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CHAPTER 1
BASIC COST CONCEPTS
1. BASICS
1. Define the term “Cost”.
1) Meaning of Cost:
(a) Cost refers to the expenditure incurred in producing a product or in rendering a
service.
(b) Cost is a measurement, in monetary terms, of the amount of resources used for the
purpose of production of goods or rendering services.
(c) Cost is expressed from the producer or manufacturer’s viewpoint, (i.e. not that of
consumer / end user).
(d) Cost ascertainment is based on uniform principles and techniques.
2. Define the terms “Costing”, “Cost Accounting” and “Cost Accountancy”.
1) Costing: The technique and process of ascertaining costs.
2) Cost Accounting: The process of accounting for cost which begins with recording of
income and expenditure or the bases on which they are calculated and ends with the
preparation of periodical statements and reports for ascertaining and controlling costs.
3) Cost Accountancy: The application of costing and cost accounting principles, methods
and techniques to the science, art and practice of cost control and the ascertainment of
profitability. It includes the presentation of information derived there from for the
purpose of managerial decision-making.
3. List the objectives of Cost Accounting
The primary objective of study of cost is to contribute to profitability through Cost Control
and Cost Reduction. The following objectives of Cost Accounting can be identified –
1) Ascertainment of Cost: This involves collection of cost information, by recording them
under suitable heads or account, and reporting such information on a periodical basis.
2) Determination of Selling Price: Selling Prices are influenced by internal and external
factors. However, generally, prices cannot be fixed below cost. Hence, Cost Accounting
is required for determination of appropriate Selling Prices.
3) Ascertaining the profit of each activity: Profit of each department / activity / product
can be determined by comparing its revenue with appropriate cost. So, Cost Accounting
ensures profit measurement on an objective basis.
4) Assisting Management in decision – making: Business decisions are taken after
analyzing cost and benefits of each option, and the Manager chooses the least cost option.
Thus, Cost Accounting and reporting system assists Managers in their decision – making
process.
5) Cost Control and Cost Reduction: In the long run, higher profits can be achieved only
through Cost Control and Cost Reduction. Cost Accounting seeks to ensure profit by
providing support for cost control / reduction decisions.
4. Distinguish between Cost Reduction and Cost Control.
Particulars Cost Reduction Cost Control
1. Permanence Permanent, Real and genuine savings
in cost.
Could be a temporary saving
also.
2. Saving Focus Saving in Cost per unit. Saving either in Total Cost
or Cost per unit.
3. Product
Quality
Product’s Utility, Quality &
Characteristics are retained.
Quality Maintenance is not a
guarantee.
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4. Performance
Evaluation
It is not concerned with maintenance
of performance according to
standards.
The process involves setting
up a target, investigating
variances and taking
remedial measures to correct
them.
5. Nature of
Standards
Continuous process of critical
examination includes analysis and
challenge of standards.
Control is achieved through
compliance with standards.
Standards by themselves are
not examined.
6. Dynamism Fully dynamic approach. Less dynamic than Cost
Reduction.
7. Coverage Universally applicable to all areas of
business. Does not depend upon
standards, though target amounts may
be set.
Limited applicability to
those items of cost for which
standards can set.
8. Nature of
Costs
Emphasis here is partly on present
costs and largely on future costs.
Emphasis on present and
past behavior of costs.
9. Analysis To find out substitute ways and new
means.
Competitive analysis of
actual results with
established norms.
10. Nature of
Function
(a)Value Engineering, (b)
Standardization and Simplication, (c)
Work Study, (d) Variety Reduction,
(e) Quality Measurement & Research,
(f) Operations Research, (g) Market
Research, (h) Job Evaluation and
Merit Rating, (i) Improvement in
Product Design, (j) Mechanisation and
Automation, etc.
Budgetary Control and
Standard Costing.
5. Compare Cost Accounting with Financial Accounting. Does Cost Accounting
supplement Financial Accounting? Discuss.
The broad areas of difference between Financial and Cost Accounting are –
Particulars Financial Accounting Cost Accounting
1. Users of
Information
Financial Statements are used by
Internal management and also
outside parties like Government,
Creditors, Customers, Employees,
etc.
Detailed cost information is
presented to internal management
for proper planning, decision –
making and cost control.
2. Statutory
Compliance
Requirements of Statutes like
Companies Act, Income Tax Act,
etc. are met through Financial
Accounting.
Generally Cost Accounting is
voluntary, except in cases where
Cost Accounting Records Rules
mandatorily apply to the
enterprise.
3. Nature /
Objectivity
Transactions are recorded in a
subjective manner. Accounting
Policies may differ from one Firm
to another Firm.
Expenditure is recorded in an
objective manner. Costing
principles and techniques are
generally uniform to all Firms.
4. Focus Focus of accounting is on recording
the transactions.
Focus of accounting is to control
cost.
5. Nature of
Cost
Generally Historical Costs are used
for recording purposes. Projected
Financial Statements may also be
drawn for budgeting purposes.
It considers both historical costs
and predetermined, i.e. Standard
Costs. It also extends to plans and
policies to improve future
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performance.
6. Stock
Valuation
Stocks are valued at Cost or Net
Realisable Value whichever is less.
Stocks are valued generally at
Cost.
7. Cost
Analysis
Cost / Expenditure and Profits are
generally shown as a whole for the
period.
Costs are analysed product – wise,
department – wise, activity – wise,
etc.
8. Time Period Financial Statements are generally
prepared at the end of the financial
period, usually one year, for
reporting purposes.
Cost data and reports are
presented on a continuous basis
for the Cost Period. The cost
period (also called Control Period)
may be shorter than the financial
year.
9. Forecasting
& Planning
Has limited use for forecasting and
planning. Only broad parameters
like GP, NP, ROI, EPS, etc. can be
laid down.
Specific and detailed plan for each
product / activity / sub – level can
be laid down. Hence, more useful
for budgeting.
10. Utility for
decisions
Helps only for future decisions with
respect to product pricing, make or
buy, asset retainment vs
replacement, etc.
Helps Current & future decisions,
e.g. product price reduction and
higher volume in order to earn
target profit, resource re –
allocation, etc.
11. Control and
Assessment
Financial Accounting suffers from
limitations of lack of analysis of
information, and absence of
detailed control and assessment
parameters.
Better tools of control, analysis
and assessment are available,
some examples are Variance
Analysis, Budgetary Control, &
Marginal Costing.
Note: Cost Accounting supplements Financial Accounting for analysis and decision – making
purposes, as described above.
COST CLASSIFICATION BASES
6. How are Costs analysed based on Behaviour / Nature / Variability?
Time – Period based
Current
Historical
Pre – determined
Variability based
Fixed
Variable
Semi –
variable
Elements based
Materials
Labour
Expenses
Relationship based
Direct
Indirect
Functions – based
Production
Administration
Selling
Distribution
R & D
Pre – production
Conversion
Controllability based
Controllable
Non – Controllable
Normality based
Normal
Abnormal
Payment – based
Explicit
Implicit
Cause & Effect based
Engineered
Discretionary
Decision – making
based
Relevant
Irrelevant
Attributabillity
based
Product
Period
COST
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On the basis of Behaviour / Nature / Variability, Costs are classified as under –
Type and Description Examples
1. Fixed Cost is the cost which does not vary with the change in
the volume of activity in the short – run. These costs are not
affected by temporary fluctuation in activity of an enterprise.
These are also known as Period Costs.
Salaries, Rent, Insurance,
Audit Fees, Depreciation,
etc.
2. Variable Cost is the cost of elements which tends to directly
vary with the volume of activity. Variable Cost has two parts –
(a) Variable Direct Cost, and (b) Variable Indirect Costs.
Variable Indirect Costs are termed as Variable Overhead.
Materials Consumed,
Direct Labour, Sales
Commission, Utilities,
Freight, Packing, etc.
3. Semi Variable Costs contain both fixed and variable
elements. They are partly affected by fluctuation in the level
of activity.
Factory Supervision,
Maintenance, Power,
Telephone, etc.
7. How are Costs classified on the basis of Elements?
On the basis of elements, Costs are classified as under –
Type and Description Explanation
1. Material Cost is the cost of
material of any nature used for
the purpose of production of a
product or a service.
Material Cost includes cost of Procurement,
Freight Inwards, Taxes & Duties, Insurance, etc,
directly attributable to the acquisition.
Trade Discounts, Rebates, Duty Drawbacks,
Refunds on account of MODVAT, CENVAT,
Sales Tax and other similar items are deducted
in determining the costs of material.
2. Labour Cost means the
payment made to the employees,
permanent or temporary, for
their services. (N 01)
Labour Cost includes Salaries and Wages paid
to permanent employees, temporary employees
and also to employees of the contractor.
Salaries & Wages include all Fringe Benefits
like PF Contribution, Gratuity, ESI, Overtime,
Incentives, Bonus, Ex-Gratia, Leave
Encashment, Wages for Holidays and Idle Time,
etc.
3. Expenses are other than Material
Cost or Labour Cost, which are
involved in an activity.
Expenditure on account of utilities, payment for
bought – out services, job processing charges, etc. can
be termed as Expenses.
8. How are Costs classified on the basis of Relationship?
Based on Relationship, costs are classified into –
Type and Description Components
1. Direct Costs:
Costs which are directly related to / identified with /
allocated to a Cost Centre or a Cost Object, in an
economically feasible way, are called Direct Cost.
Total of all Direct Costs is called Prime Cost.
Direct Material Cost,
Direct Labour Cost, and
Direct Expenses.
2. Indirect Costs:
All Costs other than Direct Costs are called Indirect Costs.
Total of all Indirect Costs is called as Overheads (or
Oncost), since they are generally incurred over various
products (Cost Units), various departments (Cost Centres)
and over various heads of expenditure accounts.
Indirect Material,
Indirect Labour, and
Indirect Expenses.
A summary of Direct and Indirect Costs is given below –
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Item and Description Example
1. Direct Material: Costs of Material which can
be directly allocated to a Cost Centre or a Cost
Object in an economically feasible way.
Raw Materials Consumed for production for
a product or service, which are identifiable
in the product or service.
2. Direct Labour: Cost of Wages of workers
who are readily identified or linked with a
Cost Centre or Cost Object.
Wages include all Fringe Benefits like PF
Contribution, Gratuity, ESI, Overtime,
Incentives, Bonus, Ex – Gratia, Leave
Encashment, Wages for holidays and idle
time, etc.
3. Direct Expenses: Expenses other than Direct
Material or Direct Labour, which can be
identified or linked with the Cost Centre or
Cost Object.
Expenses for special moulds used in a
particular Cost Centre, Hire Charges for
tools & equipments for a Cost Centre,
Royalties in connection to a product, Job
Processing Charges, etc.
4. Indirect Material: Cost of Material which
cannot be directly allocable to a particular
Cost Centre or Cost Object.
Consumable Spares and Parts, Lubricants,
etc, i.e. materials which are of small value
and cannot be identified in or allocated to a
product / service.
5. Indirect Labour: Wages of Employees which
are not directly allocable to a particular Cost
Centre.
Salaries of Staff in the Administration and
Accounts Department, Salaries of Security
Staff, etc. (N 01)
6. Indirect Expenses: Expenses other than of
the nature of Material or Labour, and cannot
be directly allocable to a particular Cost
Centres.
Insurance, Taxes and Duties, etc. not being
allocable to a particular Cost Centre.
9. Distinguish between Controllable & Uncontrollable Costs.
One the basis of controllability, Costs are classified into –
1) Controllable Costs: These are costs which can be influenced and controlled by managerial
action.
2) Non – Controllable Costs: These are costs that cannot be influenced and controlled by a
specific member(s) of the organization.
Note: The line of difference between controllable and non – controllable costs is very thin. No
cost is uncontrollable. Controllability is a relative term and is subject to the following factors –
(a) Time: Certain costs are controllable in the long – run and not in the short – run.
(b) Location: Certain costs are not influenced and decided at a particular location / cost centre.
For example, if rent agreements of all factory premises are executed centrally at the Head
Office, Factory Mangers cannot control the incurrence of Rent Cost.
(c) Product / Output: Certain costs are controllable by reference to one product or market
segment and not by reference to the other. For example, some products require more
advertising and sales promotion efforts than other products.
10. How are Costs classified on the basis of Normality?
On the basis of Normality / Expectation, Costs are classified into –
Type Description Treatment
1. Normal
Cost Costs which can be reasonably expected to be
incurred under normal, routine and regular
operating conditions.
