COST

STUDY NOTES
UNIT I

COST ACCOUNTING
Cost accounting is the classifying, recording and appropriate allocation of expenditure for
the determination of the costs of products or services, and for the presentation of suitably
arranged data for purposes of control and guidance of management. It includes the
ascertainment of the cost of every order, job, contract, process, service or unit as may be
appropriate. It deals with the cost of production, selling and distribution.

Objectives of Cost Accounting:

Following are the main objectives of cost accounting:

1. Ascertainment of the cost per unit of the different products that a business concern
manufacturer.

2. To correctly analyse the cost of both the process and operations.

3. Disclosure of sources for wastage of material, time, expenses or in the use of the
equipment and the preparation of reports which may be necessary to control such wastage.

4. Provide requisite data and help in fixing the price of products manufactured or services
rendered.

5. Determination of the profitability of each of the products and help management in the
maximization of these profits.

6. Exercise effective control of stocks of raw material, work-in-progress, consumable stores,

and finished goods so as to minimize the capital invested in them.

7. Present and interpret data for management planning, decision-making, and control.

8. Help in the preparation of budgets and implementation of budgetary control.

9. Aid management in the formulation and implementation of incentive bonus plans on the
basis of productivity and cost savings.

10. Organization of cost reduction programmes with the help of different departmental
managers.

11. To provide specialized services for cost audit in order to prevent errors and frauds.
12. To facilitate prompt and reliable information to management.

13. Determination of costing profit or loss by linking the revenues to costs of those products
or services by selling which the revenues have arisen.

Advantages of Cost Accounting

Cost Accounting has manifold advantages, a list of which is given below .

• Measuring and Improving Efficiency

• Control over Stock
• Disclosure of profitable and unprofitable activities
• Guidance for future production policies
• Periodical determination of profit and losses
• To find out exact cause of decrease or increase in profit
• Control over material and supplies
• Relative efficiency of different workers
• Reliable comparison
• Helpful to government
• Helpful to consumers
• Classification and subdivision of cost
• To find out adequate selling price
• Proper investment in inventory
• Correct valuation of inventory
• Decision on manufacturing or purchasing from outside
• Reliable check on accounting
• Budgeting
 Difference between Financial Accounting and Cost Accounting
The main differences between Financial and Cost Accounting are as follows:
Financial Accounting Cost Accounting
(a) It provides the information about the business in a (a) It provides information to the management for
general way. i.e. Profit and Loss Account, Balance proper planning, operation, control and decision
Sheet of the business to owners and other making.
outside partners.
(b) It classifies, records and analyses the transactions (b) It records the expenditure in an objective manner,
in a subjective manner, i.e. according to the i.e. according to the purpose for which the costs
nature of expense. are incurred.
(c) It lays emphasis on recording aspect without (c) It provides a detailed system of control for
attaching any importance to control. materials, labour and overhead costs with the
help of standard costing and budgetary control.

(d) It reports operating results and financial (d) It gives information through cost reports to
position usually at the end of the year. management as and when desired.
(e) Financial Accounts are accounts of the whole (e) Cost Accounting is only a part of the financial
business. They are independent in nature. accounts and discloses profit or loss of each
product, job or service.
(f) Financial Accounts records all the commercial (f) Cost Accounting relates to transactions
transactions of the business and include all connected with Manufacturing of goods and
expenses i.e. Manufacturing, Office, Selling services, means expenses which enter into
etc. production.
(g) Financial Accounts are concerned with external (g) Cost Accounts are concerned with internal
transactions i.e. transactions between business transactions, which do not involve any cash
concern and third party. payment or receipt.
(h) Only transactions which can be measured in (h) Non-Monetary information likes No of Units /
monetary terms are recorded. Hours etc. are used.
(i) Financial Accounting deals with actual (i) Cost Accounting deals with partly facts and
figures and facts only. figures and partly estimates / standards.
(j) Financial Accounting do not provide information on (j) Cost Accounts provide valuable information on
efficiencies of various workers/ Plant & the efficiencies of employees and Plant &
Machinery. Machinery.
(k) Stocks are valued at Cost or Market price (k) Stocks are valued at Cost only.
whichever is lower.
(l) Financial Accounting is a positive science as it is (l) Cost Accounting is not only positive science but
subject to legal rigidity with regarding to also normative because it includes techniques of
preparation of financial statements. budgetary control and standard costing.

(m) These accounts are kept in such a way to meet the (m) Generally, Cost Accounts are kept voluntarily to
requirements of Companies Act 2013 as per Sec meet the requirements of the management,
128 & Income Tax Act, 1961 Sec 44AA. only in some industries Cost Accounting
records are kept as per the Companies Act.
CLASSIFICATION OF COSTS
Costs may be categorized according to (1) management function, (2) ease of traceability, (3)
timing of charge against revenue, (4) behavior in accordance with activity, and (5) relevance
to decision making.

According to Management Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished
goods. It includes cost of raw materials used (direct materials), direct labor, and factory
overhead.

