales by total assets.
Total Sales
Total asset turnover =
Total Assets

14.6.3.2 Net Asset Turnover

This is computed by dividing the sales by net assets of the firm.
Total Sales
Net asset turnover =
Net Assets

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Net assets represent total assets minus current liabilities, Intangible and fictitious assets
like goodwill, patents, accumulated losses, deferred expenditure and so on.

14.6.3.3 Fixed Asset Turnover

This ratio is computed by dividing the sales by net fixed assets of the business.
Total Sales
Fixed asset turnover =
Net Fixed Assets

Net fixed assets represent the cost of fixed assets minus depreciation.

14.6.3.4 Current Asset Turnover

This ratio is computed by dividing the sales by current assets of the business.
Total Sales
Current asset turnover =
Current Assets

14.6.3.5 Net Working Capital Turnover Ratio

A higher ratio is an indicator of better utilization of current assets and working capital
and vice-versa (a lower ratio is an indicator of poor utilization of current assets and
working capital). It is calculated by dividing sales by working capital.
Total Sales
Net Working Capital turnover ratio =
Net Working Capital

Net Working capital is represented by the difference between current assets and current
liabilities of the firm during the period.

14.7 PROFITABILITY RATIOS

Profitability is the ability of a business to earn profit over a period of time. The
profitability ratios show the combined effects of liquidity, asset management (activity)
and debt management (gearing) on operating results. The overall measure of success of a
business is the profitability which results from the effective use of its resources.

The profitability ratio of the firm can be measured by calculating various profitability
ratios. General two groups of profitability ratios are calculated. Given below,
a. Profitability in relation to sales.
b. Profitability in relation to investments.

Profitability in relation to sales

1. Gross profit ratio
2. Net profit ratio
3. Operating profit ratio
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4. Operating Ratio
5. Expenses Ratio

14.7.1 Gross Profit Margin or Ratio

A company's cost of goods sold represents the expense related to labour, raw materials
and manufacturing overhead involved in its production process. This expense is deducted
from the company's net sales/revenue, which results a company’s gross profit. The gross
profit margin is used to analyze how efficiently a company is using its raw materials,
labour and manufacturing-related expenses to generate profits.

It measures the relationship between gross profit and sales. This ratio is also called the
average mark up ratio. It is calculated by dividing gross profit by sales.
Gross Profit X 100
Gross profit ratio =
Net sales

Gross profit is the difference between sales and cost of goods sold. Higher the ratio, the
higher is the profit earned on sales. This ratio should be adequate to cover the
administrative, selling and distribution expenses and to provide for fixed charges of
finance, dividends and building up the reserves.

14.7.2 Net Profit Ratio

The net margin indicates the management’s ability to earn sufficient profit on sales, not
only to cover all revenue operating expenses of the business, the cost of borrowed funds
and the cost of goods or servicing, but also to have sufficient margin to pay reasonable
comparison to shareholders on their contributions to the firm.
It measures the relationship between net profit and sales of a firm. It indicates
management’s efficiency in manufacturing, administrating, and selling the products.
It is computed by dividing net profit after tax by sales. This ratio is generally expressed
in percentage.
Earning After tax or Profit After Tax
Net profit margin or ratio =
Net Sales
The net profit ratio indicates the proportion of sales revenue available to the owners of
the firm and the extent to which sales revenue decrease or the cost can increase without
inflicting a loss on the owners. So the Net Profit Ratio shows the firm’s capacity to face
the adverse economic situations.

14.7.3 Operating Profit Ratio

Operating ratio is the test of the operational efficiency of business. It shows the
percentage of sales which may be absorbed by cost of sales and operating expenses and
operating profit. It establishes the relationship between total operating expenses and net
sales. It is calculated by dividing operating expenses by the net sales.

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Operating Profit X 100

Operating profit ratio =
Net sales

Operating profit is the difference between net sales and total operating expenses.
Operating profit = Net sales – cost of goods sold – administrative expenses –
selling and distribution expenses

14.7.4 Operating Ratio

It Establishes The Relationship Between total operating expenses and net sales. It is
calculated by dividing operating expenses by the net sales. A rise in the operating ratio
indicates decline in the efficiency.

Operating Expenses X 100

Operating ratio =
Net sales

Operating expenses includes cost of goods produced/sold, general and administrative

expenses, selling and distributive expenses.

Lower the Operating ratio, better is the performance of company because it would leave
higher margin to meet interest, dividend etc.

