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ICMAB Learning Manual for
COST ACCOUNTING
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Copyright of this Study Material is reserved by the Institute of Cost and Management Accountants of
Bangladesh and prior permission from the Institute is necessary for reproduction of this Study Materials
either in whole or in part.
First Edition
: 2021
Published By: The Institute of Cost and Management Accountants of Bangladesh, ICMA Bhaban, Nilkhet,
Dhaka-1205, Bangladesh.
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Foreword
The Institute of Cost and Management Accountants of Bangladesh (ICMAB) is the only national Institute
imparting training and education in the field of Cost and Management accounting and regulating the
profession of Cost and Management Accountants in Bangladesh. The Cost and Management Accounting
(CMA) professional program offered by the ICMAB is for the aspiring professional accountants aiming for
the role of a strategic business partner in their career. This program offers courses under seven interrelated
pillars to embed marketable skills with the student’s cognitive construct. The seven pillars ensure to enlighten
students providing necessary technical skills with a reasonable aptitude for numbers to demonstrate the
convergence of global perspective, business acumen, regulatory requirements, ethical judgment, critical
and strategic thinking, creativity, teamwork, research skills, IT skills, and persuasive communication skills.
A future-ready professional expected to produce by the CMA program will go beyond converting data
into dialogues in the age of digitization and be able to contribute to the global economy with practices of
international standards.
Targeting the objective of CMA program, the Institute has designed a curriculum of 20 subjects, an
integrated case study, and an articleship. The Institute has published its detailed syllabus giving reference
to various books and publications of national and international author. In addition to the above, the Institute
has programme to publish study materials covering its detailed syllabus to make the subject matter easier
and understandable to the students. Under its publication programme, the ‘ICMAB Learning Manual for
Cost Accounting’ is published for the students of Intermediate Level-I. There may be some printing and
other mistakes for which I express my sincere apology and I shall be grateful if the same are pointed out by
the readers for correction in its next edition. I offer my sincere gratitude to the author, the officers and staff
of the Institute who have worked hard for publication of this study material. The views expressed in this
study material are of the author and does not necessarily express the views of the Institute.
Md. Munirul Islam FCMA
Chairman
Education Committee, ICMAB
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Table of Contents
About the CMA Pillar
7
About the Course
8
Detailed Contents
10-13
Part A: Cost Accounting Fundamentals
14
Chapter A1 [1]
Introduction to Cost Accounting
15-24
Chapter A2 [2]
Bangladesh Cost Accounting Standards
25-37
Chapter A3 [3]
Cost Concepts, Classification and Cost Statements
38-57
Part B: Elements of Costs
58
Chapter B1[4]
Costing of Materials
59-84
Chapter B2 [5]
Costing of Labor
85-99
Chapter B3 [6]
Costing of Overhead
100-114
Chapter B4 [7]
Cost Accounting Records as per BCAS
115-120
Part C: Cost Accounting Methods and Techniques
121
Chapter C1 [8]
Job, Batch and Contract Costing
122-137
Chapter C2 [9]
Process Costing
138-152
Chapter C3 [10] Service Costing
153-161
Chapter C4 [11] Standard Costing
162-183
Chapter C5 [12] Joint Product and by-product Costing
184-194
Chapter C6 [13] Activity-based Costing
195-210
Part D: Contemporary Cost Accounting Tools
211
Chapter D1 [14] Target Costing
212-221
Chapter D2 [15] Quality Costing
222-233
Chapter D3 [16] Life-cycle Costing
234-247
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About the Pillar
The Cost and Management Accounting (CMA) pillar aims to provide learners a clear understanding of
the Cost and Management Accounting Systems (CAS and MAS) appropriate for an entity. This pillar is
designed to enable learners in using Cost Accounting as a tool for Cost Management and Management
Accounting for the best fit decisions. The CMA pillar will help to ascertain, analyze, report, and control
costs, revenue, and other relevant financial and non-financial information to support operational and
strategic decisions that satisfy the optimum utilization of existing resources. Considering the dynamic
nature and increasingly competitive environment, the CMA pillar introduces digital costing and Bangladesh
Cost Accounting Standards (BCAS) alongside customary cost and management accounting techniques. It is
expected that by conceptualizing the contents of different courses under the pillar, learners will be proficient
in understanding and applying appropriate cost and management accounting techniques under different
levels of complexities, ambiguity, and uncertainty. The first two courses of the CMA pillar are ‘Cost
Accounting’ and ‘Management Accounting’ (in the intermediate level), followed by the ‘Strategic Cost and
Management Accounting’ (in the advanced level). At the Intermediate level, learners will be exposed to
cost and management accounting tools and techniques related to short-term decisions and internal affairs of
an organization. Contrary, learners will be exposed to strategic decision-making scenarios accommodating
external affairs in long –term of the organization at the advanced level.