Cost that is normally incurred at a given of
output in the conditions in which that level of
output is achieved.
They are included in
the Cost Sheet as
regular cost and used
for decision - making
purpose.
2. Abnormal Costs over and above normal cost, which is not They are not
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Cost incurred under normal operating conditions, e.g.
fines and penalties, abnormal wastages, etc.
Unusual or a typical cost whose occurrence is
usually irregular and unexpected and due to some
abnormal situation of production.
considered in the cost
of production for
decision – making,
and are charged to
Profit & Loss A/c.
11. Distinguish between Product Cost and Period Cost.
Why should Product Costs be computed?
On the basis of attributability to the product, Costs are classified as under –
Particulars Product Cost Period Cost (N 08)
1. Meaning These are costs which are assigned to the
product and are included in inventory
valuation. These are also called as
Inventoriable Costs.
These are costs which are not
assigned to the products but
are charged as expenses
against the revenue of the
period in which they are
incurred.
2. Examples Manufacturing Costs, e.g. Cost of Raw
Materials, Direct Wages, Production OH,
Depreciation of Plant, Equipments, etc.
Non – Manufacturing Costs,
e.g. General Administration
Costs, Salesmen Salary,
Depreciation of Office
Assets, etc.
3. Inclusion in
Inventory
Valuation
These are included in inventory valuation.
They are treated as assets till the goods to
which they are assigned are actually sold.
These are not included in
Inventory Valuation. They
are written off as expense in
the period in which they are
incurred.
Note:
Absorption vs Marginal Costing: Under Absorption Costing System, Total
Manufacturing Costs (i.e. Variable and Fixed) are regarded as Product Costs. However,
under Marginal Costing system, only variable Manufacturing Costs are considered as
Product Costs.
Purposes of computing Product Costs are as under –
(a) Preparation of Financial Statements – focus on Inventory Valuation and reporting
profits.
(b) Product Pricing – focus on costs assigned & incurred on the product till it is made
available to customer / user.
(c) Cost – plus – Contracts with Government Agencies – focus is on reimbursement
of costs specifically assigned to the particular job / contract.
12. List the various items of costs on the basis of relevance to decision-making.
On the basis of relevance to decision – making, Costs are classified into (A) Relevant, and (B)
Irrelevant Costs.
(A) Relevant Costs: These are costs which are relevant and useful for decision – making
purposes.
1) Marginal Cost: Marginal Cost is the total Variable Cost, i.e. Prime Cost plus Variable
Overheads. It is assumed that variable Cost varies directly with production whereas Fixed
Cost remains constant irrespective of volume of production. Marginal Cost is relevant for
decision – making, as this cost will be incurred in future for additional units of production.
2) Differential Cost: It is the change in costs due to change in the level of activity or pattern or
method of production. Where the change results in increase in cost it is called Incremental
Cost, whereas if costs are reduced due to decrease of output, the difference is called
Decremental Costs.
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3) Opportunity Cost: This refers to the value of sacrifice made or benefit of opportunity
foregone in accepting an alternative course of action. For example, a Firm may finance its
expansion plan by withdrawing money from its bank deposits. Then, interest lost on the Bank
Deposit is the opportunity cost for carrying out the expansion plan. Similarly, if a person quits
his job and enters into business, the salary forgone from employment constitutes opportunity
cost. Opportunity Cost is a relevant cost where alternatives are available. However,
opportunity cost is not recorded in formal accounts and is computed only for decision –
making and analytical purposes.
4) Out – of – pocket Costs: These are costs which entail current or near future outlays of cash
for the decision at hand. Such costs are relevant for decision – making, as these will occur in
near future. This cost concept is a short – run concept and is used in decisions relating to
fixation of selling price in recession, make or buy, etc. Out – of – pocket Costs can be avoided
or saved, if a particular proposal under consideration is not accepted.
5) Replacement Cost: It is the cost at which there could be purchase of an asset or material
identical to that which is being replaced or revalued. It is the cost of replacement at current
market price and is relevant for decision – making.
6) Imputed Costs: These are notional costs appearing in the cost accounts only, e.g. notional
rent charges, interest on capital for which no payment has been made. Where alternative
capital investment projects are being evaluated, it is necessary to consider the imputed interest
on capital before a decision is arrived at, as to which is the most profitable project. These
costs are similar to Opportunity Costs.
(B) Irrelevant Costs: These are costs which are not relevant or useful for decision – making.
1) Sunk Cost: It is a cost which has already been incurred or sunk in the past. It is not relevant
for decision – making. Thus, if a Firm has obsolete stock of materials originally purchased for
Rs.50,000 which can be sold as scrap now for Rs.18,000 or can be utilized in a special job,
the value of stock already available Rs.50,000 is a sunk cost and is not relevant for decision –
making. (N 00, M 03, M 05)
2) Absorbed Fixed Cost: Fixed Costs do not change due to increase or decrease in activity.
Although such Fixed Costs are absorbed in cost of production at a normal rate, they are
irrelevant for managerial decision – making. However, if Fixed Costs are specific, they
become relevant.
3) Committed Cost: It is a cost in respect of which decision has already been taken, and such
decision cannot be altered, e.g. entering into irrevocable agreements for Rent, Technical
Collaboration, etc. Committed Costs are not relevant for decision – making. This should be
contrasted with Discretionary Costs, which are avoidable costs.
13. Write short notes on explicit and Implicit Costs.
Define Explicit Costs. How is it different from Implicit Costs?
Particulars Explicit Costs Implicit Costs
1. Meaning Costs which involve some cash
payment or outflow of resources.
Cost which do not involve any
cash payment at all.
2. Also known as Out – of – Pocket Costs. Economic / Notional / Imputed
Costs.
3. Measurement These are actually incurred,
and hence can be easily and
objectively measured.
They are not actually incurred.
They cannot be easily measured
and involve subjective
estimation.
4. Recording in books Recorded in books of account. Not recorded in books of
account.
5. Purposes Accounting, Reporting, Cost
Control & Decision Making.
Decision – Making like asset
replacement, make or buy, etc.
6. Examples Salaries, Wages, Advertisement,
etc.
Interest on own Capital, Rent of
own premises, Salary of
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Proprietor, etc. which are not
actually paid.
Note: Depreciation is considered as “Deemed Explicit Cost”, since the cost of Assets purchased (by
making a cash outlay in the past) is written off / apportioned during the life – time of those assets.
14. Enumerate the types of costs on the basis of Functions.
On the basis of Functions to which they relate, Costs are classified as under –
1) Production Cost: The cost of the set of operations commencing with supply of materials,
labour and services and ending with the primary packing of product. Thus it is equal to the
total of Direct Materials, Direct Labour, Direct Expenses and Production Overheads. In a
wider sense, it includes all Direct Costs and all Indirect Costs related to the production
(including Research and Development Cost apportioned, if any)
2) Administration Cost: The cost of formulating the policy, directing the organization and
controlling the operations of the undertaking, which is not directly related to Production,
Selling, Distribution, Research or Development activity or function. Examples: Office Rent,
Accounts and Secretarial Department Expenses, Audit and Legal Expenses, Directors
Remuneration, etc. (N 96)
3) Selling Cost: The cost of seeking to create and stimulate demand and of securing orders.
These are also called Marketing Costs. Examples: Market Research, Advertisement, Salaries,
Commission and Travel Expenses of Salesmen, Show – room Expenses, Cost of Samples, etc.
(N 99)
4) Distribution Cost: The cost of the sequence of operations which begins with making the
packed product available for dispatch and ends with making the reconditioned returned empty
package, if any, available for re – use. Examples: Distribution Packing (secondary packing),
Carriage Outwards, Maintenance of Delivery Vans, cost of transporting articles to central or
local storage, cost of moving articles to and from prospective customers (as in Sale or
Return), cost of warehousing saleable products, etc. (N 99)
5) Research Cost: Cost of development of new product and manufacturing process,
improvement of existing products, process and equipment, finding new uses for known
products, solving technical problems arising in manufacture and application of products, etc.
(N 92, M 96, N 98, N 00) 6) Development Cost: The cost of the process which begins with the implementation of the
decision to produce a new improved product, or to employ a new or improved method and
ends with commencement of formal production of that product or by that method, i.e. cost
incurred for commercialization / implementation of research findings. (N 92, M 96, N 98,
N 00) 7) Pre – Production Cost: The part of Development Cost incurred in making a trial production
run prior to formal production. (N 00)
8) Conversion Cost: The total of Direct Wages, Direct Expenses and Production Overhead,
Cost of converting Raw Materials to the finished stage or converting a material from one
stage of production to the other. (M 03)
Special Note as regards Distribution Costs:
Primary Packaging Cost is included in Production Cost. Secondary Packaging Cost is
Distribution Cost.
In exceptional cases, e.g. in case of Heavy Industries Equipment supply, installation cost at
delivery site for Heavy Equipments which involves assembling of parts, testing, etc is
included in Production Cost but not Distribution Cost. For example, Installation Cost of a
Gas Turbine at Plant Site is included in the Cost of Production of Gas Turbine.
15. What is a Cost Centre? Discuss the various types of Cost Centres.
1) Cost Centre: It is defined as –
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(a) A location – e.g. Chennai Factory, Kolkata Factory, etc.
(b) A person – e.g. Sales Manager L, M, etc.
(c) An item of equipment – e.g. Machinery P, Q or Process I, II, etc.
Or a group these, for which cost may be ascertained and used for the purpose of Cost
Control.
2) Classification : cost Centres can be classified as under –
(a) Based on Type:
Personal Cost Centre Impersonal Cost Centre
It consists of a person or group of persons. It consists of a location or an item
equipment (or group of these).
(b) Based on Role:
Production Cost Centre Service Cost Centre
It is a Cost Centre where Raw Material is
processed and converted into Finished
Product.
It is a Cost Centre which serves as an
ancillary unit and renders services to a
Production Cost Centre.
Here, both Direct and Indirect Costs are
incurred.
Here, only Indirect Costs are incurred.
There are no Direct Costs, as there is no
measurable and saleable output.
Examples: Machine Shops, Welding
Shops and Assembly Shops, etc.
Examples: Power – House, Gas Production
Plant, Material Service Centres, Plant
Maintenance Centres, etc.
(c) Based on Activity:
Operation Cost Centre Process Cost Centre
It consists of machines and / or persons,
carrying out similar operations.
It consists of machines and / or persons,
engaged on a specific process or a
continuous sequence of operations.
All machines / operators performing the
same operation are brought together under
a Cost Centre, the purpose being
ascertainment of cost of each operation
irrespective of its location inside the
factory.
Cost is analysed and related to a series of
operations in sequence. Generally, these
constitute a single location, as in Oil
Refineries and other process industries.
16. Define a Cost Unit. Give suitable illustrations.
1) Cost Unit is a unit of production, service or time or combination of these, in relation to which
costs may be ascertained or expressed. It should be one with which expenditure can be most
readily associated.
2) Cost Unit is a form of measurement of volume of production or service. This unit is generally
adopted on the basis of convenience and practice in the Industry concerned.
3) Cost Units differ from one business to the other. They are usually units of physical
measurement, e.g. number, weight, area, volume, time, length and value.
17. Define a Cost object. Give suitable illustrations.
1. Cost object is anything for which a separate measurement of cost is desired.
2. Cost object is defined as any unit of Cost Accounting selected with a view to accumulating all
cost under that unit.
3. Cost objects may be a product, a service, a project, a customer, a brand category, an activity, a
programmed, a division or department, a group of Plant and Machinery, a group of employees
or a combination of several units.
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18. Write short notes on the various methods of costing.
Businesses vary in their nature and in the type of products or services they produce. Hence,
different methods of cost ascertainment are used in different businesses. Costing methods to
be employed are determined based on – (a) the method of production and (b) the unit of cost
used. The various methods of costing are –
METHODS OF COSTING
For Goods For Services- Operating Costing
Specialized Production Standardised Production
Job Batch Contract Single / Unit Process / Joint
Costing Costing Costing /Output Operation and By-
Costing Costing Product
Costing
Work is
undertaken
on receiving
a customer’s
order /
assignment.
Output under a
Job consists of
similar units, it
is not feasible
to ascertain
cost per unit.
Execution of
work is
distributed
over two or
more
financial
years.
Product(s) is
produced
from single
process.
One product is
produced from
a series of
sequential
processes.
Many
products are
produced
from many
sequential &
parallel
processes.