14.7.5 Expenses Ratio

While some of the expenses may be increasing and other may be declining. To know the
behavior of specific items of expenses, the ratio of each individual operating expense to
net sales should be computed. The various variants of expenses are,

Cost of goods sold X 100

Cost of goods sold ratio =
Net Sales

Administrative Expenses X 100

Administrative Expenses Ratio =
Net sales

Selling and distribution expenses X 100

Selling and Distribution
Expenses Ratio =
Net sales

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Material Consumed X 100

Material Consumption ratio =
Net Sales

14.8 PROFITABILITY IN RELATION TO INVESTMENTS

1. Return on gross investment or gross capital employed

2. Return on net investment or net capital employed
3. Return on shareholder’s investment or shareholder’s capital employed.
4. Return on equity shareholder investment or equity shareholder capital employed.

14.8.1 Return on Gross Capital Employed

This ratio establishes the relationship between net profit and the gross capital employed.
The term gross capital employed refers to the total investment made in business.

It is computed by dividing the Earnings After Tax (EAT) by gross capital employed.

Earnings After Tax (EAT) X 100

Return on gross capital employed =
Gross capital employed

14.8.2 Return on Net Capital Employed

It is calculated by dividing Earnings before Interest & Tax (EBIT) by the net capital
employed of the business during the period. The term net capital employed in the gross
capital in the business minus current liabilities. Thus it represents the long-term funds
supplied by creditors and owners of the firm. This ratio is also known as Return on
Investments (ROI).

Earnings Before Interest & Tax (EBIT) X 100

Return on Net Capital Employed =
Net capital employed

Capital Employed = Equity Share Capital + Preference Share Capital + Reserve &
Surplus + Long term Debts – Fictitious Assets – Non Operating Assets such as
Investments

= Net Fixed Assets + Net Working Capital

Returns on capital employed judges the overall performance of the firm. This ratio must
be compared with the past ratio of the firm or with the industry average.

14.8.3 Return on Share Capital Employed

This ratio establishes the relationship between earnings after taxes and the shareholder
investment in the business. This ratio reveals how profitability the owners’ funds have
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been utilized by the firm. This ratio is also known as return on shareholders fund (equity
share holder as well as preference share holder).
It is calculated by dividing Earnings after tax (EAT) by shareholder capital employed.

Earnings after tax (EAT) X 100

Return on share capital employed =
Shareholder capital employed

This ratio indicates that how well the funds of owner have been used by the firm. This
ratio also shows that how much the firm is earning for its owner or shareholders.

14.8.4 Return on Equity Share Capital Employed

Equity shareholders are entitled to all the profits remaining after the all outside claims
including dividends on preference share capital are paid in full. The earnings may be
distributed to them or retained in the business. Return on equity share capital
investments or capital employed establishes the relationship between earnings after tax
and preference dividend and equity shareholder investment or capital employed or net
worth.

It is measured by dividing earnings after tax and preference dividend by equity

shareholder’s capital employed.

Earnings after tax (EAT) - preference dividends X 100

Return on equity =
Equity share capital employed

Higher percentage indicates the management is utilizing its equity base and the better
return is to investors of the firm.

EARNINGS PER SHARE

It measures the profit available to the equity shareholders on a per share basis. It is
computed by dividing earnings available to the equity shareholders by the total number of
equity share outstanding at the year end.

Earnings after tax – Preference dividends (if any)

Earnings per share =
Number of Equity shares

DIVIDEND PER SHARE

The dividends paid to the shareholders on a per share basis aas dividend per share. Thus
dividend per share is the earnings distributed to the ordinary shareholders divided by the
number of ordinary shares outstanding.

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Earnings paid to the ordinary shareholders

Dividend per share =
Number of ordinary shares outstanding

DIVIDENDS PAY OUT RATIO (PAY OUT RATIO)

It measures the relationship between the earnings belonging to the equity shareholders
and the dividends paid to them. It shows what percentage shares of the earnings are
available for the ordinary shareholders are paid out as dividend to the ordinary
shareholders. It can be calculated by dividing the total dividend paid to the equity
shareholders by the total earnings available to them or alternatively by dividing dividend
per share by earnings per share.

Dividend paid to equity share holders

Dividend ratio (Pay out ratio) =
Earnings available to equity share holders

Or

Dividend per share

Earnings per share

Dividend and Earnings Yield

While the earnings per share and dividend per share are based on the book value per
share, the yield is expressed in terms of market value per share. The dividend yield may
be defined as the relation of dividend per share to the market value per ordinary share and
the earning ratio as the ratio of earnings per share to the market value of ordinary share.

Dividend Per share

Dividend Yield =
Market value of ordinary share

Earnings per share

Earnings yield =
Market value of ordinary share

Price Earning Ratio

The reciprocal of the earnings yield is called price earnings ratio. It is calculated by
dividing the market price of the share by the earnings per share.

Market price of share

Price earnings (P/E) ratio =
Earnings per share

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Illustration -1
Calculate Liquidity, Activity and Profitability Ratios and Solvency Ratios from the
Following financial statement for the year 2007-2008.

