Cost Accounting

1Cost Accounting

GCM S5 04 ACCExam Code : CO

Cost Accounting

SEMESTER V

COMMERCE

KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

2 Cost Accounting

Subject Experts

Prof. Nayan Barua , Gauhati University

Prof. H.C. Gautam , Gauhati UniversityDr. S.K. Mahapatra , Gauhati University

Course Coordinator(s): Dr. Devajeet Goswami, Dr . Dipankar Malakar , Mr. SanjibGhimire, Commerce, KKHSOU

SLM Preparation T eam

UNITS CONTRIBUTORS

1 Dr. Jiban Up adhyaya , Sikkim Government College and

Mr. Sanjib Ghimire , KKHSOU

2 & 3 Dr. Jiban Up adhyaya , Sikkim Government College and

Dr. Nasim Wazid Ali , DHSK Commerce College

4 Dr. Amar Gaut am, Hojai College and Mr. Sanjib Ghimire , KKHSOU

5 & 6 Dr. B. B. Dam , Retired, Gauhati Commerce College

7 Dr. Nasim Wazid Ali , DHSK Commerce College

8 Dr. Amar Gaut am, Hojai College

9 & 13 Mr. Sanjib Ghimire , KKHSOU

10, 11 & 12 Dr. Pradeep Kr . Jain , Gauhati University

Editorial T eam

Content : Prof. H.C. Gautam , Gauhati University

Structure, Format & Graphics : Dr. Devajeet Goswami, Dr . Dipankar Malakar ,

Mr. Sanjib Ghimire, Commerce, KKHSOU

First Edition : June, 2019

ISBN: 978-93-89123-51-7

© Krishna Kanta Handiqui State Open University

This Self Learning Material (SLM) of the Krishna Kanta Handiqui State University

is made available under a Creative Commons Attribution-Non Commercial-Share Alike 4.0License (International) : http.//creativecommons.org/licenses/by-nc-sa/4.0

Printed and published by Registrar on behalf of the Krishna Kanta Handiqui State OpenUniversity.

Head Office : Patgaon, Rani Gate, Guwahati -781017; Web : www .kkhsou.inCity Office: Housefed Complex, Dispur , Guwahati-781006

The University acknowledges with thanks the financial support provided by theDistance Education Bureau, UGC for preparation of this study material.

3Cost Accounting

SEMESTER 5

COST ACCOUNTINGCOMMERCE

CONTENTS

Pages

UNIT 1 : Introduction to Cost Accounting 7-17

Meaning, Objectives, Functions and Scope of Cost Accounting;

Evolution of Cost Accounting; Costing as an aid to management,

Relationship between Cost and Financial Accounting

UNIT 2 : Elements of Cost 18-40

Concept of Cost; Elements of Cost, Meaning of Cost Unit and Cost

Centre; Procedure of Linking Costs with Cost Centres and Cost Unit:

Cost Sheet; Meaning and Advantages of Preparation of Cost Sheet.

UNIT 3 : Material Control 41-53

Meaning of Material; Meaning of Material Control, Objectives,

Essentials and Advantages of Material Control, Functions and

Techniques of Material Control.

UNIT 4 : Material Purchase and Store Keeping 54-69

a) Introduction; Purchase Requisition; Receiving and Inspecting of

Materials.

b) The Store Keeper; Requisition for Store; Reordering Level;

Minimum level; Maximum Level; Bin Card; Store Ledger; Perpetual

Inventory System; ABC Analysis.

UNIT 5 : Labour Cost 70-77

Introduction; Labour Turnover: Meaning, Causes, Effects; Measures

of Control; Methods of Time Keeping, Idle Time, Over Time

UNIT 6 : Labour Remuneration and Incentives 78-96

Meaning of Remuneration and Incentives; Features of a Good Wage

System; Methods of Wage payments: Time Wage System, Piece

Rate System, Premium and Bouns Plan; Halsey Premium Plan,

4 Cost Accounting

Rowan Plan; Taylor’s Differential Plan; Incentive System; Requisites

of a Good Incentive Plan.

UNIT 7 : Overheads 97-106

Meaning, Classification and Collection of Overheads, Allocation and

Apportionment of Overheads, Basis of Apportionment.

Unit 8 : Overhead Absorption 107-125

Absorption of Overheads; Methods of Absorption of Overheads; Over

and Under absorption of Overheads;

Unit 9 : Administration, Selling and Distribution of Overheads 126-136

Meaning of Value of Shares, Types of Share Value, Importance of

Valuation of Shares, Factors affecting the Value of Shares, Methods of

Valuation of Shares

Unit 10 : Process Costing 137-148

Introduction; General Principles; Process Losses; Wastage Scrape;

Normal Loss; Abnormal Loss and Abnormal Gain; Ascertainment of

Cost under Process Costing System.

Unit 11 : Standard Costing 149-177

Introduction; Preliminaries to the Establishment of Standard Cost;

Variance Analysis; Material Labour and Overhead; Advantages and

Disadvantages of Standard Costing; Standard Costing Vs Budgetary

Control.

Unit 12 : Job Costing 178-187

Introduction; Procedure for Job Costing Accounting; Advantages and

Limitations of Job Costing; Reports in Job Costing System.

Unit 13 : Book Keeping in Cost Accounting 188-205

Cost Accounting Records, Ledgers and Cost Statements; Items

excluded from Cost and Normal and abnormal items/cost; Integral

accounts; Reconciliation of cost accounting records with financial

accounts.

5Cost Accounting

COURSE INTRODUCTION

The course ‘Cost Accounting’ of B.Com fifth semester will help the learners to gain knowledge

in this field. In modern days business information plays an important role. Both management and other

stakeholders are interested in this information. In this respect accounting information plays the crucial

role by supplying cost and profit information to the managers. Cost information is helpful for the

management in taking decisions regarding production, selling, profitability etc. Cost accounting helps in

finding out the cost per unit of a product. On this basis, the management can set the price of the

product. Thus, cost accounting helps in decision- making. Management accounting helps in preparing

accounting reports to facilitate managerial decision- making. Preparing of various financial reports and

budgets are essential for the efficient management of resources of the organisation. All these aspects

have been covered in this course to equip the learners with sufficient knowledge in this area.

While going through a unit, you will notice that some along-side boxes, which have been included

to help you know some of the difficult, unseen terms. Some ‘‘ACTIVITY’’ (s) has been included to help

you to apply your own thoughts. Again, we have included some relevant concepts in ‘‘LET US KNOW’’

along with the text. At the end of sections, you will get ‘‘CHECK YOUR PROGRESS’’ questions. These

have been designed to self-check your progress of study. It will be better if you solve the problems put in

these boxes immediately after you go through the sections of the units and then match your answers

with ‘‘ANSWERS TO CHECK YOUR PROGRESS’’ given at the end of each unit.

6 Cost Accounting

7Cost Accounting

UNIT 1: INTRODUCTION TO COST ACCOUNTING

UNIT STRUCTURE

1.1 Learning Objectives

1.2 Introduction

1.3 Meaning of ‘Cost’, ‘Costing’ and ‘Cost Accounting’

1.4 Objectives of Cost Accounting

1.5 Scope of Cost Accounting

1.6 Evolution of Cost Accounting

1.7 Costing as an Aid To Management

1.8 Relationship between Cost Accounting and Financial Accounting

1.9 Let Us Sum Up

1.10 Further Reading

1.11 Answers To Check Your Progress

1.12 Model Questions

1.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

• explain the meaning of cost, costing and cost accounting

• describe the scope of cost accounting

• explain role of costing as an aid to management

• explain the relationship between cost and financial accounting.

1.2 INTRODUCTION

You are aware that a business firm is formed to earn profit. For this,

it has to invest money and incur expenses on various items and then

generates incomes by selling goods or generating services for reasonable

consideration. In these activities, therefore, cost is an important subject

matter to which the firm has to take care of. This is the reason why Cost

Accounting is taught in commerce and management and practiced in

business firms. In this unit we will discuss the preliminaries of cost accounting

covering the meaning, objectives, nature and scope of cost accounting,

8 Cost Accounting

costing as an aid to management and relationship between cost and financial

accounting.

1.3 MEANING OF ‘COST’, ‘COSTING’ AND ‘COSTACCOUNTING’

The term ‘Cost’ is understood in a variety of ways. In ordinary

language cost means expenses. But in Cost Accounting it has special

meaning. The Institute of Cost and Management Accountants, London, has

defined the term as, ‘‘the amount of expenditure, actual or notional, incurred

on or attributable to a given thing’’. Therefore, when we use the term cost, it

must relate to certain thing. Cost is always attached to a good, or service

which is consumed or used. It can be regarded as the price paid for attaining

the objective.

When a manufacturer buys raw materials he pays price at a certain

rate. This price paid by the manufacturer is called cost of materials. If he

incurs additional expenses, e.g., freight, insurance etc., to bring the raw

materials to his place of work, these are also added to the price to find out

the cost of raw materials.

Thus cost represents a sacrifice of values, a foregoing or a release

of something of value. It is the price of economic resources used as a result

of producing or doing the thing costed. It is the amount of expenditure incurred

on a given thing. Therefore, cost has been defined as ‘‘the amount measured

in money or cash expended or other property transferred, capital stock issued,

services performed or a liability incurred in consideration of goods or services

received or to be received’’.

‘Costing’ is the process of ascertainment of cost. It is different from

cost accounting. It is referred to as classifying, recording and appropriate

allocation of expenditure for determination of the costs of products or services.

It consists of rules and principles of ascertainment of costs of a product or

service.

Cost accounting is a broader term. The system of accounting which

is concerned with determination of costs of doing something which can be

manufacturing or producing an article or rendering service or even conducting

Introduction to Cost AccountingUnit 1

9Cost Accounting

any activity or function, and keeping records of costs is called ‘Cost

Accounting’.

To be very precise, ‘Cost Accounting’ is the application of costing

principles, methods and techniques in the ascertainment of costs and

analysis of savings and/or expenses as compared with previous experience

or with standards. Cost accounting is the technique and process of

ascertainment of costs, which begins with recording of expenses or the

bases on which they are calculated and ends with preparation of statistical

data.

The costing terminology of I.C.M.A. London, defines cost accounting

as, ‘‘The process of accounting for costs from the point at which expenditure

is incurred or committed to the establishment of its ultimate relationship

with cost centres and cost units. In its widest sense, it embraces the

preparation of statistical data, the application of cost control methods and

the ascertainment of the profitability of activities carried out or planned.’’

Wheldon defines cost accounting as, ‘‘Classifying, recording and appropriate

allocation of expenditure for determination of costs of products or services

and for the presentation of suitably arranged data for purposes of control

and guidance of management.’’

CHECK YOUR PROGRESS

Q 1: Define the terms: (a) Cost (b) Costing and

(c) Cost Accounting

a) ................................................................................................

................................................................................................

................................................................................................

b) ................................................................................................

................................................................................................

................................................................................................

c) ................................................................................................

................................................................................................

................................................................................................

Introduction to Cost Accounting Unit 1

10 Cost Accounting

1.4 OBJECTIVES OF COST ACCOUNTING

After knowing the meaning of cost, costing and cost accounting, let

us now explain the objectives of cost accounting. The specific objectives of

cost accounting are given below:

• To ascertain cost of product or services rendered.

• To enable the cost accountant to properly value the inventory.

• To keep records of cost in a systematic manner.

• To provide necessary cost data and information to assist management

in decision making.

• To provide information for planning and control through the techniques

of standard costing and budgetary control.

• To indicate to the management any inefficiencies and the extent of

various forms of waste, like materials, time, expenses or in the use of

machinery, equipment and tools. This may indicate appropriate

remedial action.

• To assist the management in fixation of selling price.

• To present comparative cost data for different periods.

1.5 SCOPE OF COST ACCOUNTING

In this section we will discuss the scope of cost accounting. Cost

accounting broadly covers three subject matters. These are:

a) Ascertainment of Cost;

b) Control over Costs; and

c) Reporting or Presentation.

All these are briefly discussed below.

a) Cost Ascert ainment:

Cost Ascertainment involves five processes. These are

(i) Ascertainment of cost,

(ii) Analysis of cost

(iii) Deciding on absorption of cost

(iv) Apportionment of cost to various units, and

(v) Allocation of these costs


11Cost Accounting

b) Cost Control

Another scope of cost accounting is cost control. Institute of Cost and

Works Accountants, London defines it as ‘‘Tool for guidance and regulation

by executive action for control of cost of operating an undertaking’’. This

process involves:

(i) Setting up targets for expenses and activities like production, sales,

purchase etc.;

(ii) Measuring actual expenses and volume of activities through cost

ascertainment techniques;

(iii) Comparison of actual result with budgeted and finding out deviations

and identifying areas of efficiencies and deficiencies;

(iv) Analysing the causes of deviation and fixing responsibility and

(v) Taking action for improvement of performance in future.

c) Reporting

The cost accountant can not control everything that are listed above.

The management will take or can authorize the cost accountant to take

actions. Therefore, there is the need of reporting to the management. This

function is concerned with the presentation of information obtained through

cost methods and techniques of costing to the management in suitable

report forms. The proper system of reporting would ensure that concerned

person receives right type of information at an appropriate time. The reporting

system differs from organisation to organisation, depending on peculiar

needs.

CHECK YOUR PROGRESS

Q 2: Mention any three objectives of Cost

Accounting.

a) ................................................................................................

................................................................................................

................................................................................................

b) ................................................................................................

................................................................................................

................................................................................................


12 Cost Accounting

c) ................................................................................................

................................................................................................

................................................................................................

1.6 EVOLUTION OF COST ACCOUNTING

The evolution of cost accounting as a specialised subject of study

and research can be attributed to several factors. These are explained below:

Earlier development of cost accounting can be credited to the

mathematicians and industrial engineers, rather than accountants and

managers. After industrial revolution the development of industry and system

of different forms of organisation and capitalistic structure of organisation

gave new dimension to accounting. This had given rise to the need for more

detailed analysis of costs.

Initially, attempt was made to cover transactions concerned with

movement of material within the organisation and emphasis was laid on

cost ascertainment.

Towards the end of 18th century, emphasis was shifted to present

costing information to management so that it can assist in planning,

controlling and decision making.

The need was felt for more elaborate study in Cost Accounting in

U.S.A., England and later in India. After 1st World War, the Institute of Cost

and Works Accountants was set up in U.K. and National Association of

Cost Accountants was set up in U.S.A. The Institute of Cost and Works

Accountants was set up in India in 1944 and statutory recognition was given

to it in 1959. The Companies Act amendments in 1965 brought about

provisions regarding maintenance of cost accounting records in cases,

where Central Government considers it necessary.

1.7 COSTING AS AN AID TO MANAGEMENT

You have found that one of the most important objectives of cost

accounting is to provide necessary cost data and information to assist

management in decision making. This objective refers to three subject


13Cost Accounting

matters of cost accountingm of a) ascertainment of Cost; b) Control over

Costs, and c) Reporting or Presentation.

Here you should remember that cost accounting is advanced stage

of financial accounting and its benefits are reaped by various parties directly

or indirectly concerned with the organization, viz., Management, Owners,

Workers, Government, Consumers, and Lenders etc.

Now we will list some of the advantages of cost accounting to the

management. Management is the first beneficiary and user of the cost

accounting. The information revealed by cost accounting aims at mainly

assisting the management in decisions-making and optimising profit. The

advantages to management are:

a) Management can exercise cost control and reduction measure with

the help of data provided.

b) The prices of the products can be fixed and revised in a scientific

manner.

c) With proper method and control over inventory, losses due handling

of materials can be minimised.

d) Standard costing and variance analysis helps the management to take

timely and proper measures to rectify the mistakes. This helps

improvement performance.

e) Management can decide production at optimum level and utilise the

plant capacity to maximum extent.

f) In case, the organisation manufactures several products, the ideal

mix or combination of products can be determined.

g) Cost accounting helps to maximise profits through proper profit

planning.

h) Cost accounting provides base data for quotation or tenders.

1.8 RELATIONSHIP BETWEEN COST ACCOUNTINGAND FINANCIAL ACCOUNTING

In conclusion, one can say that the cost accounting takes over or

begins from the stage where financial accounting ends. Financial Accounting

records and summarises transactions of financial nature affected during a


14 Cost Accounting

particular period. The information generated by financial accounting is re-

cast to know cost of an activity, production or services rendered during that

period as also identifying areas of weaknesses and strength and suggesting

measures for improvement.

Thus, financial accounting and cost accounting are closely connected

with each other, yet both the systems of accounting have certain differences

which can be summed up as follows:

Distinctions between Financial Accounting and Cost Accounting

Point of

Distinction Financial Accounting Cost accounting

1. Coverage Financial Accounting deals Cost accounting is with

whole or entire matter of mainly connected with

organisation connected manufacturing activities.

with financial implication.

2. Cost basis It is concerned with It is not only concerned

historical records. with historical records

but also with pre-

determined cost.

3. Interested Both internal and external Only internal party, i.e.,

parties parties are interested management is

including management, interested.

shareholders, creditors,

government etc.

4. Purpose The main purpose is to The objective is to render

prepare Profit & Loss useful information on

Account and Balance Sheet. cost for guidance to

management.

5. Principles Generally Accepted No such Generally

applied Accounting Principles are Accepted Accounting

applied. Principles are applied.

6. Valuation Stocks are valued at Cost Stocks are valued at

of sock or Market Value whichever cost.

is lower.


15Cost Accounting

7. Classifica- It does not classify cost Makes clear

tion of Cost into fixed and variable cost. classification into fixed

and variable cost.

8. Department- It does not give department- It gives departmentwise

wise analysis wise analysis. For this analysis. As such

departmental accounts corrective measures can

are to be prepared. be taken.

9. Legal Financial Accounts of Cost accounts are kept

requirements companies are required voluntarily. Recently it

to be kept as per the has been made

provisions of company law. obligatory for some

manufacturing companies.

10. Results Reveals amount of profit Reveals costing profit or

earned or loss sustained, loss for the job, process

values of assets and or unit wise.

liabilities at the end of

accounting period.

CHECK YOUR PROGRESS

Q 3: Mention three differences between cost and

financial accounting.

a) ................................................................................................

................................................................................................

................................................................................................

b) ................................................................................................

................................................................................................

................................................................................................

c) ................................................................................................

................................................................................................

................................................................................................


16 Cost Accounting

1.9 LET US SUM UP

In this unit, we have learnt :

• The term cost always related with certain things or goods. It also mean

expreses to a given things.

• Costing consists of rules and priciples of ascertainment of costs of a

product or service.

• Cost account is a technique which ascertains the cost, record

expenses and prepare of statistical data.

• Cost accounting boardly covers three subject matters as

ascertainment of cost; control over costs and reporting or presentation.

• Cost accounying takes over or begins from the stage where financial

accounting ends. Financial accounting records and summaries

trasactions of financial nature affected during a particular period.

1.10 FURTHER READING

1) Cost Accounting by Manas Dutta, Pearson.

2) Cost Accounting by Nigam and Jain, PHI.

1.11 ANSWERS TO CHECK YOURPROGRESS

Ans to Q No 1: (a) ‘Cost’ is ‘‘the amount of expenditure, actual or notional,

incurred on or attributable to a given thing’’.

(a) ‘Costing’ is the process of ascertainment of cost.

(a) Cost Accounting is “the application of costing principles, methods

and techniques in the ascertainment of costs and analysis of

savings and/or expenses as compared with previous experience

or with standards”.

Ans to Q No 2: (a) To ascertain cost of product or services rendered.

(b) To enable the cost accountant to properly value the inventory.


17Cost Accounting

(c) To keep records of cost in a systematic manner.

Ans to Q No 3: (a) Financial accounting deals with whole or entire matter of

organisation connected with financial implication.

Cost accounting is mainly connected with manufacturing activities.

(b) Financial accounting is concerned with historical records. Cost

accounting is not only concerned with historical records but also

with pre-determined cost.

(c) The main purpose financial accounting is to prepare Profit and

Loss Account and Balance Sheet.

The purpose of cost accounting is to render useful information on

cost for guidance to management.

1.12 MODEL QUESTIONS

Q 1: What is Cost Accounting?

Q 2: What are the objectives of costing?

Q 3: Distinguish between costing and Cost Accounting.

Q 4: Explain the importance of Cost Accounting.

Q 5: Mention any three points of distinctions between Financial Accounting

and Cost Accounting.

Q 6: Mention any four advantages of Cost Accounting to the management.

Q 7: ‘‘Cost Accounting has become an essential tool of management’’.

Comment.

*** ***** ***


18 Cost Accounting

UNIT 2: ELEMENTS OF COST

UNIT STRUCTURE


2.2 Introduction

2.3 Classification of Cost

2.4 Elements of Cost

2.5 Meaning of Cost Unit

2.6 Meaning and Types of Cost Centre

2.7 Methods of Costing

2.8 Meaning of Cost Sheet

2.9 Advantages of Cost Sheet

2.10 Components of Cost

2.11 Preparation of Cost Sheet

2.12 Let Us Sum Up






• explain the meaning of cost

• discuss the classification of cost

• explain the various elements of costs

• describe the meaning and advantages of cost sheet

• prepare cost sheet.

2.2 INTRODUCTION

In Unit 1 we have discussed the meaning, objectives and scope of

cost accounting. Very often, the management desires to know, the detail

nature of costs incurred and costs to be incurred. The purpose to know the

cost after it is incurred and before it is incurred, might be different. It may be

to keep the cost within control or it may be used for profit planning. Many

19Cost Accounting

times, it is required to submit tenders, to give quotations, to prepare the

price lists etc. In this unit we will focus on different classes of costs and

elements of costs. We will also discuss the preparation cost sheet.

2.3 CLASSIFICATION OF COST

There are different types of costs. The list of all these costs which

are incurred is quite long. Therefore, these costs are classified on some

basis. Cost Classification is the process of grouping costs according to

their common features. Costs are to be classified in such a manner that

they are identified with cost centre or cost unit. Costs are generally classified

on the following basis.

A. On the basis of Time: (i) Historical Cost (ii) Pre-determined

Cost.

B. On the basis of Behaviour : (i) Variable Cost (ii) Fixed Cost.

C. On the basis of Controllability (i) Controllable Cost (ii) Non-

Controllable Cost.

D. On the basis of Function: (i) Manufacturing Cost, (ii) Administration

Cost, (iii) Selling and Distribution Cost, (iv) Research and Development

Cost (v) Production Cost.

E. On the basis of Elements of Cost:

(i) Direct cost (Direct Material, Direct Labour, Direct Expenses),

(ii) Indirect Cost, (Indirect Material, Indirect Labour, Indirect

Expenses),

F. Other basis: (i) Conversion Cost, (ii) Normal Cost,

(iii) Avoidable Cost, (iv) Unavoidable Cost.

A. (i) Historical Cost :

Historical Costs are past costs which are already incurred. These

are recorded costs. These costs may be already paid or an obligation

to pay in a future date as given.

Example: Salary Paid, Rent Paid, Furniture Purchased, Carriage,

Goods Purchased etc.

(ii) Pre-determined Cost :

These are estimated costs. These costs may be budgeted cost

Elements of Cost Unit 2

20 Cost Accounting

or standard cost. For planning and decision making purpose these

costs are considered.

Example: Budgeted Salary, Budgeted Rent, Standard cost of Material

per unit etc.

B. (i) Fixed Cost:

Fixed cost is that portion of the total cost which remains constant

irrespective of output up to the capacity limit. It is also called period

cost as it depends upon the passage of time. The amount of this cost

is unaffected by variations in output. These costs provide conditions

for production rather than costs of production. They are created by

contractual obligations and managerial decisions.

Examples of fixed cost: Rent of Building, insurance, salaries, cost

of fixed assets etc.

(ii) Variable Cost :

Variable costs are those costs which vary in proportion to output.

In other words, it is a cost which changes according to the changes in

output. If the output increases, variable cost also will increase. These

are generally direct costs. It is concerned with output or product.

Therefore, it is called as a ‘‘product’’ cost. If the output is doubled,

variable cost will also be doubled.

Example of Variable Cost: Direct material Cost, Direct labour Cost,

Direct expenses, Variable overheads.

(iii) Semi-variable Cost :

Semi-variable Cost is also referred to as semi-fixed or partly variable

cost. It remains constant up to a certain level and changes after point.

These costs vary in some degree with volume but not in direct or

same proportion.

Examples of Semi-variable Cost:

Repairs and maintenance of machinery, Depreciation, Supervision,

Telephone charges, Maintenance of building, etc.

C. (i) Controllable Cost:

Controllable Costs are those costs which can be influenced by

the action of manager. In formulating cost reduction measures these

are used.

Elements of CostUnit 2

21Cost Accounting

Examples of Controllable Cost: Stationery Cost, Indirect Wages,

Electricity, Telephone Expenses, Traveling expenses, etc.

(ii) Non-Controllable Cost :

It is the cost which cannot be influenced by the action of manager.

These costs are committed costs.

Examples of Controllable Cost: Salary, Rent, Bank Interest etc.

(D) (i) Manufacturing cost :

Manufacturing costs are related directly to production function. It

is the cost of operating the manufacturing process.

Examples of Manufacturing cost : Direct materials, Direct labour,

Direct expenses, and overheads relating to production.

(ii) Administration cost :

Establishment expenses are generally called Administration costs.