Multiple Costing: It represents a combination of two or more methods of costing given above. For
example, if a Company manufactures Cars including its components, the component parts will be
costed by Batch Costing System, but the cost of assembling the Car will be computed by the Single or
Output Costing method. The whole system of costing is known as Multiple Costing.
The following table summarizes the various methods of costing applied in different industries-
Nature of Output Method Cost Ascertainment Examples of Industries
A. Based on
customer
specifications:
- Single Unit Job Costing For each order / job /
assignment.
Automobile Workshops,
Interior Decoration, etc.
- No. of similar
units
Batch costing For each batch / lot of
units produced.
Pharmaceuticals, Printing
Press i.e. visiting cards,
invitations, etc.
- Execution of
works
Contract Costing For each contract. Roads, Brickworks,
Colliery, Paint
Manufacturing, etc.
B. Similar units of
single product,
from:
- Single Process
(N 95)
Unit or Output
or Single Costing
For the entire activity,
but averaged for the
output.
Quarries, Brickworks,
Colliery, Paint
Manufacturing, etc.
- Series of
Processes
Process or
Operation
For each process or
operation.
Oil Refining, Breweries,
etc.
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Costing
C. Multiple
varieties of
activities and
processes
Multiple Costing Combination of any of
the methods listed
above.
Production of TVs,
Computers etc, Automobile
Assembly.
D. Rendering
Services
Operating
Costing
For every type of
service (no identifiable
tangible cost unit).
Transport, Hotels, Cinema,
Banks, Hospitals,
Professional Institutions,
etc.
19. List the Method of Costing and Cost Unit applicable for the following industries.
Industry Method of Costing Unit of Cost
1. Interior Decoration Job Per Job
2. Advertising Job Per Job
3. Toy Making Batch Per Batch
4. Pharmaceuticals Batch / Unit Per Unit / Box
5. Ship Building Contract Per Ship
6. Bridge Construction Contract Per Contract
7. Cement Unit Per Tonne or Per Bag
8. Coal Single / Unit Per Tonne
9. Brick Works Single / Unit Per 1,000 Bricks
10. Steel Process Per Tonne
11. Oil Refining Process Per Tonne
12. Soap Process Per Unit
13. Sugar Company having own
sugarcane fields
Process Per Tonne or Per Quintal
14. Hospital / Nursing Home Operating Per Patient-Day or Room-Day
15. Road Transport Operating Per Tonne-Km / Passenger- Km
16. Radio Multiple Per Unit or Per-Batch
17. Bicycles Multiple Per Unit or Per Batch
18. Furniture Multiple Per Unit
20. Write short noted on Direct Expenses.
1. Direct Expenses or Chargeable Expenses: These are expenses other than materials and
labour which can be allocated directly to jobs, products, processes, cost centers’ or cost
units. Direct Expenses are “cost other than material and wages which are incurred for a
specific product or saleable services”.
2. Nature of Direct Expenses: (a) These are expenses other than Direct Materials and
Direct Labour, (b) These are either allocated or charged completely to Cost Centres or
Cost Units, (c) These are included in the Prime Cost of a product.
3. Examples:
(a) Hire Charges of special machinery
or plant for a particular production
order or job.
(b) Payment of Royaties.
(c) Cost of special moulds, designs &
patterns.
(d) Sub-Contracting Expenses or
outside work costs, where jobs are
sent out for special processing.
(e) Experimental cost before
undertaking the job.
(f) Travel & Conveyance Expenses for
a particular job.
4. Documentation: The basic document which is used for charging of Direct Expenses to
products or batches or work order, is the Invoice received from Suppliers of such service.
The payment to supplier of service is made on the basis of the Invoice, and the expenses
are booked in the accounts.
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5. Identification of Direct Expenses: For the identification of Direct Expenses with the
main product or service, the code number of that product or service should be inscribed
on invoice received from supplier of services. For example, if a machine is hired to
complete a particular product, then the Hire Charges paid for that machine is a Direct
Expenses of that particular product. For charging these Hire Charges to that particular
product, the invoice / bill received towards Hire Charges should be coded / inscribed with
the Product Code, to ensure that this expense is charged to that particular product.
Alternatively, if cash is paid, then the Cash Book Analysis will show the Product Code
which is to be charged with the cost of hiring machinery.
CHAPTER 2
MATERIALS
1. What is Just in Time (JIT) Purchases? What are its advantages?
Just in Time (JIT) Purchases means organizing the purchase of goods or materials such that
their receipt in Stores Department immediately precedes their use. The advantages of JIT
purchases are-
1. Cost Savings: JIT purchases results in cost savings. The costs of stock-out, inventory
carrying, materials handling and breakage are reduced.
2. Cost of consumption: due to frequent purchases of Raw Materials, its issue price will be
equal to the replacement price. The method of pricing for valuing materials issues will be
realistic to reflect current costs.
3. Supplier Co-ordination: Suppliers of Raw Materials co-operate with the Company and
supply requisite quantity of goods or materials for which order is placed just before the
start of production.
4. Materials Management: Goods spend less time in warehouses or on store shelves before
they are exhausted. Risk of obsolescence is thereby reduced.
2. What is ABC Analysis?
1. Meaning: ABC Analysis is a form of inventory control wherein different degrees of
control are exercised over different items of materials, on the basis of the investment
(value) involved. For example, in the making of aircraft, cryogenic engines involving
high costs will be monitored closely, while cost of tyres, nuts and bolts, etc. will be given
comparatively lesser attention.
2. Categorization: Under this system, Raw Materials Items are divided into three categories
according to their importance in terms of value and frequency of replenishment during a
period. These categories are –
(a) A Category –Highly Important.
(b) B Category - Moderately important.
(c) C Category – Least Important.
3. Analysis & Control: The three categories are classified and differential control is
established as under-
Category % in Total
Value
% in Total
Quantity
Extent of Control
A 70% 10% Constant and Strict Control through
Budgets, Ratios, Stock Levels, EOQ,
Procedural checks, etc.
B 20% 20% Need based selective control – periodic
review – not strict or excessive.
C 10% 70% Little control – focus on saving associated
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costs.
Note: ABC Analysis is also called by other names such as HML (High Moderate Low)
Analysis, (or) 70-20-10 Analysis, (or) Pareto Analysis, (or) Selective Stock Control.
3. What are the advantages of ABC analysis? The advantages of ABC analysis are –
1. Smooth Flow: ABC analysis ensures that minimum investment will be made in
inventories of stocks of materials or stocks to be carried, without affecting the production
schedule.
2. Cost Savings: The cost of placing orders, receiving goods and maintaining stocks is
minimized, specially if the system is coupled with the determination of proper economic
order quantities.
3. Control by exception: Management time is saved, since attention need be paid only to
some of the items rather than all the items.
4. Standardization of work: With the introduction of the ABC system, much of the work
connected with purchases can be systematized on a routine basis to be handled by sub-
ordinate staff.
4. What is meant by Bill of Materials (BOM)?
1. Meaning: (a) Bill of Materials (BOM) is a schedule of standard quantities of materials required for
any job or other unit of production. It is also known as “Materials Specification
List” or just “Material List”.
(b) It lays down the exact description and specifications of all materials and quantities
required for a job or product.
2. Prepared by: BOM is prepared by the Engineering or Planning Department, in a
standard form.
3. Copies: 5 copies to be used as given in the following table-
Department Purposes of BOM
Stores
Department
(a) To provide a basis for preparing material Purchase
Requisitions.
(b) To act as authorization for issuing total material
requirement.
(c) To reduce paperwork / clerical activity in verification of
every item of materials to be issued.
Purchase
Department
To compare with purchase requisition and place the purchase order.
Cost Accounting
Department
(a) To prepare budgets or estimates of material cost for jobs /
processes / products.
(b) To account for standard cost, compute material cost
variances, analyze reasons, and control excess cost of
material used.
Production
control Dept
(a) To control usage of materials.
(b) To save time otherwise spent in preparing separate
requisitions of materials.
Engineering or
Planning Dept
For record, reference and control purposes.
5. Write a brief note on Purchase Requisitions.
1. Meaning: Purchase Requisition is a form used for making a formal request to the
Purchasing Department, to procure the specified items of materials.
2. Prepared by: Purchase Requisition is usually prepared by – (a) Store-Keeper (for regular
materials), and (b) Head of production planning or Technical Department (for special
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materials). It should be signed and approved by a responsible official, (e.g. Works
Manager), in addition to the one originating it.
3. Copies: 4 copies to be used by – (a) Purchase, (b) Planning, (c) Cost Accounting, and (d)
Stores Departments.
4. Pre-conditions: The following conditions should have been fulfilled in order to initiate
the purchase procedure-
(a) The item of material should be included in the Standard List (BOM) of the Purchase
Department as “Regular Item”. If a new item is required, suitable sanction and
approval shall be obtained.
(b) The stock of the item should have reached the Re-Order Level. This is the level at
which action can be taken to initiate the purchase procedure.
(c) There should be proper co-ordination between Purchase, Stores and Production
Departments.
6. What is Material Requisition Note (MRN)?
1. Meaning:
(a) Materials Requisition Note (MRN) is the document for issue of materials from Stores
to Production Department.
(b) MRN authorizes the Store-Keeper to issue the requisitioned materials and record the
same in Bin Card.
(c) The purpose of Material Requisition Note is to draw material from the Stores by the
concerned departments.
2. Origination:
(a) Where a “Materials List” (i.e. BOM) has been prepared: MRN can be prepared
by the production Department. Such requisition can be either for the whole of all
specified materials or in different lots, drawn upto the limit specified in the BOM
List.
(b) Where a “Materials List” (i.e. BOM) has been prepared: MRN should ideally be
prepared by the Planning Department. If there is no Planning Department, it may be
prepared by the concerned Production Department. In all cases, it should be duly
approved by a responsible official.
3. Copies: 3 Copies to be used by-
(a) Stores Department – for issuing materials
(b) Cost Accounting Department – to account for cost thereof.
(c) Receiving Department, i.e. department requiring the material – for control purposes.
7. Distinguish between Bin Card and Stores Ledger.
Particulars Bin Card Stores Ledger
1. Maintained by Store- Keeper. Cost Accounting Department.
2. Nature Stores Recording Document Accounting Record.
3. Contents Quantitative only. Quantitative cum Financial
Record.
4. Time of recording At the time of transaction. After the transaction takes place.
5. Source documents Recorded at source. No separate
source document required.
Posted from Material Requisition
Slips, Goods Received Notes, etc.
6. Manner of posting Each transaction is recorded
separately.
Transactions are posted on
summary basis.
8. What are the advantages of Perpetual Inventory Records?
Perpetual Inventory Records refer to the inventory records, i.e. Bin Card and Stores Ledger,
that are maintained on a upto date basis at all points of time. The following are its advantages-
1. Physical stocks can be counted and book balances adjusted as and when desired without
waiting for the entire stock- taking to be done.
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2. Interim Financial Statements can be quickly prepared as stock figures are readily available.
3. Discrepancies are easily located and corrective action can be promptly taken to avoid their
recurrence.
4. A systematic review of the perpetual inventory reveals the existence of surplus, dormant,
obsolete and slow-moving materials, so that remedial measures are taken in time.
5. Fixing various stock levels and checking actual balances in hand with them, assist the Store
Keeper to maintain stock within limits and initiate purchase requisitions for correct quantity at
the proper time.
9. Distinguish between Periodic and Continuous Stock Verification.
Stock verification involves physical counting of actual stock available and comparing the same
with books and records to ascertain discrepancies if any. There are two methods of stock
verification- (1) Periodic, and (2) Continuous Stock Verification. The differences between these
two methods are –
Particulars Periodic Stock Taking Continuous Stock Taking
1. Timing Stock Verification takes place at
the end of a financial period, say
a year.
Stocks are verified at regular
intervals during the year. Since
stock-taking takes place regularly, it
is called continuous stock-taking.
2. Coverage All items of stocks are covered
in a single stretch of verification,
say over two or three days.
In each verification, two or three
items are covered on random basis.
In the entire period, all items are
covered on rotation basis.
3. Effect on work Regular stores procedures like
materials receipts, issues, etc.
may have to be stopped to
facilitate stock-taking.
There is no interference with regular
work flow.
4. Control Discrepancies can be known
only at the end of the period.
Responsibility cannot be easily
fixed.
Discrepancies are ascertained
immediately in order to take
corrective action and avoid
recurrence.
5. Records Inventory Records may also be
updated periodically, say weekly
or monthly, in fact, at any time
before physical verification.
Due to surprise element involved,
Inventory records must be
maintained up-to-date at all times.