Operating Statement as on 31st March 2008

Rs.
Sales 80,00,000.00
Less: Cost of Goods Sold 56,00,000.00
Gross Profit 24,00,000.00
Less: Interest on Loans 3,20,000.00
Profit Before Tax 20,80,000.00
Less: Income Tax @ 50% 10,40,000.00
Profit After Tax 10,40,000.00
Less: Dividend Paid 4,40,000.00
Retained Profit 6,00,000.00

Balance Sheet

2006-2007 2007-2008
Cash 4,00,000.00 3,20,000.00
Sundry Debtors 6,40,000.00 8,00,000.00
Marketable Securities 4,00,000.00 6,40,000.00
Stock 36,80,000.00 43,20,000.00
Prepaid Expenses 56,000.00 24,000.00
Total Current Assets 51,76,000.00 61,04,000.00
Total Assets 1,12,00,000.00 1,28,00,000.00
Current Liabilities 12,80,000.00 16,00,000.00
Loans 32,00,000.00 32,00,000.00
Capital 40,00,000.00 40,00,000.00
Accumulated Earnings 9,36,000.00 16,24,000.00

Solution

Liquidity Ratios

Current Asset Rs. 61,04,000

Current Ratio = = 3.81
Current Liabilities Rs. 16,00,000

Liquid Asset Rs. 17,60,000

Liquid Ratio = = 1.1
Current Liabilities Rs. 16,00,000

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Profitability Ratios

Gross Profit X 100 Rs. 24,00,000 X 100

Gross profit ratio = 30%
Net sales Rs. 80,00,000

Net Profit X 100 Rs. 10,40,000 X 100

Net profit ratio = = 26%
Net sales Rs. 80,00,000

Earnings after tax (EAT) X 100 Rs. 10,40,000

Return on equity = 18.5%
Equity share capital employed Rs. 56,24,000

Activity ratios
Cost of Goods Sold Rs. 56,00,000
Inventory Turnover Ratio = 1.4
Average Inventory Rs. 40,00,000

Net Sales Rs. 80,00,000

Debtors Turnover Ratio = 11.1
Average Debtors Rs. 7,20,000

Solvency Ratios

Long term Debts (Debts) Rs. 32,00,000

Debt equity ratio = 0.57
Shareholder Funds or Equity Rs. 56,24,000

EBIT Rs. 24,00,000

Debt Service Ratio = 7.5
Interest Rs. 3,20,000

Illustration – 2

With the help of following information, complete the Balance Sheet of ABC Limited.
Owner’s Fund Rs. 1,00,000
Current Debt to Total Debt 0.40
Total Debt to total Equity 0.60
Fixed Assets to Owner’s Equity 0.60
Total Assets Turnover Ratio 2.00
Inventory Turnover Ratio 8.00

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Solution
Total Debt is 60% of Total Equity, therefore, Rs. 60,000.
Current Debt is 40% of Total Debt i.e. 40% of Rs. 60,000 or Rs. 24,000
Long Term Debt = Rs. 60,000 – Rs. 24,000 = Rs. 36,000
Fixed Assets is 60% of Owner’s Fund, therefore, Rs. 60,000

Total Assets = Owner’s Fund + Total Debt

= Rs. 1,00,000 + Rs. 60,000
= Rs. 1,60,000

Current Assets = Total Assets – Fixed Assets

= Rs. 1,60,000 – Rs. 60,000
= Rs. 1,00,000

Assets Turnover Ratio is 2, therefore, Rs. 3,20,000

Inventory Turnover Ratio is 8 times, therefore, Rs. 40,000

Check Your Progress

1. Ratio Analysis can be used by management to plan and control the functions
of business. Explain.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………
2. Which ratios would you consider most important while evaluating the
performance and profitability of business of the firm.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………
3. Explain the significance of debt equity ratio as a measure of long term
solvency of the firm.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………
4. Why liquidity ratio is considered to be more dependable than current ratio?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………………….

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 UNIT-15 BUDGETING – I

LEARNING OBJECTIVES

15.1 Introduction
15.2 Definition of Budget
15.3 Control
15.4 Budgetary Control
15.5 Objectives of Budget
15.6 Steps Involved in the preparation of budgets
15.7 Classification of Budgets
15.8 Classification on the Basis of Period
15.8.1 Long Term Budgets
15.8.2 Short Term Budgets
15.9 Classification on the Basis of Coverage
15.9.1 Master Budgets
15.9.2 Functional Budgets
15.9.2.1 Production Budgets
15.9.2.2 Sales Budget
15.9.2.3 Cash Budget

15.1 INTRODUCTION

All the business is full from uncertainty of return and high risk of return. This uncertainty
of risk and return may be controlled, almost minimized, by different managerial tools and
techniques. Budgeting is one of the most useful and widely used management technique
of planning and controlling in business. Therefore, the budgetary control becomes an
essential tool of management for planning and controlling of cost and profit.