On successful completion the CMA pillar, the aspiring professional accountant will be able to:
1. comprehend the changing role of cost and management accountant in the contemporary business
environment;
2. apply the pertinent cost and management accounting techniques in the age of digitization;
3. apply the provision of Bangladesh Cost Accounting Standards (BCAS) to generate a reliable cost of
goods sold figure;
4. recognize, analyze, evaluate, and select the best available alternative to accomplish strategic goals of
the organization;
5. adopt appropriate performance management systems for organizational units;
6. analyze and interpret internal operational and external environmental information to demonstrate the
way of achieving competitive advantages; and
7. formulate CAS and MAS to ensure optimum value creation considering the environmental and
behavioural aspects.
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About the Course
Knowledge Pillar
Level
Course Code
Course Name
Total Marks
: CMA
: Intermediate Level- I
: CM 121
: Cost Accounting (COA)
: 100
Course Structure
The syllabus comprises the following main topics with the relative study weightings:
Segment
A
B
C
D
Segment Title
Cost accounting fundamentals
Elements of Costs
Cost Accounting methods and techniques
Contemporary cost accounting tools
Weight (%)
10%
20%
45%
25%
Course Description
This is the first course of the Cost and Management Accounting pillar. This course provides the in-depth
knowledge of understanding and applying different cost accounting methods and techniques to manage
different cost elements considering the nature of organizational operations. In the process, analysis and
decision orientation is also emphasized. The subject covers fundamentals of cost accounting concepts introducing Bangladesh Cost Accounting Standards; elements of costs in explaining different cost elements;
appropriateness and application of different cost accounting methods and techniques; and also provides
preliminary idea of the contemporary cost accounting issues. On completion of this subject students will
be developed skills of analysis, evaluation and synthesis in cost and in the process, created an awareness of
current developments and issue in the area.
Course Objectives
The main objective of this course is to enable learners to provide in-depth knowledge of cost accounting
concepts, principles and methods to apply and analyze cost accounting data to meet the requirements of
different manufacturing organization. This course ensures the conceptual foundation of different types of
cost and its implication in the organization for a learner to provide data that are required for management
decision making. The course aims to provide the basic concepts and principles of cost accounting that one
can apply in preparing management reports and provide a base to develop analytical skill.
Course Learning Outcomes
On successful completion of this course, the aspiring professional accountants will be able to:
1. describe the fundamentals of cost accounting concepts, conventions and doctrines;
2. understand the underlying principles of Bangladesh Cost Accounting Standards;
3. identify and ascertain cost of a cost object preparing necessary cost statements;
4. apply different cost accounting methods and techniques;
5. build argument in selecting a cost accounting method/technique in a given context;
6. apply and analyze the principles relating to the costing and control of different organizational resource;
and
7. understand the application of cost accounting in a digital and lean management ecosystem.