Such records are called Perpetual
Inventory Records.
6. Interim results This does not facilitate or help
the quick compilation of interim
or final financial results.
It provides stock figures on real-
time basis. Hence final accounts can
be compiled quickly. Interim
Results can also be prepared easily.
10. Distinguish between ROL and ROQ.
Particulars ROL ROQ
1. Meaning It is the stock level at which next
purchase procedure should be initiated.
It is the quantity that should be
placed in the Purchase Order.
2. Question It answers the question when to
purchase
It answers the question what
quantity to purchase.
3. Formula ROL = Max. Usage x Maximum Lead
Time
ROQ = EOQ = 2AB
C
11. What is Economic Order Quantity? How is it computed?
“Optimum level of inventory is that which minimizes the total costs”. Discuss.
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1. Meaning: Economic Order Quantity (EOQ) refers to the quantity to be purchased every time,
so as to minimize the total of all costs associated with purchase. The size of the order for
which the total purchase-related costs (i.e. Total of (a) Ordering Costs p.a. (b) Carrying Costs
p.a. and (c) Purchase Price p.a. are minimum, is known as the EOQ.
2. Computation: By applying Wilson’s formula-
EOQ = 2AB/C, where A = Annual Requirement of Raw Materials (in units)
B = Buying Cost per order
C = Carrying Cost per unit of Raw Materials per annum.
3. Note:
(a) Associated Costs of EOQ = (b) Associated Costs of EOQ may also be computed as = 2ABC
(c) At EOQ under Wilson’s Formula, Buying Costs p.a. = Carrying Costs p.a. = ½ of
Associated Costs p.a.
Quantity
12. Write short notes on the First – in – First – Out Method (FIFO).
1) Features:
(a) It is a method of pricing the issues of materials, in the order in which they are purchased.
(b) The prices at which earliest lots / consignments of materials were received are used firs,
before subsequent prices are used for pricing issues.
2) Advantages:
(a) Simple to understand and easy to operate.
(b) Gives better results in case of falling prices.
(c) Closing Stock of Material will reflect Current Market Prices.
(d) Cost of Consumption will be at actual cost, i.e. Opening Stock + Purchases (-) Closing Stock.
3) Disadvantage:
(a) Leads to complicated calculations and clerical errors, when the prices fluctuate frequently.
(b) Costs charged to the same job may show a variation from period to period, as each issue of
material to production is related to a specific purchase price.
(c) In case of rising prices and real profits of the Firm being low, this method will inflate profits,
since Cost of Raw Materials Consumed will be taken at old (lower) prices.
13. What do you understand by Last-In-First-Out (LIFO)? What are its advantages?
1. Features:
(a) It is a method of pricing the issues of materials, in the reverse order in which they are
purchased.
(b) The prices of the most recently received consignments, i.e. immediately last available
consignment, are exhausted first before previous consignment prices are taken up.
2. Advantages:
(a) Cost of Materials Consumed will reflect Current Market Prices approximately. This will
lead to better matching
(b) Does not inflate profits during periods of rising prices, unlike FIFO Method.
(c) In case of falling prices, profit tends to rise due to lower material cost, yet the finished
products appear to be more competitive and are at Market Price.
(d) In the long run, the use of LIFO helps to iron out the fluctuations in profits.
(e) During inflation, LIFO will tend to show the correct profit and thus there is some tax
saving.
3. Disadvantages:
(a) Leads to complicated calculations and clerical errors, when the prices fluctuate
frequently.
(b) Cost of different similar batches of production carried on at the same time may differ a
great deal.
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(c) In time of falling prices, there will be need for writing off stock value considerably, to
stick to the principle of stock valuation, i.e. Cost or Market Price whichever is lower.
(d) This method is not acceptable under the Accounting Standards or to the Income Tax
Authorities.
14. Write short notes on Base Stock Method.
1. Under this method, a minimum quantity of stock is always valued at a fixed price, based upon
the earliest lot of materials. It is used as Base Stock or Reserve Stock to meet emergency
consumption requirements.
2. The quantity in excess of the Base Stock may be valued either on FIFO or LIFO basis.
3. This is more a method of valuing inventory than a method of valuing issues, since Base Stock
is valued at earliest price and balance stock is valued using FIFO or LIFO.
4. This method is not an independent method as it uses FIFO or LIFO. Its advantages and
disadvantages therefore will depend upon the use of the other method, viz. FIFO or LIFO.
15. Briefly describe the Simple Average Price Method.
1. Features: Materials issued are valued at Average Price, which is calculated by dividing the
total of all units rate by the number of unit rates.
Simple Average Price = Total of unit prices of each purchase
Total number of purchases
Example: If Materials issued are from 3 consignments with prices of Rs. 20, Rs. 27 and Rs.
22, the Simple Average Price would be (20+27+22) /3 = Rs. 23
2. Advantages:
(a) Useful when materials are received in uniform lots of similar quantity, else, it will give
wrong results.
(b) Useful when purchase prices do not fluctuate considerably.
(c) Simple to understand and easy to operate.
3. Disadvantages:
(a) Materials Issue Cost does not represent actual cost price. Since the materials are issued at
a price obtained by averaging cost prices, a profit or loss may arise from such type of
pricing.
(b) Gives incorrect results, if the prices of material fluctuate frequently.
(c) Price determination in unscientific, since there is averaging of prices without considering
quantity.
16. Write short notes on the Weighted Average Price Method.
1. Meaning: Weighted Average Price Method gives due weight age to quantities purchased and
the purchase price to determine the issue price.
Weighted Average Price = Total Cost of Materials received
Total Quantity Purchased
Note: Weighted Average Issue Price is calculated by dividing the Total Cost of Materials in
Stock, by the Total Quantity of Materials prior to each issue.
2. Advantages:
(a) It smoothens the price fluctuations, if any, due to material purchases.
(b) Issue prices need not be calculated for each issue unless new lot of materials is received.
3. Disadvantages:
(a) Materials Cost does not represent actual cost price, but only an approximate average.
(b) It may be difficult to operate, since every new lot received would require re-computation
of issue prices.
17. How is the Periodic Simple Average Price Method applied?
1. Features:
(a) At the end of each period, the price paid during that period for various consignments are
added up, and this total is divided by the number of purchases made during the period.
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(b) The rate so computed is then used to price all materials issues made during the period,
and also for valuing the Closing Stock of Raw Materials.
Periodic Simple Average Price = Total of Prices paid in a period
No. of purchases in the period
Note: This method is similar to Simple Average Price Method. However, the Average is
calculated only at the end of the concerned period.
2. Advantages:
(a) It is simple to operate, as it avoids calculation of issue price after every receipt.
(b) This method can usefully be employed in costing continuous processes where each
individual order is absorbed into the general cost of producing large quantities of articles.
3. Disadvantages:
(a) This method cannot be applied in jobbing industry where each individual job order is to
be priced at each stage of its completion.
(b) It is unscientific, as it does not take into consideration the quantities purchased at
different prices.
(c) It also suffers from all disadvantages of Simple Average Price Method.
18. Explain the accounting treatment for Waste. RTP, M 86
1) Waste:
(a) It represents the portion of basic raw materials lost in processing, having no recoverable
value.
(b) Waste may be – (i) visible – remnants of basic raw materials, or (ii) invisible – disappearance
of basic raw materials through evaporation, smoke, etc.
(c) Shrinkage of material due to natural causes may also be a form of a material wastage.
2) Accounting Treatment:
(a) Waste may be classified into Normal and Abnormal Waste.
(b) Cost of Normal Waste is absorbed in the cost of net output, whereas Abnormal Waste is
transferred to the Costing Profit and Loss Account, as a Loss.
19. Explain the accounting treatment for Scrap. RTP, M 86, N 08
1) Meaning: Scrap is the incidental residue from certain types of manufacture, usually of small
amount and low value, recoverable without further processing.
2) Control Measures: Measures to control Scrap Losses and obtain maximum gainful utilization of
raw material are –
(a) Proper product designing by the Production Planning Department.
(b) Use of standardized materials, equipment, personnel and efficiency by the Production
Department.
(c) Preparation of periodical scrap reports, comparison of actual with standards and identifying
deviations and corrective action taken by the Cost Control Department.
3) Accounting Treatment: Scrap may be treated in cost accounts in the following ways –
(a) Other Income: Where the value of scrap is negligible, such value may be excluded from
costs. Hence, the cost of scrap is borne by good units. Income / Receipt from Scrap
Realisation is treated as Other Income.
(b) NRV of Scrap: The Net Realisable Value (NRV) of Scrap, i.e. Sales Value less Selling and
Distribution Cost, is deducted from Overheads. Alternatively, the NRV can be reduced from
Materials Cost. This method is followed when scrap cannot be aggregated job or process –
wise.
(c) Specific Identification: When scrap is identifiable with a particular job or process and its
value is significant, the Scrap Account is charged with full cost. The credit is given to the job
or process concerned. The profit or loss in the Scrap Account, on realization, will be
transferred to the Costing Profit and Loss Account.
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20. Write short notes on accounting treatment for material spoilage. RTP, M 86, M 03, M 05,
M 07, N 07, M 09
1) Meaning: Spoilage refers to materials which are badly damaged in manufacturing operations, and
they cannot be rectified economically, and hence taken out of process to be disposed of in some
manner without further processing.
2) Classification: For accounting purposes, Spoilage is classified into Normal and Abnormal, and
dealt as under –
(a) Normal Spoilage Costs (i.e. which is inherent in the operation and hence unavoidable) are
included in costs either charging spoilage loss to the job / Process or by charging it to
Production OH so that it is spread over all products. Any value realized from spoilage is
credited to Job / Process a/c or OH a/c, as the case may be.
(b) Costs of Abnormal Spoilage (i.e. arising out of causes not inherent in manufacturing
process) are charged to the Costing P & L Account. When spoiled work is the result of rigid
specification, the cost of spoiled work is absorbed by good production while the cost of
disposal is charged to Production OH.
21. What is meant by “Defective Work”? Explain the accounting treatment for Defective Work.
RTP, M 86, M 00, M 03, N 03, M 05, M 07, N 07, N 08, M 09
1) Meaning: Defective Work signifies those units of production which can be rectified and turned
out as good units by the application of additional material, labour or other service, e.g. duplication
of pages or omission of some pages in a book.
2) Reasons: Defective arise due to sub – standard materials, bad supervision, improper planning,
poor workmanship, inadequate equipment and careless inspection. To some extent, defectives
may be unavoidable, but with proper care it is possible to avoid defect in the goods produced.
3) Reclamation of loss from defective units: In the case of articles that have been spoiled, it is
necessary to take steps to reclaim as much of the loss as possible. For this purpose –
(a) All defective units should be sent to a place fixed for the purpose,
(b) These should be dismantled,
(c) Goods and serviceable parts should be separated and taken into stock,
(d) Parts which can be made serviceable by further work should be separated and sent to the
workshop and taken into stock after the defects have been removed, and
(e) Parts which cannot be made serviceable should be collected in one place for being melted or
sold.
4) Treatment of Defectives: Defectives are generally treated in two ways –
(a) They can be brought upto the standard by incurring further costs – additional material and
labour,
(b) They can be sold as inferior products (seconds) at lower prices, where possible.
5) Control over Defectives: Control of defectives may cover the following two areas –
(a) Control over defectives produced.
(b) Control over re – working costs.
For exercising effective control over defectives produced and the cost of re – working, standards
for normal percentage of defectives and reworking costs should be established.
6) Spoilage vs Defectives: Spoilage cannot be repaired or re – conditioned. However, Defectives
can be either rectified and transferred into standard production or sold as seconds.
CHAPTER 3
LABOUR COST
1. How is Idle Time Cost treated in Cost Accounts? RTP, N 85, M 93, M 94, M 00,
M 03, M 06, N 08
Classification and Analysis: For Cost Accounting and analysis purposes, Idle Time is classified into
–
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Particulars Normal Idle Time Abnormal Idle Time
1. Meaning It refers to the idle time inherent in every
work situation. It is estimated in advance.
It refers to the idle time over and
above normal idle time. Abnormal
= Actual Less Normal.
2. Nature It is unavoidable and cannot be eliminated
totally.
It is avoidable. It is further sub –
classified into – (i) Controllable,
and (ii) Non – Controllable.
3. Treatment Cost of Normal Idle Time is treated as a
regular part of cost of production. It is treated
–
(a) Either as Direct Wages by inflating the
Wage Rate (for Direct Workers) or
(b) As Production OH (for Indirect Workers).