In modern business, management plans its operation in advance for effective and efficient
utilization of its resources. Later on it is compared with the actual results from the
budgeted figures and reasons are investigated.

15.2 DEFINITION OF BUDGET

According to CIMA London, “A budget is a financial and/or quantitative statement,

prepared and approved prior to a defined period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective. It may include income,
expenditure and the employment of capital.” From the above definition, it is clear that
budget is the financial plans done in advance for pre-determined period of future
prepared by the top management. Financial plans are done for various divisions of
business.

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15.3 CONTROL

Control may be defined as comparing the results with the plans and take corrective
actions, whenever the results are in adverse. It is a technique according to which plan of
actions are guided for future. Control requires two things, specific plans according to
which the work is to be executed and compare the results with plan.

The reasons for variance must be investigate and accordingly the corrective and
preventive actions should be taken.

15.4 BUDGETARY CONTROL

Budgetary control is the process of preparation of budgets and comparing the budgeted
figures for arriving at deviations and actions for future.

According to CIMA London, “Budgetary Control is the establishment of budgets relating

to 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 a basis for revision.

Budgetary control forms an integral part of management control system. Every

management prepares budgets for efficient and effective utilizations of its resources.

15.5 OBJECTIVES OF BUDGET

The main objectives of budgeting are:

i. Optimum use of capital.
ii. To prevent wastage, scrap and damages along with reduction in expenses of the
firm.
iii. To facilitate various departments to operate efficiently and economically.
iv. To plan and control the income and expenditure of the firm,
v. To create a good business practice by planning for future.
vi. To fix accountabilities and responsibilities on different departments.
vii. To co-ordinate the activities of various departments.
viii. To ensure the availability of liquidity and working capital.
ix. To ensure the matching of sales with production.
x. To ascertain the variances and investigate the reasons thereof.
xi. To plan and control capital expenditure in most profitable direction.
xii. To plan and control the expenditures on research and development.
xiii. To take the necessary corrective action before/after preparation of budget.

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15.6 STEPS INVOLVED IN THE PREPARATION OF BUDGETS

I. Budget Controller
Budget controller is responsible for the budget programme. The controller has
technical knowledge of the business and budgets.
II. Formulation of Budget Committee

The committee consists of all heads of various departments such as production, sales,
finance, personnel etc. it is the budget committee who discuss and approved the
budget figures.

III. Fixation of budget period

IV. Identification of key factors
V. Identification of budget centers
VI. Preparation of budget manual
VII. Preparation of manual

15.7 CLASSIFICATION OF BUDGETS

Budgets are classifieds in the following categories on the basis of their nature.
I. On the basis of period
i. Long Term Budgets
ii. Short term Budgets
II. On the basis of coverage
i. Master Budgets
ii. Functional Budgets
III. On the basis of capacity
i. Flexible Budgets
ii. Fixed Budgets
IV. on the basis of conditions
i. Basic Budgets
ii.Current Budgets

Now the above all budgets are discussed in the following paragraphs

15.8 CLASSIFICATION ON THE BASIS OF PERIOD

15.8.1 Long Term Budgets

Long term budgets are prepared for long term in the business. Usually, it is prepared for
those things for which the business is required to wait for five to ten years. Normally, this
budget is prepared for long term assets planning, projects etc.

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15.8.2 Short Term Budgets

Short term budgets are those budgets which are prepared for the short period of time. It
may be for one month to one year. Usually this budget is prepared for budgeting the
normal operation of business.

15.9 CLASSIFICATION ON THE BASIS OF COVERAGE

15.9.1 Master Budgets

This budget is a summary of various functional budgets. In this budget, usually the whole
organization’s activities are covered such as production, sales etc. this budget is prepared
on the basis of certain standard of the business. Such as for production master budget,
installed capacity of machineries are considered as well as demand of the product
considered from the past data.

15.9.2 Functional Budgets

This budget is concerned with the various division of the organization. It is prepared on
the basis of each individual department. Functional budgets are classified in the following
categories.
i. Production Budgets
ii. Sales Budgets
iii. Cash Budgets
iv. Purchase Budgets
v. Material Budgets
vi. Labour Budgets
vii. Overhead Budgets
a. Works overhead
b. Administration overhead
c. Selling and distribution overhead

The above categories of budgets are only illustrative list of budgets prepared by the
organization. The above list may be varied in accordance with the nature of business and
their importance in organization. Such as Material Budgets shall be very important in the
manufacturing industry whereas purchase shall be more important in trading industry.