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Objectives Mapping
PrOs
PrO1
POs
CLOs
6
POs
PO1
1, 7
CLOs
CLO1
PrO2
2, 3
PrO3
TLOs
1, 2, 12, 15, 20, 23
PO2
1, 3, 4
CLO2
3, 6, 7, 8, 9, 10, 12
6
PO3
2
CLO3
4, 5, 6, 14, 16, 20,
PrO4
2
PO4
5
CLO4
7, 10, 11, 13, 14, 17, 20, 22
PrO5
1, 6
PO5
6
CLO5
8, 13, 15, 20, 21,
PrO6
1
PO6
7
CLO6
7, 9, 14, 17, 18, 19, 21, 23
PrO7
4, 5, 6,7
PO7
5
CLO7
24, 25, 26
Here, PrOs = Program Objectives; POs = Pillar Objectives; CLOs = Course Learning Outcomes; TLOs
= Topic Learning Outcomes
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Detailed Contents
A. Cost accounting fundamentals
A1. Introduction to cost accounting
• Definition of Cost Accounting;
• Comparison of Cost Accounting with Financial Accounting and Management Accounting;
• The role of Cost Accounting;
• Methods and Techniques of Cost Accounting;
• Characteristics of an ideal Cost Accounting Systems;
• Installation of a Cost Accounting System;
• Modern Trends in Cost Accounting.
A2. Bangladesh Cost Accounting Standards
• Bangladesh Cost Accounting Standards Board;
• Objectives and Functions of Cost Accounting Standards Board;
• BCAS issued by ICMAB.
A3. Cost concepts, classification and cost statements
• The Concepts of Cost and explain why the concept of ‘cost’ needs to be defined, in order to be meaningful;
• Cost Classification for Inventory Valuation and Profit Measurement;
• Financial, Cost and Management Accounting Concepts;
• Describe how information can be used to identify performance within an organization;
• Explain the differences between financial information requirements for companies, public bodies and
society;
• Prepare the statement of cost of goods sold.
B. Elements of Costs
B1. Costing of Materials
• Classification of Materials;
• Objectives of materials management and control;
• Accounting for materials;
• Stock control in Advanced Manufacturing Environment;
• Inventory System – Periodic System & Perpetual System;
• Maintenance of General Ledger and Subsidiary Ledger;
• Methods of pricing issues FIFO, LIFO, Weighted / Moving Average;
• Valuation of closing / inventory for Balance sheet;
• Pricing of returns –selection of pricing Method. Recording;
• Corresponding BCAS.
B2. Costing of Labor
• Productivity and Labor Costs;
• Remuneration methods;
• Recording labor costs;
• Employee cost reporting and measurement of efficiency;
• Corresponding BCAS.
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B3. Costing of Overhead
• Define Overheads; Overhead allocation, apportionment of overhead;
• Absorption of factory overhead;
• Absorption and treatment of over or under absorption of overheads;
• Accounting for specific items of production overheads;
• Treatment of Non –Manufacturing Overheads;
• Corresponding BCAS.
B4. Cost Accounting Records as per BCAS
• Maintaining Cost Accounting Records (CARs);
• Learn how CARs are maintained for different sectors/Industries;
• Total Cost Management and Framework process.
C. Cost Accounting methods and techniques
C1. Job, batch and contract costing
• Job and batch costing; Nature of job costing – Job Cost sheet and job ledger – Recording costs on Jobs
–Recording completed jobs & Batch costing – Economic Batch quantity;
• Contract costing; Differences between job and contract costing, calculating the percentage of completion, calculating the profit based on the percentage of completion.
C2. Process costing
• The basics of process costing;
• Objective of Process Cost System;
• Characteristics of a Process Cost System;
• Comparison of Job Order and Process Cost Accumulation System;
• FIFO, LIFO and Weighted average cost flow methods;
• Treatment of Normal loss, abnormal loss, Normal and abnormal losses with scrap value and waste with
Disposal Cost, Addition of units and effect on cost, Treatment of Abnormal gain in process costing.
C3. Service costing
• Distinguishing features of service costing;
• Features of service organization;
• Cost units and analysis;
• Application of service costing in different organization.
C4. Standard costing
• Purpose of Using Standard Costing;
• Variance Analysis;
• Materials, Labor and overhead standards;
• Variance Analysis for Costs, volume and price variances, sales mix and yield variances;
• Responsibility analysis for cost variances;
• Reconcile standard profit and actual profit using absorption and marginal costing systems;
• Accounting disposition of variances;
• Interpretation of variances and Inter-relationships between variances.
C5. Joint product and by-product costing
• Joint Products in Process Accounts;
• Accounting treatment of By-Products;
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•
•
Methods of Allocation of joint cost;
Decision to sell by- product at the time of separation or by further process.