These are the costs which are incurred for formulating the policy,

directing the organisation and controlling the operations.

Examples of Administration cost: Office Rent, Stationery, Salary

to office staff, Office lighting etc.

(iii) Selling and distribution cost :

These are the cost which relate to sale and delivery. Distribution

cost is incurred for distribution of products.

Example of Selling & distribution cost: Commission to sales man,

After sales expenses, Advertisements, Market research, warehousing,

Packing and cartage etc.

(iv) Research and development costs :

These cost are incurred to discover new ideas, processes,

products by experiment. It includes the cost of the process which

begins with the implementation of the decision to produce a new or

improved product.

Example of Research and development costs: Salary to Scientists

and other staff engaged in research, Patent cost etc.


22 Cost Accounting

CHECK YOUR PROGRESS

Q 1: What is variable cost ?

..................................................................................

.................................................................................

Q 2: What is fixed cost ?

........................................................................................................

........................................................................................................

2.4 ELEMENTS OF COST

You have come through various types of costs. After discussing the

classification of costs, let us now focus on Elements of Cost. Elements

mean nature of items. A cost is composed of three elements: material cost,

labour cost and expenses. All these three elements of cost may be direct or

indirect. These are explained below.

Direct cost :

It is the cost which is directly chargeable to the product manufactured.

It is easily identifiable. Direct cost consists of direct material, direct labour

and direct expenses. These three elements are explained below.

Direct Material: It is the cost of basic raw material used in production

of a product. No finished product can be produced without basic raw

materials. It becomes a part of the product. This cost is easily identifiable

and chargeable to the product. For example, leather in shoe, pulp in paper,

steel in steel furniture, sugarcane for sugar etc. But it is also true that raw

material for one manufacturer may be finished product for another.

Direct Labour: This cost is known as direct wages and it is the

amount of wages paid to those workers who are engaged in the production

process for conversion of raw materials into finished goods. The amount of

wages can be easily identified and directly charged to the product.

Direct Expenses: Direct Expenses are the directly chargeable

expenses to the product. It can be easily identified with the product. For

example, rental charges paid nor payable for a special machine used for

manufacturing a product, cost of designing the product or architects fees,


23Cost Accounting

surveyors fees, octroi duty, royalty on production, etc.

Indirect Cost :

Indirect costs are those in the total costs which cannot be identified

and charged directly to the product. It has to be allocated, apportioned and

absorbed over the units manufactured on a suitable basis. It consists of the

three elements:

(a) Indirect Material: These are expenses on such materials which are

not visible in the product but are required to produce it. Examples of

indirect materials are lubricants, grease, cotton waste, stationery etc.

(b) Indirect Labour: It is the amount of wages paid to those workers who

are not engaged on the manufacturing process.

(c) Indirect Expenses: It is the amount of expenses which is not

chargeable to the product directly. It is the cost of giving service to the

production department. It includes factory expenses, administrative

expenses, selling and distribution expenses etc.

CHECK YOUR PROGRESS

Q 3: What is direct cost?

.......................................................................................

........................................................................................................

Q 4: Mention the element of indirect cost.

........................................................................................................

........................................................................................................

2.5 MEANING OF COST UNIT

Let us first discuss the concept of cost unit. According to the

terminology of ICMA (Institute of Cost & Management Accountants, London),

the cost unit is defined as “a quantitative unit of product or service in relation

to which costs are ascertained.” In very simple words, it is a unit of finished

product, service or time or combination of all these in relation to which cost

is computed and expressed.

The following are some examples of cost units usually selected by


24 Cost Accounting

different industries for calculating cost:

Name of Industries Product/Service Cost Unit

Cement Cement Per tonne

Chemical Chemical Per tonne, kg, litre,

gallon etc

Shoes Shoes Per pair of shoes

Bricks Kilns Bricks Per 1,000 bricks.

Electricity Electric energy,

power Per kilowatt.

Transport Service Per passenger km, per

tonne km.

Timber Timber Per cubic foot.

Hotels Service Per room per day.

Cotton Textile Yarn Per kg

Printing press Service Per 1,000 copies

2.6 MEANING AND TYPES OF COST CENTRE

Now you are aware about the various cost units used by different

industries. In this section we will discuss the concept of cost centre. A cost

centre, as defined by ICMA terminology is “a location, person, or item of

equipment (or group of these) in respect of which costs may be ascertained

and related to cost units.” A cost centre basically refers to a section of the

factory for which costs are accumulated and to which costs are charged. It

may be a location such as a department or a sales area, an item of equipment

such as a machine, or a person such as a machine operator or a machine

attendant etc. In order to facilitate charging of cost to cost units, it is

necessary to divide the whole organization into several sections which can

be used for accumulating cost for subsequent distribution over the cost

units. So, each such section of the organization is known as cost centres.

Cost centre helps in accumulating the cost, controlling the cost and its

subsequent allocation to cost units.

Types of Cost Centre

Let us discuss the various cost centres-

Client: Theorganization who

appoints an auditor

and pays fee for hisservice.


25Cost Accounting

• Personal Cost Centre: It consists of a person or group of persons;

costs like works manager, store keeper, sales manager etc are

analysed and accumulated.

• Impersonal Cost Centre: It is a location or item of equipment. It may

represent a sales area, show room or warehouse etc while a cost

centre relating to an item of equipment may be a machine or group of

machines etc.

• Operation Cost Centre: It consists of machines which carry out some

similar operations, e.g., machines and workers engaged in running

various machines.

• Process Cost Centre: It is a cost centre where a specific process or

continuous sequence of operation is carried out.

• Production Cost Centre: A production cost centre is one where actual

production process is carried out. The manufacturing costs are

charged to production cost centres.

• Service Cost Centre: It is a cost centre which provides service to

other cost centres. Only non manufacturing costs are charged to such

service cost centres.

In creating cost centres, the following factors should be taken into account:

• The volume of work to be performed.

• The extent of cost control that can be exercised.

• Responsibilities to be identified.

• The possibilities of using the cost centre to the cost accounting

department.

CHECK YOUR PROGRESS

Q 5: What is cost centre and cost unit?

.................................................................................................

........................................................................................................

Q 6: What is production cost centre?

........................................................................................................

........................................................................................................


26 Cost Accounting

2.7 METHODS OF COSTING

Costing refers to the technique and processes of determining cost

of goods manufactured or services rendered. The basic principles of

ascertaining costs are the same in every system of cost accounting. But

the method of analyzing and presenting the cost may vary from industry to

industry. The method of costing to be used for collecting and presenting

cost depends on the nature of production. There are actually two methods

of costing, namely Job Costing and Process Costing.

JOB COSTING: The terminology of ICMA defines job costing as

“that form of specific order costing which is applies where work is undertaken

to customers’ special requirements” The job is usually carried out in the

factory. Each job is treated as a distinct unit and all cost incurred for the job

is recorded separately.

Merits and Demerits:

The following are the merits of Job Costing:

• It records costs in a more accurate and systematic manner.

• It facilitates comparison of cost of two jobs and thereby enables the

management to ascertain the profitability of the jobs and accept only

such jobs which are more profitable.

• It facilitates preparation of cost estimates of similar jobs.

• It facilitates better cost control through comparision of actual costs

with that of the estimates.

• It facilitates easy identification and control of spoilage and defectives.

• It serves as a good basis for preparation of price quotations and

tenders.

The demerits of the Job Costing are as follows:

• It proves to be an expensive method of costing because all costs related

to the job are accumulated and ascertained separately which involves

a great deal of time, energy and money.

• The possibilities of mistakes are high as the cost of one job may be

wrongly posted to another job.

• Cost comparision may not always be possible particularly when there

occurs a drastic change in the economy.


27Cost Accounting

Applicability :

This type of costing is suitable to printers, machine tool

manufacturers and furniture manufacturers, interior decorators, advertising

firms etc.

The variants of job costing are:

BATCH COSTING: The ICMA defines it as “that form of specific

order costing which applies where similar articles are manufactured in

batches either for sale or for use within the undertaking. In most cases the

costing is similar to job costing.” In other words, it is a method of costing

where the cost of a group of product is ascertained. Costs are collected

according to batch order number and the total cost is divided by the numbers

in a batch to find out the cost of each product.

Merits and Demerits:

The following are the merits of Batch Costing:

• The burden of accounting work is considerably reduced as the batch

constitutes a group of homogeneous items.

• The variations in the costs arising under this method of costing are

smoothened as a result of averaging the costs. It means the total

costs are spread over the articles produced by a particular batch. As

such, it gives a consistent cost of production for every article produced

by a particular batch.

• It can reap the benefit of reduced cost of production arising from the

use of economic batch quantity.

• Under this method, the supervision can be made more effective and

the supervision cost can also be minimized by spreading the same

over all the units that constitute the batch. Thus, it can take care of the

problem of idle time of the supervisor as well as of the workers.

• The loss of time occurring in job costing as a result of inter-transfer of

materials and labour etc is minimized under this batch costing.

This method of costing also suffers from the following demerits:

• There arises some problems with regard to determination of an ideal

quantity or size for forming the batch.

• When quantity of goods to be produced differs from customer to


28 Cost Accounting

customer, then again it creates some problem to determine the batch

size.

• Another problem associated with this method is that if the production

of a batch is wrongly carried out either owing to use of sub-standard

materials or defective operations then the whole batch of goods will

have to be discarded which is a big loss to the producer.

Applicability :

It is usually applied in general engineering factories, biscuit factories

and pharmaceutical industries, ready made garments, electronic items like

TV and computers etc.

CONTRACT COSTING: The ICMA defines it as “that form of specific

order costing which applies where work is undertaken to the customers’

special requirements and each order is of a long duration. The work is usually

of a contractual nature. Generally, the method is similar to job costing,

although it has some distinctive features.” For each individual contract, a

separate account is kept to record the expenses incurred for executing the

contract. The method is applicable in construction works, construction

industries engaged in roads, building and bridges construction etc.

PROCESS COSTING:

Process Costing is used where production moves from one process

or department to the next until its final completion and there is a continuous

mass production of identical units through a series of processing operations.

According to Kohler’s Dictionary for Accountants, process costing is “a

method of cost accounting whereby costs are charged to processes or

operations and averaged over the units produced.” ICMA defines process

costing as “that form of operation costing which applies where standardized

goods are produced.”

Characteristics or features of Process Costing:

The following are the characteristics of features of Process Costing:

• The factory is divided into various process or departments which

perform a certain limited operation. Each process or department is

known as cost centre.

• The finished products are uniform in all respects such as size, shape,


29Cost Accounting

quality, colour and chemical content etc.

• The output of one process goes to constitute input of subsequent

processes until finished product emerges therefrom.

• It is not possible to distinguish finish products while they are in the

stage of processing.

• The cost of production of one process transferred to subsequent

processes.

• It is quite common to incur normal loss and wastages. There may

occur some extra loss in addition to the normal loss owing to some

abnormal reasons.

• Production of the main output is sometimes accompanied by some

secondary output. It is called ‘joint product’ if the secondary output is

also of equal value. It is known as by-product if it is of small economic

value.

• The semi finished products (work-in-progress) are expressed in terms

of completed units. It is technically called ‘equivalent units’.

• The cost of production is ascertained at each stage of production

process and finally after completion of the final products.

• Production process is predetermined and a definite sequence of

production is followed. The raw materials and work-in-progress flow

from one process to another according to the sequence of production.

• The process itself constitutes the cost unit for the purpose of costing.

• Production is undertaken on a continuous basis and on a large scale

in anticipation of demands.

Merits and Demerits of Process Costing:

The following are some of the important merits of Process Costing:

• The cost of process as well as finished products can be computed

conveniently at short intervals.

• Control over costs and production can be gainfully reaped as

predetermined and actual data are available for comparision for each

of the processes.

• It involves lesser amount of time, energy and money because of

simplicity of this method of costing.


30 Cost Accounting

• The average cost of homogeneous products can be easily computed.

• Expenses can be allocated to different processes on some rational or

equitable basis and therefore there is no difficulty in calculating the

accurate cost.

• It enables correct valuation of the closing inventories.

This method of costing is not free from some demerits. The following are

some of the demerits of Process costing:

• The cost ascertained at the end of the process is called historical

costing which is of little use for managerial control. Since it is based

on historical costs, it naturally has all the weaknesses of historical

costing.

• The system of costing conceals weaknesses and inefficiencies in

processing.

• It does not evaluate the efforts put in by the individual workers and

supervisors.

• The valuation of work-in-progress on the basis of degree of completion

is merely a guess work or estimation.

• If production is not homogeneous, then the average cost may give a

misleading picture of cost.

Applicability:

The Process costing is applied in the following industries:

• Manufacturing industries such as iron and steel, cement, paper, rubber,

ceramics, automobile plants and paint industries.

• Chemical industries such as perfumery, soap, oil and medicines etc.

• Mining industries such as mineral oil, coal, gold, iron, zinc and gas

etc.

• Public utility industries such as generation and distribution of electricity,

gas supply and water supply etc.

CHECK YOUR PROGRESS

Q 7: Name the different methods of costing.

...................................................................................

................................................................................................


31Cost Accounting

Q 8: What is job costing?

........................................................................................................

........................................................................................................

Q 9: State any two features of process costing.

........................................................................................................

........................................................................................................

2.8 MEANING OF COST SHEET

In this section we will discuss the meaning of cost sheet. Cost

sheet is a statement of costs where the details of cost incurred for producing

a particular level of output and cost per unit within a certain period is listed.

In this statement both quantity and amount are shown for each element of

cost. This statement is prepared before the actual production as well as

after the production. It shows the elements of cost which helps in the

determination of total cost. Cost sheet is a statement which provides for the

assembly of the detailed cost of a cost centre or cost unit. It is a statement

showing the details of the total cost of job, operation or order. It brings out

the composition of total cost in a logical order, under proper classifications

and sub-divisions. The period covered by the cost sheet may be a week, a

month or so. Separate columns are provided to show the total cost and

cost per unit. In case of multiple products a separate cost sheet may be

prepared for each product. Alternatively, separate columns of total cost and

unit cost may be provided for each product in the same cost sheet. A cost

sheet is prepared under output or unit costing method.

2.9 ADVANTAGES OF COST SHEET

Let us discuss the advantages of cost sheet.

The following are the purposes and advantages of cost sheet:

• The purpose of cost sheet is to provide detail cost information to the

management. The management generally wants to know the break

up of total cost under different elements. Cost sheet serves this

purpose.


32 Cost Accounting

• It reflects total cost as well as cost per unit.

• It helps in comparison with previous years as well as with the cost of

similar product of other companies.

• It facilitates preparation of tenders or quotations.

• It enables the management to fix up selling price.

• It provides the basis for cost control and reduction.

CHECK YOUR PROGRESS

Q 10: What is cost sheet?

....................................................................................

........................................................................................................

Q 11: Mention the advantages of cost sheet.

........................................................................................................

........................................................................................................

2.10 COMPONENTS OF COST

Total Cost = Prime Cost + Factory Overheads + Administrative

Overheads + Selling & distribution Overheads.

(i) Prime Cost = Direct Materials + Direct Wages + Direct Expenses.

(ii) Prime Cost + Factory Overheads = Works Cost or Factory Cost.

(iii) Works Cost + Administrative Overheads Cost of Production or

Office Cost

In some cases Works Cost or Factory Cost is termed as Cost of

Production

(iv) Cost of Production + Selling & distribution Overheads = Total Cost

Cost of Production (proportionate to number of units sold)

+ Selling & distribution Overheads = Cost of Sales

Cost of Sales + Profit (- Loss) = Selling Price

Compone nts of Direct Materials Cost:

Opening Stock of Materials + Purchases + Carriage Inwards +

Custom Duty and Octroi + Dock Charges + Freight Inward

Materials Consumed = Opening Stock of Materials + Purchases – closing

Stock of Materials


33Cost Accounting

Components of Factory Overheads:

(i) Factory Rent,

(ii) Rate, Insurances;

(iii) Factory Lighting

(iv) Factory Supervision

(v) Power

(vi) Fuel & Oil, Grease, Water etc

(vii) Laboratory Expenses

(viii) Depreciation of Plant & Machinery

(ix) Depreciation of Factory Building

(x) Repairs & Maintenance of Factory

(xi) Indirect Wages

(xii) Materials Handling Charges

(xiii) Technical Director’s Fees

(xiv) Factory Stationary

(xv) Salary of Works Manager, Supervisor’s, Works Clerical Staff

Composition of Office and Administrations Overheads

(i) Office Rent Rate & Taxes

(ii) Staff Salaries

(iii) Office Lighting

(iv) Office Cleaning

(v) Printing & Stationery

(vi) Postage & Telegram

(vii) Office Conveyance

(viii) Depreciation of Office Building & Furniture

(ix) Office Equipments

(x) Office Repairs

(xi) Sundry Expenses

(xii) General Expenses

(xiii) Legal Expenses

ILLUSTRATION : 1

From the following particulars of a manufacturing firm,

prepare a statement showing


34 Cost Accounting

a) Cost of materials used;

b) Works cost;

c) Cost of production;

d) Percentage of works overhead to productive wages;

e) Percentage of general overhead to works cost. :

Stock of materials

Opening 40,000

Closing 1,40,000

Purchased of Raw Materials 11,00,000

Stock of Finished Goods : opening 50,000

Closing 60,000

Finished Goods sold 24,00,000

Direct Wages 5,00,000

Works Overhead Charges 1,50,000

Office & General Expenses 1,00,000

Solution :

Cost Sheet

Product Code: ………….

Level of Production: ………..; Month…………… ; Year……………..

Opening Stock of materials 40,000

Purchase of Raw Materials 11,00,000

Total 11,40,000

Less, Closing Stock of materials 1,40,000

Materials consumed 10,00,000

Add, Direct Wages 5,00,000

Prime Cost (I) 15,00,000

Add, Works Overhead Charges 1,50,000

Works Cost (II) 16,50,000

Add, Office and General Expenses1,00,000

Cost of Production (III) 17,50,000

Add, opening Stock of Finished Goods 50,000

Value of goods available for sale 18,00,000

Less, closing Stock of Finished Goods 60,000

Cost of Goods Sold (IV)(Cost of Sal es or Selling Cost) 17,40,000


35Cost Accounting

Sales: (V) 24,00,000

Profit (V – IV) 6,60,000

Calculations of relevant Percentages :

Note:

(i) Percentage of Works Overhead Charges is calculated on Direct

Wages;

(ii) Percentage of General Overhead is calculated on Works Cost

(iii) Cost of Sales is calculated on Sales.

(iv) Profit is calculated on Sales.

1. Percentage of Works Overhead Charges

to Productive Wages

30%1005,00,0001,50,000 =×=

2. Percentage of General Overhead

to Works Cost

06%610016,50,0001,00,000

.=×=

3. Percentage of Cost of Sales to Sales

72.5%10024,00,00017,40,000 =×=

4. Percentage of Profit to Sales

.5%210024,00,0006,60,000

7=×=

2.11 PREPARATION OF COST SHEET

Cost sheet is defined by CIMA, U.K. as “a document which provides

for the assembly of the detailed cost of a cost centre or cost unit.” Thus

cost sheet is a periodical statement of cost designed to show in detail the

various elements of cost of goods produced like prime cost, factory cost of

production and total cost. It is prepared at regular intervals, e.g., weekly,

monthly, quarterly, yearly, etc. Comparative figures of the previous period

may also be shown in the cost sheet so that assessment can be made

about the progress of the business. In a typical cost sheet, cost information


36 Cost Accounting

are presented on the basis of functional classification:

(a) Direct Material Cost

(b) Direct Labour Cost

(c) Direct Expenses

(d) Production/Manufacturing Overheads

(e) Administration Overheads

(f) Selling Overheads

(g) Distribution Overheads

Specimen Cost Sheet

ILLUSTRATION: 2

Prepare a cost sheet of the following information:

Number of Units manufactured during the month 1,000

Rs.

Direct materials consumed 20,000

Direct labour 8,000

Period From..........................

To.........................................

Cost Units

................

Sl.

No.

Cost Items Amount(Rs) Amount(Rs)

1. Direct Materials Consumed:

Opening Stock of Raw Materials

Add: Purchases

Add: Incidental charges

Less: Closing Stock of Raw Materials

xxxxx

xxxxx

xxxxx

(xxxxx)

xxxxx

2 Direct Labour xxxxx

3 Direct Expenses xxxxx

4 PRIME COST (1+2+3) xxxxx

5

6

7

Add: Production/Factory Overheads

Add: Opening work in process

Less: Closing work in process

xxxxx

xxxxx

(xxxxx)

xxxxx

8 FACTORY COST OR WORKS COST (4+5+6-7) xxxxx

9 Add: Administrative Overheads xxxxx

10 COST OF GOODS MANUFACTURED (8+9) xxxxx

11

12

Add: Opening Finished goods stock

Less: Closing Finished goods stock

xxxxx

xxxxx

xxxxx

13 COST OF FINISHED GOODS SOLD (10+11-12) xxxxx

14 Add: Selling & Distribution overheads xxxxx

15 COST OF SALES (13+14) xxxxx


37Cost Accounting

Indirect labour (in factory) 2,500

Supervision costs (in factory) 1,000

Factory premises rent 1,600

Factory lighting 600

Oil for machines 100

Depreciation of machines 500

Office overheads 8,000

Office salaries 2,000

Misc. office expenses 1,000

Selling and distribution overheads 6,000

Note: A profit margin of 25% on the total cost of goods is expected on the

sale.

Solution:

Cost Sheet (for the period.......)

Particulars Total for

1,000

units(Rs)

Per

unit(Rs)

Direct materials consumed 20,000

Direct labour 8,000

Prime Cost

Works/Factory Overheads:

Indirect Labour 2,500

Supervision costs 1,000

Factory Rent 1,600

Factory lighting 600

Oil for machines 100


Works Cost

Office and Admin. Overheads:

Office overheads 8,000


Misc. Expenses 1,000

Cost of Production

Selling and Distribution Overheads:

Total cost

Profit 25% of Total Cost

Sales

28,000

6,300

28,000

6.30

34,300

11,000

34.30

11.00

45,300

6,000

51,300

12,825

38,475

45.30

6.00

51.30

12.82

38.48


38 Cost Accounting

2.12 LET US SUM UP

In this unit we have discussed the following aspects-

l Classification of cost means grouping of costs on the basis of their

common features.

l The various bases for classification of cost are- time, behaviour,

controllability, function, elements of cost etc.

l The elements of direct cost are direct material, direct labour and direct

expenses.

l The elements of indirect cost are indirect material, indirect labour and

indirect expenses.

l Cost sheet shows the cost incurred for producing a particular level

output. It provides detailed information about the costs incurred.

l Cost sheet helps the management in controlling the cost.





Ans to Q No 1: Those costs which vary according to output are called

variable cost. If the output increases, variable cost will also increase

and vice-versa. Examples of variable cost are direct material cost,

direct labour cost etc.

Ans to Q No 2: Fixed cost is that pertion of the total cost which remains

constant irrespective of output to the capacity limit. This cost is not

affected by variation in output.


39Cost Accounting

Ans to Q No 3: Direct costs are directly charged to the product manufactured.

It consists of the costs of direct materials, direct labour and direct

expenses.

Ans to Q No 4: Indirect material, indirect labour and indirect expenses.

Ans to Q No 5: A cost centre basically refers to a section of the factory for

which costs are accumulated and to which costs are charged.

A cost unit is defined as “a quantitative unit of product or service in

relation to which costs are ascertained.

Ans to Q No 6: A production cost centre is one where actual production

process is carried out. The manufecturing costs are charged to

production cost centre.

Ans to Q No 7: Broadly there are two methods of costing, namely job costing

and process costing. The variants of job costing are specific order

costing, batch costing and contract costing.

Ans to Q No 8: It is that form of specific order costing which is applies

where work is undertaken to customers’ special requirements.

Ans to Q No 9: (i) The factory is divided into various process or departments

which perform a certain limited operation. Each process or department

is known as cost centre.

(ii) The finished products are uniform, size, quality etc.

Ans to Q No 10: Cost sheet is a statement of costs where the details of

cost incurred for producing a particular level of output and cost per

unit within a certain period is listed. It brings out the composition of

total cost in a logical order, under proper classifications and sub-

divisions. The period covered by the cost sheet may be a week, a

month or so.

Ans to Q No 1 1: i) It reflects total cost as well as cost per unit.

ii) It helps in comparison with previous years as well as with the cost

of similar product of other companies


40 Cost Accounting


Q 1: Discuss the various classification of cost.

Q 2: Discuss the elements of indirect cost.

Q 3: What is cost sheet? Sate two advantages of cost sheet.

Q 4: Write short note-

a) Fixed cost

b) Controllable cost.

c) Administration cost.

*** ***** ***


41Cost Accounting

UNIT 3: MATERIAL CONTROL

UNIT STRUCTURE


3.2 Introduction

3.3 Meaning of Material

3.4 Meaning and Objective of Material Control

3.5 Essentials of a Sound Material Control Procedure

3.6 Functions of Material Control

3.7 Techniques of Material Control

3.8 Let Us Sum Up

3.9 Further Reading





• explain the meaning of Material

• explain the meaning of Material control

• describe the Qualitative and Quantitative techniques of Material

control.