15.9.2.1 Production Budgets

Production is one of the important departments of the company or organization. It is
responsible for optimum utilization of resources of the company. Especially those items
which are scare or treated as key factor for the production. During the preparation of
production budget, we consider the demanded quantity for sales, stock to be kept in store,
available resources for production and key factors of the production.

15.9.2.2 Sales Budget

A sale is the backbone of the firm. An organization may grow only where the sales is
increasing during the period. The organization may earn and pay his expenses only where
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his sales is sufficient for these. Sales budget is prepared on the basis of age, geographical
location, weather and other factors in accordance with the nature of product of company.

15.9.2.3 Cash Budget

Cash is the life line of the business. Therefore it must be budgeted in advance to meet the
future requirement of expenditures and other payments of debts. In cash budget, we
consider the cash receipts and cash expenditures including the finance available and
payable for the specified period by the company. After preparation of cash budget, the
management comes to now that how much cash is in surplus or deficit during the period.
Accordingly the management takes action for investment of the surplus amount or
arranges funds in advance in case of deficit.

Fixed Budget
Fixed budget is prepared for the fixed activity level of the business. In this budget, all the
expenditures and revenues are not classifieds as fixed, variable and semi-variable at the
particular level of activity. For example, the company has installed capacity of !0,000
units per day, used capacity 7,000 units per day and generating profit of Rs 50,000 per
day. If we prepare the fixed budget at utilization capacity up to 8,000 units per day. After
preparation of this budget, we would know that how much profit shall increase or
decrease along with change in other things.

According to CIMA London, “A fixed budget is a budget designed to remain unchanged

irrespective of the level of activity actually attained.
The feature of fixed budget is given below.
i. Prepared for one fixed level of activity in business.
ii. It does not change with change in the level of activity.
iii. Expenses are not classified in to fixed, variable and semi-variable.

Purchase Budget
Purchase budget is prepared to budget the expenditures on purchase of material and
services. In the purchase budget, we prepare, basically, two budgets. One is fort he
services to be acquired during the period and second is material to be purchase during the
period. During the preparation of purchase budget, various past data are used of the firm
such as material price, cost of various services.

Material Budgets
Material budget is prepared with the line of production budget. At the time of preparation
of material budget, one should keep in mind the requirement of material in production of
the company and the discount allowed on the material to be acquired by the vendor. The
discount allowed by the vendor should be compared with the Economic order quantity in
terms of cost of material.

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Labour Budget
Human resource is an important factor for the organization. It must be utilized in the
optimum manner. In Labour budget, we budget the overall cost of various types of labour
required for the production such as skilled labour, unskilled labour and semi-skilled
labour. It is also prepared on the basis of gender, qualifications and age of the employee
and their experience. In labour budget, we also keep some provision for contingency for
labour such as staff welfare expenses, overtime payment, if any, and so on.

Overhead Budget
Overhead is also an important part of production budget. It is classified in the following
categories.

Works or Production Overhead

This budget is prepared with the help of Material budget, Labour budget and production
budget of the company. In this budget, we do budgeting for indirect material, indirect
labour and indirect expenses to incur in the factory. This budget is prepared on the basis
of past data along with the anticipated increase.

Administration Overhead
Administrations overhead are those overhead which is incurred by the company to
maintain the administration of the company. Administration includes the cost of
stationery used in office, salary to the directors and so on. Basically the administration
overhead is the cost for planning, organizing, directing and other function of the
management.

Selling and Distribution Overhead

Selling and distribution expenses include all those expenditure which are required for
selling of products and their distribution in the market. It includes the cost of
advertisement, business promotion and the freight incurred and paid by the company for
customers. It is prepared on the basis of past data of the company.

Flexible Budgets
Flexible budgets are those budgets which are prepared for different level of activities of
the business. However it may not prepared for the activity which is in excess of the
installed capacity of the business. This budget shall be in the line of fixed budget.

According to CIMA London, “A flexible budget is a budget which, by reconising the

difference between fixed, semi-variable and variable costs is designed to change to the
level of activity attained.”

The main feature of flexible budget is as follows.

i. Prepared for different levels.
ii. Expenses are classified in to fixed, variable and semi-variable.
iii. Changes with the change in level of activity.
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Basic Budgets
The budgets which are remains unchanged during a long period of time is known as basic
budgets. Such as budget for fixed assets and fixed costs.

Current Budgets
The budgets which are prepared for the short period of time and is related to the current
conditions of the business is known as current budget.

Advantages of Budgetary Control

1. To assist in carrying business activities efficiently
Budgetary control helps the management in efficiently and effectively management of
business activities.

2. Proper control over expenditures

The organization can keep close control over the expenditures of the business. The budget
fixed the line for expenditures for any departments of the organization. It also facilitates the
measurement of performance of the individual department of the organization.