C6. Activity-based costing
• Outline of an ABC system;
• Cost Pools and Cost Drivers;
• Designing an ABC system;
• Absorption costing versus ABC;
• Marginal costing versus ABC;
• Benefits of ABC System;
• Application of ABC/ABM;
• Use of ABC/ABM in improving activities;
• Variance analysis in ABC system;
D. Contemporary cost accounting tools
D1. Target costing (TC)
• Underlying philosophy of TC;
• Western vs. Japanese cost management;
• Factors influencing the TC process;
• Process of target costing;
• Application of TC indifferent sectors with special focus on market driving, product level and component level TC;
• TC vs. Kaizen costing;
• Corresponding BCAS.
D2. Quality costing (QC)
• Cost of quality models;
• P.A.F models of QC;
• Trade-off between the levels of conformance and nonconformance costs;
• Opportunity/Intangible cost models;
• ABC models of QC;
• Application of QC indifferent sectors;
• Corresponding BCAS.
D3. Life-cycle costing
• Concept of LCC;
• Underlying features of LCC;
• Significance and benefits of LCC;
• Application of LCC;
• LCC for project;
• Limitations of LCC;
• Life-cycle budgeting;
• Corresponding BCAS.
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Linking CMA Pillar Objectives (POs)
with the CMA Professional Program Objectives (PrOs)
PrOs
POs
PrO1
6
PrO2
2, 3
PrO3
6
PrO4
2
PrO5
1, 6
PrO6
1
PrO7
4, 5, 6, 7
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COST ACCOUNTING (COA)
PART-A
Cost Accounting Fundamentals
[WEIGHT 10%]
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CHAPTER-A1
INTRODUCTION TO COST ACCOUNTING
CHAPTER OVERVIEW
Cost accounting was thought initially to be a technique used to determine
the cost of products or services based on historical data. Due to the highly
competitive of the market, it was realized over time that cost determination
is not as important as cost control. As a result, cost accounting began to
be regarded as a technique for cost control rather than cost ascertainment.
Cost reduction has now entered the scope of cost accounting as a result of
technological advancement in all fields. Cost accounting concerned with
recording, categorizing, and summarizing costs in order to determinethe
costs of products or services, as well as planning, controlling, and trying
to reduce such costs and providing information to managers and decision
makers.
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Chapter Learning Outcomes (CpLOs)
1. Understanding the scope and mechanisms of cost accounting
2. Identify the basic principles and trends in cost accounting
This Study Note Covers (Subtopics)







Definition of Cost Accounting
Comparison of Cost Accounting with Financial Accounting and Management Accounting
The role of Cost Accounting
Methods and Techniques of Cost Accounting
Characteristics of an ideal Cost Accounting Systems
Installation of a Cost Accounting Systems
Modern Trends in Cost Accounting
Level of Study Required
R, U
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
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COST ACCOUNTING DEFINITION
Cost accounting is described as “a systematic set of procedures for recording and reporting aggregate and
detailed measurements of the cost of manufacturing goods and performing services. It includes methods for
identifying, categorizing, allocating, aggregating, and reporting such costs, as well as comparing them to
standard costs.” (IMA) [1] In the 1950s, the primary focus of cost accounting was on inventory valuation
and income determination, with little emphasis on management decision-making. [2]
During this time period, there was a lack of a market for intermediary products, cost information became
important as a tool for measuring the efficiency of various processes. However, some industrialists used
the concept of prime cost around 1875. The period 1880 AD-1925 AD saw the development of complex
product designs as well as the emergence of multi-activity diversified corporations such as Du Pont, General
Motors, and others. During this time, scientific management was developed, leading accountants to convert
physical standards into cost standards, which were then used for variance analysis and control. (3)
The costing language of C.I.M.A, London describes 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 canter’s and cost units. In its widest usage, it embraces the preparation of statistical
data, the application of cost control methods and the ascertainment of profitability of activities carried out
or planned”.