Cost of Abnormal Idle Time
constitutes a Loss, which should
be debited to Costing Profit and
Loss A/c. If it is controllable, the
responsibility should be fixed on
the person in default.
4. Focus In the long run, normal idle time may be
reduced through improved technologies,
methods & procedures.
Controllable Idle time should be
eliminated through proper
managerial action.
2. How is Overtime Premium treated in Cost Accounting? RTP, M 85, N 95, M 02, M 03, N
04, M 06, M 08
Overtime Premium is generally treated on the basis of the situation demanding Overtime Work –
Situation Accounting Treatment of Overtime Premium
1. Due to genuine labour shortage. Treated as Regular Cost of Production, as Direct
Labour, by inflating normal wage rate.
2. At Customer’s desire, e.g. immediate
delivery, etc.
Charged to the Job directly. Such amount will be
suitably recovered from the customer by charging at a
higher rate.
3. Irregular overtime to meet production
requirements due to unexpected
developments.
Charged to Job – treated as Factory Overheads.
4. Due to fault of a particular department,
e.g. non – availability of materials
during normal time.
Charged to the department in default, in order to fix
responsibility and prevent recurrence.
5. Due to abnormal conditions, e.g. strike,
etc.
Charged to Costing Profit and Loss Account as Loss.
3. What is Labour Turnover? What are the terms associated with Labour Turnover? RTP, N
85, N 94, M 96, M 03, N 04
1) Meaning: Labour Turnover is the rate of change in the composition of labour force during a
particulars period, measured against a suitable index. It arises because every Firm is a dynamic
entity and not a static one.
2) Terms: The terms associated with computation of Labour Turnover are – (a) Separation, (b)
Replacement, (c) New Recruitment, (d) Accession, and (e) Average Labour Force. These
concepts are as under –
Term (a) Separation (b) Replacement (c) New Recruitment
Explanation Left and discharged Substitutions New additions due to
expansion, etc.
Old Worker Goes Out Goes Out -
New Worker - Comes In Comes In
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(d) Accessions represent the total number of
new workers joining the Firm, whether
by way of replacement or otherwise.
So, Accessions = Replacements + New Recruitments.
(e) Average Labour Force=[Number of workers at the beginning + Number of workers at the end]
2
4. What are the causes of Labour Turnover? N 85, M 11
The major causes of labour turnover are – (1) Unavoidable Causes, and (2) Avoidable Causes.
1. Unavoidable Causes 2. Avoidable Causes
These are causes under which it becomes
obligatory on the part of management to ask one
or more of their employees to leave the Firm, e.g.
–
(a) Seasonal nature of the business,
(b) Shortage of Materials, Power, low product
demand, etc.
(c) Change in the Plant location,
(d) Disability, making a worker unfit for work,
(e) Disciplinary measures,
(f) Personal reasons, e.g. ill health, premature
retirement, family responsibilities, etc.
These are causes that require the attention of
management on a continuous basis so as to keep
the labour turnover ratio as low as possible, e.g.
–
(a) Dissatisfaction with job, remuneration, hours
of work, working conditions, etc.
(b) Strained relationship with management,
supervisors or fellow workers,
(c) Lack of training facilities and promotional
avenues,
(d) Lack of recreational and medical facilities,
(e) Low wages and allowances.
CHAPTER 4
OVERHEADS
1. What is Overhead Cost?
1) Meaning: Overheads comprise of Indirect Materials, Indirect Employee Costs and Indirect
Expenses, which are not directly identifiable or allocable to a cost object in an economically
feasible way. So, the total of all Indirect Costs, viz. Indirect Materials, Indirect Labour and
Indirect Expenses, is collectively called as “Overheads” (or on cost).
2) Exclusions: (a) expenditure arising out of abnormal situation in business activity, (b) Items not
related to business activities, e.g. Donation, Loss / Profit on Sale of assets, etc. and (c) Borrowing
Cost and other financial charges including foreign exchange fluctuations, will not form part of
OH.
3) Nature of OH: Indirect Costs are called Overheads, since they are incurred generally (and not
specifically) –
(a) Over various products,
(b) Over various Departments or Cost Centres, and
(c) Over various heads of account.
2. How are Overheads classified on the basis of functions?
Based on functions, Overheads are classified into four types, viz. –
Classification Sub – Classification
1. Factory or
Manufacturin
(a) Stores Overheads (expenses connected with purchasing & handling of
materials)
Alternatively, Accessions =
Number of Workers at the end
of the period
Add: Number of Separations during
that period
Less: Number of Workers at the
beginning of the period.
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g or
Production
OH
(b) Labour Overheads (expenses connected with labour and amenities), and
(c) Factory Administration Overheads (expenses connected with
administration of Factory).
2. Office and
Administrativ
e OH
(a) Office Expenses (incurred on routine office work – Telephone, Stationery,
etc. ), and
(b) Administrative Expenses (incurred on Office Personnel, i.e. their Salaries,
Facilities, etc.)
3. Selling and
Distribution
OH
(a) Selling Expenses (incurred to persuade customers to purchase the Firm’s
products and / or engage its services, that is to maintain & expand the
market), and
(b) Distribution Expenses (incurred to execute orders).
4. R&D OH (a) Research Expenses and (b) Development Expenses.
3. List the methods of segregating Semi – Variable Costs into Fixed & Variable Costs.
Semi – Variable Expenses usually have two parts – a fixed part and a variable part. By a systematic
analysis, all Semi–Variable expenses can be segregated into variable and fixed portions. The
following methods can be applied for segregation of Semi-Variable Costs into Fixed and Variable
portions.
1) Graphical Method (or) “Line of Best Fit” Method.
2) Analytical Method (or) Best Judgement Method.
3) High and Low Points Method.
4) Comparison by Period or Level of Activity Method.
5) Least Squares Method.
4. Distinguish between Allocation and Apportionment.
The differences between Allocation and Apportionment are –
Particulars Allocation Apportionment
1. Meaning Assigning a whole item of cost
directly to a Cost Centre.
Distribution of OH to more than
one Cost Centre, on some equitable
basis.
2. Nature of Expenses Specific, Identifiable and Direct. Unallocable, General and Common
3. Number of
Departments
One Many
4. Amount of OH Charged of Full Charged in Parts or Proportions
5. How can Pre – Determined Overhead Absorption Rates be determined?
Pre – determined Overhead Absorption or Recovery Rates may be determined in any of the following
methods.
Data used for rate determination Formula for OH Recovery Rate
1. Last Year Actuals Overhead Recovery Rate = Last Year Actual Overhead
Last Year Actual Output
2. Current Year Estimates Overhead Recovery Rate = Current Year Budgeted Overhead
Current Year Budgeted Output
3. Normal Activity Levels Overhead Recovery Rate = Normal Overhead Costs
Normal Volume of Output (or Hours)
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6. Describe the accounting treatment of Under–absorption of Production Overheads.
Describe the accounting treatment for Over–absorption of Production Overheads.
DIFFERENCE IN ABSORPTION = OH Variance = Absorbed OH Less Actual OH
Absorbed OH is greater than Actual OH
(Credit Balance in OH Control A/c )
OVERABSORPTION
(represents Savings in OH Expenditure)
Absorbed OH is less than Actual OH
(Debit Balance in OH Control A/c)
UNDERABSORPTION
(represents Increase in OH Expenditure)
Accounting Treatment (any one of the following) Analysed as due to –
1. Write Off: Small
amounts may be credited
to Costing P & L A/c.
2. Deferral: May be carried
over to next year, by
transfer to OH Reserve
A/c or Suspense A/c.
3. Cost Reversal: In case of
large amounts, cost of
jobs may be reduced /
adjusted by passing
reversal journal entries.
Normal Reasons
e.g. genuine planning errors,
changes in assumptions, etc.
Treated as increase COSTS
(using Supplementary OH
Recovery Rate), and
apportioned to production, i.e.
–
Abnormal Reasons
e.g. Strike Period Wages,
Labour Court Award,
Obsolete Stores, Penalties
paid etc.
Treated as LOSS and debited
to Costing P & L Account.
(Also see Note below)
Units Sold Closing Stock of
Finished Goods
Closing Stock of WIP
Debited to Cost of Sales A/c FG Control A/c WIP Control A/c
Note: When underabsorption is small and immaterial, it is fully debited / transferred to Costing P & L
A/c, irrespective of whether it is due to normal or abnormal reasons.
Reasons for Absorption Differences: OH Absorption Rates for any period are pre – determined
based on the normal activity data. However, there may be differences between Absorbed OH and
Actual OH due to the following reasons –
1) Difference between Budgeted and Actual Expenditure. (This is called as Expenditure Variance.)
2) Difference between Budgeted and Actual Output (Volume Variance), which may arise due to –
(a) Difference between planned and actual hours. (This is called as Capacity Variance),
(b) Difference between planned and actual quantity of output per hour. (This is called as
Efficiency Variance), or
(c) Difference between planned and actual days worked (This is called as Calendar Variance.)
CHAPTER 5
COST ACCOUNTING SYSTEMS
1. Briefly describe about the Non-Integrated Accounting System.
1) Meaning: The Non – Integrated or Cost Control System seeks to recognize the movements and
flows of Cost within the Firm. For example, materials issued to production, Production OH
absorbed, abnormal costs etc. are not recognized and recorded specifically in the financial
accounting system. These cost transactions within the Firm are recorded under the cost
accounting system.
2) Ledgers: The following Ledgers are maintained under the Non – Integrated Accounting System –
(a) Stores Ledger or Raw Material Ledger – for every item of Raw Materials and Stores items.
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(b) Job Ledger or Work in Progress Ledger – for showing item of Raw Materials and Stores
items.
(c) Stock Ledger or Finished Goods Ledger – for every item of Finished Product manufactured.
(d) Cost Ledger – for preparing Control Accounts in respect of the above Subsidiary Ledgers,
and also for impersonal accounts.
2. What are the features of the Non – Integrated Accounting System?
Write short notes on General Ledger Adjustment A/c Cost Ledger Control A/c.
1) Entity Aspect: Cost Flows / movements within the Firm as well as transactions with outsiders
(Suppliers, Customers) are captured by the system, e.g. issue of materials from Stores to
Production Department is recognized as a transaction, even if no outsider is involved.
2) No Personal Accounts: The Non – Integrated System involves the use of Nominal Accounts and
three Real Accounts (Stores Ledger Control A/c, WIP Control A/c, and Finished Goods Control
A/c). Personal and other Real Accounts are not used in this system.
3) General Ledger Adjustment Account: For completing contra – posting involving Personal
Accounts and other Real Accounts (Cash, Bank, Assets, etc.), the General Ledger Adjustment
Account is used. This account is also called as Cost Ledger Adjustment, or Cost Ledger Control,
or General Ledger Control A/c.
4) Costing P&L A/c: A Trial Balance is drawn under this System. The Costing P&L Account is
prepared, to ascertain the Profits as per Cost Records. Balance Sheet is not prepared under this
System.
5) Reconciliation: Non – cost transactions are not fully recorded by this System. Hence, whenever
Non – Integrated System is in use, regular Financial Accounting should also be done in parallel.
This creates the need for reconciling between Profits as per Cost Records and Profits as per
Finished Records.
CHAPTER 6
CONTRACT COSTING
1. What do you mean by Contract Costing?
1) Contract: Contract refers to a large job / assignment / work order, where the execution of work is
spread over two or more financial years. Generally, a Contract commences in one financial year,
but ends in a different year.
2) Contract Costing: Contract or Terminal Costing involves ascertainment of costs of contract. It is
an extension of principles of job costing for long – term projects like Civil Construction, Ship
Building, Interior Decoration, etc.
2. Distinguish between Job Costing and Contract Costing.
Job Costing Contract Costing
i. Job refers to any specific assignment, contract or
work order wherein work is executed as per
customer’s requirements.
Contract refers to a large job / assignment /
work order. The execution of work is
spread over two or more financial years.
ii. Job Costing is applied in Printing Press, Furniture
works, Interior Decoration and other similar work.
Contract Costing is applied in activities like
Civil Construction, Ship Building, etc.
3. What do you mean by Cost plus Contract? List its merits and demerits.
1) Meaning: A Cost plus Contract is one where the Contract Price is ascertained by adding a
percentage of profit to the total cost of the work. Such type of contracts is entered into when
contract costs cannot be estimated with reasonable accuracy due to unstable conditions e.g.
material prices, labour, etc.