3. Helpful in finding variances

Budget helps in finding the variances between the actual and budgeted figures of the
expenditures and revenue.

4. Facilitates implementation of standard costing system

The budget helps in implementation of standard costing system in the organization at a
suitable time.

5. Helpful in change of plans and policies

Budgetary control helps in changing the plans and policies in the future of the
organization. It is done on the basis of current plans and policies.

Limitations of Budgetary Control

Budgetary control has the following limitations.
1. Lack of staff cooperation
The staff does not cooperate in budgetary control exercise of the business because of
fixation of their privileges.
2. Estimates
Budgetary control shows the estimated figures for the given period of time.
3. No automatic execution
The budget can not be executed automatically in the organization. It requires the
different stages for implementations.

4. Expensive
The process of budgetary control is very expensive for the organization. It requires
various types of analysis and various meetings of the staff and so on.
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UNIT-16 BUDGETING – II

LEARNING OBJECTIVES

16.1 Introduction
16.2 Sales Budget
16.3 Production Budget
16.4 Cash Budget
16.5 Importance of Cash Budget
16.6 Methods of preparing Cash Budget
16.6.1 Receipts and Payments Method
16.6.2 Adjusted Profit and Loss Accounts
16.6.3 Balance Sheet Method
16.7 Check Your Progress

16.1 INTRODUCTION

In the previous module, we studied the basic concepts of budget and their preparation in
the organization. We also discussed the steps required for budget preparation in the
organization. After preparation of budget, the organization can keep close control over
the various departments of organization. In this unit we shall discussed the various types
of budgets in details.

16.2 SALES BUDGET

Sales are the backbone of the firm. An organization is known to be growing by the
amount of his sales during the period. The organization may earn and pay his expenses
only where his sales is sufficient for these.

Sales budget is prepared on the basis of product-wise, period-wise, area-wise, salesman-

wise and weather-wise etc. the preparation may be on the suitable basis depends upon the
basis of nature of the products and services of company. Sales manager is responsible for
the sales budget of the organization.

At the single time, the organization may use two or more factors for the preparation of
sales budgets of the organization. For example, number of sales man and the
geographical area of the particular region may be used for the preparation of one sales
budget in the organization.

Following factors should be considered at the time of preparation of sales budget.

i. Salesmen’s estimates
ii. Orders in hand
iii. Production capacity of the plant
iv. Past trends of sales
v. Availability of materials
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vi. Potential markets

vii. Level of competition in the market.
viii. Seasonal fluctuation
ix. Government policies
x. Economic conditions
xi. Cost analysis of production and distribution.

Illustration – 1

Life Care Exim Private Limited manufactures two types of products, Product A and
Product B. the company provides you the following data relating to sales for the period
ended 31st March 2008.

Sales in Kilogram
Quarter Product A Product B
First 2500 3200
Second 5900 1600
Third 5400 2000
Fourth 6200 1200
Selling Price per kg Rs. 24 Rs. 50

The targets fixed by the sales manager for the year 2008-2009 are given below.
Sales quantity increase (decrease) (20%) 25%
Selling price increase (decrease) (25%) (20%)

The company sales his product - A in area X, area Y and area Z, amounting 10%, 20%
and 70% respectively. However product - B in area X, area Y and area Z, amounting
70%, 20% and 10% respectively.

On the basis of the above information, prepare sales budget for the year 2008-2009.

Solution
Sales Budget (product-wise) for the year 2008-2009
Period Product – A Product – B
Units Rate Amount Units Rate Amount
Kg Rs. Rs. Kg Rs. Rs.
First 2000 30 60000 4000 40 160000
Second 4720 30 141600 2000 40 80000
Third 4320 30 129600 2500 40 100000
Fourth 4960 30 148800 1500 40 60000
8000 480000 5000 400000

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Sales Budget (Area-wise) for the year 2008-2009

Sales Budget for Product - A

Period X Y Z Total
Quarter Rs. Rs. Rs. Rs.
First 6000 12000 42000 60000
Second 14160 29320 99120 141600
Third 12960 25920 90720 129600
Fourth 14880 29760 104160 148800
Total 48000 96000 336000 480000

Sales Budget for Product - B

Period X Y Z Total
Quarter Rs. Rs. Rs. Rs.
First 112000 32000 16000 160000
Second 56000 16000 8000 80000
Third 70000 20000 10000 100000
Fourth 42000 12000 6000 60000
Total 280000 80000 40000 400000

Working Notes

Total Sales quantity of product – A for the year

Existing Sales 20000 Kg
Less: Decrease in sales 20% of 20000 Kg

Budgeted Sales for 2008 -2009 shall be 16000 Kg (20000 Kg – 4000 Kg)
Further the sales shall be divided in the ratio of 1:2:7 among the Area X, Area Y and
Area Z.