Management has recognized the importance of cost accounting due to the extreme limitations of financial
accounting. Whatever type of business it is, it involves spending money on labour, materials, and other
items needed for manufacturing and disposing of the product. At each stage, management must avoid
the possibility of waste. It must ensure that no machine is idle, that efficient labour is compensated
monetarily, that by products are properly utilized, and that costs are properly calculated. This apart from
management, the installation of a good costing system benefits creditors and employees in a number of
cost accounting improves an organization’s productivity and efficiency and serves as an important tool in
bringing prosperity to the nation. Management benefits greatly from cost accounting. [14]. It gives detailed
costing information to management in order for them to maintain effective control over stores and inventory,
increase organizational efficiency, and reduce waste and losses. It makes easier to delegate responsibility
for important tasks and rate employees. [3]
COMPARISON OF COST ACCOUNTING WITH FINANCIAL ACCOUNTING
AND MANAGEMENT ACCOUNTING
Financial accounting is concerned with reporting purposes that is guided by authoritative guidelines. These
guidelines must be followed by organizations in their financial reports to external parties. [5]
Cost accounting measures and reports financial and non-financial information related to an organization’s
resource acquisition or consumption. It contains information for both management and financial accounting.
[5]
Management accounting measures and reports financial information as well as other types of information
that are primarily intended to assist managers in achieving the organization’s goals. [5]
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Elements
Cost Accounting
Preliminary Used by Internal
users
management at different
levels.
Motive
Provides information of
ascertainments of costs
to control costs and for
decision making about the
costs.
It records and presents
Timeliness
estimated, budgeted data. It
makes use of both historical
costs and predetermined costs.
Limitations
No need to follow Generally
accepted accounting
principles (GAAP).
Financial Accounting
Management Accounting
External(Investors,
government authorities,
creditors)
Assist investors, creditors,
and others make investment,
credit, and other decisions
Internal(Managers of
business, employees)
Delayed or historical
Current and future oriented
Generally accepted
accounting principles
(GAAP), Financial
accounting standard board
(FASB) and Securities
exchange commission
(SEC).
Quality
of Use estimated and budgeted Objective, auditable,
information
information
reliable, consistent and
precise.
Scope
Takes various types
Highly aggregated
of costs-potential
information about the
business ventures, budget
overall organization.
preparation, profitability
analysis etc.
Implications Concern about the internal Concern about adequacy of
efficacy.
disclosure.
Features
Not compulsory to produce
Help managers plan and
control business operations
GAAP does not apply,
but information should be
restricted to strategic and
operational needs.
More subjective and
judgmental, valid, relevant
and accurate.
Disaggregated information
to support local decisions.
Concern about how reports
will affect employee’s
behavior.
Must be accurate and timely. Usually approximate
Compulsory under company but relevant and flexible
law is an end in itself.
Except for few companies,
it is not mandatory Is a
mean to the end.
THE ROLE OF COST ACCOUNTING
Cost accounting provides management with the accounting tools they need to plan and control activities
[4]. Specifically, cost data collection, presentation, and analysis should aid management in completing the
following tasks: [4]
1. Developing and carrying out plans and budgets for operating under anticipated competitive and
economic conditions.
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2. Developing costing methods and procedures that allow for cost control and, if possible, cost reductions
or improvements.
3. Creating inventory values for costing and pricing purposes, as well as controlling physical quantities on
occasion.
4. Calculating a company’s costs and profits for an annual accounting period or a shorter period of time.
5. Selecting one of two or more alternatives that may increase revenues or decrease costs.
METHODS AND TECHNIQUES OF COST ACCOUNTING
The general fundamentals of costing are the same in all cost accounting systems, but the methods of cost
analysis and presentation vary from industry to industry. Different methods are used because business
enterprises vary in their nature and in the type of products or services they produce or render. [6]
Process Costing
When a product goes through separate steps or processes, the result of one process being the input to the
next process, it is frequently desired to determine the cost of each production step or process. This is called
the cost of processes. This method is used when it is difficult to exchange the main cost item for a particular
order because its identity is lost in continuous production volume. “The process cost is generally adopted
in textile industries, chemical industries, petroleum refineries, soap making, papermaking, tanneries, etc.
Job Costing
It refers to a costing system in which costs are determined in terms of specific jobs or orders that are not
comparable with each other. Industries where this costing method is generally applied are printing press,
automobile garage, repair shop, shipbuilding, house building, engine and machine building, etc.