2. Non-manufacturing costs - not incurred in transforming materials to finished goods.

These include selling expenses (such as advertising costs, delivery expense, salaries and
commission of salesmen) and administrative expenses (such as salaries of executives and
legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a
particular product, department, or branch. Examples include materials and direct labor.
Some operating expenses can also be classified as direct costs, such as advertising cost for a
particular product.

2. Indirect costs - those that cannot be traced to a particular object of costing. They are also
called common costs or joint costs. Indirect costs include factory overhead and operating
costs that benefit more than one product, department, or branch.

According to Timing of Charge against Revenue

1. Product costs - are inventoriable costs. They form part of inventory and are charged
against revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials,
direct labor, and factory overhead) are product costs.

2. Period costs - are not inventoriable and are charged against revenue immediately. Period
cost include non-manufacturing costs, i.e. selling expenses and administrative expenses.
According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct
materials, direct labor, and sales commission based on sales.

2. Fixed costs - costs that remain constant regardless of the level of activity. Examples
include rent, insurance, and depreciation using the straight-line method.

3. Semi variable costs - costs that vary in total but not in proportion to changes in activity. It
basically includes a fixed cost potion plus additional variable cost. An example would be
electricity expense that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words,
these costs refer to those that will affect a decision.

2. Standard cost - predetermined cost based on some reasonable basis such as past
experiences, budgeted amounts, industry standards, etc. The actual costs incurred are
compared to standard costs.

3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the
other/s. Example: If a business chooses to use its building for production rather than rent it
out to tenants, the opportunity cost would be the rent income that would be earned had
the business chose to rent out.

4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike
relevant costs, they do not have an impact on the matter at hand.

5. Controllable costs - refer to costs that can be influenced or controlled by the manager.
Segment managers should be evaluated based on costs that they can control.
UNIT II

Material Cost
Material is any substance that forms part of or composed of a finished product. i.e. material
refers to the commodities supplied to an undertaking for the purpose of consumption in the
process of manufacturing or of rendering service or for transformation into products.
Material cost is the significant constituent of the total cost of any product. It constitutes
40% to 80% of the total cost.

The materials are of two types, namely:

(I) Direct materials: The materials which can be easily identified and attributable to the
individual units being manufactured are known as direct materials. These materials also
form part of finished products. All costs which are incurred to obtain direct materials are
known as direct material costs.

(ii) Indirect materials: Indirect materials, on the other hand, are those materials which are
of small value such as nuts, pins, screws, etc. and do not physically form part of the finished
product. Costs associated with indirect materials are known as indirect material costs

Techniques of Material Control

The various techniques of material control include:

Setting of various stock level

In this technique of material control, we study and control by calculating different level of
quantity of stock. With our past records, we have the data of normal usage, maximum
usage, minimum usages, re-order quantity and minimum and maximum period and its mid
will be average period. With this data, we can find following stock level

a) Re-ordering level

It is the level of stock quantity between minimum and maximum level and material order
was sent for getting fresh stock.

Formula maximum usage of stock X maximum delivery period

b) Minimum level

It is the minimum balance, which must be maintained in hand at all times, so that there is no
stoppage of production due to non-availability of inventory.

Re-order level - (Normal usage X average period)

c) Maximum level

It shows maximum quantity which should be in the stock, if we buy more, it means we are
wasting money.

Re-order level X re-order quantity - (minimum usage X minimum period)

d) Average Stock Level

This is the average of minimum and maximum level and it can be calculated by adding
minimum level and maximum level and divided by 2.

(minimum level + maximum level)/ 2

e) Danger level

It is the level at which normal issues of the raw material inventory are stopped and
emergency issues are only made.

Average consumption X lead time for emergency purchases

ABC ANALYSIS

ABC analysis is a technique that is followed for the purpose of exercising control over
materials according to their importance or value. Category ‘A’ consists of materials which
consists 5% to 10% of the total items in a store and represent 70% to 85% of the total store
value. It represents less items with high value. Category ‘B’ consists of materials which
consists of 10% to 20% of the total items in a store and represent 10% to 20% of the total
store value. This category represents medium quantity and value.

Category ‘C’ consists of materials which consists of 70% to 855 of the total items in a store
and represent 5% to 10% of the store value. This category represents high quantity but
small value. It is also known as Always Better Control method since it aims at obtaining
maximum control over materials and minimum cost of control
TWO BIN SYSTEM

Two bin system is used for the material control. It is that technique of material control in
which we have two bins, one is used for in use minimum stock and second bin is used for
reserve stock or to keep the remaining quantity of material. This system of inventory control
is also called in USA Kanban. First bin is utilized for issuing the material for production and
then, second bin is used. Its record is done on bin cards and store ledger card.