3.2 INTRODUCTION

You are aware that to produce something, materials are required. In

other words, the first requirement in production process of an item is

material. Materials are an essential element of cost. In most cases cost of

materials constitutes significant portion of total cost. The entire process of

manufacture would be disrupted or even stopped if right type of material is

not available in the right quantity at right time. If this function is not performed

properly the entire production process would be affected and other resources

like men and machine would remain idle. Material Control function is aimed

to ensure smooth production process. Moreover, the Costing Department

42 Cost Accounting

has an important function to discharge in the context of materials. This

function relates to the following:

a) Pricing the Receipts of materials and

b) Pricing the Issues of materials.

These two are important functions because the selling price is to be

fixed for the finished product on the basis of prices of materials and therefore,

the profit is influenced by the material prices. For this reason the quantity

has to be valued or priced properly.

3.3 MEANING OF MATERIAL

Material is the basic element of a production function. The principal

material used for manufacturing a product is called raw material. It becomes

a part of the product. No finished product can be manufactured without raw

materials. It is easily identifiable and chargeable to the product. For example,

steel in steel furniture production, sugarcane for sugar production, wheat in

bread production are the basic raw materials.

What is raw material for one manufacturer may be finished product

for another. In costing, the principal material used for manufacturing is called

‘Direct material’ . It generally includes the following:

1. All materials specially purchased for production or the process.

2. All components purchased for production or the process.

3. Material transferred from one cost centre to another or one process to

another.

4. Primary packing materials, wrappings, cardboard boxes etc.,

necessary for preservation or protection of product.

Examples of Direct Materials are wood for wooden furniture,

limestone for cement, bamboo or soft wood for paper etc.

Other materials used for manufacturing are called Indirect

Materials. Examples of Indirect Materials are lubricant, cotton, brush, wash

cloth etc.

Material ControlUnit 3

43Cost Accounting

CHECK YOUR PROGRESS

Q 1: Give examples of (a) Direct Materials and

(b) Indirect Materials.

(a) ........................................................................................................

........................................................................................................

........................................................................................................

(b) ........................................................................................................

........................................................................................................

........................................................................................................

3.4 MEANING AND OBJECTIVE OF MA TERIALCONTROL

Let us now focus on another important aspect of material. It is

material control. Material control is a function which can be termed as

systematic control over purchasing, storing and using material in a

manufacturing organisation. Thus, material control is the art and science of

maintaining the material level of a given group of items, incurring the least

total cost, consistent with other relevant targets and objectives set by the

management.

The objective of material control is to maintain a regular supply of

materials as and when they are needed and avoiding at the same time

excessive holding of stock of materials.

This function is steered to ensure that right type of material is made

available in right quantity at right time for production and other activities of

the organisation. Since materials constitute a significant percentage of

working capital, it must be regulated in the right direction so that costs can

be minimised to maintain a reasonable rate of profit. To perform this function,

it is essential that some material must be held in balance to be used without

delay. The holding of such material as stock also involves blocking of funds

and also other risks of loss or damage or obsolescence. Material Control

aims to minimise this risk also.

Material Control Unit 3

44 Cost Accounting

3.5 ESSENTIALS OF A SOUND MATERIAL CONTROLPROCEDURE

To establish a sound material control system certain conditions

should be ensured in the organisation. Some of these conditions are given

below.

i) Centralised purchasing organisation under authority of competent

person,

ii) Co-ordination between related departments particularly production,

purchase, inspection, stores and accounts,

iii) Proper storage of all materials,

iv) There should be effective system of internal check,

v) There should be use of standard printed forms for requisitions, order

placing, goods receipt, inspection report, and issue for consumption

and stock records.

CHECK YOUR PROGRESS

Q 2: What is material control ?

...................................................................................

........................................................................................................

Q 3: What is the objective of material control ?

........................................................................................................

........................................................................................................

3.6 FUNCTIONS OF MATERIAL CONTROL

The following are the functions of material control-

a) Purchasing of Materials

b) Receiving and Inspection

c) Storing of Materials

d) Issue of Materials

e) Inventory Control

f) Inventory Records

g) Accounting of Materials.


45Cost Accounting

a) Decision to purchase is very crucial. Every material, stores, spares,

components required by the various departments are required to be

bought. The purchasing department considers the following before it

proceeds to purchase.

a) Purchase Budget and

b) Indent or Requisition of materials from consuming or using

department.

A purchase indent or requisition is the formal request to purchasing

department to purchase certain type of material . It gives full information

about:

i) Description of materials

ii) Quantity and

iii) Time when same will be required.

It is prepared by consuming department and sent to Stores

Department and Purchase Department.

The Purchase Department then initiates steps to obtain material.

b) Purchase organisation has additional responsibility of receiving and

inspection of materials purchased. This function tries to ensure whether

material of right quality as required is actually received or not. Purchase

function includes Receiving, Inspecting and Quality Control of materials

received from suppliers. The Receiving officer shall inspect and verify

the supply challan with the copy of Purchase Order. Normally when

the materials are delivered by the supplier, the same is accompanied

by a Delivery Challan. To ensure that the right type of material is

received, materials are subject to inspection.

c) Storing of Materials: This involves physical safety of material as

well as maintaining stores record. After the material is received it is

essential that it is stored safely so that the damage due to handling,

temperature or theft or deterioration is minimised and at the same

time it is made available as and when required for consumption.

Storekeeping is a service function. Store-keeping is that aspect of

material control, which is concerned, with the physical storage of


46 Cost Accounting

goods. The storekeeper should consider peculiar quality or property

of material and store it accordingly.

d) Issue of Material: This function ensures that right type of material is

made available and issued to consuming or production department.

e) Inventory Control : With a view to maintain quality of material held

as stock at such a level that same is neither too excessive nor too

less than required and to minimise risk involved in holding stocks.

f) Inventory Records: Keeping stock records of various types of

materials by maintaining records of receipt and issue of materials and

stock in terms of quantity and value.

g) Accounting of Materials: Primarily above functions can be divided

into three divisions:

i) Purchasing

ii) Storing, and

iii) Accounting

CHECK YOUR PROGRESS

Q 4: State the functions of material control.

..................................................................................

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

3.7 TECHNIQUES OF MATERIAL CONTROL

Material control techniques can be grouped into two categories:

(i) Qualitative techniques and (ii) Quantitative techniques. These are

briefly explained below.

(i) Qualitative techniques:

In qualitative techniques the following are generally applied depending

upon the degree of control required.


47Cost Accounting

(a) A.B.C. Analysis:

This is also known as, ‘’Always Better Control Analysis’’ technique. It

enables the management to decide the degree of control necessary and is

based on ‘’management by exception’’ principle.

The technique is based on the study of the quantity and value of

different types of materials. In many cases it is found that out of various

materials used by an organisation, there are items, which are used in low

quantity but are of high value. At the same time there are materials which

are used in large quantity but having low value. There for control purpose

the materials are classified as under:

A. Items are low quantity with high value.

B. Items are medium quality and value.

C. Items are high quantity with small value.

The exact quantification of high / low classification depends on

comparative value and differs from organisation to organisation and also

from time to time.

The technique requires that:

‘A’ group items should be closely controlled at all stages of material

handling. The procedure should be elaborate and subject to surprise

verification.

‘B’ group items also need elaborate control but the extent and

frequency may be less.

‘C’ group items in view of lower value are not subjected to detailed

control procedures. The procedure may be made simpler.

Thus, time, attention and cost involved in material control is divided

equitably on terms of value. In the times of changing prices, the analysis of

materials in A, B, C groups should be reviewed periodically. The technique

is aimed at obtaining maximum control over stock/ material and minimum

cost of control.

(b) V-E-D Classification :

A-B-C Classification is on the basis of consumption value of an item

and does not give any importance to the criticality of the item and therefore,

only A-B-C Classification is not adequate. Classification done on the basis


48 Cost Accounting

of criticality of the item is known as V -E-D, where the items are classified

as Vital, Essential and Desirable. Vital items are those items which are very

critical for the operations and do not permit any corrective time i.e. they

cannot be procured off the shelf if they are not available. Essential items are

comparatively less vital and work without them cannot be managed for few

days. All remaining items are known as Desirable items.

(c) HML Analysis:

In this technique materials are classified on the basis of cost or

value. Materials which are of the highest value are classified as ‘H’ Items,

materials which are of the madium value are classified as ‘M’ Items and

materials which are of the low value are classified as ‘L’ Items, and

accordingly control over the materials is exercised.

(d) F – S – N Analysis:

In this technique materials are classified on the basis of movement

or frequency of use. Materials which are frequently used are FAST moving

items, Materials which are frequently used are FAST moving items, materials

which are not used frequently are SLOW moving items, and materials which

are rarely used are NON moving items, and accordingly control over the

materials is exercised.

(e) S – D – E Analysis:

In this technique materials are classified on the basis of availability.

Materials which are scarce are S category items moving items, Materials

which are difficult to procure are D category items and Materials which are

easily available are E category items and accordingly control over the

materials is exercised.

(ii) Quantitative techniques

Now we shall discuss some important material control techniques

which are of quantitative in nature. These are (a) Stock Level, (b) Economic

Order Quantity, (c) Stores Ledger and Bin Card

(1) Stock Level:

This technique is applied to fix stock levels in terms of quantity to

ensure proper control so as to ensure that optimum quantity of materials is

bought and stored. It also answers question when to buy? and assists the


49Cost Accounting

management to budget and prepare time schedule of purchases. The

technique requires fixation of stock level in respect of every type of material.

The different limits fixed are:

a) Maximum Level: This level indicates maximum quantity of stock

to be held at any time. The quantity of stock should not exceed

the level. This is to minimise stock holding costs.

b) Minimum Level : This level indicates minimum quantity of stock

to be held at any time. This is to avoid risk of dislocation of

production process.

c) Re-Order Level: This level indicates the time to place order for

material. It gives signifies the action point for procuring the

material. This level is between the minimum and maximum levels.

The object of this level is to indicate the time to place order so

that stock is not reduced to a level less than the minimum level.

d) Danger Level: It indicates the level of stock when the normal

issue should be stopped. It indicates the need of urgent attention

and emergency steps to replenish stock by procuring materials.

The quantity of this level is between minimum and nil stock level.

The stock levels are fixed on some non-cost factors. These are:

Capital involvement, Storage space, Storage loss, Carrying Cost, Availability

of materials, Rate of consumption of material, Lead time or Time lag, and

Price advantages.

(2) Economic Order Quantity:

The economic order or re-order quantity is the predetermined fixed

quantity of materials to be purchased to minimise the total cost involved in

the purchase and storage of the materials. This technique helps to determine

how much to buy. There are different inventory models to determine how

much to buy. Different models take different costs into account. One of the

popular models developed is Economic Order Quantity (EOQ) model .

This model assumes that price of the material remains constant

with time and also does not vary with order quantity. This model can be

developed mathematically by differentiating total cost of inventory (ordering

cost + inventory carrying cost) with respect to quantity.


50 Cost Accounting

The formula to calculate EOQ is given below:

C

2ASEOQ =

Where,

A = Annual usage in units,

S = Ordering Cost,

C = Annual Carrying Cost per unit.

Example:

From the following information calculate the most economical quantity

of material to be purchased.

Annual requirement: 6,000 units

Cost per unit: Rs. 2.50

Ordering cost per order: Rs. 15

Carrying cost is 20% of the cost per unit

The most economical quantity of material to be purchased is EOQ

C

2ASEOQ =

Where,

A = Annual usage in units = 6000 units

S = Ordering Cost = Rs. 15 per order

C = Annual Carrying Cost per unit. = 20% of Rs. 2.50 = Re. 0.50

0.50156,0002 ××=∴ EOQ

= 600 units

The purchase and storing function involve certain costs. When stock

is increased, number of purchases can be reduced. Thus, cost of storing

(carrying) would increase but cost of placing order would decrease and

likewise in opposite direction. The economic order quantity strikes a balance

between the two with an objective to minimise total cost.

To determine the EOQ the following essential information is required:

• Cost of placing an Order: This is the aggregate cost of purchase,

and receiving function spread over number of likely orders. This is

expressed as cost per order.


51Cost Accounting

• Cost of carrying stock: This takes into account the cost of storage,

handling, insurance cost spread over quantity or value of material.

• Consumption during period: This gives the information about total

consumption in terms of units.

CHECK YOUR PROGRESS

Q 5: Mention any three qualitative techniques of

material control.

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

3.8 LET US SUM UP

In this unit we have discussed the following-

• The principal material used in production of a product is called raw-

material.

• The principal material used for manufacturing is called direct material.

• The material which facilitates the production process is called indirect

material.

• Material control refers to a systematic procedure of purchasing, storing

and using materials in a manufacturing concern.

• Efficient material control helps the company to run the production

process smoothly and relives the company of holding excessive stock

of materials.

• The techniques of material control are broadly divided into qualitative

and quantity techniques.


52 Cost Accounting

3.9 FURTHER READING

1) Cost Accounting by Jain S P & Narang K.L

2) Cost Accounting by Nigam & Sarma

3) Cost Accounting by Manash Dutta


Ans to Q No 1: (a) Examples of Direct Materials are wood for wooden

furniture, limestone for cement, bamboo or soft wood for paper etc.

(b) Examples of Indirect Materials are lubricant, cotton, brush, wash

cloth etc.

Ans to Q No 2: Material control is a function which can be termed as

systematic control over purchasing, storing and using material in a

manufacturing organisation.

Ans to Q No 3: The objective of material control is to maintain a regular

supply of materials as and when they are needed and avoiding at the

same time excessive holding of stock of materials.

Ans to Q No 4: The functions of material control-

• Purchasing of Materials

• Receiving and Inspection

• Storing of Materials

• Issue of Materials

• Inventory Control

• Inventory Records

• Accounting of Materials

Ans to Q No 5: Three qualitative techniques of material control are:

(i) ABC Analysis

(ii) VED Analysis

(iii) FSN Analysis


53Cost Accounting


Q 1: Mention the functions of Purchase Organisation.

Q 2: What are the considerations that guide the quantity of materials to be

purchased?

Q 3: Explain the meaning and objective of material control.

Q 4: Describe any two quantitative techniques of material control.

*** ***** ***


54 Cost Accounting

UNIT 4 : MATERIAL PURCHASE AND STOREKEEPING

UNIT STRUCTURE


4.2 Introduction

4.3 Purchase of Materials

4.4 Purchase Requisition

4.5 Purchase Order

4.6 Receiving and Inspecting of Materials

4.7 Material Storage and Store-Keeping

4.8 Store Records

4.9 Perpetual Inventory System

4.10 Just-in-Time(JIT) Purchases

4.11 Let Us Sum Up





After going through this unit, you will be able to

• describe the steps followed in Purchase of Materials

• explain the process of material storage and store-keeping

• discuss the various records maintained in storage of inventories

• discuss the method and process of preparing stores ledger

• discuss the concept Perpetual Inventory System and JIT purchases.

4.2 INTRODUCTION

For any industry where raw material is used in production and

manufacturing of goods and services, purchase of these materials has

bearing on all vital factors of manufacture such as quantity, quality, cost,

efficiency, economy, prompt delivery, volume of production and so on.

55Cost Accounting

Purchasing is the first step of material handling. Purchasing is an important

function and shall be performed carefully. Wrong purchases increase the

cost of materials, stores equipments and the finished goods. The quality of

the finished goods is largely dependent upon the purchase function. Hence,

it is essential to see that the function of purchase is performed effectively,

efficiently and economically. According to Alfora and Beatty, “Purchasing is

the procuring of materials, supplies, machines, tools and services required

for the equipment, maintenance and operation of a manufacturing plant’’.

Once the material is received, it is the responsibility of the store-

keeper, to ensure that material movements in and out of stores are done

only against the authorized documents. Stores-keeper is responsible for

proper utilization of storage space & exercise better control over the material

in the stores to ensure that the material is well protected against all losses

such as theft, pilferage, fire, misappropriation etc.

In this unit, we shall focus on the various aspects of material purchase

and store keeping relevant from the point of view of material control and

pricing.

4.3 PURCHASE OF MATERIALS

Expect a few manufacturing industries like steel, iron, cement, oil

and natural gas etc. which have its own source of raw materials, majority of

the manufacturing industries have to purchase raw materials. As such,

purchase of materials has been an important function for a manufacturing

organization. Until and unless the company is able to ensure a steady and

timely flow of required quantity of desired quality of raw materials at a

reasonable price, the company may not function smoothly. The following

steps are generally followed by purchase department in a big manufacturing

company :

a) Receiving requisition from various departments

b) Indenting for materials

c) Finalising the quantity of each item to be purchased

d) Issue of Tenders

Material Purchase and Store Keeping Unit 4

56 Cost Accounting

e) Receiving quotations.

f) Selection of supplier and Placing of order.

g) Receiving the stores thereof

h) Inspection regarding quantity and quality.

i) Acceptance of Inspected Materials.

j) Checking and passing the invoice for payment.

4.4 PURCHASE REQUISITION

According to ICMAI, New Delhi, “Purchases Requisition is a

document issued to the Purchase Department to procure materials of given

description and of the required quality and quantity within a specified period”.

It is a formal request and it authorizes the Purchase Department to issue a

Purchase Order to secure materials intended for periodic requirements of

a given material or materials to provide guidance to the Purchase

Department to estimate the future requirements in order to secure maximum

purchase benefits in the form of higher discount and better credit terms.

The extent and range of materials requirements provide a basis for

preparation of a purchase budget. The actual requirements of a given period

can be summarised from the purchases requisition and compared with the

purchase budget in order to determine the variances and the reasons thereof.

This form is filled by storekeeper for regular items and by the departmental

head for special materials not stocked as regular items.

The Purchase Requisition is prepared in three copies. Original will be sent

to Purchase department, Duplicate copy will be retained by the indenting

(request initiating) department and the triplicate will be sent to approver for

approving the purchase requisition.

Purchase Requisition provides the three basic things :-

(a) What type of material is to be purchased?

(b) When to be purchased?

(c) How much is to be purchased?

The specimen form of Purchase Requisition is as shown below :

Material Purchase and Store KeepingUnit 4

57Cost Accounting

4.5 PURCHASE ORDER

Purchase Order (PO) is a request made in writing to selected

supplier to deliver goods of requisite quality, quantity, (as per the purchase

requisition) at the prices, terms and conditions agreed upon. It is a

commitment on the part of the purchaser to accept the delivery of goods

contained in the Purchase Order if the terms included therein, are fulfilled.

Purchase Order contains the following details :-

(a) Purchase Order No; (b) PO Date; (c) Supplier Name and Address;

(d) Material Code; (e) Material description; (f) Grade & Other particulars of

the material; (g) Quantity to be supplied; (h) Price; (i) Place of delivery; (j)

Taxes; (k) Terms of Payment (Credit period) .....etc

Usually a purchase order is made in five copies, one each for

suppliers, Receiving/Stores Department, Originating Department, Accounts

Department and filing. Thus we see that all the departments concerned

with the materials are informed fully about all the details of every purchases

and it becomes easier for everyone to follow up on any relevant matter.

ABC Ltd Purchase Requisition or Indent Purchase Req Type: Special /Regular: Purchase Req No : Purchase Requisition Date : Department : S. No.

Material Code

Description of the Goods

Quantity Required

Material Required by date

Remarks

Requested by Approved by For use in Purchase Dept. Quotations from (1) PO Placed : Yes /No (2) PO No: (3)


58 Cost Accounting

CHECK YOUR PROGRESS

Q 1: Define the terms: (a) Purchase Requisition

and (b) Purchase Order

(a) .....................................................................................................

(b) .......................................................................................................

4.6 RECEIVING AND INSPECTING OF MATERIALS

Once the purchase order is executed, necessary arrangement is

made to receive the delivery of materials. The stores department will receive

the material after the gate entry. It will compare the quantities received with

the Purchase Order. It is a valuable document as it forms the basis of

accounting entry in the stores ledger and stock records. It is the document

basis for quality control department to carry inspection of the material in

warded. It also forms the basis of payments to be made to the supplier in

respect of the materials supplied by him. Suppliers invoices are checked

with goods received notes which such for actual receipt of the goods supplied

by the supplier. One copy of such note is also sent to Inspection Department

who after inspection of materials approves the note for Stores Department

to receive the materials. If some materials are not found in good condition

or are not in conformity with the purchase order are returned back to the

vendor along with a Material Returned Note.

4.7 MATERIAL STORAGE AND STORE-KEEPING

As soon as the material is received, it is the responsibility of the

store-keeper to ensure that material movements in and out of stores are

done only against the authorized documents. Further, proper storage of

such materials is also very important. Apart from the preservation of quality,

the store-keeper also ensure safe custody of the material. It should be the

function of the store-keeper that the right quantity of materials always should

be available in stock.

Duties of store keeper:


59Cost Accounting

The duties of store-keeper are as follows :-

(a) To exercise general control over all activities in stores department.

(b) To ensure safe storage of the materials.

(c) To maintain proper records.

(d) To initiate purchase requisitions for the replacement of stock of all

regular materials, whenever the stock level of any item in the store

reaches the Minimum Level.

(e) To initiate the action for stoppage of further purchasing when the stock

level approaches the Maximum Level.

(f) To issue materials only in required quantities against authorized

requisition documents.

(g) To check and receive purchased materials forwarded by the receiving

department and to arrange for storage in appropriate places.

4.8 STORE RECORDS

The store-keeper is required to maintain certain records of its

inventory. These records of stores are usually maintained in following forms:

Bin Card: Bin Card is a quantitative record of receipts, issues and

closing balance of items of stores. It is maintained by stores department.

Separate bin cards are maintained for each item and are placed in shelves

or bins. This card is debited with the quantity of stores received, credited

with the quantity of stores issued and the balance of quantity of store is

taken after every receipt or issue. The balance quantity of the item may be

easily known at any time. To have an up to date balance of stores, the principle

of ‘before touching the item, bin card should be touched’. For each item of

stores, Material Code, Minimum Quantity, Maximum Quantity, Ordering

Quantity, Balance Quantities are stated on the bin card. Bin card is also

known as ‘Bintag’ or ‘Stock card’.


60 Cost Accounting

Stores Ledger: Stores Ledger is maintained by the costing

department to make record of all receipts, issues of materials with quantities,

values (Sometimes unit rates also). It is maintained by the Cost/ Accounts

Department. The source documents for posting the ledger are Goods

received notes, Material requisition notes etc. Ledger resembles with bin

cards except that receipts, issues and balances are shown along with their

money value. The ledger contains an account for every item of stores in

which receipts, issues and balances are recorded both in quantity and value.

ABC Ltd. BIN CARD Material Code: Maximum Level: Material Description: Minimum Level: Location: Re-ordering Level: Unit of Measurement: Date Doc

No. Received from / Issued to

Receipts Issue Balance Verification with Stores ledger Date Verified by

ABC Ltd STORES LEDGER Date Receipts Issues Balance

Qty Rate Amt. Qty Rate Amt. Qty Rate Amt.


61Cost Accounting

Difference between Bin Card and Stores Ledger:-

Illustration - 1

The following is a summary of the recepits and issues of materials

in a factory of ABC Ltd during the month of June 2019.

Date Particulars Qty. Rate per unit (Rs.)

1 Received 2500 10

3 Received 300 12

7 Issued 2200 -

11 Received 200 14

15 Issued 1100 -

20 Received 300 11

31 Issued 200 -

Prepare a statement showing the pricing of issues on the basis of –

a) FIFO method

b) LIFO method

c) Simple Average method

d) Weighted Average method

Bin Card Stores Ledger It is maintained by the store keeper It is maintained in the Costing department It contains only quantitative details of materials received, issued and returned to stores.

It contains information both in quantity and value

Entries are made when transactions take place

It is always posted after the transaction

Each transaction is individually posted Transactions may be summarized and then posted

Inter-department transfers do not appear in Bin-card

Material transfers from one job to another job are recorded for costing purpose


62 Cost Accounting

Solution:

a) FIFO Method

b) LIFO Method

ABC Ltd STORES LEDGER ACCOUNT(FIFO)

Date Receipts Issues Balance Qty Rate Amt. Qty Rate Amt. Qty Rate Amt.

2019 June 1

2500 10 25000 - - - 2500 10 25000

June 3 300 12 3600 - - - 2500 10 25000

300 12 3600

June 7 - - - 2200 10 22000 300 10 3000

300 12 3600

June 11 500 14 7000 - - - 300 10 3000

300 12 3600

500 14 7000

June 15 - - - 300 10 3000 - - -

300 12 3600 - - -

500 14 7000 - - -

June 20 300 11 3300 300 11 3300

June 31 - - - 200 11 2200 100 11 1100

ABC Ltd STORES LEDGER ACCOUNT(LIFO)


2019 June 1

2500 10 25000 - - - 2500 10 25000

June 3 300 12 3600 - - - 300 12 3600

2500 10 25000

June 7 - - - 300 12 3600

1900 10 19000 600 10 6000

June 11

500 14 7000 - - - 500 14 7000

600 10 6000

June 15

- - - 500 14 7000

600 10 6000 - - -

June 20

300 11 3300 300 11 3300

June 31

- - - 200 11 2200 100 11 1100


63Cost Accounting

c) Simple Average Method

d) Weighted Average Method

CHECK YOUR PROGRESS

Q 2: Define the terms: (a) Bin Card and (b) Stores

Ledger.

(a) ............................................................................

(b) ..................................................................................................

Q 3: Mention two duties of a store-keeper.

.......................................................................................................