Batch Costing
This method is also a type of cost of work. A batch of similar products is considered one job and the cost of
that complete batch is determined. It is then used to determine the unit cost of the items produced. However,
it should be noted that the articles produced must not lose their identity during manufacture.
Operation Costing
This method is adopted when one wishes to know the cost of carrying out an operation in a service, for
example welding. For large companies, it is often necessary to know the cost of different operations.
Contract Costing
Although the cost of the contract in principle does not differ from the cost of labor, it is convenient to treat
the cost accounts of the contract separately. The term is generally applied to the costing method adopted
when large-scale contracts at different sites are executed, such as in the case of the construction of buildings.
Terminal Costing
This method is also a type of cost of work. This method emphasizes the essential nature of labor cost, that
is, the cost can be properly terminated at a given time and tied to a particular job.
Multiple or Composite Costing
Some products are so complex that no single costing system is applicable. It is used where there are a
variety of components produced separately and then assembled in a complex production. This method is
applicable to companies manufacturing automobiles, airplanes, machine tools, typewriters, radios, cycles,
sewing machines, etc. [6]
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Calculation of unit or single costs or at exit or single exit
This method is used when a single item is produced or the service is rendered by a continuous manufacturing
activity. The cost of the entire production cycle is determined as one process or a series of processes and the
unit cost is obtained by dividing the total cost by the number of units produced. This method is suitable for
industries such as brick making, coal mines, flour mills, cement making, etc. [6]
The following costing techniques are used by management to control costs and make management decisions: [7]
Activity Based Costing
Costing by Activity (ABC) restates the relationship between the costs and the objects to which the costs are
to be assigned. Unlike traditional cost accounting, which views cost objects such as products and divisions
as directly causing the consumption of resources, ABC maintains that costs, with the exception of material
costs, are caused by the activities that make up the resources. Commercial operations. [12]
Historical (or conventional) Costing
It refers to the determination of costs after they have actually been incurred. This means that the cost of a
product can only be calculated after it is produced. This system is only useful for determining costs, but not
useful for exercising cost control. It can only serve as a guide for future production when conditions remain
the same in the future.
Absorption Costing
Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing
all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct
materials, direct labor, rent, and insurance, are accounted for by using this method. Absorption costing is
required by generally accepted accounting principles (GAAP) for external reporting.
Marginal Costing
It refers to the determination of marginal costs by distinguishing between fixed costs and variable costs and
the effect on profit of changes in volume or type of production. In this case, only variable costs are charged
to products or operations while fixed costs are charged to the income statement in the period in which they
arise.
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Budget & Budgetary Control Costing
Budgetary control is a system of controlling cost which includes preparation of Budgets coordinating the
departments and establishing responsibilities comparing performance with budgeted and acting upon results
to achieve the maximum profitable.
Differential Costing
Differential cost refers to the difference between the cost of two alternative decisions. The cost occurs when
a business faces several similar options, and a choice must be made by picking one option and dropping
the other
Standard Costing
It refers to the preparation of standard costs and their application to measure deviations from standard costs
and the analysis of variations in order to maintain maximum production efficiency.
Uniform Costing
A technique in which standardized principles and methods of cost accounting are employed by a number
of different firms and enterprises is referred to as uniform cost. It helps to compare the performance of one
business with that of another. [7]
CHARACTERISTICS OF AN IDEAL COST ACCOUNTING SYSTEM
An ideal costing system is one that achieves the goals of a costing system and brings all the benefits of costing to the
business. Here are the main features that an ideal costing system should have, or things to consider before
installing a costing system. [8]
•
•
•
•
•
•
•
•
•
•
•
A costing system should be tailor-made, practical and should be designed according to the nature,
conditions, requirements and size of the business.
The costing system should be simple and clear so that it can be easily understood even by a person
of average intelligence. Facts, figures and other information provided by cost accounting should be
presented in the right form at the right time to the right person in order to make it more meaningful.
The costing system should be flexible so that it can be changed according to changing conditions and
circumstances.