CONTINUOUS STOCK VERIFICATION

Continuous stock verification is that technique of material control in which company

appoints some experts who verifies all the stock physically with its record. It is just like
internal audit of store. These experts are independent from store and they have right to
check the material at any time without providing advance information to store staff. This
surprise checking through continuous stock verification makes store staff more responsible
for duty. There are also other benefits of continuous stock like it will make store keeper
more sober and moral to do the duty. He knows that the store is also controlled by experts.
He tries to best to reduce all inherent shortcomings. Continuous stock verification will also
helpful to remove all discrepancies between actual stock and book record of stock and
expert can identify for this mistake and take action against him.

VED ANALYSIS

This technique of material control is used in connection with the spare parts. Under this

• ‘V’ stands for ‘Vital’

• ‘E’ stands for ‘Essential’

• ‘D’ stands for ‘Desirable’

Vital spare parts are those parts, the unavailability of which will interrupt the production
process for quite some time. Essential spare parts are those spares, the absence of which
cannot be tolerated for more than few hours or a day. Desirable spare parts are those
spares which are needed but their non-availability for even a week or so will not lead to
interruption in production.
MATERIALS TURNOVER

Turnover of materials refers to movement into and out of an organization. It can be

calculated by comparing balance of stores with the total issues or withdrawal during a
particular period of time.

Material Turnover Ratio= Value of materials consumed during the period/ value of average
stock.

Average stock= Opening stock+ Closing stock/ 2

High material turnover ratio indicates that the material item is fast moving and exhausts
easily. Low material turnover indicates that the material items are slow moving and
organization should not go for over stocking of materials.

PERPETUAL INVENTORY SYSTEM

Perpetual Inventory System refers to a system of maintaining such records as will reflect the
receipts, issues and balance of all items of materials in store all the times. Thus it is a system
of ascertaining balance after every receipt and issue of materials through stock records to
facilitate regular checking and to avoid closing down the firm for stock taking .The records
maintained in a manufacturing concern for material accounting are divided into two parts:

Bin Card: It is maintained in the stores department and shows the quantities of materials
received, issued and balance in hand after each receipt and issue.

Stores Ledger: It is maintained by costing office and deals with the quantities and values of
materials received, issued and balance in hand.

ECONOMIC ORDER QUANTITY

Economic order quantity is that size of the order which given maximum economy in
purchasing any item of material. There are two main costs that are considered while
determining the economic order quantity, these are:

Material Acquisition Costs are related to the number of orders placed during a given period.
These costs are part of wages and operating expenses for departments like production
control, purchasing, receiving and stores is incurred for purchasing and possessing the
materials.

Material carrying costs includes the interest charges on investment in materials, insurance
costs, storage costs etc. these costs may be variable or semi-variable in nature as they tend
to change nearly in direct proportion to the level of stock carried in the manufacturing
concern.

PRICING OF MATERIAL ISSUES

The important methods followed in pricing of issue of materials are:- 1. Actual Cost Method
2. First-In First-Out (FIFO) Method 3. Last-In First-Out (LIFO) Method 4. Highest-in First-Out
(HIFO) Method 5. Simple Average Cost Method 6. Weighted Average Cost Method 7.
Periodic Average Cost Method 8. Standard Cost Method 9. Replacement Cost Method 10.
Next in First Out (NIFO) Method 11. Base Stock Method.

1. Actual Cost Method:

Where materials are purchased specially for a specific job, actual cost of materials is
charged to that job. Such materials will normally be stored separately and issued only to
that particular job.

2. First-In First-Out (FIFO) Method:

CIMA defines FIFO as “a method of pricing the issue of material using, the purchase price
of the oldest unit in the stock”. Under this method materials are issued out of stock in the
order in which they were first received into stock. It is assumed that the first material to
come into stores will be the first material to be used.
Last-In First-Out (LIFO) Method:
Under this method most recent purchase will be the first to be issued. The issues are priced
out at the most recent batch received and continue to be charged until a new batch
received is arrived into stock. It is a method of pricing the issue of material using the
purchase price of the latest unit in the stock.

Highest-in First-Out (HIFO) Method:

Under this method, the materials with highest prices are issued first, irrespective of the date
upon which they were purchased. The basic assumption is that in fluctuating and
inflationary market, the cost of material are quickly absorbed into product cost to hedge
against risk of inflation. This method is used when the material is in short supply and in
execution of cost plus contracts. This method is not popular and not acceptable under
standard accounting practices.

Simple Average Cost Method:

Under this method all the materials received are merged into existing stock of materials,
their identity being lost. The simple average price is calculated without any regard to the
quantities involved. The simple average cost is arrived at by adding the different prices paid
during the period for the batches purchased by dividing the number of batches. For
example, three batches of materials received at Rs. 10, Rs. 12 and Rs. 14 per unit
respectively.

The simple average price is calculated as follows:

Rs. 10 + Rs. 12 + Rs. 14/3 batches = Rs. 36/3 batches = Rs 12 per unit

This method is not popular because it takes into consideration the prices of different
batches but not the quantities purchased in different batches. This method is used when
prices do not fluctuate very much and the stock values are small in value.