Q 4: Mention two differences between Bin Card and Stores Ledger.

.......................................................................................................

ABC Ltd STORES LEDGER ACCOUNT(Simple Average Method)


2019 June 1

2500 10 25000 - - - 2500 10 25000

June 3 300 12 3600 - - - 2800 28600

June 7 - - - 2200 10+12 = 11 2

24200 600 4400

June 11 500 14 7000 - - - 1100 11400

June 15 - - - 1100 10+12+14 = 12 3

13200 - - -

June 20 300 11 3300 300 3300

June 31 - - - 200 11 2200 100 1100

ABC Ltd STORES LEDGER ACCOUNT(Weighted Average Method)


2019 June 1

2500 10 25000 - - - 2500 10 25000

June 3 300 12 3600 - - - 2800 10.214 28600

June 7 - - - 2200 10.214 22471 600 6129

June 11 500 14 7000 - - - 1100 11.935 13219

June 15 - - - 1100 11.935 13219 - - -

June 20 300 11 3300 300 11 3300

June 31 - - - 200 11 2200 100 11 1100


64 Cost Accounting

4.9 PERPETUAL INVENTORY SYSTEM

Perpetual Inventory represents a system of records maintained by

the stores department. It may be defined as ‘a system of records maintained

by the controlling department, which reflects the physical movements of

stocks and their current balance’. Thus it is a system of ascertaining balance

after every receipt and issue of materials through stock records to facilitate

regular checking and to avoid closing down the firm for stock taking. To

ensure the accuracy of the perpetual inventory records (bin card and Stores

ledger), physical verification of stores is made by a programme of continuous

stock taking.

The operation of the perpetual inventory system may be as follows:-

(a) The stock records are maintained and up to date posting of

transactions are made there in so that current balance may be known

at any time.

(b) Different sections of the stores are taken up by rotation for physical

checking. Every day some items are checked so that every item may

be checked for a number of times during the year.

(c) Stores received but awaiting quality inspection are not mixed up with

the regular stores at the time of physical verification, because entries

relating to such stores have not yet been made in the stock records.

(d) The physical stock available in the store, after counting, weighing,

measuring or listing as the case may be, is properly recorded in the

bin cards / Inventory tags and stock verification sheets.

Advantages of perpetual inventory system:

(a) The system obviates the need for the physical checking of all items of

stock and stores at the end of the year.

(b) It avoids the dislocation of the routine activities of the organisation

including production and dispatch.

(c) A reliable and detailed check on the stores is maintained.

(d) Errors, irregularities and loss of stock through other methods are

quickly detected and through necessary action recurrence of such

things in future is minimised.


65Cost Accounting

(e) As the work is carried out systematically and without undue haste the

figures are readily available.

(f) Actual stock can be compared with the authorised maximum and

minimum levels, thus keeping the stocks within the prescribed limits.

The disadvantages of excess stocks are avoided and capitalised up

in stores materials cannot exceed the budget.

(g) The reorder level of various items of stores are readily available thus

facilitating the work of procurement of stores.

(h) For monthly or quarterly financial statements like Profit and Loss

Account and Balance Sheet the stock figures are readily available and

it is not necessary to have physical verification of the balances.

4.10 JUST-IN-TIME (JIT) PURCHASES

Just in time (JIT) is an inventory management strategy that strives

to improve a business return on investment by reducing in-process inventory

and associated carrying costs. Inventory is seen as incurring costs, or waste,

instead of adding and storing value, contrary to traditional accounting. In

short, the Just-in-Time inventory system focuses on “the right material, at

the right time, at the right place, and in the exact amount” without the safety

net of inventory.

The advantages of Just-in-Time system are as follows:-

(a) Increased emphasis on supplier relationships. A company without

inventory does not want a supply system problem that creates a part

shortage. This makes supplier relationships extremely important.

(b) Supplies come in at regular intervals throughout the production day.

Supply is synchronized with production demand and the optimal

amount of inventory is on hand at any time. When parts move directly

from the truck to the point of assembly, the need for storage facilities

is reduced.

(c) Reduces the working capital requirements, as very little inventory is

maintained.

(d) Minimizes storage space.

(e) Reduces the chance of inventory obsolescence or damage.


66 Cost Accounting

CHECK YOUR PROGRESS

Q 5: Define Perpetual Inventory Sysytem.

....................................................................................

........................................................................................................

Q 6: What do you mean by Just in Time Purchases(JIT).

........................................................................................................

........................................................................................................

4.11 LET US SUM UP

In this unit we have discussed the following aspects of material

purchase and store keeping:

• Purchasing of materials is an important function and need to be

performed carefully.

• According to Alfora and Beatty, “Purchasing is the procuring of

materials, supplies, machines, tools and services required for the

equipment, maintenance and operation of a manufacturing plant’’

• Stores-keeper is responsible for proper utilization of storage space &

exercise better control over the material in the stores to ensure that

the material is well protected against all losses such as theft, pilferage,

fire, misappropriation etc.

• Purchases Requisition is a document issued to the Purchase

Department to procure materials of given description and of the required

quality and quantity within a specified period.

• Purchase Order (PO) is a request made in writing to selected supplier

to deliver goods of requisite quality, quantity, (as per the purchase

requisition) at the prices, terms and conditions agreed upon.It is a

valuable document as it forms the basis of accounting entry in the

stores ledger and stock records. It is the document basis for quality

control department to carry inspection of the material in warded.


67Cost Accounting

• It should be the function of the store-keeper that the right quantity of

materials always should be available in stock

• Bin Card is a quantitative record of receipts, issues and closing balance

of items of stores. It is maintained by stores department. Bin card is

also known as ‘Bintag’ or ‘Stock card’.

• Stores Ledger is maintained by the costing department to make record

of all receipts, issues of materials with quantities, values (Sometimes

unit rates also).

• Perpetual Inventory System is a system of ascertaining balance after

every receipt and issue of materials through stock records to facilitate

regular checking and to avoid closing down the firm for stock taking

• Just in time (JIT) is an inventory management strategy that strives to

improve a business return on investment by reducing in-process

inventory and associated carrying costs.

• Just-in-Time inventory system focuses on “the right material, at the

right time, at the right place, and in the exact amount” without the

safety net of inventory.


1) Narang, Aggrawal & Jain (2016), ‘Cost Accounting Principles and

Practice’, Kalyani Publications

2) M. N. Arora (2016), ‘Cost Accounting: Theory, Problems and Solutions’,

Himalaya Publishing House, Mumbai

3) Manash Dutta (2003), ‘Cost Accounting: Principles and Practice’,

Pearson


Ans to Q No 1: (a) According to ICMAI, New Delhi, “Purchases

Requisition is a document issued to the Purchase Department to


68 Cost Accounting

procure materials of given description and of the required quality and

quantity within a specified period”.

(b) Purchase Order (PO) is a request made in writing to selected supplier

to deliver goods of requisite quality, quantity, (as per the purchase

requisition) at the prices, terms and conditions agreed upon.

Ans to Q No 2: (a) Bin Card is a quantitative record of receipts, issues and

closing balance of items of stores. It is maintained by stores

department.

(b) Stores Ledger is maintained by the costing department to make record

of all receipts, issues of materials with quantities, values. It is

maintained by the Cost/ Accounts Department.

Ans to Q No 3: Two duties of store-keeper are as follows :-

(a) To exercise general control over all activities in stores department.

(b) To ensure safe storage of the materials.

Ans to Q No 4: Two difference between Bin Card and Stores Ledger are as

follows:-

Bin Card Stores Ledger

It is maintained by the store keeper It is maintained in the Costing

department.

It contains only quantitative details It contains information both in

of materials received, issued and quantity and value.

returned to stores.

Ans to Q No 5: Perpetual Inventory system may be defined as ‘a system of

records maintained by the controlling department, which reflects the

physical movements of stocks and their current balance’.

Ans to Q No 6: Just in time (JIT) is an inventory management strategy that

strives to improve a business return on investment by reducing in-

process inventory and associated carrying costs. Just-in-Time

inventory system focuses on “the right material, at the right time, at

the right place, and in the exact amount” without the safety net of

inventory.


69Cost Accounting


Q 1: Mention the steps followed by Purchase Department in manufacturing

organisations.

Q 2: Explain briefly the procedure of Purchase Requisition.

Q 3: Write briefly about Purchase Order.

Q 4: Discuss the duties of a store keeper.

Q 5: Discuss the records maintained by Store Keeper relating to storage

of materials.

Q 6: Discuss the difference between Bin Card and Stores Ledger.

Q 7: Write briefly about Perpetual Inventory System.

Q 8: Discuss Just in Time Purchases and its advantages.

*** ***** ***


70 Cost Accounting

UNIT 5 : LABOUR COST

UNIT STRUCTURE


5.2 Introduction

5.3 Meaning of Labour Turnover

5.4 Meaning of Idle Time

5.5 Concept of Over Time

5.6 Let Us Sum Up

5.7 Further Reading


5.9 Model Questions


After going through this unit you will be able to:

• explain the meaning of labour cost

• explain the meaning of idle time

• discuss the concept of over time

• discuss the different methods of wage payment.

5.2 INTRODUCTION

In this unit we will be discuss the concept of labour cost. You know

that in any organization, labour plays an important role. Without labour the

production of an industry is not possible. In some skill based industry, the

proportion of labour cost may vary from 35% to 50%. So it is regarded as

one of the important segments of study in costing. In this unit we will

specifically focus on labour turnover, idle time, over time and on the methods

of wage payment.

5.3 MEANING OF LABOUR TURNOVER

Labour turnover signifies rate of change in the labour force. It indicates

movement of workers into and out of the organisation due to accession or

71Cost Accounting

separation during a particular period of time. It is a parameter indicating the

overall health of an industry or an establishment in terms of wages, industrial

relations, working conditions and other welfare facilities provided by the

employers to the workers. Higher rate of labour turnover indicates lack of

stability in the labour force, which in turn may not be considered conducive

to the productivity of labour. For higher productivity of labour, it is essential

that labour force remains stable over a period of time.

Turnover is measured for individual companies and for their industry

as a whole. If it is high relative to its competitors than it means the company

have a shorter average tenure than those of other companies in the same

industry. It is become costly, lowering productivity and morale and tends to

get worse if not dealt with. Labour turnover does not just create costs, but

some level of labour turnover is important to bring new ideas, skills and

enthusiasm to the labour force. A natural level of labour turnover can be a

way in which a business can slowly reduce its workforce without having to

resort to redundancies.

Causes:

The causes of leaving the job by workers may be —

• Poor morale and low level of motivation within the workforce

• Better prospects

• Change of Residence or other personal causes like marriage or

pregnancy in case of women employees.

• Enrolling for national or emergency services.

• Lower Rate of Remuneration.

• Death, Retirement or Disability or workers which is unavoidable.

Effect:

Labour turnover involves costs in a variety of ways —

• Cost of replacement or employing another person.

• Loss of trained and experienced personnel.

• Cost of training new person.

• Loss due to increase in wastage or lower efficiency of new employee.

Labour Cost Unit 5

72 Cost Accounting

CHECK YOUR PROGRESS

Q 1: What is labour turnover?

....................................................................................

..................................................................................................................

..................................................................................................................

5.4 MEANING OF IDLE TIME

Idle Time may be defined as the unproductive time for the employer

even the labour is employed and paid. It is that time during which the workers

spend their time without giving any production or benefit to the employer

and concern. Generally idle time means that time for which the employer

pays, but from which he obtains no production.

Otherwise it is the difference between the times for which workers

are paid but the workers do not work. So it is a loss to the organisation. It

can be minimized but, cannot be controlled during idle time; the workers

remain due and contribute nothing towards production. It is the difference

between actual hour and actual hour worked. The idle time may arise due to

non-availability of raw materials, shortage of power, machine breakdown

etc.

There are two types of idle times:

1. Normal idle time and

2. Abnormal idle time

1. Normal idle Time: It refers that any loss of time is inherent in every

situation which cannot be avoided but effective effort should be made

to reduce it. Any cost associated with the normal idle time is mostly

fixed in nature. Normal idle time is permitted but abnormal idle time

should be avoided.

Normal idle time wages is treated as a part of cost of production.

Thus, in case of direct workers an allowance for normal idle time is

built into labour cost rates. In the case of indirect workers, normal idle

time wage is spread over all the products or jobs through the process

of absorption of factory overheads.

Blue Chip :

Extremely valuable

Labour CostUnit 5

73Cost Accounting

The reasons may be:

1) The time taken by the worker while he walks between factory

gate and place of work.

2) Time taken for lunch and tea break.

3) Time taken for obtaining work.

4) Time taken for changing from one job to another.

5) Waiting time for getting instructions, tools and or raw materials,

spare parts etc.

6) It may be for personal affairs.

2. Abnormal idle time: It occurs due to some abnormal reasons.

Abnormal idle time can be avoided if proper precautions are taken.

Thus the factors which are responsible for controlling and avoiding

idle time must be taken care of and planning has to make to reduce it.

Abnormal idle time cost is not included as a part of production cost

and is shown as a separate item in the Profit and Loss Account. So

that normal cost is not distributed. The abnormal idle time may arise

due to the following avoidable reasons:

1) Faulty planning.

2) Lack of co-operation and co-ordination.

3) Power failure.

4) Time lost due to delayed instructions.

5) Time lost due to inefficiency of workers.

6) Time lost due to non-availability of raw materials, spare parts,

tools etc.

7) Time lost due to strikes, lock outs and lay-off.

CHECK YOUR PROGRESS

Q 2: What is meant by idle time ?

...................................................................................

..................................................................................................................

..................................................................................................................

Labour Cost Unit 5

74 Cost Accounting

5.5 CONCEPT OF OVER TIME

The term “Over time” refers the extra work done beyond the normal

working hours or scheduled time by a worker. According to Factories Act,

the wage rate of overtime work has to be paid at double the normal rate of

wages. The extra amount of remuneration is paid to the worker in addition

to normal rate of wages is said to be overtime premium.

Effect Of Over Time Payment On Productivity: The following are the

effects of over time payment on productivity:

1) Overtime premium is an extra payment over normal wages and hence

will increase the production cost.

2) The efficiency of workers during overtime work may fall and hence

output may be reduced.

3) To earn more, workers may not concentrate on work during normal

hours and thus the output during normal hours may fall.

4) Reduced output and increased premium will increase the cost of

production.

Accounting T reatment of Overtime W ages:

The following are the ways of charging of overtime premium:

1) If overtime is resorted to at the desire of the customer then overtime

premium is charged to concerned job directly.

2) If overtime is required to cope with general production schedule or for

meeting urgent orders, the overtime premium should be treated as

overhead cost of particular department or cost centre which works

overtime.

3) If overtime is worked on account of abnormal conditions such as flood,

earthquake etc. that should be charged to costing profit and loss

account.

Control of Overtime:

Control of overtime is essential to minimize the cost of production

and increase the overall performance of the efficiency. Effective control of

overtime can be possible through the following ways:

1) Effective sound planning of production

Labour CostUnit 5

75Cost Accounting

2) Adequate supervision.

3) Ensuring availability of raw materials, spare parts

4) Encouraging productivity

5) Reducing labour turnover

6) Ensuring effective system of repairs and maintenance, material

handling and smooth flow of production

7) Fair and equitable remuneration to efficient and inefficient workers.

CHECK YOUR PROGRESS

Q 3: State any two effects of over time payment on

productivity.

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

LET US KNOW

Factory overheads are the total cost involved in operating

all production facilities of a manufacturing business. It is

indirect labour, indirect material and all other factory

expenses which cannot conveniently be identified. It is manufacturing

expenses other than direct labor and direct materials costs.

5.6 LET US SUM UP

In this unit, we discussed on the following:

• Labour turnover signifies the movement of workers into and out of the

organisation due to accession or separation during a particular period

of time.

• Idle Time is that time during which the workers spend their time without

giving any production or benefit to the employer and concern.

• Abnormal idle time refers that any loss of time which may occur due

to some abnormal reasons

Labour Cost Unit 5

76 Cost Accounting

• Normal idle time wages is treated as a part of cost of production.

• Abnormal idle time cost is not included as a part of production cost

and is shown as a separate item in the Costing Profit and Loss Account.

• The term “Over time” refers the extra work done beyond the normal

working hours or scheduled time by a worker.

5.7 FURTHER READING




Ans to Q No 1: Labour turnover means the movement of workers into and

out of the organisation due to accession or separation during a particular

period of time. It reflects the overall health of an industry or

establishment in terms of wages, industry relations, working conditions

etc.

Ans to Q No 2: Idle time is the unproductive time for the employer even the

labour is emplayed and paid. During this time the workers spend their

time without giving my production or benefit to the employer.

Ans to Q No 3: (i) Overtime payment is an extra payment over normal

wages and hence will increase the production cost.

(ii) The efficiency of workers during overtime work may fall and hence


5.9 MODEL QUESTIONS

Q 1: What do you mean by ideal wage system?

Q 2: What are the different methods of wage payment?

Q 3: Critically examine the advantages and disadvantages of time wage

system.

Labour CostUnit 5

77Cost Accounting

Q 4: What are the differences between time rate system and piece rate

system?

Q 5: What do you understand by piece rate system? Discuss the merit

and demerits of piece rate system.

Q 6: What do you understand by Taylor’s Differential Piece Rate system?

Explain its significance.

*** ***** ***

Labour Cost Unit 5

78 Cost Accounting

UNIT 6 : LABOUR REMUNERATION ANDINCENTIVES

UNIT STRUCTURE


6.2 Introduction

6.3 Meaning of Labour Remuneration and Incentives

6.4 Features of Good Wage System

6.5 Methods of Wage Payment

6.6 Time Rate System

6.7 Piece Rate System

6.8 Bonus System or Incentive Schemes

6.9 Indirect Monetary Incentive

6.10 Non-monetary Incentive Schemes

6.11 Requisites of a Good Incentive Plan

6.12 Let Us Sum Up


6.14 Answers to Check Your Progress



After going through this unit you will be able to:

• explain the meaning of remuneration and incentives

• explain the features of a good wage system

• explain the various methods of labour remuneration and incentives

• discuss the requisites of a good incentive plan.

6.2 INTRODUCTION

In this unit we will be discuss the concept of labour remuneration

and incentives. You know that in any organization, labour plays an important

role. The labour force need to compensated adequately to motivate them to

work efficiently.The remuneration and incentives paid to the labour force of

79Cost Accounting

an organisation constitute a major component of total cost of an organisation.

So it is regarded as one of the important segments of study in costing. In

this unit we will specifically focus on labour remuneration and incentives.We

shall also dicuss the various methods of wage payment.

6.3 MEANING OF LABOUR REMUNERA TION ANDINCENTIVES

Remuneration is the reward for labour under normal circumstances

and is generally based on either time spent or on the result produced. The

former is called “time-related” remuneration and the latter is known as “Piece-

related” remuneration. The fixation of method of remuneration in a proper

manner is vitally important for any organisation because it deals with the

most sensitive item of the input, i.e., Labour. To motivate the labour force to

work more efficiently and effectively, the top level management often

implements various performance related incentives for them. These

incentives are found to be very effective not only in improving the performance

of the labour force but also in retaining them resulting in reduced labour

turnover. Incentive may be defined as “the stimulation of effort and

effectiveness by offering monetary inducement or enhanced facilities”. It

may be monetary or non-monetary. Although incentive schemes increases

the labour cost of an organisation, but a carefully designed incentive plan

will serve as an investment for better productivity.

6.4 FEATURES OF GOOD WAGE SYSTEM

A carefully designed wages payment system will motivate the labour

force to work efficiently and effectively. As such, development and

implementation of a good wage system is very essential for any labour

intensive organisation. The features of a good wage system are as follows:

(a) The system should be simple to understand and the various segments

of the system, should clearly mention in detail.

(b) The employees should be able to accept the method without any doubts

or hesitation in their mind.

Labour Remuneration and Incentives Unit 6

80 Cost Accounting

(c) The method should be flexible enough to adopt any changes or variation

which may become inevitable at a later stage.

(d) The method should be able to cut down/stabilize the labour turnover

which is often causes due to unsatisfactory or unacceptable method

of remuneration.

(e) The method should assure fair wages to the employees so that both

the employers and the employees can gain by such methods, the

former by way of higher productivity and the latter by way of higher

earnings.

(f) Incentive payments should be a part of the method of remuneration

with a view to increase the labour productivity.

(g) The method should be able to minimise the level of absentees so that

avoidable wastages in labour cost can be reduced.

(h) The method should ultimately result into higher production and

improved quality of the output.

CHECK YOUR PROGRESS

Q 1: What do you mean by labour remuneration?

.........................................................................

.................................................................................................................

6.5 METHODS OF WAGE PAYMENT

The workers should be well remunerated in an organisation. Such

remuneration to the labour is generally termed as ‘wages’. There are two

basic methods of wages payment: (1) Time Wage System and (2) Piece

Wage System.

A variety of bonus and premium plans have been designed to

overcome the drawbacks of these two basic methods of wage payments. A

system of incentive plans also takes into consideration. The primary

principles of these two basic plans are known as Incentive or Bonus or

Premium Plan. Thus, wage payment methods may be classified in the

following four groups.

Labour Remuneration and IncentivesUnit 6

81Cost Accounting

1) Time Rate Systems

2) Piece Rate Systems

3) Bonus System (or) Incentives Schemes

4) Indirect Monetary Incentives.

These may be further classified as under:

1) Time Rate System:

a) At Ordinary Levels

b) At High Wage Levels

c) Guaranteed Time Rates.

2) Piece Rate System:

a) Straight Piece Rate

b) Piece Rates with Guaranteed Time Rate

c) Differential Piece Rates:

i) Taylor’s Differential Piece Rate System

ii) Merrick Differential Piece Rate System

iii) Gantt Task and Bonus Plan.

3) Bonus System or Incentive Schemes:

(A) Individual Incentive Plans:

a) Halsey Premium Plan

b) Halsey-Weir Premium Plan

c) Rowam Plan

d) Barth Variable Sharing Plan

e) Emerson Efficiency Plan

f) Bedaux Point Premium System

g) Accelerating Premium Plan

(B) Group Incentive Bonus Plans:

a) Budgeted Expenses bonus plan

b) Priest Man bonus Plan

c) Towne’s Gain-sharing Plan

d) Scanlon Plan

4) Indirect Monetary Incentives

a) profit- Sharing

b) Co-partnership

5) Non-Monetary Incentives


82 Cost Accounting

6.6 TIME RATE SYSTEM

a) Time Rate at Ordinary Levels: Under Time Wage System, wages

are paid on the basis of time spent on the job irrespective of the quantity

of work produced by the workers. In this case the amount of work

done is not considered. This is also known as Time Rate or Day Wage

System. The unit of time may be in a day, a week, a fortnight or a

month. The formula for calculation of payment of time rate of ordinary

levels is as follows:

Remuneration or Earnings = Hours Worked × Rate Per Hour

Time wage system is suitable under the following conditions:

• Where the units of output are difficult to measure, e.g. watchman.

• Where the quality of work is more important e.g., artistic furniture,

fine jewellery, carving etc.

• Where machinery and materials used are very sophisticated and

expensive.

• Where supervision is effective and close supervision is possible.

• Where the workers are new and learning the job.

• Where the work is of a highly varied nature and standard of

performance cannot be established.

Advantage

• It is simple and easy to calculate.

• Earning of workers are regular and fixed.

• Time rate system is accepted by trade unions.

• Quality of the work is not affected.

• This method also avoids inefficient handling of materials and

tools.

Disadvantages

• No distinction between efficient and inefficient worker is made

and hence they get the same remuneration.

• Cost of supervision is high due to strict supervision used for

high productivity of labour.


83Cost Accounting

• labour cost in difficult to control due to more payment may be

made for the lesser amount of work.

• No incentive is given to efficient workers. It will depress the

efficient workers.

• There are no specific standards for evaluating the merit of

different employees for promotions.

b) Time Rate at High Levels: Under this system, efficient workers are

paid higher wages in order to increase production. The main object of

this method designed to remove the drawbacks of time rate at ordinary

levels. This system is simple and easily understandable. When higher

rate of wages are paid, it not only reduces labour turnover but also

increases production and efficiency.

c) Guaranteed Time Rates: Under this method the wage rate is

calculated by considering to changes in cost of living index. Accordingly,

the wage rate is varied for each worker according to the change in

cost of living index. This system is suitable during the period of raising

prices.

6.7 PIECE RATE SYSTEM

In case of “Piece Rate System” or “Payment by Result”, the payment

of wages is depending on the amount of work performed by the worker.

Thus, a workman is paid in direct proportion to his output under this system.

Advantages:

• It facilitates direct relation between efforts and reward.

• This system encourages the efficient workers to increase

production.

• Under this system efficient workers are recognized and

rewarded.

• It helps to reduce the cost of supervision and idle time.

• Tenders or quotations can be prepared confidently and accurately.

Disadvantage:

• Where a concern is producing large quantities, it is difficult to fix

a piece rate.


84 Cost Accounting

• In order to maximize their earnings, workers working with high

speed may affect their health.

• The quality of output cannot be maintained.

• This system is not encouraging to the inefficient workers.

• Temporary delays or difficulties may affect the earnings of the

workers.

Piece Rate System is suitable where

• Quality and workmanship are not important.

• Work can be measured accurately.

• Quantity of output directly depends upon the efforts of the worker.