A costing system is like other economic goods. It costs money, just like economic goods. If the system
is too expensive, management may not be willing to pay because buyers are unwilling to pay for the
goods if they are expensive relative to their utility. A costing system should not be expensive and should
be adapted according to the financial capacity of the company.
The costing system should be such that it can provide the facts and figures necessary for management
to assess performance by comparing it with past figures, or figures of other concerns or against industry
in whole or to another department of the same company.
The system must provide accurate and timely information so that it can be useful to management in
making appropriate decisions and actions for cost control purposes.
The necessary cooperation and participation of managers from the various departments concerned is
essential for the development of a good cost accounting system.
The costing system should not sacrifice utility by introducing meticulous and unnecessary details.
A carefully phased program should be prepared using network analysis for system introduction.
The existing system of delegation and division of powers and responsibilities should not be disturbed
by the costing system.
All forms and forms, etc. system requirements must be of uniform paper size and quality
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•
•
•
•
•
Filling out forms by foremen and workers should involve as little clerical work as possible because
most workers are not well educated.
There should be an efficient warehouse and inventory control system as materials generally represent a
greater proportion of the total cost.
There should be a well-defined salary procedure for recording the time spent by workers at different
jobs, for preparing pay slips and for paying wages.
A solid plan must be devised for the collection, allocation, distribution and absorption of overhead in
order to accurately determine the cost.
If possible, analytical accounts and financial accounts should be nested in an integral accounting
system. If this is not possible, systems should be designed so that the two sets of accounts can be easily
reconciled.
INSTALLATION OF A COST ACCOUNTING SYSTEMS
The steps to install a costing system are given below:
 The costing system will be simple if the objective is only to determine costs, but it will need to be
developed if the objective is to have information that will help management to exercise control and
make decisions.
 Study of the existing organization and routine
 The appropriate cost accounting system and the extent of detail required can be decided after a careful
study of the manufacturing process and their ancillary services. The structure of the cost accounts must
follow the natural production chain
 Determination of cost rates which involves a careful study of plant conditions and decisions must
be made regarding the classification of costs into direct and indirect, grouping of indirect costs into
production, sales, administration, etc. pricing issues, overhead recovery methods, and overhead
calculation.
 No costing system can function effectively without the cooperation of all officials. Before the system
is implemented, the implications of the system must be explained to everyone, indicating to them the
resulting benefits for each and for the company as a whole.
 It is always preferable that the cost office is located next to the factory in order to avoid delays in the
delivery of documents or in the elimination of discrepancies and doubts. Costing staff must be allowed
access to the works if they are to perform their duties properly.
MODERN TRENDS IN COST ACCOUNTING
In response to technological changes, theorists and practitioners began to develop new methods of
calculating costs, such as:
•
•
The just-in-time method, which is both a manufacturing and cost accounting method.
Activity Based Costing (ABC) method, which aims, on the one hand, to make a more precise distribution
of indirect costs in production costs, and on the other hand, it aims to establish a relationship between
indirect costs and the activities they induce.
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•
•
•
•
•
•
•
•
•
Costs - The target method (target cost) aims to find a maximum allowable cost per product based on
previous market research prior to product design.
The retroactive accounting method (BFA) uses an inverse approach to production flow starting with
the value of goods sold against which costs will be allocated over products sold and inventory. Thus,
according to the JIT (Just-in-time) method, production is “pulled” downstream by customer orders,
and it is not “pushed” upstream as in the case of planning based partially on the sales forecasts that
are adjusted by the stock of finished products. At this stage, the inherent risk (usually presented by
traditional methods) of excessive inventory growth with severe financial consequences disappears,
especially if the end products and components are not standardized. The JIT system, perfectly suited to
repetitive manufacturing, organizes manufacturing not according to a schedule but according to orders
received from customers, which allows:
Improving business efficiency.
Reduction of stocks (objective: zero stock), loss of jobs, materials and raw materials and, consequently,
reduction of production and storage costs, creating an increase in profit margins;reduction of the
working capital requirement, therefore an increase in the return on capital. [13]
Cost is the amount of expenditure (actual or notional) incurred on, or attributable to a specified thing
or activity.
Costing is the techniques and processes of ascertaining costs.