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2) Advantages and Disadvantages:
Advantages Disadvantages
(a) The Contractor is assured of a fixed
percentage of profit. There is no risk of
incurring any loss on the contract.
(b) It is useful particularly when the work to be
done is not definitely fixed at the time of
making the estimate.
(c) Contractee can ensure himself about the
cost of the contract, as he is empowered to
examine the books and documents of the
Contractor, to ascertain the accuracy of the
costs.
(a) There is no incentive to the Contractor to
avoid wastages and achieve economy in
production.
(b) The Contractee may not know the actual
cost of contract till its completion, unlike a
Fixed Price Contract, where his outflow /
cost is pre – determined.
4. What do you mean by Fixed Price Contract? What are its advantages and disadvantages?
1) Meaning: A Fixed Price Contract is one where the Contract Price is fixed and determined in
advance at the time of entering into the agreement. Such type of contracts is entered into when
contract costs can be reasonably estimated with a degree of certainty.
2) Advantages and Disadvantages:
Advantages Disadvantages
(a) The Contractee’s outflow on the contract is
known and determined in advance.
(b) It is useful specially when the costs of
work to be done can be determined with
certainty.
(a) Contractor may resort to the use of
materials of lesser quality / price to increase
his profit margin.
(b) Contractor may incur losses if he had not
estimated the contract costs properly or if
price levels increase due to abnormal
reasons, after entering into the agreement.
(c) Contractee cannot have any idea about the
real costs since he cannot examine the
books of the Contractor.
5. What do you mean by Escalation Clause?
1) In Fixed Price Contracts, the Contract Price is fixed and pre – determined. If there is an increase
in prices of materials, rates of labour, etc. during the period of execution of a contract, the Total
Contract Costs may rise and the Contractor’s profit may be reduced.
2) This increase in prices may induce the Contractor to use materials of lower quality and price in
order to maintain his profit margin on the contract.
3) To overcome such a situation, the agreement generally contains a stipulation that the Contract
Price will be increased by an agreed amount or percentage, if the prices of materials, wages etc.
rise beyond a particular limit. Such a stipulation / condition is called Escalation Clause.
4) Accounting Treatment: The amount of reimbursement due should be determined by reference to
the Escalation Clause. The amount due from the Contractee should be recorded by the following
Journal Entry in the Contractor’s Book, at the end of every each year –
Contractee’s Account Dr.
To Contract Account
6. List the rules / principles for recognition of profit on incomplete contracts.
Profit on Incomplete Contracts is recognized based on the Notional Profit and Percentage of
Completion. The rules of recognition are –
Note: Alternatively, the amount due under Escalation Clause can
be added to the value of Work – in – Progress at the end of every
year.
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Description Percentage of Completion Profit to be transferred to P & L A/c
1. Initial Stages ≤ 25% NIL
2. Work Performed
but not substantial
26% to 50% 1 x Notional Profit x Cash Received
3 Work Certified
3. Substantially
completed
51% to 90%
(See Note c)
2 x Notional Profit x Cash Received
3 Work Certified
4. Almost complete 91% to 99%
(See Note c)
Profit is recognized on the basis of
Estimated Total Profit (See Question 16)
5. Fully complete 100% Notional Profit x Cash Received
Work Certified (See Note d)
Notes:
(a) Percentage of Completion = Work Certified
Contract Price
(b) If there is a loss at any stage, i.e. irrespective of percentage of completion, such loss should be
fully transferred to the Profit and Loss Account.
(c) Substantially completed can also be considered as 51% to 95% completed. In such case, the
next slab of Almost Complete contracts will be taken as 95% to 99% completed.
(d) For fully complete contracts, the balance portion of profit is recognized only upon receipt of
Retention Money. If entire amount is fully received, the whole of profit can be recognized.
(e) The principle of prudence / conservatism is generally followed for recognizing profit. Hence,
for exact 50% completion, 1/3rd
of Notional Profit will be recognized (and not 2/3rd
).
CHAPTER 7
JOINT PRODUCTS AND BY PRODUCTS
1. What do you mean by Joint Products?
Meaning: Joint Products are - Example
1. Two or more products,
2. Produced from the same process or operation,
3. Considered to be of relatively equal
importance.
In refining Crude Petroleum, gasoline, fuel oil,
lubricants, paraffin, coal tar, asphalt and
kerosene are all produced. These are known as
Joint Products.
2. What are Co–Products?
Meaning: Co-Products are - Example
1. Two or more products,
2. Belonging to the same line of activity, but
arising from different processes or
operations,
3. Considered to be of relatively equal
importance.
Rice and Wheat are agricultural produce, but
they arise from different cultivation processes.
So, they are Co-Products. Similarly Timber
Boards made from different trees are Co-
Products.
3. What are By-Products?
1) Definition: By-Products are “products recovered from material discarded in a main process, or
from the production of some major products, where the material value is to be considered at the
time of severance from the main product.”
2) Meaning: By-Product refers to incidental waste, arising during the course of manufacture, which
has a commercial name and value. It refers to secondary or subsidiary product incidentally arising
during the manufacturing process.
3) Examples: (a) Molasses arising in the manufacture of sugar, (b) Tar, Ammonia and Benzole
obtained on carbonization of coal, and (c) Glycerine obtained in the manufacture of soap.
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CHAPTER 8
PROCESS COSTING
1. What is a Process? What is Process Costing?
1) Process: Process is a district stage in manufacturing or production, wherein Raw Material is
converted from one identifiable form into another, before it is finally converted into the saleable
final product.
2) Process Costing:
(a) It is a method of costing, whereby costs are charged to processes or operations, and averaged
over units produced.
(b) This method is useful in the manufacturing of products like steel, soap, chemicals, rubber,
vegetable oil, paints, varnish, etc. For these products, the production process is continuous
and the output of one process becomes the input of the following process till completion.
2. Compare Process Costing and Job Costing.
Particulars Job Costing Process Costing
1. Meaning Job refers to specific contract work order
or arrangement, where work is executed
as per customers’ requirements.
Process refers to a stage in
manufacture where raw materials are
converted from on form to another.
2. Nature of
work
Specialized production based on
customers’ specifications.
Standardized mass production.
3. Quantity of
Output
Each job is distinct from the other.
Output consists of one or a few items
only.
Output of each process consists of
similar (homogeneous) units, in
large quantities.
4. Cost Centre Job itself. Process itself.
5. Cost Unit Job itself. Output of the process
6. Cost
Compilation
Costs are compiled by reference to job,
irrespective of its time of completion.
Costs are compiled by reference to
processes, for a specific time period.
7. Cost
Assignment
Cost is computed for each job or unit of
work. It is not averaged.
Cost is first ascertained for the
process, and then averaged over the
number of units produced.
8. Cost
Transfers
There is no transfer of costs from one job
to another.
Cost of one process is transferred to
next process, by reference to Process
Flow.
9. WIP
valuation
Different jobs might be complete at
different degrees. Hence, WIP consists of
job-wise cost incurred till date.
The concept of equivalent
production is applied. It is presumed
that all units of closing WIP are
uniformly semi-complete on an
average.
10. Supervision
& Control
Close supervision is necessary, since
each job is distinct from the other.
Comparatively easier, since
processes are standardized.
11. Cost
reduction
Comparatively less scope for Cost
Reduction, and required active
management decisions.
Cost Reduction scope is high, due to
mass production and economic of
scale.
CHAPTER 9
OPERATING COSTING
1. What is Operating Costing?
1) Meaning: Operating Costing is the method of asetaining the costs of providing / operating /
rendering a service.
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2) Applicability: It is applicable to undertakings that provide services rather than produce
commodities. This method is usually adopted in the case of – (a) Transport Companies, (b)
Gas and Water Works Departments, (c) Electricity Supply Companies, (d) Canteens, (e)
Hospitals, (f) Theatres, (g) Schools etc. that are engaged in the provision of services.
2. How are cost units determined in the rendering of services?
The principle of Operating Costing is to accumulate costs under suitable headings and to express
them in terms of number of units of service rendered. Unlike production activities where cost unit is
readily ascertainable, operating costing requires the determination of cost units / denominator factors
for expression of costs.
The factors that have a bearing on cost are identified based on study of technical and operating data.
Thereafter, the cost units that are unique to a specific service are identified as the denominator factors.
Some illustrations of cost units usually used in various service undertakings are as below –
1. Hospitals - Patient –Days, Room – Days, Operations. (M 02)
2. Hotels - guest Days, Room Days. (M 02)
3. Passenger Transport - Kilometres, or Passsenger – Kilometres. (M 02)
4. Cargo Transport - Quintal – Kilometres or Tonne – Kilometres.
5. Canteens - Number of meals served, Number of tea cups sold etc.
6. Electricity Supply – Kilowatt Hours.
7. Boiler Houses - Quantity of Steam raised.
8. Cinema House - Number of Tickets, Number of Shows.
3. Write short notes on Absolute and Commercial Tonne – Kilometres.
Composite units like Tonne – Kilometres, Quintal – Kilometres etc. may be computed in two ways –
1. Absolute (Weighted Average) Tonne – Kilometres: This is the sum total of Tonne –
Kilometres, arrived at by multiplying various distances by respective load quantities carried.
2. Commercial (Simple Average) Tonnes – Kilometres: It is derived by multiplying total
distance (i.e. Kilometres), by average load quantity (Tonnes).
CHAPTER 10
STANDARD COSTING
1. Define the term Standard Cost. Is it the same as Estimated Cost?
1) Standard Cost is the pre – determined operating cost calculated from Management’s standards
of efficient operation and the relevant necessary expenditure.
2) It is used as a basis for – (a) Price Fixing, and (b) Cost Control through variance analysis.
3) It reflects – (a) quantities of material and labour expected to be used, (b) prices expected to be
paid for materials and labour during the coming year, and (c) Factory Expenses applicable to
production based on good performance and practical capacity operation of the factory.
4. Distinguish between Standard Costing and Budgetary Control
Describe and contrast the scope and techniques of Standard Costing and Budgetary
Control.
Particulars Standard Costing Budgetary Control
1. Meaning Standards Costs are pre-determined
costs representing what the costs
should be, at the level of efficient
conditions of production and
operation.
Budgets are financial and / or
quantitative statements, prepared
and approved prior to a defined
period of time, of the policy to be
pursued during that period for
achieving that objective.
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2. Coverage They are generally restricted to
Costs.
They include estimates of Income,
Costs and employment of Capital.
3. Scope The scope of Standard Costing is
comparatively narrow, since it
covers mainly Production Costs.
Budgeting is more wide-ranging as
it relates to the operations of the
business as a whole. It covers
capital, sales and financial
expenses in addition to production.
4. Basis These are determined by the
collection of technical data related to
production and applying costs to
each element of production.
These are determined based on
Management’s plans of what
should b e done to achieve a certain
objective and how to actually
achieve it.
5. Cost Objective Standard Costing is concerned with
the ascertainment and control of each
element of cost for each unit.
Budgetary Control is concerned
with the origin of expenditure at
functional levels.
6. Control Focus Control is exercised by comparing
sales and production units values at
standard cost with actual costs, i.e.
actual costs are compared with
standard cost of actual output.
Control over budgetary figures is
exercised by comparing actual
figures with those budgeted.
Particulars Standard Costing Budgetary Control
7. Finance vs
Cost
Standard Cost is a projection of Cost
Accounts.
Budget is a projection of Financial
Accounts.
8. Variance
Reporting
Under the Standard Costing system,
variances are usually revealed
through different accounts.
Control is exercised by statistically
putting budgets and actual side by
side. Variances are normally not
revealed in the accounts in case of
Budgetary Control.
9. Scope of
Variance
Analysis
Standard Costing System is a more
technically improved system by
which various causes of variances for
each cost element can be analyzed in
minute detail and corrective action
taken accordingly.
Under Budgetary Control System,
Co9ntrol over expenses is general
and broad in nature, and not in as
detailed manner as in Standard
Costing.
10. Effect of
temporary
conditions
Standard Costs are usually semi-
permanent in nature and may not be
changed unless and until there are
changes in the basic price structure or
in the methods of operations.
Budgeted Costs are estimated
considering actual conditions and
attainable targets of a period, in
view of the conditions that are likely
to be prevalent in that year. The
effect of short-term changes in cost
structure, etc. will be fully reflected
in Budgeted Costs.
11. Permanence Standard Costs are usually semi-
permanent in nature and may not be
changed unless and until there are
changes in the basic price structure or
in the methods of operations.