• Production of standardized goods in a factory.

• Job is of a repetitive nature.

There are three important methods of paying labour remuneration

falling under Piece Rate System:

a) Straight Piece Rate (b) Piece Rates with Guaranteed Time

Rates and (c) Differential Piece Rates.

a) Straight Piece Rate: Under this system workers are paid according

to the number of units produced at a given rate per unit. Thus, total

earnings of each worker are calculated on the basis of his output

irrespective of the time taken by him. The following formula is used for

measuring piece work earning:

Straight Piece Work Earnings = Units Produced × Rate Per Hour

b) Piece Rate with Guaranteed Time Rates: Under this method, the

worker earning from piece work less than the guaranteed minimum

wage, will get the fixed amount of guaranteed time rate. A guaranteed

rate would be paid per hour rate or day rate or week rate.

c) Differential Piece Rates: This system is designed to provide for

variation of piece rates at different levels of output. Accordingly increase

in wages is proportionate to increase in output. Under this system

efficient workers get ample reward and at the same time inefficient

workers are motivated to earn more. The following are the important

types of differential piece rates:


85Cost Accounting

i) Taylor’s Differential Piece Rates System.

ii) Merrick’s Differential Piece Rates System.

iii) Gant Task Bonus Plan.

i) Taylor ’s Dif ferential Piece Rates system

F.W. Taylor, who is the father of scientific management, introduced

this plan. Under this system, two piece rates are applicable on the

basis of standard of performance established. Accordingly one is high

rate and the other one is lower rate. Thus high piece rate is applicable

for standard and above the standard performance. Lower piece rates

are applicable for those workers with below the standard performance.

EXERCISE : 1

Calculate the earnings of workers A and B under

Straight Piece rate system and Taylor’s Differential

piece Rate system from the following Particulars:

Standard time allowed 50 units per hour.

Normal time rate per hour Rs. 100

Differentials to be applied.

80% of piece rate at or above standard.

120% of piece rate at or above standard.

In a day of 8 hours A produced 300 units and B produced 450

units.

Solution 1:

Calculation of Piece Rates:

Standard Production Per Hour = 50 units

Standard production for 8 hours = 50 × 8 = 400 units

Rate Per Hour = Rs. 100

Piece Rate Per Unit = 50

100 = Rs. 2 per unit

Straight Piece Rate System

A for 300 units @ Rs. 2 = 300 × 2 = Rs. 600

B for 450 units @ Rs. 2 = 450 × 2 = Rs. 900


86 Cost Accounting

Low Piece Rate at 80% differential = 100

802× = Rs. 1.60

High Piece Rate at 80% differential = = Rs. 2.40

Standard production in 8 hours = 8 × 50 units per hour

= 400 units

Earnings

A produced 300 units (below standard) = 300 × 1.60

Therefore Low Piece Rate of Rs. 1.60 applicable = Rs. 480

B produced 450 units (below standard) = 450 × 2.40

Therefore High Piece Rate of Rs. 240 applicable = Rs. 1080

ii) Merrick Differential Piece Rate System:

This is also termed as Multiple Piece Rate System. This plan is

designed to overcome the drawback of Taylor’s Differential Piece Rate

System. Under this method, three piece rates are applied with different levels

of performance. Accordingly

Performance Differential Piece Rate

1) Less than 83% Normal Piece Rate (or) Basic

Piece Rate

2) From 83% to 100% 110% of Normal Piece Rate

3) More than 100% 120% of Normal piece Rate

iii) Gantt’ s Task Bonus Plan:

This system is designed by Henry L. Gantt. Under this system

standard time for every task is fixed through time and motion study. The

main feature of this system is a good combination of time rate, differential

piece rate and bonus. In this system day wages are guaranteed to all workers.

Wages under this system are calculated as follows:

Performance Earnings

(Out put)

1) Output Below Standard Time Rate (Guaranteed)

2) Output at Standard Wages of Time Rate plus

Bonus of 20% of the Time

Rate


87Cost Accounting

3) Output at Above High Piece Rate on

Standard worker’s output

6.8 BONUS OR INCENTIVES SCHEMES

Incentive Scheme of wage payment is also known as Premium Bonus

Plans. It is introduced in order to increase production with ensuring proper

industrial climate. Wage incentive plans may be of two types: (A) Individual

Incentive Plans and (B) Group Incentive Plans.

A. Individual Incentive Plans: Under individual incentive plans,

remuneration can be measured on the performance of the individual

worker. In the case of the group incentive scheme earnings can be

measured on the basis of the productivity of the group of workers or

entire work force of the organization. Various types of incentive

schemes are combinations of time and piece rate systems. Different

individual incentive plans are discussed below—

1) Halsey Premium Plan: This plan was developed by F.A. Halsey.

This system also termed as Split Bonus Plan or Fifty-Fifty Plan.

Under this plan, standard time is fixed for each job or operation

on the basis of past performance. If a worker completes his job

within or more than the standard time then the worker is paid a

guaranteed time wage. If a worker completes his job within or

less than the standard time, then he gets a bonus of 50% of the

time saved plus normal earnings. Under this method, the total

earnings are calculated as follows:

Total Earning = Guaranteed Time Wages + Bonus of 50% of

Time saved

(Or)

Total Earning = T × R + 50% (S - T) R

Where T - Time Taken; R - Hourly Rate; S - Standard Time

Total Earnings = Time taken × hourly rate +

10050

(Time Saved ×

Hourly Rate)


88 Cost Accounting

EXERCISE : 2

A. Calculate the total earnings of the worker under

Halsey Premium Plans:

Standard Time 12 hours

Hourly Rate Rs. 3

Time Taken 8 hours

Solution 2:

Earnings under Halsey Premium Plan:

Standard Time = 12 hours

Time Taken = 8 hours

Time Saved = Standard Time - Time Taken

= 12 - 8 = 4 hours

Rate per hour = Rs. 3

Total Earnings = T × R + 50% (S - T) R

= 8 × 3 + 10050

(4 × 3)

= 24 + 6

Total Earnings = Rs. 30

Merits:

1) It is simple to understand.

2) Total earnings of each worker can be easy to calculate.

3) Both employer and employee get equal benefit of time saved.

4) This system not only benefits efficient worker but also provides average

worker to get guaranteed minimum wages.

5) This system is based on time saved and it can reduce the labour

cost.

Demerits:

1) Lack of co-operation among the employees.

2) Under this system establishment of standard is very difficult.

3) Earning are reduced at high level of efficiency.

2) The Halsey -Weir Scheme: Under this system the worker gets the

bonus of 30% of the time saved instead of 50% of time saved under

Labour Remuneration and IncentivesUnit 6 Labour Remuneration and IncentivesUnit 6

89Cost Accounting

Halsey Plan. Except for this, Halsey Plan and Halsey-Weir Systems

are similar in all other respects.

3) Rowan Plan: This plan was introduced by James Rowan of England.

It was similar to the Halsey Plan in many respects except that it differs

in calculation of bonus. Under this system, bonus is determined as

the proportion of the time taken which the time saved bears to the

standard time allowed. Under this system the following formula is

applied to calculation of bonus:

WagesTimeTimeStandard

SavedTimeBonus ×=

Total Earnings =Time taken × Hourly Rate + TimeStandardSavedTime

× T × R


Time Wages = Time Taken × Hourly Rate

EXERCISE : 3

A. From the following information, calculate total

earnings of a worker

under Rowan System:

Standard Time= 10 hours



Solution 3:

Calculation of total earnings under Rowan Plan:

Standard Time= 10 hours



= 10 - 8 = 2 hours

Rate per hour = Rs. 3 Per hour

Total Earnings = T × R + = TimeStandardSavedTime

× T × R

= 8 × 3 + 102

(8 × 3)

Labour Remuneration and Incentives Unit 6Labour Remuneration and Incentives Unit 6

90 Cost Accounting

= 24 + 4.8

= Rs. 28.8

4) Emerson’ s Efficiency Sharing Plan: Under this plan, earning of a

worker is by combining guaranteed day wages with a differential piece

rate. Accordingly the level of efficiency is determined on the basis of

establishment of standard task for a unit of time. If the level of worker’s

efficiency reaches 67% the bonus is paid to him at a normal rate. The

rate of bonus increases in a given rate as the output increases from

67% to 100% efficiency. Above 100% efficiency, the bonus increases

to 20% of the wage earned plus additional bonus of 1% is added for

each increase of 1% in efficiency.

EXERCISE : 4

From the following particulars calculate total earnings

of a worker under Emerson’s Efficiency Sharing Plan:

Standard output per day of 8 hours is 16 units

Actual output of a worker for 8 hours is 20 units

Rate per hour is Rs. 2.50

Solution 4:

Calculation of earnings under Emerson’s Sharing Plan:

Level of performance = 100OutputStandard

OutputActual ×

125%100units 10units20 =×=

Bonus Payable

At 100% efficiency = 20% of time wages

Further increase of 1% in the bonus is given for every 1% increase in the

efficiency.

For next 25% efficiency @ 1% = 25% of Time Wages each 1%

increase in efficiency

Total Bonus Payable = 45% of Time Wages.

Earning

Time Wages for 8 hours @ Rs. 2.50 per hour = Rs. 20.


91Cost Accounting

Add: 45% bonus of time wages = 10045

× 20 = Rs. 9

Total Earning = Rs. 20 + Rs. 9 = Rs. 29

5) Barth V ariable Sharing Plan: This scheme introduced to attract newly

recruited and skilled employees who are motivated to learn work. It

provides sufficient incentives to inefficient workers who are motivated

to increase productivity. Earning under this method is calculated by

applying the following formula:

Earnings = Rate per hour × Standard Time x Time taken

EXERCISE : 5

A) From the following particulars calculate earnings of

a worker under Brath Variable sharing plan:

Standard Time = 12 hours



Solution:

Calculation of earnings under Barth Variable sharing plan:

Earnings = Rate per hour × Standard Time x Time taken

= 5 × 12 x 8

= Rs. 48. 98

6) Bedaux Point Premium System: This plan was introduced by Charles

E. Bedaux in 1911. Under this plan, standard time fixed for each

operation or job is expressed in terms of Bedaux point or ‘B’. For

example, a standard time of 360 B means the operation or job should

be completed within 360 minutes. The chief advantage of this plan is

that it can be applied to any kind of job. Under this system, worker is

paid at the time for actual hours worked and 75% of the wages for the

time saved are paid as bonus to the worker and 25% to the foremen,

supervisors etc. The following is the formula for calculation of total

wages of a worker:

Total earnings = S x R + 75% of R (S —— T)


92 Cost Accounting

7) Accelerating Premium Bonus Plan: Under this plan, bonus is

determined on the basis of time saved unlike a fixed percentage under

Halsey Plan and as decreasing percentage under Rowan Plan. The

bonus is paid to workers at an increased rate. This provides increasing

incentives to efficient workers.

B. Group or Collective Bonus Plan : The incentive schemes explained

so far as applicable to individual performance depending directly on

production. However it is not the individual workers who produce the

goods or services (operation) alone but group of several other workers

are required to jointly perform a single operation. It is, therefore, essential

that a group incentive scheme be introduced. Bonus is calculated for

a group incentive scheme. The bonus is calculated for a group of

workers and the total amount is distributed among the group of workers

on any one of the following basis:

a) Equally by all the workers of the group.

b) Pro-rata on the time rate basis.

c) Pre-determined percentage basis.

d) Specified proportion basis.

The following are the important types of group incentive bonus plans:

1) Budgeted Expenses Bonus Plan: Under this method, bonus

is determined on the basis of savings in actual expenditure

compared with total budgeted expenditure.

2) Priest man Bonus Plan: Under this plan standard performance

is fixed by the management and committee of works. The group

of workers get bonus when actual performance exceeds the

standard performance irrespective of individual’s efficiency or

inefficiency.

3) Towne’ s Gain-Sharing Plan: Under this plan, bonus is

calculated on the basis of savings in labour cost. The group of

workers get bonus when actual costs is less than the standard

costs, one-half of the savings is distributed among workers

including foremen in proportion with the ages earned.


93Cost Accounting

4) Scanlon Plan: Scanlon Plan is designed with the chief aim of

reducing the cost of operations in order to increase the production

efficiency. This plan is generally applicable in industries where

the operation cost is high. Under this scheme, bonus is

determined on the basis of standard costs or wastages and

percentage of the reduction in operation cost.

6.9 INDIRECT MONETARY INCENTIVE

Indirect schemes are regarded beneficial to both employers and

workers. Under indirect monetary incentives workers are given a share of

profit and co-partnership.

Profit Sharing: Profit sharing and bonus is also known as Profit

Sharing Bonus. Under this scheme, there is an agreement between the

employer and employee by which employee receives a share of the profits

which is fixed in advance. Accordingly profit sharing bonus refers to the

distribution of profit on the basis of certain percentage of one’s monthly

earnings. The amount to be distributed depends on the profits earned by an

enterprise. The proportion of the profits to be distributed among the

employees is determined in advance.

Co-partnership: This system provides not only a worker to become

partner in the business but also to share in the profit of the concern. There

are different degrees of partnership and share of responsibilities allowed to

the workers to take part in its control.

6.10 NON-MONETARY INCENTIVE SCHEMES

Under this system, employees are provided better facilities, instead

of additional monetary payments. Some of the examples of non-monetary

incentives are free education for children rent free accommodation,

medical facilities canteen facilities, welfare facilities and entertainment

facilities etc.


94 Cost Accounting

6.11 REQUISITES OF A GOOD INCENTIVE PLAN

A good incentive plan should have the following characteristics:

1. Simple: It should be simple to understand and easy to operate.

2. Economical: It should be economical to introduce and operate.

3. Fair: It should be fair to both employees and employer.

4. Guaranteed W ages: It should guarantee hourly wages to every worker

irrespective of level of his efficiency.

5. Adequate Incentive: It should provide adequate incentive to efficient

workers.

6. Earning Limitations: It should place no limit on the earnings of

workers.

7. Penalty: It should not penalise the workers for reason beyond their

control such as machine break down, power failure etc.

8. Prompt Payment: It should provide for prompt payment of incentives

at short intervals of time.

9. Moral Boosting: It should be capable of improving the morale of

workers.

10. Managerial Support: It should have managerial support in so far as

production material, quality control, maintenance, and non-monetary

incentives are concerned.

11. Flexibility: It should be flexible enough so as to introduce the

necessary changes (if any required)

6.12 LET US SUM UP


• Labour turnover signifies the movement of workers into and out of the

organisation due to accession or separation during a particular period

of time.

• Idle Time is that time during which the workers spend their time without

giving any production or benefit to the employer and concern.


95Cost Accounting

• Abnormal idle time refers that any loss of time which may occur due

to some abnormal reasons

• Normal idle time wages is treated as a part of cost of production.

• Abnormal idle time cost is not included as a part of production cost

and is shown as a separate item in the Costing Profit and Loss Account.

• The term “Over time” refers the extra work done beyond the normal

working hours or scheduled time by a worker.





Ans to Q No 1: Labour turnover means the movement of workers into and

out of the organisation due to accession or separation during a particular

period of time. It reflects the overall health of an industry or

establishment in terms of wages, industry relations, working conditions

etc.

Ans to Q No 2: Idle time is the unproductive time for the employer even the

labour is emplayed and paid. During this time the workers spend their

time without giving my production or benefit to the employer.

Ans to Q No 3: (i) Overtime payment is an extra payment over normal

wages and hence will increase the production cost.

(ii) The efficiency of workers during overtime work may fall and hence



Q 1: What do you mean by ideal wage system?


96 Cost Accounting

Q 2: What are the different methods of wage payment?

Q 3: Critically examine the advantages and disadvantages of time wage

system.

Q 4: What are the differences between time rate system and piece rate

system?

Q 5: What do you understand by piece rate system? Discuss the merit

and demerits of piece rate system.

Q 6: What do you understand by Taylor’s Differential Piece Rate system?

Explain its significance.

Q 7: Write short notes on:

(a) Halsey Plan, (b) Rowan Plan, (c) Emerson’s Efficiency Plan,

(d) Halsey-Wair Plan, (e) Gantt Task Bonus Plan, (f) Barth’s System.

Q 8: What do you mean by Collective Bonus Plan? Explain the type of Group

Incentive Plans.

*** ***** ***


97Cost Accounting

UNIT 7 : OVERHEADS

UNIT STRUCTURE


7.2 Introduction

7.3 Classification and Control of Overheads

7.4 Allocation and Apportionment of Overheads

7.5 Re-Apportionment of Service Department Costs to Production

Department and Its Methods

7.6 Let Us Sum Up

7.7 Further Reading


7.9 Model Questions


After going through unit, you will be able to:

• explain the meaning of overhead and the basis of its classification

• discuss the allocation and apportionment of overheads

• explain the re-apportionment of service department costs to

production department and its methods.

7.2 INTRODUCTION

Overheads can be defined as ‘burden’ or ‘on cost’. These overheads

represent costs which are ‘over-the-head’ of direct material, direct labour

and direct expenses (i.e., prime cost). These are additional cost incurred in

the manufacturing process. According to ICMA terminology, an overhead

has been defined as the “aggregate of indirect material cost, indirect labour

cost and indirect expenses.” In order to determine whether an item of cost

is overhead or not, it should be seen if it is possible to identify the item of

cost with cost unit or cost centre. If this identification is not possible then the

item of cost should be considered as an item of overhead cost. As for

example, rent and rates, heating and lighting, power etc cannot be identified

98 Cost Accounting

with finished products. Hence, they are obviously overheads. Sometimes, it

may not be convenient to identify an item of cost with finished product. In

such a case the item of cost is again treated as overheads. For example,

nails used in furniture making and buttons used in readymade garments

are overheads.

7.3 CLASSIFICATION AND CONTROL OF OVERHEADS

Overheads can be classified according to their behavioural pattern

or managerial functions as under:

Overheads may be fixed, variable and semi-variable in case of

behavioural point of view.

Fixed Overheads: It remains constant irrespective of the level of

output or production. Fixed overhead remain fixed in aggregate but it tends

to vary per unit when the level of production undergoes a change. Managing

director’s salary, factory rent, audit fees etc are examples of fixed overheads.

Variable Overheads: Variable overheads are those indirect

expenses which tend to vary in direct proportion to the changes in the level

of production. They increase or decrease exactly according to the change

in the volume of output. Variable overheads per unit remain constant but

they change in aggregate with change in the level of output. Examples of

variable overheads are like oil and fuel, indirect materials, indirect labour,

stores consumed, and salaries of salesmen etc.

Semi-Variable Overheads: It is also known as semi-fixed

overheads. Basically these are indirect expenses which neither remains

fixed nor they vary directly with the change in the level of output. These

overheads are partly fixed and partly variable in nature. A part of these

expenses remain constant upto a certain level and beyond that they tend to

change with change in the level of activity. Some examples of semi-variable

overheads are like cost of power, telephone, repairs and maintenance,

depreciation of machineries working in multiple shifts etc.

Classification of overheads from the point of view of behaviour into

fixed, variable and semi-variable is particularly useful for control purposes

and also in the following areas:

OverheadsUnit 7

99Cost Accounting

Cost Control:

The classification of overheads into fixed and variable helps in

controlling costs. Fixed costs are generally policy costs which is difficult to

be controlled. These costs are not affected by any variation in production or

level of activity and therefore, they are more or less non controllable. Variable

expenses vary with the volume of output. The management can control

these costs by adopting several cost control devices.

Decision Making:

The classification of overheads between fixed and variable also helps

in decision making. For example, decision regarding the price to be charged

during depression or recession or for local and export sales etc. Similarly,

decision to make or buy, lease or purchase, shut down or continue etc are

also taken after classifying the costs into fixed or variable costs.

Break Even Analysis:

The classification of overheads into fixed and variable helps in the

preparation of break even charts for undertaking a study of cost-volume-

profit relationship which is very much essential for profit planning, policy

formulation and control.

Flexible Budgeting:

The classification of overheads into fixed and variable helps in the

preparation of flexible budget. It enables a firm to estimate costs for different

levels of activity and make comparison with the actual expenses incurred.

Recovery or absorption of overheads:

The classification of overheads into fixed and variable helps in

determining separate absorption rates for fixed and variable overheads. The

fixed overhead rate also serves as a measure of utilization of facilities and

the under absorption indicates the extent of idle capacity.

CHECK YOUR PROGRESS

Q 1: Define overhead.

..................................................................................

…………………………………………………………

………………………………………………………………………………

Overheads Unit 7

100 Cost Accounting

7.4 ALLOCA TION AND APPORTIONMENT OFOVERHEADS

Allocation is the process by which cost items are charged direct to

a cost unit or cost centre. It is the process of charging the traceable amount

of overhead to cost centre or cost unit. Overhead costs by their very nature

cannot often be related to one particular cost centre. Where a cost is directly

attributed to a department, e.g., electricity metered separately for a particular

department, allocation can take place. It is like direct allotment of the cost to

a particular department for which it was incurred. If a cost can be specifically

identified with a department then that cost is allocated to that department.

According to CIMA cost allocation is “the charging of discrete, identifiable

items of cost to cost centres or cost units. Where a cost can be clearly

identified with a cost centre or cost units, then it can be allocated that

particular cost centre or cost units.” For example, depreciation of machinery

of machining department can be directly allocated to machining department.

The salary of stores clerk can be allocated to stores department. Cost of

coal used in Boiler can be directly allocated to Boiler House division.

Some costs cannot be identified as arising from the activities of one

specific department or function. Non allocable cost, however, must be

apportioned on some logical basis to be divided between related cost centres.

CIMA defines it as “the allotment of two or more cost centres of proportions

of the common items of cost and the estimated basis of benefits received.”

As for example, rent, rates and taxes incurred for the entire factory cannot

be directly allocated to different cost centres, but can be apportioned to

more than one cost centre on some equitable basis for benefits received.

The basis normally adopted for rent, rates and taxes being the floor area

occupied by various cost centres. Thus, apportionment is the division of

cost among two or more centres in proportion to the estimated benefits

received applying some acceptable basis. The following chart will illustrate

the point:

OverheadsUnit 7

101Cost Accounting

Sl Types of Overheads Basis of Apportionment.

No

1 Rent, rates, repairs, insurance Area occupied

and depreciation of building

2 Lighting Number of lighting points or

area occupied.

3 Power Horse power of machineries

or machine hours worked.

4 Depreciation, insurance, Book value of assets or capital cost

repairs and maintenance of assets.

of plants and vehicles

5 Personnel, staff welfare, No of employees in each

canteen expenses etc department or wages paid.

6 Stores expenses No of stores requisition served or

value of material issued or stored.

7 Carriage Inward Value of materials purchased.

8 Maintenance of plants Maintenance hours

9 Inspection expenses No of employees in production

department.

10 Remuneration of works Direct labour hours, wages paid

director or number of employees.

Distinction between allocation and apportionment of overheads:

1. Under allocation of overheads, the entire amount is charged to a

particular department while under apportionment only a proportionate

amount is charged to a particular department.

2. Allocation is a first step in departmentalization of overheads whereas

apportionment is the next step.

3. Allocation is a simple process while apportionment is a complicated

one.

4. In case of allocation, indirect cost can be conveniently identified with a

particular department while it is not possible to identify overheads to a

department under apportionment process.

Overheads Unit 7

102 Cost Accounting

CHECK YOUR PROGRESS

Q 2: Distinguish between allocation and apportionment

of overheads.

i) ………………………………......……………………………………

ii) ………………………………….....…………………………………

ILLUSTRATION:

The Modern Company is divided into four departments: P1, P2 and

P3 are producing departments and S1 is a service department. The actual

costs for a period are as follows:

Rs.

Rent 1,000

Repairs to Plant 600

Depreciation of Plant 450

Employers’ Liability for insurance 150

Supervision 1.500

Fire insurance of stock 500

Power 900

Light 120

The following information is available in respect of four departments:

P1 P2 P3 S1

Area (Sq meters) 1,500 1,100 900 500

Number of Employees 20 15 10 5

Total Wages (Rs) 6,000 4,000 3,000 2,000

Value of Plant (Rs) 24,000 18,000 12,000 6,000

Value of Stock (Rs) 15,000 9,000 6,000 —-

HP of Plant 24 18 12 6

Apportion the cost to various departments on the most equitable basis.

OverheadsUnit 7

103Cost Accounting

OVERHEAD DISTRIBUTION SUMMAR Y.

Costs Basis of Total P1 P2 P3 S1

apportionment Amount.

Rs. Rs. Rs. Rs. Rs.

Rent Floor area 1,000 375 275 225 125

Repairs Value of Plant 600 240 180 120 60

to Plant

Depreciation Value of Plant 450 180 135 90 45

Light Floor area 120 45 33 27 15

Power H P of Plant 900 360 270 180 90

Supervision No of employees 1,500 600 450 300 150

Fire Insurance Stock Value 500 250 150 100 --

Employers’ No of employees 150 60 45 30 15

Liability for

Insurance

Total: 5,220 2,110 1,538 1,072 500

7.5 RE-APPORTIONMENT OF SERVICEDEPARTMENT COSTS TO PRODUCTIONDEPARTMENTS AND ITS METHODS

The costs incurred in the service department need to be

reapportioned to the production departments or to the cost centres where

production is going on. This process of reapportionment of overhead

expenses is known as ‘Secondary Distribution’. The chart given below shows

various bases of apportionment which may be adopted for service

departments:

Sl.No. Service department costs Basis of apportionment.