Weighted Average Cost Method:

It is a perpetual weighted average system where the issue price is recalculated every time
after each receipt taking into consideration both the total quantities and total cost while
calculating weighted average price. For example, three batches of material received in
quantities of 1,000 units @ Rs. 15, 1,300 units @ Rs. 16 and 800 units @ Rs. 14.

The weighted average price is calculated as follows:

(1,000 units x Rs. 15) + (1,300 units x Rs. 16) + (800 units x Rs. 14)/1,000 units + 1,300 units +
800 units

= Rs. 15,000 + Rs. 20,800 + Rs. 11,200/3,100 units = Rs. 47,000/3,100 units = Rs. 15.16 per
unit

Standard Cost Method:

Under this method, material issues are priced at a predetermined standard issue price. Any
variance between the actual purchase price and standard issue price is written off to the
Profit and Loss Account. Standard cost is a predetermined cost set by the management prior
to the actual material costs being known and the standard issue price is used for all issues to
production and for valuation of closing stock. If initially the standard price is set carefully
then it reduces all the clerical work and errors tremendously and the stock recording
procedure is simplified. The realistic production cost comparisons can be made easier by
eliminating fluctuations in cost due to material price variance. In a situation of fluctuating
prices, this method is not suitable.

Replacement Cost Method:

This method is also called as ‘market price method’. The replacement cost is a cost at which
material identical to that can be replaced by purchasing at the date of pricing material
issues; as distinct from the actual cost price at the date of purchase. The replacement price
is the price of replacing the material at the time of issue of materials or on the date of
valuation of closing stock.

MATERIAL LOSSES
Material losses do occur in every type of manufacturing organization. These losses may be
in the form of waste, spoilage or defective work. There is no uniformity in the terminology
and accounting treatment of these items. Material losses take place in one way or the other
in the process of material handling, storage and issue to respective departments or jobs.
Normal Loss:
It is that loss which cannot be avoided and it has a tendency to occur, such as
(a) Loss due to evaporation
(b) Loss due to breaking
(c) Loss in loading and unloading of materials.
Abnormal Loss:
This loss arises on account of inefficiency and mischief etc., such as:
(i) Improper storage
(ii) Breakage of material
(iii) Theft and Pilferage
(iv) Use of defective weighing machine
(v) Fire, accident, flood, earth quacks etc.
(vi) Other unavoidable reasons.

Classification of Material Losses

Material losses can be classified on the basis of: - 1. Wastage 2. Spoilage 3. Scrap 4.
Defectives 5. Obsolete Materials.
Waste:
That portion of raw materials, which is lost in the process of manufacturing is known as
waste. Waste may be visible or invisible. Quantity of production is reduced on account of
wastes. If waste is a part of abnormal loss, it is transferred to P/L A/c.
Scrap:
The incidental residue of small quantity and low value is known as scrap. Scrap increases the
cost of production and a proper control is to be made on it. Sale of scrap may be treated as
other income and can be credited to P/L A/c. The realised value of scrap may be credited to
the process account.
Spoilage:
When materials are damaged, which cannot be brought to normal conditions is known as
spoilage. Normal spoilage is a part of total cost, while abnormal spoilage is to be transferred
to profit and loss account.
Defectives:
The production which is below the fixed standard and can be rectified by incurring
additional expenditure is known as defective item. Proper control should be exercised over
the defective goods. The rectification costs should be debited to the concerning jobs. In case
of abnormal defective work, the cost may be transferred to costing profit and loss account.
LABOUR COST
Payment of remuneration to the workers for their service to the firm is known as labour
payment. This is the second element of total cost. It may be direct or indirect in nature. If it
is treated as a direct expense, it will be included with prime cost and if it relates to factory, it
will be treated as an item of factory cost.

Classification of Labour Cost

The labour cost may be classified in the following ways.
1. Direct Labour Cost
Direct Labour cost is that portion of salary or wage, which can be identified with and
charged to a single unit cost of production.
2. Indirect Labour Cost
It is not identifiable within the production of goods and services even though directly
incurred. These costs are incurred in the production place. Sometimes, some cost center
may render service to the production departments or production activities. Such cost
centers purchase, engineering and time keeping.
3. Controllable Labour Cost
A labour cost can be controlled by the management during production period and even
during absence of production. A standard time and time rate may be fixed and request the
labour to complete the job or order within such time. If so, the labour cost can be controlled
to some extent.
4. Non-Controllable Labour Cost
A labour cost, which cannot be easily controlled by the management. A job or order can be
completed by a group of labours. The efficiency of such group of labours differ in nature. A
labour can use his/her efficiency in full as per the prevailing environment in the product
place. If so, the cost cannot be controlled by the management.
TIME KEEPING AND TIME BOOKING
Time-keeping department is concerned with the recording of time of each worker engaged
in the factory. The recording of time is for two purposes, i.e., for Time-keeping and Time
Booking. Time-keeping is concerned with the recording of time of workers for the purpose
of attendance and wage calculations whereas time booking is the reporting of each worker’s
time for each department, operation and job for the purposes of cost analysis and
apportionment of labour costs between various jobs and departments. Time booking
signifies the time spent by a worker on each job, process or operation.