They are estimated usually for one
year and take into account the
practical problems of operations and
are kept at a level, which the Firm
hopes to achieve in the year for
which the budget is being prepared.
12. Parts vs
Whole
A Standard Costing System cannot be
operated in parts. All items of
expenditure included in cost units are
to be considered.
Budgetary control is possible even
in parts or for particular type of
expense according to the attitude of
management, e.g. Advertising or
R&D Expenses Budget.
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5. Outline the relationship between Standard Costing and Budgetary Control.
1. Budgeted and Standard Costs are intended to exercise cost control and judge performance by
setting up targets.
2. Both systems provide benchmarks against which the actual performance and costs are
compared, variances are calculated and the reasons for the variances ascertained.
3. A Budgetary Control System can operate without Standard Costs. The two systems are not
inter-dependent, i.e. they can exist independently.
4. However, when Budgets are being developed, Standard Costs are of immense help since they
are long-term estimates of the same activity and represent Management’s view of the level of
efficiency that should prevail. Similarly, for determination of standards, information on past
budgeted and actual costs is useful.
Though the two are not independent, they are inter-related & function well as complementary to one
another.
Chapter 11
MARGINAL COSTING
1. What is Marginal Costing?
1. Marginal Costing is a technique of decision-making, which involves-
(a) Ascertainment of Total Costs,
(b) Classification of Costs into – (i) Fixed and (ii) Variable, and,
(c) Use of such information for analysis and decision-making.
2. Marginal Costing is the ascertainment of Marginal Cost, and of the effect on Profit of changes
in volume or type of output, by differentiating between Fixed Costs and Variable Costs.
2. Explain the concepts of Variable Cost and Fixed Cost, in the context of Marginal Costing.
Particulars Variable Cost Fixed Cost
1. Meaning Variable Cost is that portion of cost,
which changes or varies
proportionately based on output /
volume/ quantity.
Fixed Costs are costs which are assumed to
remain constant, for a given period of
time, irrespective of level of output during
that period.
2. Items Variable Cost = Direct Materials +
Direct Labour + Direct Expenses +
Variable Production OH + Variable
S&D OH.
Fixed Cost = Fixed Production OH +
Administrative OH + Fixed S&D OH.
3. Examples Raw Materials, Labour (based on
number of units produced), Power,
Royalty (based on production), etc.
Rent, Salary, Insurance, etc.
4. Cost per
unit
Variable Cost per unit is assumed to
remain constant at all levels of
output.
Fixed Cost per unit of output will vary
inversely with changes in the level of
output. As output increases, Fixed Cost per
unit decreases, and vice-versa.
5. Point of
incurrence
Variable Costs are incurred only
when production takes place.
Hence, no production means any
Variable Costs.
Fixed Costs are incurred even at zero level
of output. Hence, even at Nil Activity
Level, Fixed Costs will be incurred.
6. Cost
Behaviour
Once incurred, variable Costs will
increase proportionately based on
the level of output / quantity.
Fixed Costs, once incurred, will be
constant at all output levels.
7. Nature Variable Costs are considered as Fixed Costs are treated as period-related
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product-related costs. costs.
8. Inclusion
in
Inventory
Variable Costs are Product Costs,
and hence included in inventory
valuation. So, Inventory Value
comprises Direct Materials + Direct
Labour + Direct Expenses +
Variable Production OH.
Fixed Costs are not included in Inventory
Valuation. They are charged off fully to the
Profit and Loss Account in the period in
which it is incurred.
3. Distinguish between Marginal Costing and Absorption Costing.
Particulars Marginal Costing Absorption Costing
1. Cost
Recognition
Only Variable Costs are included
for product costing & inventory
valuation.
All product-related costs, whether Fixed or
Variable, are considered for product costing
& inventory valuation.
2. Classification Classification of expenses is
based on nature, i.e. Fixed and
Variable.
Classification of expenses is based on
functions, i.e. Production, Administration,
Selling and Distribution.
3. Treatment of
Fixed Costs
Fixed Costs are regarded as a
Period Cost. Profitability of
different products is analyzed by
their PV Ratio (and not Net Profit
Ratio).
Fixed Costs are charged to cost of
production. Each product bears a reasonable
share of Fixed Cost and thus the profitability
of a product is influence by the
apportionment of Fixed Costs.
4. Presentation Cost data presented highlight the
Total Contribution and
contribution of each product.
Cost data are presented on conventional
pattern. Net Profit of each product is
determined after subtracting Fixed Cost
along with their variable costs.
5. Effect of
Stockholding
on Cost pu
Difference in the quantity of
Opening Stock and Closing Stock
does not affect the unit cost of
production.
Difference in the quantity of Opening and
Closing Stock affects the unit cost of
production due to the impact of related
Fixed Cost.
6. Variance
Reporting
Only Fixed OH Expenditure
Variance can be computed.
There is no Volume Variance
since Fixed Overheads are not
“absorbed”.
All Fixed OH Variances (Expenditure,
Volume, etc.) can be computed and reported.
6. Write a brief note on Profit Volume Ratio (PV Ratio).
1. Meaning: Profit Volume Ratio (PV Ratio) is the relationship between contribution and Sales
Value. It is also termed as Contribution to Sales Ratio.
2. Formula: PV Ratio = Total Contribution x 100 (or) Contribution per unit x 100 (or)
Total Sales Value Sales Price per unit
= Change in Contribution x 100 (or) Change in Profit x 100 (or)
Change in Sales Change in Sales
3. Significance of PV Ratio:
(a) PV Ratio is considered to be the basic indicator of the profitability of the business.
(b) The higher the PV Ratio, the better it is for a business. In the case of a Firm enjoying
steady business conditions over a period of years, the PV Ratio will also remain stable
and steady.
(c) If PV Ratio is improved, it will result in higher profits.
4. Improvement of PV Ratio:
(a) By reducing the Variable Cost,
(b) By increasing the Selling Price, or
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(c) By increasing the share of products with higher PV Ratio in the overall sales mix. (where
a Firm produces a number of products)
5. Uses of PV Ratio:
(a) To compute the Variable Costs for any volume of Sales.
(b) To measure the efficiency or to choose a most profitable line. The Overall Profitability
line. The Overall Profitability of the Firm can be improved by increasing the sales /
output of a product giving a higher PV Ratio.
(c) To determine Break-Even Point and the level of output required to earn a desired profit.
(d) To decide the most profitable sales-mix.
7. Write short notes on the Break Even Point (BEP).
1. Meaning: Break-Even Point (BEP) is the level of Sales at which Total Contribution equals
Fixed Costs. Hence, at that level, there is neither a Profit nor a Loss to the Firm (Total
Revenue = Total Costs, and Profit / (Loss) = Zero).
2. Formula:
(a) Break Even Point (in Rs.) = Fixed Costs
PV Ratio
This is denoted as BES. (Break Even Sales Value)
(b) Break Even Point (Qtty) = Fixed Costs
Contribution per unit
This is denoted as BEQ. (Break Even Quantity)
Total Revenue
Actual Sale Value
Total Costs
MOS Value
Costs and Profit
Revenues BES BEP 0
in Rs.
Loss Fixed Costs
BEQ MOS Qtty Actual Sale Qtty
Quantity
3. Assumptions underlying Break Even Analysis: (a) Total Costs can be easily classified into Fixed and Variable categories.
(b) Selling Price per unit remains constant, irrespective of quantity sold.
(c) Variable Costs per unit remain constant. However Total Variable Costs increases with
increase in output levels.
(d) Fixed Costs remain the same for a period, irrespective of output.
(e) Productivity or Efficiency of the factors of production will remain the same.
(f) The state of technology, process of production and quality of output will remain
unchanged.
(g) There will be no significant change in the level of Opening and Closing Inventory.
(h) The Company manufactures and sells a single product. In the case of a multi-product
Company, the sales-mix remains unchanged.
(i) Both Revenue and Cost functions are linear over the range of activity under
consideration.
(j) All resources required for production are abundantly available.
4. Significance of BEP: BEP represents the Cut-Off Point for Profit or Loss of the business. At
the BEP, the Profit or Loss equals zero. The significance of BEP may be summarized as-
Level of Sales Impact on Profits
Less than BEP Firm incurs Losses. [Contribution < Fixed Cost]
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Equal to BEP No Profit & No Loss. [Contribution = Fixed Cost]
Greater than BEP Firm earns Profits. [Contribution > Fixed Cost]
Note: A Firm should operate above the Break-Even Point in order to earn Profits.
8. What are the limitations of Break-Even Chart?
1. The Variable Cost line need not necessarily be a straight line because of the possibility of
operation of law of increasing returns or law of decreasing returns.
2. The Selling Price may not be a constant factor. Any increase or decrease in output is likely to
have an influence on the Selling Price per unit.
3. When a number of products are produced, separate Break-Even Charts will have to be
prepared. This poses a problem of apportionment of Fixed Expenses to each product.
4. Break-Even Charts ignore the Capital Employed in business, which is one of the important
guiding factors in the determination of profitability and returns.
5. The Break Even Chart assumes that business conditions will not change. This assumption is
not realistic.
9. What are the different types of Break-Even Charts?
1. Contribution Break-Even Chart: This chart shows Contribution earned by the Firm at
different levels of activity.
2. Cash Break-Even Chart: In this chart, Variable Costs are assumed to be payable in cash.
Besides this, the Fixed Expenses are divided into two groups, viz. (a) those expenses which
involve cash
3. Control Break-Even Chart: Both budgeted and actual cost data are depicted in this chart.
This chart is useful in comparing the actual performance of the Firm with the budgeted
performance, for exercising control.
4. Analytical Break-Even Chart: This chart shows the break-up of Variable Expenses into
important elements of cost, viz., Direct Materials, Direct Labour, Variable Overheads, etc.
Also the appropriations of Profit such as Equity Dividends, Preference Dividends, Reserves,
etc are depicted in this chart.
5. Product wise Break-Even Chart: Separate Break-Even Charts for different products can
also be prepared to compare the profitability of the products or their contribution.
6. Profit Graph: Profit Graph is a special type of Break-Even Chart, with shows the Profit or
Loss at different levels of output.
Contribution Break Even Chart
BEP
Total Sales
Total Costs
Total Contribution
Fixed Costs
Output
Cash Break Even Chart (M 01)
Total Sales
Total Costs
Total Cash
Cost
Total Fixed Costs
Cash Fixed Costs
Total BEP
Cash BEP
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10. What do you understand by Margin of Safety?
1. Meaning: Margin of Safety (MOS) represents the difference between the Actual Sales and
Break-Even Point Sales. It can be expressed as a percentage of Total Sales, or in Value, or in
terms of quantity.
2. Formula:
(a) Margin of Safety (in Rs.) = Total Sales Less BEP Sales
(or)
= Profit
PV Ratio
(b) Margin of Safety (Qtty) = Total Sales Qtty Less BEQ
(or)
= Profit
Contribution per unit
Total Revenue
Actual Sale Value
Total Costs
MOS Value
Costs and Profit
Revenues BES BEP 0
in Rs.
Loss Fixed Costs
BEQ MOS Qtty Actual Sale Qtty
Quantity
Actual BEP
Control Break Even Chart
Total Sales
Actual Total Costs
Budgeted Total Cost
Output
Output
Budgeted BEP
Analytical Break Even Chart
Total Sales
Total Costs
Reserves
Equity & Pref
Dividends
Variable OH Direct Labour
Direct Matls
Fixed Costs
Output Product Wise Break Even Chart
BEP
Product A
BEP
Product B
Loss
Area
Profit
Area
Profit Graph
BEP
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3. Significance:
(a) Upto BEP, the Contribution earned by the Firm is sufficient only to recover Fixed Costs.
However, beyond the BEP, the Contribution is called Profit (since Fixed Costs are fully
recovered by then).
(b) Profit is the Contribution earned out of Margin of Safety Sales.
(c) The size of the Margin of Safety shows the strength of the business.
(d) A low MOS indicates that the Firm has large Fixed Expenses and is more vulnerable to
changes in Sales.
4. Improvement in Margin of Safety:
(a) Increase in Selling Price, provided the demand is inelastic so as to absorb the increased
prices.
(b) Reduction in Fixed Expenses.
(c) Reduction in Variable Expenses.
(d) Increasing the Sales Volume provided capacity is available.
(e) Substitution or introduction of a product mix such that more profitable lines are
introduced.
11. Discuss the relationship between Angle of Incidence, BEP and MOS.
ϴ ϴ ϴ
ϴ
Condition 1: Low BEP & Large AOI: Fixed Costs are low and the rate of profit earning is high.