1 Maintenance department Hours worked for each department

2 Payroll or time keeping Total labour or machine hours or

number of employees in each

department.

3 Employment or personnel Rate of labour turnover or no of

department employees in each department.

Overheads Unit 7

104 Cost Accounting

4 Store keeping department Number of requisitions or value of

materials of each department.

5 Purchase department Number of purchase orders or

value of materials in each department.

6 Welfare, ambulance, Number of employees in each

canteen services department

7 Building service department Area available in each department

8 Internal transport services Weight or value or graded product

handled or distance covered.

9 Transport department Crane hours, truck hours,

or mileage etc

10 Power House (Electric Wattage, horse power of machines

power cost) etc

11 Power House Floor area or cubic content.

The different methods of re-apportionment of service department

costs to production departments are as follows:

METHODS OF SECONDARY DISTRIBUTION

Apportionment to production Apportionment to both

Department only Production and service department

On reciprocal basis On non- reciprocal basis

Simultaneous Repeated Distribution Method Trial & Error Method

Equation Method

Apportionment to Production Department Only:

Under this method, the costs of service departments are directly

apportioned to production departments ignoring the service rendered by

one service department to another service department.

Apportionment to both Production and Service Departments:

Under this method, the costs of service department are apportioned

to both production departments and other service departments on some

i

ii i

i

i

i

i ii

OverheadsUnit 7

105Cost Accounting

equitable basis. This is usually done on reciprocal basis or non-reciprocal

basis.

Simultaneous Equation Method:

Under this method, the true cost of the service departments are

ascertained first with the help of simultaneous equations which are

subsequently re-distributed to production departments on the basis of

percentage of service rendered. It is the most popular method.

Repeated Distribution Method:

Under this method, the totals as shown in the departmental

distribution summary are put in a line. Then the services department’s total

are exhausted in turn repeated according to the agreed percentage of

services rendered until the figures become too small to matter.

Trial and Error Method :

Under this method, the cost of one service department is apportioned

to another centre. The cost of another centre plus the share of cost received

from the first centre is again apportioned to the first cost centre and this

process is repeated till the balancing figure becomes negligible.

7.6 LET US SUM UP

In this unit we have discussed the following:

• The concept of Overhead besides knowing the meaning of overhead

and the basis of its classification.

• The need for control of overheads.

• The meaning of allocation and apportionment of factory overhead and

the basis of such apportionment and the distinction between allocation

and apportionment.

• The methods used for re-distribution of service department cost to

production department.

Overheads Unit 7

106 Cost Accounting

7.7 FURTHER READING

1) Cost Accounting: Jain & Narang, Kalyani Publishers, New Delhi.

2) Cost Accounting: Dr N K Agarwal, Asian Books (p) Ltd, Delhi.

3) Cost Accounting; Principles & Practice: Nigam & Jain, Prentice Hall of

India, New Delhi.


Ans to Q No 1: An overhead has been defined as the “aggregate of indirect

material cost, indirect labour cost and indirect expenses.”

Ans to Q No 2: (a) Under allocation of overheads, the entire amount is

charged to a particular department while under apportionment only a

proportionate amount is charged to a particular department.

(b) Allocation is a first step in departmentalization of overheads whereas

apportionment is the next step.

7.9 MODEL QUESTIONS

Q 1: What do you mean by Overheads? What are the advantages of

classifying overheads into fixed and variable?

Q 2: What do you mean by factory overheads? Explain the various bases

of apportionment of overheads to various departments with illustrations

as to items of expenses.

Q 3: Explain the different methods of apportionment of service department

cost to production departments.

Q 4: Define cost allocation and cost apportionment. Explain fully the

distinction between cost allocation and cost apportionment.

Q 5: What are the different methods of secondary distribution of overheads?

Explain in brief the three methods available for dealing with reciprocal

services giving examples for each.

*** ***** ***

OverheadsUnit 7

107Cost Accounting

UNIT 8: OVERHEAD ABSORPTION

UNIT STRUCTURE

8.1 Learning objectives

8.2 Introduction

8.3 Meaning of Overhead Absorption

8.4 Overhead Rates

8.5 Methods of Absorption Overhead

8.6 Under absorption and over absorption of Overheads

8.6.1 Causes of under and over absorption of Overhead

8.6.2 Methods of Treatment for Overhead Adjustment

8.7 Administration, Selling and Distribution Overheads

8.8 Let Us Sum Up

8.9 Further Reading


8.11 Model Questions.


After going through this unit, you will be able to :

• describe the meaning of overhead absorption

• discuss the overhead rates

• outline the methods of absorption overhead

8.2 INTRODUCTION

In the earlier unit we discussed about the overhead, now in this

unit you will get a fair idea on the concept of absorption of overhead.

Here we are going to discuss the meaning of overhead absorption. The

overhead rates will also be discussed.

And at the end of the unit the different methods of absorption

overhead will be discussed.

108 Cost Accounting

8.3 MEANING OF OVERHEAD ABSORPTION

Absorption of overhead is also termed as levy, recovery, or

application of overhead. Cost absorption refers to the process of

absorbing all overhead costs allocated to apportioned over particular

cost centre or production department by the unit produced. Accordingly,

the distribution of the overhead cost to the cost centers or cost units is

known as Overhead Absorption.

8.4 OVERHEAD RATE

The apportionment of overhead expenses is done by adopting

suitable basis such as output, materials, prime cost, labour hours,

machine hours etc. In order to determine the absorption of overhead in

costs of jobs, products or process, a rate is calculated and it is called

as “Overhead Absorption Rate” or “Overhead Rate.” The overhead rate

can be calculated as below :

Overhead ExpensesOverhead Rate = ————————————

Total Quantity or Value

Different overhead rates are applied based on the features and objectives

of the business organization. The following are the important overhead

absorption rates generally employed :

1) Actual Overhead Rate

2) Predetermined Overhead Rate

3) Blanket Overhead Rate

4) Multiple overhead Rate

5) Normal Overhead Rate

6) Supplementary Overhead Rate

Each of the above overhead absorption rates has been explained

in the following pages :

1) Actual Overhead Rate : Actual overhead rate as otherwise called

the historical rate. This rate is calculated by dividing the actual

overhead absorbed by the actual quantity or value of the base

selected for a particular period. Assuming that overhead rate is

Overhead AbsorptionUnit 8

109Cost Accounting

calculated on monthly basis, the following formula is expressed

as:

Actual Overhead during the monthActual Overhead Rate = ———————————————————————— × 100

Actual Quantity or value of the base for the month

2) Predetermined Overhead Rate : Predetermined overhead rate

is determined in advance of actual production and the rate is

computed by dividing the budget overhead for the accounting period

by the budgeted base for the period. The formula is :

Budgeted Overheads for the PeriodPre-determined Overhead Rate = ——————————————————— × 100

Budgeted base for the Period

3) Blanket Overhead Rate: Blanket overhead rate is also termed

as Single Overhead Rate. A single overhead rate when computed

for the entire factory is known as Blanket Rate. It is calculated as:Overhead of Entire Factory

Blanket Rate = ——————————————————

Total Quantum of the Base Selected

Single rate may be applied suitably in small concerns and only where

a single product is manufactured.

4) Multiple Overhead Rate : Multiple overhead rates involves

computation of separate rates for each production department,

service department, cost centre, each product or line and for each

production factor. The following formula is used for calculating

multiple overhead rate :

Overhead Cost Allocated and Apportioned

to Each Cost CentreMultiple Overhead Rate = —————————————————————

Corresponding Base

5) Normal Overhead Rate : Normal Overhead Rate is a

predetermined rate calculated with reference to normal capacity. It

is calculated as :

Normal OverheadNormal Overhead Rate = —————————————

Base at Normal Capacity

6) Supplementary Overhead Rates : These rates used to carryout

adjustment between overhead absorbed and overhead incurred.

Overhead Absorption Unit 8

110 Cost Accounting

These are used in addition to some other rates and is calculated

as under :

Actual Overhead Incurred - Absorbed OverheadSupplementary Overhead Rates = ———————————————————————

Base Unit or Hours

CHECK YOUR PROGRESS

Q1: Fill in the blanks:

a.Absorption of overhead is also termed as

levy, recovery, or …………………… of

overhead

b. Actual overhead rate as otherwise called the …………….

rate

c. Predetermined overhead rate is determined in advance of

…………………………. production

d. Blanket overhead rate is also termed as …………………..

Rate.

e. ……………………… is a predetermined rate calculated with

reference to normal capacity

Q2: What are the important overhead absorption rates generally

employed?

.....................................................................................................

.....................................................................................................

.....................................................................................................

.....................................................................................................

8.5 METHODS OF ABSORPTION OVERHEAD

There are number of methods applicable for computing overhead

absorption rate. The following are the various methods of absorbing

“Manufacturing Overhead” depending upon the suitable basis selected

for the purpose:

1) Direct Material Cost Method

2) Direct Labour Cost Method


111Cost Accounting

3) Direct Labour Hours Method

4) Prime Cost Method

5) Unit of Output Method

6) Machine Hour Rate Method

1. DIRECT MATERIAL COST METHOD :

Under this method, the rate of absorption is calculated on the basis of

direct material cost method. The rate of manufacturing overhead

absorption is determined by dividing the manufacturing overhead by the

direct material cost. The result obtained the rate of absorption is

expressed as percentage. Thus, the overhead rate is calculated by the

following formula :

Factory OverheadsDirect Material Percentage Rate = —————————— × 100

Direct Material Cost

EXERCISE : 1

Manufacturing overhead budget for 2003 = Rs.20,000

Cost of direct materials = Rs.80,000

Calculation :

20,000Direct Material Percentage Rate = ----------------- × 100

80,000

= 25%

2) DIRECT LABOUR COST METHOD:

Direct Labour Cost Method is also termed as Direct Wages Method.

Under this method direct wage rate can be determined by dividing the

estimated factory overhead cost apportioned by the predetermined direct

wages, and the result obtained is expressed as a percentage. The

following formula for calculating the percentage rate is :

Factory OverheadPercentage of Direct Labour Rate = ————————— × 100

Direct Wages


112 Cost Accounting

EXERCISE : 2

Direct Wages paid in factory

during the year 2003, = Rs. 10,000

Factory overhead during that

the period was = Rs. 4,000

4,000Direct Labour Percentage Rate = ----------------- × 100 = 40%

10,000

3) DIRECT LABOUR HOURS METHOD:

Under this method the rate is determined by dividing the production of

Factory overheads by direct labour hours of each department. This

method is designed to overcome the objections of direct labour cost

method. This method is most suitable in such industries where the

production is carried out manually or by skilled labours. Thus, the direct

labour hour rate will be calculated by applying the following formula :

Factory OverheadDirect Labour Hour Rate = ——————————

Direct Labour Hour

4) PRIME COST METHOD :

Under this method, both direct material cost and direct labour cost are

taken into account for determination of recovery rate. The actual or

predetermined rate of factory absorption is computed by dividing actual

or budgeted overhead expenses by the aggregate of direct material or

direct labour cost of the department. The following formula is used for

calculation of overhead recovery rate :

Factory OverheadOverhead Recovery Rate = --------------------------------- × 100

Prime Cost


113Cost Accounting

EXERCISE : 3

You are required to find out (I) Direct Material Cost

Rate (2) Direct Labour Cost Rate (3) Direct Labour

Hours and (4) Prime Cost rate from the following particulars :

Total Overhead for the period Rs. 25,000

Total direct labour cost (Direct wages) Rs. 8,000

Total materials used or Direct material cost Rs. 10,000

Total direct labour hours Rs. 2,000

Solution : 3

Factory Overhead1) Direct Material Cost Rate = —————————— × 100

Direct Material Cost

25000= ———————— × 100 = 250%

10000

Factory Overhead2) Direct Labour Cost Rate = —————————— × 100

Direct Wages

25000= —————————× 100 = 312.5%

8000

Factory Overhead3) Direct Labour Hours Rate = --------------------------------- × 100

Direct Labour Hours

25000= ————————— × 100 = 1250%

2000

Factory Overhead4) Prime Cost Rate = —————————— × 100

Prime Cost


114 Cost Accounting

25000= —————————— × 100

10000 + 8000

25000= —————— × 100 = 138.88%

18000

5. UNIT OF OUTPUT METHOD:

This method is also termed as Production Unit Method of Cost Unit

Rate method. Under this method absorption rate is determined on the

basis of number of units produced is known as Cost Unit Rate. The

recovery rate is calculated by dividing the actual or budgeted factory

overheads by the number of cost units produced. The formula is :

Factory OverheadCost Unit Rate = ————————————

No. of Units Produced

This method is most suitable in such industries where the production of

same grade is carried out.

6) MACHINE HOUR RATE:

Machine hour rate means the cost of expenses incurred in running a

machine for one hour. It is one of the scientific methods of absorbing

factory expenses where the process of manufacturing are carried out by

machines. Under this method, overhead costs are allocated on the basis

of the number of hours a machine or machines are used for a particular

job. According to the Institute of Cost and Management Accountants,

England a machine hour rate is “an actual or Predetermined rate of cost

apportionment or overhead absorption, which is calculated by dividing

the cost to be apportioned or absorbed by the number of machine hours

expended or to expended.”

Expended:

Spent


115Cost Accounting

The machine hour rate is determined by dividing the amount of overhead

cost to be apportioned or absorbed by the number of machine hours.

Machine hour rate can be calculated as below :

Factory OverheadMachine Hour Rate = ———————————

Machine Hours

Calculation of Machine Hour Rate : The following steps are required

for computing the machine hour rate :

1) Identify the overhead expenses relating to a specific machine or

group of machine in order to require for computing machine hour

rate.

2) Each machine or group of machine treated as a cost centre.

3) Manufacturing overhead or machine expenses are grouped into

two types :

a) Fixed or Standing Charges

b) Variable Machine Expenses.

a) Fixed or S tanding Charges : Fixed or Standing Charges

which remain constant irrespective of the use of machine.

For example, rent, insurance charges, rates, supervision etc.

b) Variable Machine Expenses : These expenses are variable

with use of the machine. For example, power, depreciation

repairs etc.

4) An hourly rate of fixed or standing charges will be calculated by

totalling of fixed charges and dividing by the number of normal

hours worked by machine.

5) Normal working hours are calculated by adding the cost relating to

non-productive time i.e. normal ideal time for maintenance and

setting up etc.

6) Separate hourly rate for each machine expenses will be calculated.

7) The total of the standing charges rate and machine expenses

rates per hour will give the machine hour rate.


116 Cost Accounting

Basis for apportionment of Machine Expenses

The following bases of apportionment of different expenses are required

to be considered for the calculation of machine hour rate :

Expenses Basis

Fixed or Standing Expenses :

1) Rent and Rates Floor area occupied by each machine.

2) Heating and Lighting No. of points used or Floor area or

heating any machine

3) Supervision Time spent on each machine

4) Lubricating Oil and Machine hours, Past experience or

Consumable Stores Capital value.

5) Insurance

Machine Expenses :

1. Depreciation Value of Machine

2. Power Horse power of each machine

3. Repairs Cost of repairs spread over its working

life.

Advantages

1) It helps to measure the relative efficiency of different machines.

2) It facilitates comparison of cost of operating different machines.

3) It helps to ascertain idle time of machines relating to non-productive

time.

4) It is the most desirable scientific method, where the time factor is

taken into account.

Disadvantages

1) It involves more clerical labour in determining the number of

machine hours worked.

2) It does not consider where the expenses not proportional to the

working hours of machines.

3) It is very difficult to measure the machine hours where the works

are completed without operating any machinery.


117Cost Accounting

EXERCISE : 4

Calculate machine hour rate of Machine X

Rs.

Consumable stores 600

Repairs 800

Heat and light 360

Rent 1,200

Insurance of building 4,800

Insurance of machines 800


Room services 60

General charges 90

Normal working hours 10,000 hours

Area of sq. fit. 100

Book value of machines 12,000

Solution : 4

Computation of Machine Hour Rate for Machine X

Particulars Total per hour Rate per hour

Rs. Rs.

Standing Charges :

Consumable stores 600

Heat and light (360 × 100/600) 60

Rent (1200 × 100/ 600) 200

Insurance of building (4800 × 100/600) 800

Insurance of Machine (800 ×12000 / 32000) 300

Room Service (60 ×100 / 600) 10

General charge (90 × 100 / 600) 15

Total Standing charges 1, 985

1,985

Standing charges per hour —————— = 0.199

10,000


118 Cost Accounting

Machine Expenses :

Repairs (800 / 10,000) 0.080

Depreciation of machines (135.48 / 10,000) 0.014

Machine Hour Rate 0.293

Working Notes

1) Heat and light, rent, insurance of building, room service and general

charges have been distributed on the basis of floor area.

2) Depreciation of machine has been calculated on the basis of book

value of machines and working hours, i.e. 10,000 × 12000 (or) 120

: 500 = 6 : 25.

700 × 6/ 31 = Rs. 135.48.

3) Insurance of machine has been apportioned on the basis of book

value of machines.

CHECK YOUR PROGRESS

Q3: Fill in the blanks

a.Under Direct Material Cost Method, the rate

of absorption is calculated on the basis of

………………………. cost method.

b. Direct Labour Cost Method is also termed as ………………...

Method.

c. Direct Labour Hours Method is designed to overcome the

objections of …………………….. cost method

d. Under Prime Cost Method, both ………………. cost and

…………………..cost are taken into account

e. Unit of Output Method is also termed as ………………………

of Cost Unit Rate method

f. Machine hour rate means the cost of expenses incurred in

running a machine for ………………….hour.


119Cost Accounting

8.6 UNDER ABSORPTION AND OVER ABSORPTIONOF OVERHEADS

Absorption of overhead may be based either on the actual rate

or predetermined rate. If the actual rates are used, the costs having

been actually incurred and overhead absorbed are equal. But in the

case of predetermined rates, the costs have been determined in advance

of incurrence of the overhead expenditure. This may lead to difference

of overhead incurred and overhead absorbed. Such a difference of

Overhead is said to be under absorption of overhead or over absorption

of overhead.

According, the term over absorption means that the amount of

overhead absorption is more than the actual is said to be over absorption

of overhead.

The term under absorption of overhead means that the amount

of overhead absorption is less than the actual overhead incurred is said

to be under absorption of overhead.

8.6.1 Cause of Under and Over Absorption of

Overhead

The following are some of the reasons for over and under

absorption of overheads:

1) Actual overhead cost incurred may be more or less than the

budgeted overhead.

2) Actual machine hours, labour hour and output may be lower

or higher than the budgeted or predetermined base.

3) Seasonal fluctuations.

4) Wrong computation of overhead absorption rate, output and

machine hours.

5) Under or Over utilization of production capacity.

8.6.2 Methods of T reatment for Overhead Adjustment

The following three important methods may be adopted for

overhead adjustment and disposal of over or under absorption of


120 Cost Accounting

overheads :

1) Carrying Over of Overheads

2) Application or use of supplementary rates

3) Write off to Costing Profit and Loss Account.

1) Carrying Over of Overheads : Under this method, the

amount of over or under absorption is carry forward to the

next year. This method may be adopted in situation where

the normal business cycle extends for more than one year.

2) Application of Supplementary Rate : Under this method,

the supplementary rate is adopted when the amount of under

or over absorbed overheads is quite large. Supplementary

rate is calculated by dividing the amount of under or over

absorbed overheads by the actual base.

Amount of Under or Over Absorbed OverheadsSupplementary Rate = ———————————————————————

Actual Base

The supplementary rate may be used as positive

supplementary rate or negative supplementary rate. In the case

of positive supplementary rate it is intended to add under absorbed

overhead to cost of production. A negative rate, however, adjusted

the cost by deducting the amount of over absorbed overhead.

3) Write off to Costing Profit and Loss Account: Under this

method, if the amount of under or over absorbed overhead is

small it may be written off to Costing Profit and Loss Account.

If due to some abnormal factors, the amount of under or over

absorbed is large it should be transferred to profit and Loss

Account.

8.7 ADMINISTRATION, SELLING AND DISTRIBUTIONOVERHEADS

Administration Overhead: Administrative overhead are incurred in

general for management to discharge its functions of planning,

Organizing, controlling, co-ordination and directing. These expenses are


121Cost Accounting

not specifically incurred. Thus, the overheads are collected under a

standing order number, allocated and apportioned to various cost centers

and units.

The administrative overhead is absorbed under any one of the following

methods :

1) Transferring to Profit and Loss account

2) Apportioning to Works Overheads

3) Apportioning to selling Overheads.

Selling and Distribution Overhead: Selling and distribution expenses

are incurred for promoting sales, securing order, creating demand and

distribution of products or output from producers to the ultimate

consumers. The incidence of selling and distribution overheads depends

on external factors such as distance of market, nature of competition

etc. which are beyond the control of management. They are dependent

upon customer’s behaviour, liking etc. These expenses are the nature

of policy costs and hence not amenable to control. The overhead rate

of selling and distribution overheads can be determined by any one of

the following basis:

a) A rate per article or unit of production

b) A percentage on the selling price of each article or production unit.

c) A percentage on the factory cost.

CHECK YOUR PROGRESS

Q4: What do you mean by under absorption and

over absorption of overheads?

................................................................................

..................................................................................................................

.................................................................................................................

Q5: What do you mean by selling and distribution overhead and

administration overhead?

.....................................................................................................

.....................................................................................................

Amenable :

Open to being acted

upon in a certain way.


122 Cost Accounting

8.8 LET US SUM UP


• The distribution of the overhead cost to the cost centers or cost

units is known as Overhead Absorption.

• In order to determine the absorption of overhead in costs of jobs,

products or process, a rate is calculated and it is called as

“Overhead Absorption Rate” or “Overhead Rate.”

• The following are the important overhead absorption rates

generally employed :







• The following are the various methods of absorbing “Manufacturing

Overhead” depending upon the suitable basis selected for the

purpose:

1) Direct Material Cost Method

2) Direct Labour Cost Method

3) Direct Labour Hours Method

4) Prime Cost Method

5) Unit of Output Method

6) Machine Hour Rate Method

• Over absorption means that the amount of overhead absorption

is more than the actual is said to be over absorption of overhead.

• Under absorption of overhead means that the amount of overhead

absorption is less than the actual overhead incurred is said to be

under absorption of overhead.

• Administrative overhead are incurred in general for management

to discharge its functions of planning, organizing, controlling, co-

ordination and directing.


123Cost Accounting

• Selling and distribution expenses are incurred for promoting sales,

securing order, creating demand and distribution of products or

output from producers to the ultimate consumers.

8.9 FURTHER READING

1. Management Accounting: Khan & Jain

2. Cost Accounting : Hongren

3. Cost & Management Accounting: Jain & Narang

4. Cost Accounting: B. Banerjee


Ans to Q No 1: a. application b. historical c. Normal Overhead Rate

d. Single Overhead e. actual production

Ans to Q No 2: The important overhead absorption rates generally

employed are as follows :







Ans to Q No 3: a. direct material cost

b. Direct Wages

c. direct labour cost

d. material cost and direct labour

e. Production Unit Method

f. one

Ans to Q No 4: Over absorption means that the amount of overhead

absorption is more than the actual is said to be over absorption of

overhead.


124 Cost Accounting

Under absorption of overhead means that the amount of overhead

absorption is less than the actual overhead incurred is said to be

under absorption of overhead.

Ans to Q No 5: Selling and distribution expenses are incurred for

promoting sales, securing order, creating demand and distribution

of products or output from producers to the ultimate consumers.

Administrative overhead are incurred in general for management

to discharge its functions of planning, organizing, controlling, co-

ordination and directing.


Q 1. Explain absorption of overhead.

Q 2. What do you understand by overhead rates.

Q 3. Briefly explain the different kinds of overhead absorption rates.

Q 4. What do you understand by machine hour rate? How it is

computed?

Q 5. What do you mean by absorption and over absorption of overhead?

Brief explain the methods of treatment of under or over absorption

of overheads.

Q 6. Compute Machine hour rate from the following data :

Cost of machine Rs. 1,10,000

Installation charges Rs. 10,000

Estimated scrap value (after 15 years) Rs. 5,000

Rent and rates for the shop Rs. 200 P.M.

General lighting for the shop Rs. 300 P.M.

Insurance premium for the machine Rs. 960 P.a.

Repairs and maintenance Rs. 1000 P.a.

Power consumption 10 units per hour

Rate of power per 100 units Rs. 20

Estimated working hours per annum 2200 which include setting up

time of 200 hours.


125Cost Accounting

Shop supervisor’s salary per month Rs. 600

The machine occupies d of the total area of the shop. The shop

supervisor is expected to devote 1/5the

of his time for supervising the machine.

[Ans : Machine hour rate : Rs 7.95]

*** ***** ***


126 Cost Accounting

UNIT 9: ADMINISTRATION, SELLING ANDDISTRIBUTION OVERHEADS

UNIT STRUCTURE


9.2 Introduction

9.3 Administrative Overheads

9.4 Accounting of Administrative Overheads

9.5 Control of Administrative Overheads

9.6 Selling and Distribution Overheads

9.7 Accounting of Selling and Distribution Overheads

9.8 Control of Selling and Distribution Overheads

9.9 Let Us Sum Up





After going through this unit, you will be able to:-

• discuss the meaning and definition of administrative, selling and

distribution overheads

• explain the accounting and control of administrative, selling and

distribution overheads

• discuss about the distribution and absorption of selling and distribution

overheads.