These two recordings should be regularly reconciled to establish the accuracy of recording
of time because wages calculated on the basis of time-keeping should agree with the wages
charged to the various jobs or production orders on the basis of time booking.

Idle Time
There is always a difference between the time booked to different jobs or work orders and
the time recorded at the factory gate. This difference is known as idle time. Idle time is of
two types.
(a) Normal Idle Time
(b) Abnormal Idle Time
Normal Idle Time: This represents the time, the wastage of which cannot be avoided and,
therefore, the employer must bear the labour cost of this time. But every effort should be
made to reduce it to the lowest possible level. Examples of normal idle time are: time taken
in going from the factory gate to the department in which the worker is to work and back at
the end of the day, time taken in picking up the work for the day, time between the
completion of one work and the start of another work, time taken for personal needs like
tea or toilet, time taken for machine maintenance, time taken for waiting for instructions,
printouts, machine set-up time etc.
Normal Idle Time is unavoidable cost as such should be included in cost of production. The
cost of normal idle time can be treated as an item of factory expenses and recovered as an
indirect charge or added to labour cost.
Abnormal Idle Time: It is that time the wastage of which can be avoided if proper
precautions are taken. Example: time wasted due: - to breakdown of machinery on account
of inefficiency of the works engineer, failure of the power supply, shortage of materials,
waiting for instructions, waiting for tools and raw materials, strikes or lock-outs in the
factory.
It is a principle of costing that all abnormal expenses and losses should not be included in
costs and as such wages paid for abnormal idle time should not form part of the cost of
production. Hence it is debited to Costing Profit and Loss Account.

Over Time
It is the work done beyond the normal working period in a day or week. For overtime done,
the workers are given double the wages for the overtime done. The additional amount paid
on account of overtime is known as overtime premium. Overtime should be recorded
separately and thoroughly investigated to see that it is incurred only when genuinely
required. The treatment of overtime depends on the situation. If overtime is incurred for
because of the sequence of jobs, then normal wages is charged to labour cost for the
overtime also but if it is a rush job, then the overtime wages is added to the cost of labour.
On the other hand, if overtime arises due to any abnormal reason like breakdown of
machinery or power failure, overtime premium is excluded from the cost of production and
is debited to the Costing Profit and Loss Account.

System of Wage Payment

There are two principal wage systems: (i) Payment on the basis of time spent in the factory
irrespective of the amount of work done. This method is known as time wage system. (ii)
Payment on the basis of the work done irrespective of the time taken by the worker. This
method is called piece rate system.
Other methods called premium plans or bonus and profit-sharing schemes are used with
either of the two principal methods of wage payment.

Time Wage System

Under this method of wage payment, the worker is paid at an hourly, daily, weekly or
monthly rate. This payment is made according to the time worked irrespective of the work
done.

Piece Rate System (payment by result)

Under this system of wage payment, a fixed rate is paid for each unit produced, job
completed or an operation performed. Thus, payment is made according to the quantity of
work done no consideration is given to the time taken by the workers to perform the work.
There are four variants of this system.
a) Straight piece rate system
b) Taylor’s differential piece rate system
c) Merrick’s multiple piece rate system
d) Gant’s task and bonus plan
(a) Straight piece rate system
Payment is made as per the number of units produced at a fixed rate per unit. Another
method is piece rate with guaranteed time rate in which the worker is given time rate wages
if his piece rate wages is less than the time rate.
(b) Taylor’s Differential Piece Rate system
This system was introduced by Taylor, the father of scientific management to encourage the
workers to complete the work within or less than the standard time. Taylor advocated two-
piece rates, so that if a worker performs the work within or less than the standard time, he
is paid a higher piece rate and if he does not complete the work within the standard time,
he is given a lower piece rate.
(c) Merrick’s Multiple Piece Rate System
This method seeks to make an improvement in the Taylor’s differential piece rate system.
Under this method, three-piece rates are applied for workers with different levels of
performance. Wages are paid at ordinary piece rate to those workers whose performance is
less than 83% of the standard output, 110% of the ordinary piece rate is given to workers
whose level of performance is between 83% and 100% of the standard and 120% of the
ordinary piece rate is given to workers who produce more than 100% of the standard output