Large MOS shows that the Firm enjoys financial stability. Low BEP indicates that the business could
be run profitably even if there is a fall in Sales, unless the Sales are very low.
Condition 2: Low BEP & Small AOI: In this case, the conclusions are same as in Condition 1,
except that the rate of profit earning is not so high as in Condition 1. The Firm breaks – even quickly
and its Fixed Costs are low but it does not have a high rate of profit earning.
Condition 3: High BEP & Small AOI: This shows that the Fixed Costs are high and MOS is low.
The business is very vulnerable, even a small drop in activity may result in a loss.
Condition 4: High BEP & Large AOI: This shows that Fixed Costs are high and MOS is low. The
business is likely to incur losses through a small reduction in activity. However, after the BEP, the
business makes the profits at a high rate.
12. Write a brief note on Indifference Point.
1. Meaning: Indifference Point is the level of Sales at which Total Costs (and hence Total Profits)
of two options are equal. The decision-maker is indifferent as to option chosen, since both
options will result in the same amount of profit.
2. Formula:
BEP
Total Sales
Total Cost
Fixed Cost
Total Sales Total Sales
Total Sales
BEP BEP BEP
Fixed Cost
Total Cost
Fixed Cost Fixed Cost
Total Cost Total Cost
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(a) Indifference Point (in Rs.)
= Difference in Fixed Costs
Difference in PV Ratio
(or)
= Difference in Fixed Costs
Difference in Variable Cost Ratio
(b) Indifference Point (in units) = Difference in Fixed Costs
Difference in Contribution per unit
(or)
= Difference in Fixed Costs
Difference in Variable Cost per unit
Note: Indifference Point may also be
called the Cost Break Even Point.
Profit of Option Y
Indifference Point
Profit of
Option X
Amount
In Rs.
Quantity
3. Significance: Indifference Point represents a cut-off indicator for deciding on the most
profitable option. At that level of Sales (i.e. Indifference Point), Costs and Profits of two options
are equal. The profitability of different options are –
Level of Sales Most Profitable Option to be chosen Reason
Below
Indifference Point
Option with Lower Fixed Cost Lower the Fixed Costs, lower will
be the BEP. Hence, more profits
beyond BEP.
At Indifference
Point
Both options are equally profitable. Indifference Point
Above
Indifference Point
Option with Higher PV Ratio (lower
Variable Cost)
The higher the PV Ratio, the
better it is.
Note: Indifference Point is calculated only in respect of two options. Where more than two
options are considered, Indifference Point can be calculated on a comparative basis for two
combinations.
13. Distinguish between Indifference Point and Break-Even Point.
Particulars Indifference Point Break-Even Point
1. Definition Indifference Point is the level of Sales
at which Total Costs and Profits of
two options are equal.
BEP is the level of Sales at which
the Total Contribution equals Fixed
Costs. Hence, there is neither a
Profit nor a Loss to the Firm.
2. Formula Indifference Point (in Rs.)
= Difference in Fixed Costs
Difference in PV Ratio see Qn 14
Break Even Point (in Rs.) =
Fixed Costs
PV Ratio
3. Significance It is the activity level at which Total
Cost under two alternatives are equal.
It is activity level at which the
Total Revenue from a product or
product mix is equal to its Total
Cost.
4. Purpose Used to choose between two
alternative options for achieving the
same objective.
Used for profit planning.
14. What do you understand by Key Factor or Limiting Factor?
1. Key Factor represents a resource whose availability is less than its requirement. It denotes
the Resource Constraint situation. It is a factor, which at a particular time or over a period
limits the activities of a Firm.
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2. It is also called Critical Factor (since it is vital or critical to the Firm’s success) and Budget
Factor (since budgets are formulated by reference to such limitations or restraints).
3. Some examples of Key Factors are – (a) Shortage of Raw Materials, (b) Labour Shortage, (c)
Restrictions in Plant Capacity, (d) Demand or Sales Expectancy, (e) Cash availability, etc.
4. In case of Key Factor situation, the procedure for decision-making is as under-
Step Description
1 Identify the Key Factor
2 Compute Total Contribution or Contribution per unit of the product.
3 Compute Contribution Per Unit of the Key Factor, i.e. Contribution per Direct Labour
Hour, Contribution per kg of Raw Material, etc.
4 Rank the products based on Contribution per unit of the Key Factor.
5 Allocate the key resources based on Ranks given above, and other conditions specified in
the question.
15. What is Cost-Volume-Profit Analysis? What are its objectives?
1. Cost-Volume-Profit Analysis (CVP Analysis) is the analysis of three variables, viz. Cost,
Volume and Profit, which explores the relationship existing amongst Costs, Revenue,
Activity Levels and the resulting profit.
2. CVP Analysis aims at measuring variations of Profits and Costs with Volume, which is
significant to business profit planning.
3. CVP Analysis makes use of the Marginal Costing principles for planning and for making
short-run decisions.
16. What are the limitations of Marginal Costing?
1. Difficult to classify: It is difficult to classify exactly the expenses into Fixed and Variable
category. Most of the expenses are neither totally variable nor wholly fixed.
2. Contribution is not final: Contribution of a product itself is not a guide for optimum
profitability unless it is linked with the Key Factor.
3. Wrong pricing decisions: Sales Staff may mistake Marginal Cost for Total Cost and sell at a
price, which will result in loss or low profits. Hence, Sales Staff should be cautioned against
incorrect pricing decisions, while giving them information on Marginal Cost.
4. Stock Valuation: Overheads of fixed nature cannot altogether be excluded particularly in
large contracts, while valuing the WIP. This aspect is not considered in Marginal Costing.
5. Naïve assumptions: Some assumptions regarding the behaviour of Revenues and Costs are
not necessarily true in a realistic situation. For example, additional output can be sold only by
reducing sale prices.
6. Ignores time value: Marginal Costing ignores time factor and investment. For example, the
Marginal Cost of two jobs may be the same but the time taken for their completion and the
cost of machines used may differ. The true cost of a job, which takes longer time and uses
costlier machine, would be higher. The effect of time value of money is not analyzed by
Marginal Costing.
Chapter 12
BUDGETARY CONTROL
1. Define the term Budget.
1. Definition: 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 employment of capital.
2. Features:
(a) Financial and / or Quantitative Statement.
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(b) Futuristic – prepared and approved prior to a defined period of time.
(c) Goal Oriented – for the purpose of attaining a given objective.
(d) Components – Income, Expenditure and Employment of Capital.
2. Define the term Budgetary Control. What are its salient features?
1. Definition: Budgetary Control is defined as “the establishment of budgets, relating the
responsibilities of executives to the requirements of a policy, and the continuous comparison
of actual with budgeted results either to secure by individual action the objective of that
policy or to provide a base for its revision.”
2. Salient features:
(a) Objectives: Determining the objectives to be achieved, over the budget period, and the
policy(ies) that might be adopted for the achievement of these ends.
(b) Activities: Determining the variety of activities that should be undertaken for
achievement of the objectives.
(c) Plans: drawing up a plan or a scheme of operation in respect of each class of activity, in
physical as well as monetary terms for the full budget period and its parts.
(d) Performance Evaluation: Laying out a system of comparison of actual performance by
each person, section or department with the relevant budget and determination of causes
for the discrepancies, if any.
(e) Control Action: Ensuring that when the plans are not achieved, corrective action are
taken, and when corrective actions are not possible, ensuring that the plans are revised
and objective achieved.
1. What are the different types of Budgets?
Distinguish between Fixed and Flexible Budgets.
Budgets may be classified on the following bases –
1. Time – Period 2. Conditions 3. Capacity 4. Coverage
(a) Long – term Budget & (a) Basic Budget and (a) Fixed Budget and (a) Functional Budget and
(b) Short – term Budget (b) Current Budget. (b) Flexible Budget. (b) Master Budget.
1. BASED ON TIME PERIOD:
Long Term Budget Short Term Budget
(a) Budgets which are prepared for periods
longer than a year are called Long – Term
Budgets.
(b) Such Budgets are helpful in business
forecasting and forward planning.
(c) Examples: Capital Expenditure, R&D
Budget.
(a) Budgets which are prepared for periods less
than a year are known as Short – Term
Budgets.
(b) Such Budgets are prepared in cases where a
specific action has to be immediately taken
to bring any variation under control.
(c) Example: Cash Budget.
2. BASED ON CONDITIONS:
Basic Budget Current Budget
A Budget, which remains unaltered over a long
period of time, is called Basic Budget.
A Budget, which is established for use over a
short period of time and is related to the current
conditions, is called Current Budget.
3. BASED ON CAPACITY:
Particulars Fixed Budget Flexible Budget
a) Definition It is a Budget designed to remain unchanged It is a Budget, which by
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irrespective of the level of activity actually
attained.
recognizing the difference
between fixed, semi –
variable and variable costs is
designed to change in
relation to level of activity
attained.
b) Rigidity It does not change with actual volume of
activity achieved. Thus it is known as a Rigid
or Inflexible budget.
It can be re – casted on the
basis of activity level to be
achieved. Thus it is not rigid.
c) Level of
Activity
It operates on one level of activity and under
one set of conditions. It assumes that there
will be change in the prevailing conditions,
which is unrealistic.
It consists of various budgets
for different levels of
activity.
d) Effective of
variance
analysis
Variance Analysis does not give useful
information as all Costs (fixed, variable and
semi – variable) are related to only one level
of activity.
Variance Analysis provides
useful information as each
cost is analysed according to
its behaviour.
e) Performance
Evaluation
Comparison of actual performance with
budgeted targets will be meaningless,
especially when there is a difference between
two activity levels.
It provides a meaningful
basis of comparison of the
actual performance with the
targets.
4. BASED ON COVERAGE:
Functional Budget Master Budget (M 97)
Budgets, which relate to the individual
functions in an organization, are known as
Functional Budgets, e.g. Purchase Budget,
Sales Budget, Production Budget, Plant
Utilisation Budget and Cash Budget.
It is a consolidated summary of the various
functional budgets. It serves as the basis upon
which budgeted Profit & Loss Account and
forecasted Balance Sheet are built up.
2. Write short notes on Flexible Budgets.
1. Meaning: It is a Budget, which by recognizing the difference between fixed, semi – variable
and variable costs, is designed to change in relation to level of activity.
2. Need: The need for the preparation of Flexible Budgets arises in the following circumstances
–
(a) Seasonal fluctuations in sales and / or production.
(b) Introduction of new products, product designs and versions on a frequent basis,
(c) Industries engaged in make – to – order business like shipbuilding,
(d) An industry which is influenced by changes in fashion, and
(e) General changes in sales.
3. Situations: Flexible Budgeting may be resorted to in the following situations –
(a) New Business: In case of new business venture, due to its typical nature, it may be
difficult to forecast the demand of a product accurately.
(b) Uncertain Environment: Where the business is dependent upon the mercy of nature.
(c) Factor market conditions: In the case of labour intensive industry where the production
of the concern is dependent upon the availability of labour.
3. What are the types of Functional Budgets?
Functional Budgets are broadly grouped under the following heads –
1. Physical Budgets: Budgets that contain information in terms of physical units about sales,
production, etc. For example, Quantity of Sales, Quantity of Production, Inventories,
Manpower Budgets.
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2. Cost Budgets: Budgets which provide Cost Information in respect of manufacturing, Selling,
Administration, etc. for example, Manufacturing Costs, Selling Costs, Administration Cost, R
& D Cost Budgets.
3. Profit Budgets: Budgets that enable the ascertainment of Profit, for example, Sales Budget,
Profit & Loss Budget, etc.
4. Financial Budgets: A Budget, which facilitates to ascertain the Financial Position of a
concern, for example, Cash Budgets, Capital Expenditure Budget, Budgeted Balance Sheet,
etc.
4. List the commonly used Functional Budgets.
1. Sales Budget.
2. Production Budget.
3. Plant Capacity Utilisation Budget.
4. Direct Materials – Usage & Purchase Budgets.
5. Direct Labour – Requirement & Recruitment Budgets.
6. Overhead Cost Budgets – Factory OH, Administration OH, and S&D OH Budgets.
7. Cost Summary Budgets – Primary Cost Budget, Cost of Production Budget, Ending –
inventory Budget, Cost – of – Goods – Sold Budget.
8. Specific Budgets – R&D Cost Budget, Capital Expenditure Budget, Cash Budget.
9. Budget Summaries / Master Budget – Budgeted Income Statement and Budgeted Balance
Sheet.