9.2 INTRODUCTION

In our previous units, we have already discussed in details about

overheads, its classification, allocation, apportionment, absorption etc. In

this unit, we will have further discussion on accounting and control of

administrative, selling and distribution overheads. We all have now

understood that overheads are also a very important cost element alongwith

127Cost Accounting

direct materials and direct employees. An organisation cannot ignore

overheads either for the purpose of arriving at the cost of a job or a product

or for controlling total expenditure.

Overheads are incurred not only in the factory of production but also

on administration, selling and distribution. Administrative overheads are

expenditures incurred on all activities relating to general management and

administration of an organisation. Selling overheads are expenses relating

to sale of products and include all indirect expenses in sales management

for the organisation. And distribution overheads are expenses incurred to

make the product available for sale in the market.

9.3 ADMINISTRATIVE OVERHEADS

According to CIMA, London, Administrative overhead is defined as

“The sum of those costs of general management and of secretarial

accounting and administrative services, which cannot be directly related to

the production, marketing, research or development functions of the

enterprise.” As per Cost Accounting Standards (CAS)-3 issued by the Council

of the ICWAI, Administrative Overheads are defined as “Cost of all activities

relating to general management and administration of an organisation.”

From the above definitions we can conclude that administrative

overhead constitutes the expenses incurred in connection with the

formulation of policy directing the organisation and controlling the operations

of an undertaking.

For any organisation, controlling the administrative overheads is very

difficult because unlike other variables like production or sales, they do not

vary. Examples of such overheads are, office salaries, printing and

stationery, office telephone, office rent, electricity used in the office, salaries

of administrative staff etc. The size as well as control over these overheads

depends largely on decisions of management. Organisations growing rapidly

might face the problem of controlling Administrative Overheads. Further,

multi-location set up leads to duplication of many administrative costs.

Administration, Selling and Distribution Overheads Unit 9

128 Cost Accounting

9.4 ACCOUNTING OF ADMINISTRATIVE OVERHEADS

The accounting of administrative overheads may be done with the

help three different methods as discussed below:

1) Apportioning Administrative Overheads between Production and Sales

Departments: According to this method, it is assumed that

administrative overheads are incurred both for production and for

selling and distribution. Therefore these overheads should be divided

on some equitable basis between production and selling and

distribution activity. Under this method, administrative overheads lose

their identity and get merged with production and selling and distribution

overheads. The problem is of course, selection of basis to divide these

overheads over the two principal functions of production and selling.

2) Charging to Profit and Loss Account: Under this method, administrative

overheads are charged to Costing Profit & Loss Account. According

to this method, administrative costs are all time based costs and are

not directly concerned with either the production or the selling and

distribution functions. Hence these overheads should be treated as

fixed cost and transferred to the Costing Profit and Loss Account.

Further, it is difficult to determine a suitable basis for proportioning

administrative overheads over production and sales departments.

3) Treating Administrative Overheads as a separate addition to Cost of

Production & Sales: In this method, administrative overheads are

considered as a cost of a distinct and identifiable operation of the

organisation necessary to carry on its activity. Therefore these

overheads are recovered separately on some equitable basis which

may be on cost or sales basis.

9.5 CONTROL OF ADMINISTRATIVE OVERHEADS

Usually administrative overheads are of fixed nature and difficult to

control at the lower level of management. However, some control may be

exercised by the top management as they pertain to formulating policy and

directing the organisation. The first step in the control mechanism is proper

Administration, Selling and Distribution OverheadsUnit 9

129Cost Accounting

classification of expenses and departmentalisation. The actual expenses

are collected for each department and then compared with a bench mark.

Deviation are analysed and causes for increase are mitigated by fixing

responsibility on the departmental head.

Following methods are usually applied to control administrative overheads:

(i) Figures of the previous period: Expenses could be compared with the

figures of previous year and increase or decrease are analysed.

However, comparison with previous year may not help as the condition

may have totally changed from one year to the other. To overcome

this difficulty, overhead absorption rates may be compared from period

to period; the extent of over or under absorption will reveal the efficiency

or otherwise of the department.

(ii) Control through budgets: According to this method, Budgets are

estimates for the current year, and they take into account the changed

conditions. They also built in the year’s complete plan which would

factor all changes in the cost structure. It is advisable to compare

budgeted overheads with actual for control purpose.

(iii) Use of standards. Although very scientific, this method is difficult to

operate. Administrative activities (being very subjective) cannot be

standardised. On a certain level it can be applied e.g. the time taken to

process a voucher by accountant can be standardised, or time taken

for processing a payment could be standardised.

CHECK YOUR PROGRESS

Q 1: Define Administrative Overheads.

................................................................................

........................................................................................................

Q 2: Give four examples of administrative overheads.

........................................................................................................

........................................................................................................


130 Cost Accounting

9.6 SELLING AND DISTRIBUTION OVERHEADS

Selling overheads include the costs incurred in promoting sales and

retaining customers. As per Cost Accounting Standards (CAS)-3, Selling

Overheads, also known as Selling Costs, are the expenses related to sale

of products and include all indirect expenses in sales management for the

organization. Overheads incurred for getting orders from consumers are

also Selling Overheads. Selling overheads are incurred after the production

of products or services is completed and hence known as ‘after-production

costs’. Selling overheads are incurred to create and stimulate demand and

increase the sales to the existing and potential customers.

On the other hand, overheads incurred for execution of order are

called as Distribution Overheads. Distribution overheads are incurred to

take the finished goods from the place of production to the place of resale or

consumption. As per CAS-3, Distribution Overheads, also known as

Distribution Cost, are the cost incurred in handling a product from the time

it is ready for dispatch until it reaches the ultimate consumer.

Examples of Selling Overheads are sales promotion expenses,

marketing expenses, salesmen’s salaries and commission, advertising

expenses etc. Examples of Distribution Overheads are warehouse charges,

transportation of outgoing goods, packing, commission of middlemen etc.

9.7 ACCOUNTING OF SELLING AND DISTRIBUTIONOVERHEADS

It is not easy to determine an entirely satisfactory basis for computing

the overhead rate for absorbing selling overheads. Some expenses like sales

commission, shipping costs, and direct selling expenses can be absorbed

directly. The bases usually adopted are:

(a) Sales value of goods;

(b) Cost of goods sold;

(c) Gross Profit on sales; and

(d) Number of orders or units sold.


131Cost Accounting

Generally, sales value of goods is assumed to be most logical basis

for computing the overhead rate for absorbing selling overheads.

9.8 CONTROL OF SELLING AND DISTRIBUTIONOVERHEADS

Selling and Distribution overheads are incurred to maximise the

sales. Controlling such expenses is not an easy task because-

(i) The incidence of selling & distribution overheads depends on external

factors such as distance of market, nature of competition etc. which

are beyond the control of management.

(ii) They are dependent upon customers’ behaviour, liking etc.

(iii) These expenses are of the nature of policy costs and hence not

amenable to control.

The above problems of controlling selling & distribution overheads can

be tackled by adopting the following steps:

(a) Comparing the figures of selling & distribution overhead with the figures

of previous period.

(b) Selling & distribution overhead budgets may be used to control such

overhead expenses by making a comparison of budgetary figures with

actual figures of overhead expenses, ascertaining variances and finally

taking suitable actions,

(c) Standards of selling & distribution expenses may be set up for

salesmen, territories, products etc. The laid down standards on

comparison with actual overhead expenses will reveal variances, which

can be controlled by suitable action.

CHECK YOUR PROGRESS

Q 3: Define Selling Overheads.

.................................................................................

........................................................................................................

Q 4: Mention the bases usually adopted for selling overheads.

........................................................................................................

........................................................................................................


132 Cost Accounting

EXERCISE: 1

ABC Ltd. has shown following expenses in his books

Repairs of Delivery Van 5,000

Lighting of warehouse 3000

Warehouse wages 6,800

Warehouse repairs 2,500

Lighting of office 1,300


Director’s remuneration 10,400

Travelling expenses of salesmen 1,700

Rent, rates and insurance of warehouse 3000

Rent, rates and insurance of office 2,300

Agents’ commission 7,500

Printing and stationery 3,500

Trade magazines 700

Bad debts 300

From the above information prepare a statement showing in separate

total: (a) Administration expenses, (b) Selling expenses. (c) Distribution

expenses.

Solution:

(a) Administration Expenses : Rs.


Lighting of Office 1,300




Trade magazines 700

Total 28400

(b) Selling Expenses : Rs.



Bad debts 300


133Cost Accounting

Total 9,500

(c) Distribution Expenses :

Warehousing wages 6,800


Rent, rates and insurance of warehouse 3,000

Lighting of warehouse 3,000


Total 20,300

9.9 LET US SUM UP

In this unit we have discussed the following points:

• Administrative overhead constitutes the expenses incurred in

connection with the formulation of policy directing the organisation and

controlling the operations of an undertaking.

• For any organisation, controlling the administrative overheads is very

difficult because unlike other variables like production or sales, they

do not vary.

• The accounting of administrative overheads may be done with the

help three different methods:

a) Apportioning Administrative Overheads between Production and

Sales Departments

b) Charging to Profit and Loss Account

c) Treating Administrative Overheads as a separate addition to Cost

of Production & Sales:

• Usually administrative overheads are of fixed nature and difficult to

control at the lower level of management. However, some control may

be exercised by the top management as they pertain to formulating

policy and directing the organisation.

• Following methods are usually applied to control administrative

overheads:

a) Figures of the previous period:


134 Cost Accounting

b) Control through budgets:

c) Use of standards.

• Selling overheads are incurred after the production of products or

services is completed and hence known as ‘after-production costs’.

• Selling overheads are incurred to create and stimulate demand and

increase the sales to the existing and potential customers.

• Overheads incurred for execution of order are called as Distribution

Overheads. Distribution overheads are incurred to take the finished

goods from the place of production to the place of resale or

consumption.

• Sales value of goods is assumed to be most logical basis for computing

the overhead rate for absorbing selling overheads.

9.10 FURTHER READINGS

1) Arora, M.N (2016), ‘Cost Accounting-Theory, Problems and Solutions’

Himalaya Publishing House

2) Sharma & Gupta (2001), ‘Management Accounting-Principles and

Practice’ Kalyani Publishers

3) Cost Accounting, Study Notes, ICMAI, New Delhi

4) Cost and Management Accounting, Study Notes, ICAI, New Delhi


Ans to Q No 1: According to CIMA, London, Administrative overhead is

defined as “The sum of those costs of general management and of

secretarial accounting and administrative services, which cannot be

directly related to the production, marketing, research or development

functions of the enterprise.”

Ans to Q No 2: Examples of administrative overheads are office salaries,

printing and stationery, office telephone and office rent.


135Cost Accounting

Ans to Q No 3: As per Cost Accounting Standards (CAS)-3, Selling

Overheads, also known as Selling Costs, are the expenses related to

sale of products and include all indirect expenses in sales management

for the organization.

Ans to Q No 4: The bases usually adopted are:

(a) Sales value of goods;

(b) Cost of goods sold;

(c) Gross Profit on sales; and

(d) Number of orders or units sold.


Q 1: What do you mean by Administrative Overheads.

Q 2: Write briefly about accounting and control of Administrative Overheads.

Q 3: Give the meaning of Selling Overheads.

Q 4: Explain in details the accounting and control of Selling and Distribution

Overheads.

Q 5: XYZ Ltd. has shown following expenses in his books


Salesmen Commission 5,000

Salary paid to Office Staffs 20,000

Repairs and Maintenance of Office Building 10,000

Depreciation of Office building 8,000

Accounts and Audit Expenses 15,000


Lighting of warehouse 2,000

Warehouse wages 7,100



Lighting of office 1,300




136 Cost Accounting

Rent, rates and insurance of warehouse 3000


Transit Insurance 2,000

From the above information prepare a statement showing in separate

total: (a) Administration expenses, (b) Selling expenses. (c) Distribution

expenses.

*** ***** ***


137Cost Accounting

UNIT 10: PROCESS COSTING

UNIT STRUCTURE


10.2 Introduction

10.3 Process Costing- Basic Concepts

10.3.1 Meaning

10.3.2 Characteristics of process costing

10.3.3 Difference between Job Costing and Process

Costing

10.3.4 Advantages and Disadvantages of Process Costing

10.4 Process Loss

10.5 Let Us Sum Up





After going through this unit, you will be able to :

• explain Process Costing

• describe difference between job costing and process costing

• discuss the advantages and disadvantages of process costing.

10.2 INTRODUCTION

In the earlier unit we have discussed on Cost Sheet. Here we

are going to discuss about process costing. Process costing is an

accounting methodology that traces and accumulates direct costs, and

allocates indirect costs of a manufacturing process. Costs are assigned

to products, usually in a large batch, which might include an entire

month's production. Eventually, costs have to be allocated to individual

units of product. It assigns average costs to each unit, and is the opposite

extreme of Job costing which attempts to measure individual costs of

production of each unit.

138 Cost Accounting

10.3 PROCESS COSTING – BASIC CONCEPTS

Process costing is a type of operation costing which is used to ascertain

the cost of a product at each process or stage of manufacture. Chartered

Institutes of Management Accountants defines process costing as "The

costing method applicable where goods or services result from a

sequence of continuous or repetitive operations or processes. Costs

are averaged over the units produced during the period". Process costing

is suitable for industries producing homogeneous products and where

production is a continuous flow. A process can be referred to as the

sub-unit of an organization specifically defined for cost collection purpose.

10.3.1 Meaning

Process Costing is a method of costing. It is employed

where each similar units or production involved in different series

of process from conversion of raw materials into finished output.

Thus unit cost is determined on the basis of accumulated costs

of each operation or at each stage of manufacturing a product.

Charles T. Horngren defines process costing as “a method of

costing deals with the mass production of the like units that usually

pass the continuous fashion through a number of operations called

process costing.”

The application of process costing where industries adopting

costing procedure for continuous or mass production. Textiles,

chemical works, cement industries, food processing industries etc.

are the few examples of industries where process costing is

applied.

10.3.2 Characteristics of Process Costing

1) Continuous or mass production where products which passes

through distinct process or operations.

2) Each process is deemed as a separate operations or

production centre.

3) Products produced are completely homogenous and

standardized.

Process CostingUnit 10

139Cost Accounting

4) Output and cost of one process are transferred to the next

process till the finished product completed.

5) Cost of raw materials, labour and overheads are collected

for each process.

6) The cost of a finished unit is determined by accumulated of

all costs incurred in all the process divided by the number

of units produced.

7) The cost of normal and abnormal losses usually incurred at

different stages of production is added to finished goods.

8) The interconnected processes make the final output of by-

product or Joint products possible.

10.3.3 Difference between Job Costing and Process

Costing

Job Costing Process Costing

1) Production is made against 1) Production is a continuous

specific order from the process based on future

customers. demand

2) Variety of products are 2) Homogenous products are

produced according produced in large scale.

to specifications.

3) Output and costs are not 3) Output and costs are transferred

involved in any transactions from one process to another

from one job to another. process.

4) Cost control is more 4) Effective cost control is

difficult because each possible because production

job is different from other. is standardized.

5) Cost ascertainment and 5) Costs are collected and

determination of unit cost accumulated at the end of

can be possible only when the accounting period.

job is completed.

6) There is no question of 6) Work in progress is always

work in progress at the there because production

beginning or end of the is continuous.

period.

Process Costing Unit 10

140 Cost Accounting

10.3.4 Advant ages and Disadvant ages of Process Costing

Advantages

The main advantages of process costing are :

1) Determination of the cost of process and unit cost is possible

at short intervals.

2) Effective cost control is possible.

3) Computation of average cost is easier because the products

produced are homogenous.

4) It ensures correct valuation of opening and closing stock of

work in progress in each process.

5) It is simple to operate and involve less expenditure.

Disadvantages

1) Computation of average cost does not give the true picture

because costs are obtained on historical basis.

2) Operational weakness and inefficiencies on processes can

be concealed.

3) It becomes more difficult to apportionment of joint costs,

when more than one type of products manufactured.

4) Valuation of work in progress is done on estimated basis, it

leads to inaccuracies in total costs.

5) It is difficult to measure the performance of individual workers

and supervisors.

CHECK YOUR PROGRESS

Q1. Write any two differences between job costing

and process costing.

... ........................................................................

.... .................................................................................................

Q2. Mention any two advantages and disadvantages of process

costing.

.....................................................................................................

.....................................................................................................

Apportionment:

Distribution accord-

ing to a plan


141Cost Accounting

EXERCISE : 1

Following figures show the cost of A product passes

through three processes. In March 1000 units were

produced. Prepare the process accounts and find

out per unit of each process.

Process I Process II Process III

Rs. Rs. Rs.

Raw materials 50,000 30,000 20,000

Wages 30,000 25,000 25,000

Direct Expenses 7,000 3,000 5,000

Overhead expenses were Rs. 12,000 and it should be apportioned

on the basis of wages.

Solution : 1

Process I Account

Particulars Units Amounts Particulars Units Amounts

Rs. Rs.

To Raw Materials 1,000 50,000 By Process II A/c 1,000 91,500

To wages 30,000 (Output transferred

To Direct 7,000 @ Rs . 91.50 per

Expenses unit)

To Overheads

×1200016

64,500

1,000 91,500 1,000 91,500


142 Cost Accounting

Process II Account


Rs. Rs.

To Process II A/c 1,000 91,500 By Process III A/c 1,000 1,53,250

(Transferred from (Output transferred

Process I) @ Rs . 153.25 per

To Raw Materials 30,000 unit)

To wages 25,000

To Direct Expenses 3,000

To Overheads

×1200016

53,750

1,000 1,53,250 1,000 1,53,250

Process III Account


Rs. Rs.

To Process II A/c 1,000 1,53,250 By Finished stock 1,000 2,07,000

(Transferred from (Output transferred

Process II) @ Rs . 153.25 per

To Raw Materials 20,000 unit)

To wages 25,000

To Direct Expenses 5,000

To Overheads

×1200016

53,750

1,000 2,07,000 1,000 2,07,000

10.4 PROCESS LOSSES

Process Losses may be defined as the loss of material occur at

different stages of manufacturing process. The following are the types


143Cost Accounting

of losses unavoidable during the course of processing operations such

as :

1) Normal Process Loss

2) Abnormal Process Loss

3) Abnormal Process Gain

4) Spoilage

5) Defectives

1) Normal Process Loss : The cost of normal process loss in

practice is absorbed by good units produced under the process:

This is known as Normal Process Loss or Normal Wastage. For

example, evaporation, scrap, stamping process etc. The amount

realized by the sale of normal process loss units should be credited

to process account.

(2) Abnormal Process Loss : The cost of an abnormal process loss

unit is equal to the cost of good unit. The total cost of abnormal

process loss is credited to process accounts from which it arises.

This is known as Abnormal Process Loss. Such loss may be

caused by breakdown of machinery, false production planning, lack

of effective supervision, substandard materials etc. Cost of

abnormal process loss is not treated as cost of the product. In

fact, the total cost of abnormal process loss is debited to Costing

Profit and Loss Account.

Computation of Abnormal Loss :

Normal Cost of Normal outputValue of Abnormal Loss = -------------------------------------------- × Units of Abnormal Loss

Normal Output

Where :

Quantity of Abnormal Loss = Normal Output - Actual Output

Normal Output = Input - Normal Loss

If actual output is less than normal output the balance represents Units

of Abnormal Loss.


144 Cost Accounting

(3) Abnormal Process Gain : Abnormal Process Gain may be defined

as unexpected gain in production under normal conditions. The

process account under which abnormal gain arises is debited with

abnormal gain. The cost of abnormal gain is computed on the

basis of normal production.

(4) Spoilage : Normal Spoilage (i.e. which is inherent in operation)

costs are included in costs either by charging the loss due to

spoilage to the production order or by charging it to production

overhead so that it is spread over all the products. Any value

realized from the sale of spoilage is credited to production order

or production overhead account as the case may be. The cost of

abnormal spoilage is charged to Costing Profit and Loss Account.

When spoiled work is the result of rigid specification, the cost of

spoiled work is absorbed by good production while the cost of

disposal is charged to production overhead.

5) Defectives : Defectives that are considered inherent in the process

and are identified as normal can be recovered by using the following

method.

• Charged to goods products

• Charged to general overheads

• Charged to departmental overheads

If defectives are abnormal, they are to be debited to Costing Profit

and Loss Account.

CHECK YOUR PROGRESS

Q3. What are the different types of process loss?

...........................................................................

...........................................................................

...........................................................................................................

...........................................................................................................

...........................................................................................................


145Cost Accounting

EXERCISE : 2

A product passess through three processes X, Y

and Z to its manufacture. From the following details,

ascertain the cost of the product at the end of each

stages of production.

Process X Process Y Process Z

Rs. Rs. Rs.

Raw materials 25,000 30,000 20,000

Wages 15,000 20,000 10,000

Manufacturing 5,000 8,000 7,000

Expenses

Output in Units 10,000 11,200 13,000

Opening Stock

(units in Previous

Process) ----- 7,000 5,000

Closing Stock

(units in Previous

Process) ----- 5,000 3,000

Solution : 2

Process X Account


Rs. Rs.

To Raw Materials 1,000 25,000 By Process Y 10,000 45,000

To Wages 15,000 (@ Rs. 4.5 per

unit transfereed

To Manufacturing to Process Y)

Expenses 5,000

10,000 45,000 10,000 45,000


146 Cost Accounting

Process Y Account


Rs. Rs.

To Opening Stock 7,000 31,500 By Wastage 800 -------

(@Rs. 4.5 per unit) By Process Z

Production

To Process X 10,000 45,00011200

22500134500 −11,200 1,12,000

To Raw materials 30,000 = Rs. 10 per unit

To Wages 20,000

To Manufacturing By Closing Stock 5,000 22,500

Expenses 8,000 (@ Rs. 4.5 per unit)

17,000 1,34,500 17,000 1,34,500

Process Z Account


Rs. Rs.

To Opening Stock 5,000 50,000 By Wastage 200 -------

(@Rs. 10 per unit) By Closing Stock 3,000

To Process Y 11,200 1,12,000 (@ Rs. 10 per unit)

To Raw Materials 20,000 By production 13,000 1,69,000

To Wages 10,000 @ Rs. 13 per unit

To Manufacturing

Expenses 7,000

16,200 1,99,000 16,200 1, 99, 000

10.5 LET US SUM UP

In this unit we have discussed about process costing. Process

Costing is a method of costing. The application of process costing is

where industries adopting costing procedure for continuous or mass


147Cost Accounting

production. It is employed where each similar units or production involved

in different series of process from conversion of raw materials into

finished output. Thus unit cost is determined on the basis of accumulated

costs of each operation or at each stage of manufacturing a product.

The application of process costing is where industries adopting costing

procedure for continuous or mass production. Textiles, chemical works,

cement industries, food processing industries etc.

Again, Process Losses may be defined as the loss of material occurs

at different stages of manufacturing process. The following are the types

of losses unavoidable during the course of processing operations such

as:

• Normal Process Loss

• Abnormal Process Loss

• Abnormal Process Gain

• Spoilage

• Defectives


1. Management Accounting: Khan & Jain

2. Cost Accounting : Hongren

3. Cost & Management Accounting: Jain & Narang

4. Cost Accounting: B. Banerjee


Ans to Q No 1:

ADVANTAGES

1) Determination of the cost of process and unit cost is possible at

short intervals.


148 Cost Accounting

2) Effective cost control is possible.

DISADVANTAGES

1) Computation of average cost does not give the true picture because

costs are obtained on historical basis.

2) Operational weakness and inefficiencies on processes can be

concealed.

Ans to Q No 2:

1) Normal Process Loss

2) Abnormal Process Loss

3) Abnormal Process Gain

4) Spoilage

5) Defectives


Q 1. What is process costing? What are its Characteristics?

Q 2. What are the merits and demerits of process costing?

Q 3. Write short notes on:

a) Normal Process Loss

b) Abnormal Process Loss

c) Abnormal Gain.

Q 4. What do you understand by Process Losses?

*** ***** ***


149Cost Accounting

UNIT 11: STANDARD COSTING

UNIT STRUCTURE11.1 Learning objectives

11.2 Introduction

11.3 Meaning of Standard Cost and Standard Costing

11.3.1 Difference between Estimating Costs and Standard Costs

11.3.2 Comparison between Standard Costing and Budgetary

Control

11.3.3 Advantages and Limitations of Standard Costing

11.3.4 Determination of Standard Costs

11.4 Meaning of Variance Analysis

11.4.1 Types of Variance

11.5 Cost Variance

11.5.1 Direct Material Cost Variance

11.5.2 Direct Labour Cost Variance

11.5.3 Overhead Variances

11.5.4 Classification of Overhead Variances

11.6 Let Us Sum Up



11.9 Model Questions.


After going through this unit, you will be able to -

• explain the meaning of Standard Cost and Standard Costing

• describe the advantages and limitations of Standard Costing

• discuss the determination of Standard Cost

• explain the concept of variance analysis and its various types.

150 Cost Accounting

11.2 INTRODUCTION

In the earlier unit we discussed about process costing. Now in

this unit we are going to discuss the concept of Standard Costing and

variance analysis.