Premium and Bonus Plan

The object of a premium plan is to increase the production by giving an inducement to the
workers in the form of higher wages for less time worked. Under a premium plan, a
standard time is fixed for the completion of a specific job or operation at an hourly rate plus
wages for a certain fraction of the time saved by way of a bonus. The plan is also known as
incentive plan because a worker has the incentive to earn more wages by completing the
work in less time. The following are some of the important premium plans.
(i) Halsey Premium Plan: Under this method, the worker is given wages for the actual time
taken and a bonus equal to half of wages for time saved. The standard time for doing each
job or operation is fixed. In practice the bonus may vary from 33⅓ % to 66⅔ % of the wages
of the time saved.
Thus, if S is the standard time, T the time taken, R the labour rate per hour, and % the
percentage of the wages of time saved to be given as bonus, total earnings of the worker
will be:
T x R + % (S-T) R
Under Halsey-Weir plan, the premium is set at 30% of the time saved.
(ii) Rowan Plan: The difference between Halsey plan and Rowan Plan is the calculation of
the bonus. Under this method also the workers are guaranteed the time wages but the
bonus is that proportion of the wages of the time taken which the time saved bears to the
standard time allowed.
Total Earnings = T x R + S-T x T x R
S

UNIT III
OVERHEADS
An overhead is the amount which is not identified with any product. Cost related to a cost
center or cost unit may be divided into two i.e. Direct and Indirect cost. The Indirect cost is
the overhead cost and is the total of indirect material cost, indirect labour cost, indirect
expenses. CIMA defines indirect cost as “expenditure on labour, materials or services which
cannot be economically identified with a specific saleable cost per unit”. Indirect costs are
those costs which are incurred for the benefit of a number of cost centres or cost units. So
any expenditure over and above prime cost is known as overhead. It is also called ‘burden’,
‘supplementary costs’, ‘on costs’, ‘indirect expenses.

Classification of Overheads
Overheads can be classified on the following basis:
(I)Function-wise classification: Overheads can be divided into the following categories on
functional basis.
(a) Manufacturing or production overheads e.g.: - indirect materials like lubricants, cotton
wastes, indirect labour like salaries and wages of supervisors, inspectors, storekeepers,
indirect expenses like rent, rates and insurance of factory, power, lighting of factory, welfare
expenses like canteen, medical etc.
 (b) Administration overheads e.g.: - indirect materials like office stationery and printing,
indirect labour salaries of office clerks, secretaries, accountants, indirect expenses rent, rates
and insurance of office, lighting heating and cleaning of office, etc.
(c) Selling and Distribution overheads e.g.: - indirect materials like catalogues, printing,
stationery, price list, indirect salary of salesmen, agents, travellers, sales managers, indirect
expenses like rent, rates and insurance of showroom, finished goods, godowns etc.,
advertising expenses, after sales service, discounts, bad debts etc.
ii)Behavior-wise classification: Overheads can be classified into the following categories as
per behavior pattern.
(a) Fixed overheads like managerial remuneration, rent of building, insurance of building,
plant etc.
(b) Variable overheads like direct material and direct labour.
(c) Semi-variable overheads like depreciation, telephone charges, repair and maintenance
of buildings, machines and equipment etc.
iii) Element-wise classification: Overheads can be classified into the following categories as
per element.
(a) Indirect materials (b) Indirect labour
(c) Indirect expenses

Depart-mentalisation of Overhead
When all the items are collected properly under suitable account headings, the next step is
allocation and apportionment of such expenses to cost centres. This is also known as
departmentalization or primary distribution of overhead.

Allocation of Overhead Expenses

Allocation is the process of identification of overheads with cost centres. An expense which
is directly identifiable with a specific cost centre is allocated to that centre. Thus, it is
allotment of a whole item of cost to a cost centre or cost unit. For example, the total
overtime wages of workers of a department should be charged to that department. The
electricity charges of a department if separate meters are there should be charged to that
particular department only.

Apportionment of Overhead Expenses

Cost apportionment is the allotment of proportions of cost to cost centres or cost units. If a
cost is incurred for two or more divisions or departments then it is to be apportioned to the
different departments on the basis of benefit received by them. Common items of
overheads are rent and rates, depreciation, repairs and maintenance, lighting, works
manager’s salary etc.
Basis of Apportionment
Suitable bases have to be found out for apportioning the items of overhead cost to production
and service departments and then for reapportionment of service departments costs to other
service and production departments. The basis selected should be correlated to the expenses
and the expense should be measurable by the basis. This process of distribution of common
expenses over the departments on some equitable basis is known as ‘Primary Distribution’.

Absorption of Overhead
Absorption means the distribution of the overhead expenses allotted to a particular
department over the units produced in that department. Overhead absorption is also known
as levy or recovery of overheads. Absorption is ‘recording of overheads in Cost Accounts on
an estimated basis with the help of a predetermined overhead rate, which is computed at
normal or average or maximum capacity’ Overhead absorption is accomplished by overhead
rates.

Under-absorption and Over-absorption of Overhead

The amount of overhead absorbed in costs is the sum total of the overhead costs allotted to
individual cost units by application of the overhead rate. When a predetermined rate worked
out on the basis of anticipated or budgeted overhead and base is applied to the actual base,
the amount absorbed may not be identical with the amount of overhead expenses incurred
if either the actual base or the actual expenses or both deviate from the estimates or the
budget.
If the amount absorbed is less than the amount incurred, which may due to actual expenses
exceeding the estimate and / or the output or the hours worked may be less than the
estimate, the difference denotes under-absorption. On the other hand if the amount
absorbed is more than the expenditure incurred, which may be due to the expense being less
than estimate and / or the output or hours worked may be exceeding the estimate, this would
indicate over-absorption, which goes to inflate the costs.