Sales Price of product – A for the year 2008-2009 shall be Rs. 30 (Rs. 24 + 25% of
Rs. 24)

Total Sales quantity of product – B for the year

Existing Sales 8000 Kg
Add: Increase in sales 25% of 8000 Kg

Budgeted Sales for 2008 -2009 shall be 10000 Kg (8000 Kg + 2000 Kg)
Further the sales shall be divided in the ratio of 7:2:1 among the Area X, Area Y and
Area Z.

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Sales Price of product – B for the year 2008-2009 shall be Rs. 40 (Rs. 50 - 20% of Rs.
50)

16.3 PRODUCTION BUDGET

Management of Production is an important function in the organization. The production

in the business depends upon the sales budget and level of finished goods to be kept in
the organization. The production budget provides the forecasting of cost of production
and the quantity of goods to be produced. This budget is prepared on the day, week or
monthly basis in the organization. The factory manager is responsible for preparation and
control over the production budget.

Following factors should be considered while preparing the production budget.

i. Inventories policies
ii. Quantity required for sales
iii. Capacity of plant
iv. Availability of inputs
v. Production policies

Production (in units) shall be computed with the help of following formula.
Budgeted Sales + Closing stock of finished goods – Opening Stock of finished goods

Illustration – 2
ABC Limited provides the following figures for the period of three months.
Particulars Product – A Product – B Product – C
Sales (Units)
January 100000 120000 40000
February 80000 100000 40000
March 120000 140000 40000
Sales Price Per Unit (Rs.) 10 20 40
Targets for subsequent quarter
Increase in sales quantity (%) 20 10 10
Increase in sales price (%) NIL 10 25
Opening Stock as on 01st January 50% of the sales shall be maintained as opening
stock for every month
Closing stock as on 31st March 40000 50000 10000

The company shall maintain closing stock for January and February at the percentage of
50% of the subsequent month sales.

Prepare the production budget from the above given information.

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Solution
Calculation of Sales (in units)
January February March
Product –A
Budgeted 100000 80000 120000
Add: Increase @ 20% 20000 16000 24000
TOTAL 120000 96000 144000

Product –B
Budgeted 120000 100000 140000
Add: Increase @ 10% 12000 10000 14000
TOTAL 132000 110000 154000
Product –C
Budgeted 40000 40000 40000
Add: Increase @ 10% 4000 4000 4000
TOTAL 44000 44000 44000

Production Budget for the period ended 31st March

Particulars January February March Total

Product – A (in Units)
Sales 120000 96000 144000 440000
Add: Closing Stock 48000 72000 80000 80000
Less: Opening Stock 60000 48000 72000 60000
TOTAL 108000 120000 152000 380000

Product – B (in Units)

Sales 132000 110000 154000 396000
Add: Closing Stock 55000 77000 100000 100000
Less: Opening Stock 66000 55000 77000 60000
TOTAL 121000 132000 177000 430000
Product – C (in Units)
Sales 44000 44000 44000 132000
Add: Closing Stock 22000 22000 22000 20000
Less: Opening Stock 22000 22000 20000 22000
TOTAL 44000 120000 46000 130000

16.4 CASH BUDGET

Cash budget shows the summary of cash inflows and cash outflows during a particular
period. Basically, it is prepared to know the surplus or deficit in the cash in future of the
organization. Usually, the cash budget is prepared on monthly basis. However it may be
prepared for quarter, half year and annually, if the company has sufficient data for
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projections in the future. Cash budget is prepared with the help of all budgets such as
sales budget, production budget, overhead budget, material budget and capital
expenditure budget in the organization.

16.5 IMPORTANCE OF CASH BUDGET

The cash budget helps management in the following

i. It assists the management to know the surplus or deficit of cash during the period.
ii. It enables the management to prepare the borrowing schedule, plans and policies.
iii. The cash budget provides the facility of planning of debt payment.
iv. With the help of cash budget, the management shall know the period, in which the
cash shall be surplus or deficit.
v. It enables the management to plan the payment of interest on debts and dividends
to the shareholders in advance.
vi. The cash budget helps management in deciding the cash discount for the
organization and to the organization.
vii. The cash budget helps in planning the capital expenditure for the organization.
viii. The cash budgets also helps in leasing or purchasing decision for the organization
at the time of replacement and modernization decision of the company.

16.6 METHODS OF PREPARING CASH BUDGET

Cash budget may be prepared as follows

i. Receipts and Payments Method
ii. Adjusted Profit and Loss Method
iii. Balance Sheet Method

Now we discuss the above methods in brief.

16.6.1 Receipts and Payments Method

Receipts and payments method is an old traditional method of preparing the cash budget
in the organization. Under the receipts, we cover the sum of all receipts which the
company shall get from the sources during the period and for payments, we consider the
sum of payments which is required to pay by the company during the period.