Standard Costing is a technique which helps us to control costs

and business operations. It aims at elimination wastes and increasing

efficiency in performance through setting up standards or formulating

cost plans. We will also discuss the difference between estimated Costs

and Standard Costs and the advantages and limitations of Standard

Costing. Again, we will get a fair idea on determination of Standard Cost.

Also, at the end of this unit we will discuss the variance analysis,

its various types and its classifications.

11.3 MEANING OF STANDARD COST ANDSTANDARD COSTING

Standard Cost : The word “Standard” means a “Yardstick” or “Bench

Mark”. The term “Standard Costs” refers to Pre-determined costs. Brown

and Howard defined Standard Cost as a predetermined Cost which

determines what each product or service should cost under given

circumstances. This definition states that standard costs represent

planned cost of a product.

Standard cost as defined by the “Institute of Cost and Management

Accountant”, London “is the Pre-determined Cost based on technical

estimate for materials, labour and overhead for a selected period of time

and for a prescribed set of working conditions.”

Standard Costing : Standard Costing is a concept of accounting for

determination of standard for each element of costs. These predetermined

costs are compared with actual costs to find out the deviations known

as “Variances.” Identification and analysis of causes for such variances

and remedial measures should be taken in order to overcome the reasons

for variances.

‘Chartered Institute of Management Accounts England’ defines Standard

Standard CostingUnit 11

151Cost Accounting

Costing as “the Preparation and use of standard costs, their comparison

with actual costs and the analysis of variances to their causes and

points of Incidence.”

From the above definition, Standard Costing may be summarized

as follows :

1) Determination of appropriate standards for each element of cost.

2) Ascertainment of information about actuals and use of Standard

Costs.

3) Comparison of actual costs with Standard Costs, the differences

is known as Variances.

4) Analysis of Variances to find out the causes of Variances.

5) Reporting to the responsible authority for taking remedial measures.

11.3.1 Difference between Estimated Costs and

Standard Costs

Although, Pre-determination is the essence of both Standard

Costing and estimated Costing, the two differ from each other in

the following respects :

Standard Costing Estimated Costing

1) It is used on the basis 1) It is used on the basis of

of scientific. statistical facts and figures.

2) It emphasises “What the 2) It emphasises “What the cost

cost should be”. will be”.

3) It is used to evaluate actual 3) It is used to cost ascertainment

performance and it serves for fixing sales price.

as an effective tool of cost.

4) It is applied to any industry 4) It is applicable to concern

engaged in mass production engaged in construction work.

5) It is a part of accounting 5) It is not a part of accounting

system and standard system because it is based

costing variances are on statistical facts and figures.

recorded in the books

of accounts.

Standard Costing Unit 11

152 Cost Accounting

11.3.2 Comparison between Standard Costing and

Budgetary Control

Relationship : The following are certain basic principles common

to both Standard Costing and Budgetary Control :

1) Determination of standards for each element of costs in

advance.

2) For both of them measurement of actual performance is

targeted.

3) Comparison of actual costs with standard cost to find out

deviations.

4) Analysis of variances to find out the causes.

5) Give the periodic report to take corrective measures.

Differences : Though Standard Costing and Budgetary Controls

aims at the maximum efficiencies and Marginal Cost, yet there

are some basic differences between the two from the objectives

of using the two costs.

Budgetary Control Standard Costing

1) Budgets are projections of 1) Standard Costing is projection

financial accounts. of cost accounts.

2) As a statement of both 2) Standard costing is not used

income and expenses, it for the purpose of forecasting.

forms part of budgetary

control.

3) Budgets are estimated 3) Standard Cost are the “Norms”

costs, They are “What or “What cost should be”.

the cost will be”.

4) Budget can be operated 4) Standard Costing cannot be

with standards. used without budgets.

5) In budgtetary control, 5) Under standard costing

variances are not revealed variances are revealed

through the accounts. through different accounts.


153Cost Accounting

6) Budgets are prepared on 6) Standard cost are planned and

the basis of historical facts prepared on the basis of

and figures. technical estimates.

11.3.3 Advant ages and Limit ations of S tandard Costing

Advantages of Standard Costing :

The following are the important advantages of standard costing:

1) It guides the management to evaluate the production

performance.

2) It helps the management in fixing standards.

3) Standard costing is useful in formulating production planning

and price policies.

4) It guides as a measuring rod for determination of variances.

5) It facilitates eliminating inefficiencies by taking corrective

measures.

6) It acts as an effective tool of cost control.

7) It helps the management in taking important decisions.

8) It facilitates the principle of “Management by Exception.”

9) Effective cost reporting system is possible.

Limitations of Standard Costing

Besides all the benefits derived from this system, it has a number

of limitations which are given below :

1) Standard costing is expensive and a small concern may not

meet the cost.

2) Due to lack of technical aspect, it is difficult to establish

standards.

3) Standard costing cannot be applied in the case of a concern

where non-standardised products are produced.

4) Fixing of responsibility is difficult. Responsibility cannot be

fixed in the case of uncontrollable variances.

5) Frequent revision is required while insufficient staff is

incapable of operating this system.


154 Cost Accounting

6) Advers psychological effects and frequent technological

changes will not be suitable for standard costing system.

11.3.4 Determination of S tandard Cost s

The following preliminary steps must be taken before determination

of standard cost :

1) Establishment of Cost Centers.

2) Classification and Codification of Accounts.

3) Types of Standards to be applied.

a) Ideal Standard

b) Basic Standard

c) Current Standard

d) Expected Standard

e) Normal Standard

4) Organization for Standard Costing.

5) Setting of Standards.

1) Establishment of Cost Centres : It is the first step required

before setting of Standards. According to CIMA, London Cost

centre is “a location, person or item of equipment for which

costs may be ascertained and used for the purpose of cost

control.” Cost centre is necessary for the determination of

standard costs for each product and comparison of actual

cost with the predetermined standards to ascertain the

deviations to take corrective measures.

2) Classification and Codification of Account s : Classification

of Accounts and Codification of different items of expenses

and incomes help quick ascertainment and analysis of cost

information.

3) Types of S tandards to be Applied : Determination of the

type of standard to be used is one of the important steps

before setting up of standard cost. The different types of

standards are given below :

a) Ideal Standard

Codification:

A set of rules or

principles or laws

(especially written

ones)


155Cost Accounting

b) Basic Standard

c) Current Standard

d) Expected Standard

e) Normal Standard

a) Ideal Standard : The term “Ideal Standard” refers to the

standard which can be attained under the most favorable

conditions possible. In other words, ideal standard is based

on high degree of efficiency. It assumes that there is no

wastage, no machine breakdown, no power failure, no labour

ideal time in the production process. In practice it is difficult

to attain this ideal standard.

b) Basic Standard : This standard is otherwise known as

Bogey Standard. Basic Standard which is established for

use is unaltered over a long period of time. In other words

this standard is fixed in relation to a base year and is not

changed in response to changes in material costs, labour

costs and other expenses as the case may be. The

application of this standard has no practical importance from

cost control and cost ascertainment point of view.

c) Current S tandard : The term “Current Standard” refers to

a “a standard established for use over a short period of time

related to current conditions which reflects the performance

that should be attained during the period.” These standards

are more suitable and realistic for control purpose.

d) Expected S tandard : Expected Standard may be defined

as “The standard which may be anticipated to be attained

during a future specified budget period.” These standards

set targets which can be achieved in a normal situation. As

such, it is more realistic than the Ideal Standard.

e) Normal Standard : This standard resents an average

standard in past which, it is anticipated, can be attained

over a future period of time, preferably long enough to cover

one trade cycle. The usefulness of such standards is very

limited for the purpose of cost control.


Anticipated:

Expected hopefully

Resent:

Wish ill

156 Cost Accounting

4) Organization for Standard Costing : The success of the

standard costing system depends upon the reliability of

standards. Hence, the responsibility for setting standard is

vested with the Standard Committee. It consists of

a) Purchase Manager

b) Production Manager

c) Personal Manager

d) Time and Motion study Engineers

e) Marketing Manager and Cost Accountant

5) Setting of S tandard : The Standard Committee is

responsible for setting standards for each element of costs

as given below:

I. Direct Material

II. Direct Labour

III. Overheads

a) Fixed Overheads

b) Variable Overhead

1. Standard for Direct material Cost :

The following are the standard involved in direct materials cost:

a) Material Quantity or Usage Standard.

b) Material Price Standard.

i) Material Usage S tandard : Material Usage Standard is

prepared on the basis of material specifications and quality

of materials required to manufacture a product. While setting

of standards proper allowance should be provided for normal

losses due to unavoidable occurrence of evaporation

breakage etc.

ii) Material price S tandard : Material Price Standard is

calculated by the Cost Accountant and the Purchase Manager

for each type of materials. When this type of standard is

used, it is essential to consider the important factors such

as market conditions, forecasting relating to the trends of

prices, discounts etc.

Vested: Fixed


157Cost Accounting

II. Standard for Direct Labour Cost

The following standards are established :

i) Fixation of Standard Labour Time

ii) Fixation of Standard Rate

i) Fixation of S tandard labour T ime : Labour Standard time

is fixed and it depends upon the nature of cost unit, nature

of operations performed, Time and Motion study etc. While

determining the standard time, normal ideal time is allowed

for fatigue and other contingencies.

ii) Fixation of Standard Rates : The standard rate fixed for

each job will be determined on the basis of methods of

wage payment such as Time Wage System, Piece Wage

System, Differential Piece Rate System and Premium Plan

etc.

III. Setting Standards for Overheads :

The following problems are involved while setting standards

for over heads :

1) Determination of Standard overhead cost

2) Estimating the production level of activity to be

measured in terms of common base like machine

hours, units of production and labour hours.

Setting of overhead standards is divided into fixed overhead,

variable overhead and semi-variable overhead. The

determination of overhead rate may be calculated as follows:

Standard overhead for the budget perioda) Standard Overhead Rate = ---------------------------------------------------------------

Standard Production for the budget period

Standard overhead for the budget periodb) Standard Variable Overhead Rate = -------------------------------------------------------------

Standard Production for the budget period

Standard Hour : Usually production is expressed in terms of units,

dozen, kgs, pound, liters etc. When productions are of different types,

all products cannot be expressed in one unit. Under such circumstances,


158 Cost Accounting

it is essential to have a common unit for all the products. Time factor

is common to all the operation. ICMA, London, defines a Standard Time

as a “hypothetical unit pre-established to represent the amount of work

which should be performed in one hour at standard performance.”

Standard Cost Card : After fixing the standards for direct material,

direct labour and overhead cost, they are recorded in a Standard Cost

Cord. This Standard cost is presented for each unit cost of a product.

The total Standard Cost of manufacturing a product can be obtained by

arrgegating the different Standard Cost Cards of different processes.

These Cost Cards are useful to the firm in production planning and

pricing policies.

CHECK YOUR PROGRESS

Q1. Define standard Costing.

...........................................................................

...........................................................................

Q2. Write any two advantages and limitations of Standard Costing.

.....................................................................................................

.....................................................................................................

11.4 MEANING OF VARIANCE ANALYSIS

Standard Costing guides as a measuring rod to the management

for determination of “Variances”. In order to evaluate the production

performance. The term “Variances” may be defined as the difference

between standard cost and actual cost for each element of cost incurred

during a particular period. The term “Variance Analysis” may be defined

as the process of analyzing variance by subdividing the total variance in

such a way that management can assign responsibility for off-Standard

Performance.

The variance may be favorable variance or unfavorable variance.

When the actual performance is better than the Standard, it is called

“Favorable Variance.” Similarly, where actual performance is below the

standard it is called a “Unfavorable Variance.”


159Cost Accounting

Variance analysis helps to fix the responsibility so that management can

ascertain ----

a) The amount of the variance

b) The reasons for the difference between the actual performance and

budgeted performance.

c) The person responsible for poor performance

d) Remedial actions to be taken.

11.4.1 Types of V ariances

Variances may be broadly classified into two categories (A) Cost

Variance and (B) Sales Variance.

TYPES OF VARIANCES

COST VARIANCE SALES VARIANCES

DIRECT DIRECT LABOUR OVERHEAD

MATERIAL COST VARIANCE COST VARIANCE

11.5 COST VARIANCE

Total Cost variance is the difference between Standards Cost for

the Actual Output and the Actual Total Cost incurred for manufacturing

actual output. The total cost Variance Comprises the following :

I. Direct Material Cost Variance (DMCV)

II. Direct Labour Cost Variance (DLCV)

III. Overhead Cost Variance (OCV)

11.5.1 Direct Material V ariances

Direct Material Variances are also termed as Material Cost

Variances. The Material Cost Variance is the difference between

the Standard cost of materials for the Actual Output and the Actual

Cost of materials used for producing actual output. The Material

Cost Variance is calculated as :


160 Cost Accounting

Material Cost Variance = Standard Cost - Actual Cost

MCV = SC - AC

(or)Standard Standard Actual Actual

= X _ X

Quantity Price Quantity Price

MCV = (SQ x SP) — (AQ x AP)

Note : If the actual costs is more than standard cost the variance

will be unfavorable or adverse variance and on the other hand, if

the actual cost is less than standard cost the variance will be

favorable variance. The material cost variance is further classified

into :

1) Material Price Variance

2) Material Usage Variance

3) Material Mix Variance

4) Material Yield Variance

1) Material Price V ariance (MPV) : Material Price Variance is

that porton of the Material Cost Variance which is due to the

difference between the Standard Price specified and the

Actual Price paid for purchase of materials. Material Price

Variance may be calculated by

Material Price VarianceActual Standard Actual

= X _

Quantity Price Price

MPV = AQ (SP— AP)

Note : If actual cost of materials used is more than the standard

cost the variance is adverse, it represents negative (-) symbol.

And on the other hand, if the variance is favorable it is to be

represented by positive (+) symbol.

2) Material Usage V ariance (MUV) : Material Usage Variance

is that part of Material Cost Variance which refers to the

{ { { {

{ {


161Cost Accounting

difference between the standard cost of standard quantity of

material for actual output and the Standard cost of the actual

material used. Material Usage Variance is calculated as

follows :

Standard Standard ActualMaterial Usage Variance= X _

Price Quantity Quantity

MUV = SP (SQ— AQ)

Note : This Variance will be favorable when standard cost of

actual material is more than the Standard Material Cost for actual

output, and Vice Versa.

3) Material Mix V ariance (MMV) : It is the portion of the

material usage variance which is due to the difference

between the Standard and the actual composition of mix.

Material Mix Variance is calculated under two situations as

follows :

a) When actual weight of mix is equal to standard weight

to mix

b) When actual weight of mix is different from the standard

mix.

a) When Actual W eight and S tandard W eight of Mix are

equal :

i) The formula is used to calculate the variance:

Material Mix Variance= ( ) Actual Mix

Standard Mix Price Standard −

MMV = SP (SM – AM)

where SM = Quality Standardquantity standard of weight Total

quantity actual of weight Total ×

ii) In case standard quantity is revised due to shortage of aparticular category of materials, the formula will be changedas follows :

Material Mix Variance =

−× Actual

Mix ndardRevisedSta

Mix Standard

Price

{ {


162 Cost Accounting

MMV= SP (RSM – AM)

a) When Actual W eight and S tandard W eight of Mix are dif ferent:

i) The formula is used to calculate the variance is :

Material Mix Variance

Total Weight of

Actual Mix Standard

Cost Standard

Mix

= _

Total Weight of

Standard Mix

x---------------------- �

ii) In case the Standard is revised due to the shortage of a particularcategory of materials, the alternative formula will be as follows:

Material Mix Variance

=

4) Materials Yield Variance (MYV) : It is the portion of Material Usage

Variance. This variance arises due to spoilage, low quality of

materials and defective production planning etc. Materials Yield

Variance may be defined as “the variance may be calculated as

under :

Material Yield Variance =

Standard

Where :

Standard Rate is calculated as follows :

Standard Cost of Standard MixStandard Rate = ----------------------------------------------

Net Standard Output

Verification :

The following equations may be used for verification of Material cost

variances :

1) Material Cost Variance = Material Price Variance + Material Usage

Variance


StandardCost of

Acutal Mix

StandardCost of

Acutal Mix

{ {

163Cost Accounting

2) Material Usage Variance = Material Mix Variance — Material Yield

Variance

3) Material Cost Variance = Material Mix Variance + Material Yield

Variance

Exercise : 1

Calculate Material Cost Variance from the following

information :

Standard Price of material per Kg = Rs. 4

Standard Usage of material = 800 kgs

Actual Usage of materials = 920 kgs

Actual Price of materials per kg = Rs. 3

Actual Cost of materials Rs. 2,760

Standard Cost of materials for actual production Rs. 3,200

Solution : 1

1)Material Cost Variance =

×−

×Quantity

Actual

Price

Actual

Quantity

Standard

Price

Standard

= (4 x 800) — (3 x 920)

= Rs. 3,200 — Rs. 2,760 = Rs. 440 (F)

2) Meterial Price Variance =

××Price

Actual

Price

Standard

Quantity

Actual

= 920 x (4—3)

= 920 x 1= Rs. 920 (F)

3) Material Usage Variance =

××Quantity

Actual

Quantity

Standard

Price

Standard

= 4 x (800 — 920)

= 4 x 120 = Rs. 480 (A)


164 Cost Accounting

11.5.2 Direct Labour V ariances

Labour Variances can be classified into

a) labour Cost Variance (LCW)

b) Labour Rate Variance or Wage Rate Variance

c) Labour Efficiency Variance

d) Labour Idle Time Variance

e) Labour Mix Variance

f) Labour Revised Efficiency Variance

g) Labour Yield Variance

a) Labour Cost V ariance (LCW) : Labour Cost Variance is the

difference between the Standard Cost of labour allowed for

the actual output achieved and the actual wages paid. It is

also termed as Direct Wage Variance or Wage Variance.

Labour Cost Variance is calculated as follows :

Labour Cost Variance = Standard Cost of Labour — Actual Cost of

Labour

(or)

Labour Cost Variance Standard Standard Time Actual

= x _

Rate for Actual Output Rate

Actualx

TimeLCV

Note : If actual labour cost is more than the standard labour cost,

the variance represents negative and vice versa.

b) Labour Rate V ariance : It is that part of labour cost variance

which is due to the difference between the standard rate

specified and the actual rate paid. This variances arise from

the following reasons :

a) Change in wage rate.

b) Faulty recruitment.

c) Payment of overtime.

d) Employment of casual workers etc.

It is expresses as follows :


165Cost Accounting

Labour Rate Varience Actual TimeStandard

= _

Rate

Actual

RateX

Note : If the Standard rate is higher than the actual rate, the

variance will be favorable and vice Versa.

c) Labour Efficiency V ariance : Labour Efficiency Variance

otherwise known as Labour Time Variance. It is that portion

of the Labour Cost Variance which arises due to difference

between standard labour hours specified and the actual labour

hours spent. The usual reasons for this variance are (a) poor

supervision (b) poor working condition (c) increase in labour

turnover (d) defective materials. It may be calculated as

following :

Labour effeciency VarianceHours

Standard= _ Actual

Ratex

Standard

Hours

Note : If actual time taken is more than the specified standard

time, the variance unfavorable and vice versa.

d) Labour Idle T ime Variance : Labour Idle Time Variance

arises due to abnormal situations like strike, lockout, breakdown

of machinery etc. In other words, idle time occurs due to the

difference between the time for which workers are paid and

that which they actually expend upon production. It is calculated

as follows :

Idle Time Variance = Idle Hours x Standard Rate

e) Labour Mix V ariance : It is otherwise known as Gang

Composition Variance. This variance arises due to the

differences between the actual gang composition than the

standard gang composition. Labour Mix Variance is calculated

in the same way of Materials Mix Variance. This variance is

calculated in two ways :

i) When Standard Labour Mix is equal to Actual Labour

Mix.


166 Cost Accounting

ii) When Standard Labour mix is different from Actual

Labour Mix.

i) When Standard and actual times of the labour mix are

same: The formula for its computation may be as follows :

Labour Rate Varience

=

ii) When Standard and actual times of the labour mix are

different : Changes in the composition of a gang may arise

due to shortage of a particular grade of labour. It may be

calculated as follows :

Labour Mix Variance =

Revised Standard Time Total Actual Time

Actual Time= Total Standard Time

x---------------------------

f) Labour Yield Variance : This variance is calculated in the

same way as material Yield Variance labour Yield variance

arises due to the variation in labour cost on account of

increase or decrease in yield or output as compared to relative

standard. The formula for this purpose is as follows:

Labour Yield Variance =

−×Output

Actual

imeforActualT

tputStandardOu

Output ofunit per Cost

Labour Standard

Note : If actual output is more than standard output time, the

variance is favorable and vice versa.

Verification : Labour Cost Variance = Labour Rate Variance +

Labour Efficiency Variance.


167Cost Accounting

Exercise : 2

From the following particulars, calculate labour

Variance :

Standard hours = 200

Standard rate for actual production = Re. 1 per hour

Actual hour = 190

Actual Rate = Rs. 1.25 per hour

Solution : 2

1) Labour Cost Variance = Rate) Actualhours (ActualRate

Standard

Hours

Standard×−×

= (SH X SR) — (AH X AR)

= (200 X Re. 1)—(190 x Rs. 1.25)

= Rs. 200—Rs. 237.50 = Rs. 37.50 (A)

2) Labour Rate Variance = hours ActualRate

Actual

Rate

Standard×

−

= (Re. 1 — Rs.1.25) x 190

= Rs. 0.25 x 190 = Rs. 47.50 (A)

3)Labour Efficiency Variance = Rate StandardHours

Actual

Hours

Standard×

−

= (200 — 190) x Re. 1

= 10 x Re. 1 = Rs. 10 (F)

Verification :

Labour Cost Variance = Labour Rate Variance + Labour Efficiency Variance

Rs. 37.50 (A) = Rs. 47.50 (A) + Rs. 10 (F)

Rs. 37.50 (A) = Rs. 37.50 (A)


168 Cost Accounting

11.5.3 Overhead V ariances

Overhead may be defined as the aggregate of indirect material

cost, indirect labour cost and indirect expenses. Overhead

Variances may arise due to the difference between standard cost

of overhead for actual production and the actual overhead cost

incurred. The Overhead Cost Variance may be calculated as

follows :

Overhead Cost Variance = Output ActualCost

Overhead Actual

Per Unit Rate

Overhead Standard×−

(or)

−×=Cost Overhead

Actual

Hourper Rate

Overhead Standard

Output Actualfor

Hours Standard

Essential of Cert ain Terms : For the purpose of measuring

various Overhead Variances, it is essential to know certain technical

terms related to overheads which are given below :

a) Standard Overhead Rater per unit Budgeted Overhead

= Budgeted Output

---------------------------

b) Standard Overhead Rater per unit Budgeted Overhead

= Budgeted Hours

---------------------------

c)Standard Overhead for Actual Time Budgeted Output

Actual Hours= Budgeted Hours

x-------------------------

d) Standard Hours for Actual Time Budgeted Hours

Actual Output= Budgeted Output

x-------------------------

e) When Output is measured in Standard Hours

Recorded OverheadsStandard Rate

= Per Hour

Standard Hours of

Actual Outputx


169Cost Accounting

When Output is measured in Units :

Absorbed Overheads = Standard Rate x Budgeted Output

Per Unit In Units

f) Budgeted Overheads = Standard Rate x Budgeted Output

Per Unit In Units

(or)

Standard Rate x Budgeted Output

Per Hour

g) Actual Overheads = Actual Rate Actual Output

Per unit x in units

(or)

Actual Rate Actual Hours

Per Hour

h) Standard Overheads = Standard Rate Standard Output

Per Unit x for Actual Time

(or)

Standard Rate

Per Unit x Actual Hours

Note : The term Budgeted Overheads and Standard Overheads

are not used in the same sense. It is assumed that the term

Budgeted and Standard are used interchangeably. In other words,

Budgeted Overheads are used for budgeted time or budgeted

output and standard overheads are used for actual time or

budgeted output in actual time.

11.5.4 Classification of Overhead V ariance

Overhead variances can be classified as :


170 Cost Accounting

A. Variable Overhead V ariances :

a) Variable Overhead Cost Variance

b) Variable Overhead Expenditure Variance

c) Variable Overhead Efficiency Variance

B. Fixed Overhead V ariance :

a) Fixed Overhead Cost Variance

b) Fixed Overhead Expenditure Variance

c) Fixed Overhead Volume Variance

d) Fixed Overhead Capacity Variance

e) Fixed Overhead Efficiency Variance

f) Fixed Overhead Calendar Variance

A. Variable Overhead V ariances :

Now, we are going to discuss the above classification in detail.

a. Variable Overhead Cost V ariance : This is the difference

between standard variable overhead for actual production and

the actual variable overhead incurred. The formula is as follows:

Variable Overhead Cost Variance Standard Variable Overhead

= _

For Actual Output

Actual Variable

Overheads

b. Variable Overhead Expenditure V ariance : It is the

difference between standard variable overhead allowed for

actual hours worked and the actual variable overhead incurred.

This variable may be calculated as follows :

Time

Actual

hourper

Rate Overheads

Variable Actual

HourPer Rate

Overhead Variable Standard×−=

(or)

Standard Variable= _

Overheads

Actual Variable

Overheads

c. Variable Overhead Efficiency V ariance : This variance arises

due to the difference between variable overhead recovered


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Cost Accounting

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