CAPACITY LEVELS

Theoretical or Maximum Plant Capacity

Maximum Capacity or the Ideal Capacity is the capacity for which plant is designed to
operate. It is only Theoretical Capacity. It does not give allowance for waiting, delays and
shut-down. The capacity is significant for designing the plant mechanically. For cost
considerations, this capacity is not important. Ideal Capacity is never used to determine
overhead rates for its disregard to even necessary interruptions in production process.

Practical Capacity
When this capacity is determined, allowance is given for unavoidable interruptions like time
lost for repairs, inefficiencies, breakdown, delay in delivery of raw material and supplies,
labour shortages and absence, Sunday, holidays, vacation, inventory taking, etc. Thus,
Practical Capacity is the maximum theoretical capacity with minor unavoidable
interruptions. These unavoidable interruptions are based mostly on internal influences and
do not consider main external causes like lack of customers orders.

Normal Capacity
Idle capacity due to long-term sales trend only is reduced from Practical Capacity to get
Normal Capacity. Calculation of Normal Capacity of a plant presents considerable problems.
Normal Capacity is determined for the business as a whole. Then, it is broken down by
plants and departments. For Normal Capacity determination, prime considerations are
physical capacity and average sales expectancy. It should be noted that average sales
expectancy to be considered for this purpose takes into account a period enough to level
out cyclical fluctuations. The determination of Normal Capacity helps in: i) the preparation
of flexible budgets and computation of predetermined factory overhead rates. Ii) the use of
Standard Costing, iii) estimating sales price etc., iv) scheduling production, v) inventory
valuation, vi) determination of breakeven point, vii) controlling costs.

Capacity based on Sales Expectancy

Capacity may be based on sales expectancy for the year. The distinction between Normal
Capacity and capacity based on sales expectancy should be properly understood. While
Normal Capacity considers the long-term trend analysis of sales, which is based on sales of a
cycle of years, the capacity based on sales expectancy is based on sales for the year only.
When long-term sales trends are determined, cycle of years long enough to even out cyclical
fluctuations is considered. Capacity based on sales expectancy is influenced more by general
economic conditions and forecast of industry than long term sales trend

Idle Capacity and Excess Capacity

Practical Capacity is determined after giving allowance to unavoidable interruptions like
time lost for repairs, inefficiencies, breakdown and labour shortage, etc., Even this Practical
Capacity is not normally fully achieved. Some losses due to idleness of workers and plant
facilities to occur even in most carefully administered companies. These losses are not taken
into account for determining the Practical Capacity, because for the purpose of determining
Practical Capacity only unavoidable interruptions are considered. Thus, the difference
between Practical Capacity and Normal Capacity, i.e., the capacity based on long-term sales
expectancy is the Idle Capacity. However, if Actual Capacity happens to be different from
capacity based on sales expectancy, the idle capacity will represent difference between
Practical Capacity and Actual Capacity. Idle Capacity is that part of Practical Capacity which
is not utilized due to factors like temporary lack of orders, bottlenecks and machine
breakdown, etc. Idle Capacity represents unused productive potential, which fails to be
realized due to interruptions that are not unavoidable. Idle capacity is that part of Practical
Capacity which is not utilized due to irregular interruptions.
Idle Capacity is different from Excess Capacity. Idle Capacity refers to temporary idleness of
available resources due to irregular interruptions. Excess Capacity results either from
managerial decision to retain larger production capacity or from unbalanced equipment or
machinery within departments. Excess Capacity refers to that portion of Practical Capacity
which is available, but no attempt is made for its utilization for strategic or other reasons. If
the Excess Capacity results from purchase of assets not required, it will be a prudent policy
for company to dispose of the assets which cause Excess Capacity. Alternatively, action
should be taken for utilization of resources in the form of Excess Capacity. Excess Capacity
also results from imbalance or bottlenecks in certain departments. This situation can be
remedied by attempting synchronization in the working of various departments, working
overtime, running double shift and temporary off-loading to departments having spare
capacity. While overhead rate includes cost of Idle Capacity, Excess Capacity is excluded
from overhead rate consideration.
Idle time is distinguished from Idle Capacity and its cost is separated in the accounts. Idle
time represents lost time of men and machines arising from lack of business or of material,
a breakdown of equipment, faulty supervision or other similar causes whether avoidable on
not. Idle Capacity is the difference between Practical Capacity and Actual Capacity and
represents the unused production potential.
Idle Capacity costs are represented mostly by the fixed charges of owing and maintaining
plant and equipment and of employing services, which are not used to their maximum
potential. The principal causes of idle capacity are:

UNIT FOUR

Methods of Costing

UNIT COSTING
It is an important method of costing. It is also known as output costing or single costing. It is
used to ascertain the cost of producing a unit of output. This method is called ‘unit’ costing
since every unit of production is identical in all respects and the cost unit is a standard
product.
According to J.R Batliboi, “Single or output cost system is used in business where a standard
product is turned out and it is desired to find out the cost of a basic unit of production.”
Features:
1. It is used where output can be measured in convenient physical unit
2. It is followed in concern s engaged in the production of a single product
3. It is followed in industries where manufacturing process is continuous
4. It is followed where all units of production are identical

JOB COSTING
It means ascertaining costs of an individual job, work order or project separately. According
to ICMA London, “Job costing is that form of specific order costing which applies where
work is undertaken to customer’s specific requirements and each order is of comparatively
of short duration.” Under this method of costing, each job is considered to be a distinct cost
unit. As such, each job is separately identifiable. In the case of a job, work is usually carried
out within the factory or workshop. Sometimes, a job is accomplished even in the
customer’s premises. This method of costing is applicable to ship building, printing,
engineering, machine tools, readymade garments, shoes, hats, furniture, musical
instruments, interior decorations etc.
Features:
1. Each job has its own characteristics, depending up on the special order placed by the
customer.
2. Each job is treated as a cost unit.
3. A separate job cost sheet is made out for each job on the basis of distinguishing numbers.
4. A separate work in progress ledger is maintained for each job.
5. The duration of the job is normally a short period.
6. Profit or loss is determined for each job independently of others
CONTRACT COSTING
It is a special form of job costing and it is the most appropriate method to be adopted in
such industries as building and construction work, civil engineering, mechanical fabrication
and ship building. In other words, it is a form of specific order costing which applies where
the work is undertaken to customer’s requirements and each order of long duration as
compared to job costing. It is also known as terminal costing.
The official CIMA terminology defines contract costing as “ a form of specific order costing
in which costs are attributed to individual contracts.”
Basic features:
1. Each contract itself a cost unit.
2. Work is executed at customers site
3. The existence of sub contract
4. Most of the expenses incurred upon the contracts are direct.
5. Cost control is very difficult in contract costing.

Types of contracts
Generally, there are three types of contracts:
1. Fixed price contracts: Under these contracts both parties agree to a fixed contract price.
2. Fixed price contract with Escalation clause
3. Cost plus contract: Under this contract no fixed price could be settled for a contract.

PROCESS COSTING
Process costing is the method of costing applied in the industries engaged in continuous or
mass production. Process costing is a method of costing used to ascertain the cost of a
product at each process or stage of manufacturing.
According to ICMA terminology, “Process Costing is that form of operation costing which
applies where standardized goods are produced”.
So, it is a basic method to ascertain the cost at each stage of manufacturing. Separate
accounts are maintained at each process to which expenditure incurred. At the end of each
process the cost per unit is determined by dividing the total cost by the number of units
produced at each stage. Hence, this costing is also called as “Average Costing” or
“Continuous Costing”. Process Costing is used in the industries like manufacturing
industries, chemical industries, mining works and public utility undertakings.

Characteristics of Process Costing

1. Production is continuous
2. Products pass through two or more distinct processes of completion.
3. Products are standardized and homogeneous.
4. Products are not distinguishable in processing stage.
5. The finished product of one process becomes the raw material of the subsequent process.
6. Cost of material, labour and overheads are collected for each process and charged
accordingly.

SERVICE COSTING
It is the costing procedure used for determining the cost of per unit of service rendered. It is
a method of costing applied to undertaking which provides service rather than production
of commodities. The services may be in the form of transport, supply service, welfare
service, etc. There is a difference between operating costing and operation costing.
Operating costing is a method of costing designed to find out the cost of operating or
rendering a service. On the other hand, operation costing is a method of costing applied to
determine the total cost and unit cost of each operation. Though service undertakings are of
different types, but here we discuss only transport operating costing.

Transport costing:
Transport industries include Air, Water, Rail and Road. They render services to the
community at large. We have to give utmost care while selecting the cost unit. The cost unit
of other forms operation costing is quite different from that of a service undertaking. The
cost unit of a service organization is a composite unit. The important factors to be
considered includes the number of passengers, tonnage carried, distance covered etc.
Reference Books:

➢ S.P. Jain &K.L. Narang

➢ N.K. Prasad: Cost Accounting
➢ Nigam & Sharma: Cost Accounting
➢ KhannaPandey&Ahuja: Practical Costing
➢ M.L. Agarwal: Cost Accounting
➢ Jain &Narang: Cost Accounting
➢ S.P. Iyengar: Cost Accounting
➢ S.N. Maheshwari: Cost Accounting
➢ Horngren: Cost Accounting: A Managerial Emphasis
➢ M. N. Arora: Cost Accounting
➢ Dutta: Cost Accounting

Pervaiz Ahmad Mir

Assistant Professor
GDC Kulgam