The receipts shall include the amount to be received from the borrowing and capital
raised during the period. It covers the amount received in advance from the customers or
amount held as security from the parties.

The payment shall include all the payments are required to pay during the period by the
company. The payment shall also include the payment of long term debt and their interest
during the period.

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Illustration – 3
ABC Limited provides you the following information for half year ended on June 2008.
Prepare the cash budget from the following information.

i. The company is doing any sales activity during the first month of its operation. In
subsequent month, the company is doing the sales activity in cash 25% only.
ii. The payments to the creditors for material purchase shall be done on monthly basis
from the date of invoice received.
iii. The wages and salaries shall be paid on fortnightly basis, on 22 nd and 07th of the
month.
iv. Other expenses shall be paid on one month basis except the selling and distribution
expenses which are required to paid 5% immediately of the amount of selling and
distribution expenses.
v. All the expenses and receipts are accruing evenly during the period.

Particulars Rs.
Sales 720000
Manufacturing Expenses 96000
Material consumed 300000
Wages and salaries 120000
Administrative Expenses 108000
Selling and distribution expenses 84000
Depreciation on fixed assets 100000

The company has the registration under Central Excise Act in India. The product is
classified for 10% duty on the selling price. The duty is payable at the end of every quarter
of the calendar for the sales up to February, May, August and November respectively.

Solution; Cash Budget of ABC LTD.

Particulars January February March April May June
Receipts
Opening Balance - (15000) (90000) (78400) (52400) (26400)
Cash Sales - 36000 36000 36000 36000 36000
Collection from Debtors - - 108000 108000 108000 108000

TOTAL - 21000 54000 65600 91600 117600

Payments
Wages and Salaries 15000 20000 20000 20000 20000 20000
Materials consumed - 50000 50000 50000 50000 50000
Manufacturing exp. - 16000 16000 16000 16000 16000
Administrative exp. - 18000 18000 18000 18000 18000
Selling and Distr. - 7000 14000 14000 14000 14000
Excise Duty - - 14400 - - 43200
TOTAL 15000 111000 132400 118000 118000 161200
Closing Balance (15000) (90000) (78400) (52400) (26400) (43600)
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For the half year ended 30th June

16.6.2 Adjusted profit and Loss Accounts

Under this method, the profit is adjusted to know the change in cash during the particular
period from the operating, investing and financing activities of the company. This is
similar to Cash flow statement of the company. In this budget, we deduct all non-
operating income and add the non-operating expenses in the amount of net profit earned
during the period to calculate the cash from operation. After this we do certain
adjustments for the change in working capital, investing activities and financing
activities.

16.6.3 Balance Sheet Method

Under this method, the budget is prepared by preparing the balance sheet of the firm
without considering the cash and bank balance. The difference between the assets and
liabilities are considered as balance of cash and bank during the particular period of the
firm. The assets and liabilities of this budget are prepared after considering the
anticipated change in assets and liabilities only. If the assets are more than liabilities, the
difference shall be cash credit or bank finance. If the assets are less than liabilities, the
difference shall be cash and bank balance during the particular period.

16.7 CHECK YOUR PROGRESS

1. State the factors which shall be consider during the preparation of sales budget of
the company.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………

2. What do you mean by production budget? How it is prepared?

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………

3. Explain the importance of cash budget in the organization.

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……………………

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4. Prepare the sales budget from the following information for the previous year.

East Zone West Zone

Product Selling Price Selling Price
Sales (Kg) Sales (Kg)
(Per Kg) (Per Kg)
X 6 200000 8 50000
Y 7.50 300000 5 800000
Z 8 500000 7 700000

Targets for the current year

East West
Sales Price increase (decrease) in percentage
X 25 20
Y (10) (10)
Z 20 25

Sales quantity increase (decrease) in percentage

X (20) (20)
Y 10 10
Z (20) (25)

5. Prepare the cash budget for the second quarter of the calendar year from the
following information.
Particulars February March April May June
Sales 37500 42000 45000 60000 67500
Material Consumed 22500 24000 26250 30000 30000
Wages 4500 4875 5250 6750 7250
Factory Overhead 3750 4125 4500 5625 7000
Administration Overhead 3000 3000 3000 3000 3500
Selling and Distribution 2250 2250 2625 3285 3500
overhead

Adjustments
1. Materials are purchased at the credit period of two months from the date of
purchase.
2. 20% of the sales are made for cash and balance is recovered after one month
immediately succeeding the month of sales.
3. All the payments of expenses including the amount of overhead are required to pay
after one month.
4. Advance tax for Income Tax is due on 15th June of the month amounting Rs 28750.

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