Cost accounting is the establishment of budgets, standard costs and actual costs of operations, processes, activities or products, and the analysis of variances, profitability or the social use of funds.
Principles of cost accounting are - cost should be related to its cause; cost should be charged only after
it has been incurred; the convention of prudence should be ignored; abnormal costs should be excluded
from cost accounts; past costs not to be charged to future period; principles of double entry should be
applied wherever necessary.
Costing is an aid to management, creditors, employers and national economy.
Cost center means, a production or service location, function, activity or item of equipment whose costs
may be attributed to cost units.
23
•
•
Cost unit is a unit of product or service in relation to which costs are ascertained.
Financial accounting, cost accounting and management accounting are distinct from each other.
SELF-REVIEW QUESTIONS
1. The cost accounting system is directly concerned with control of inventories, plant assets and funds
expanded on functional activities. Discuss.
2. “Cost Accounting System is neither unnecessary nor expensive, rather it is
Profitable investment”, Comment.
3. Discuss the characteristics of an ideal system of Cost Accounting and differentiate between cost accounting and financial accounting.
4. Explain different ‘Methods’ and ‘Techniques’ of costing.
5. “Financial accounting treats costs very broadly while the cost accounting does this in much greater
detail” Explain this statement and state the limitations of financial accounting.
6. Define costing and discuss the objectives of cost accounting. What are the methods of costing that are
used in cost accounting?
SELF-ASSESSMENT QUESTIONS
State whether the following statements are true or false:
1. Financial accounting is concerned with the classification, accumulation, control and assignment of
costs.
2. The cost accounting system is directly concerned with control of inventories, plant assets and funds
expanded on functional activities.
3. The cost accounting system is independent of the financial accounts.
4. Financial accounts deal with all the items of expenses, losses, income and gains in total but the cost
accounts deal with items of cost alone.
5. Financial accounts cover a short period usually a week.
6. Cost accounting will generally present a better picture to the public who can not understand the intricacies of the maintenance of accounting.
ANSWERS: SELF-ASSESSMENT QUESTIONS
1. False 2. True 3. True 4. True 5. False 6. False
24
CHAPTER-A2
BANGLADESH COST ACCOUNTING STANDARDS (BCAS)
CHAPTER OVERVIEW
The primary goals of developing cost accounting standards are to achieve
consistency and accuracy in cost accounting practices. These standards will
promote professionalism in the practice of cost and management accounting by
firms and other users while they are making important decisions that are primarily
forward-looking. These standards can serve as guidelines for maintaining cost
accounting records and preparing cost audit reports in industries where cost auditing
is required. These can also serve as inspiration for other sectors and academicians.
By integrating the standards, a systematic interview to cost measurement in the
manufacturing process or service industry can be provided. By assimilating,
aligning, and implementing cost accounting principles and practices, the standards
can provide a disciplined approach to cost assessment in the manufacturing process
or service industry.
25
Chapter Learning Outcomes (CpLOs)
Illustrate the role and applications of BCAS
This Study Note Covers (Subtopics)
Bangladesh Cost Accounting Standards Board
Objectives and Functions of Cost Accounting Standards Board
BCAS issued by ICMAB
Level of Study Required
R, U,AP
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1
CLO1
CLO1
CLO 1
CLO1
CLO1
BANGLADESH COST ACCOUNTING STANDARDS BOARD
The Institute of Cost and management accountant of Bangladesh (ICMAB) identifying the necessity
for organized approach to the measurement of cost in manufacturing or service division and to deliver
supervision to the user groups, regulators, research agencies, academic institutions, and government bodies,
to realize uniformity and reliability in classification, cost measurement and assignment of product and
services. The Institute/Board has until now issued 31 cost accounting standards, guidance notes on cost
accounting standards and generally accepted cost accounting principles.
OBJECTIVES AND FUNCTIONS OF COST ACCOUNTING STANDARDS BOARD
The objective of the cost accounting standards board is to improve high excellence cost accounting
standards to allow the organization to take knowledgeable decisions and to permit regulators to accomplish
more efficiently by systematizing, harmonizing, and integrating cost accounting practices and principles.
The functions of cost accounting standard boards are as follows:
(a) to provide the structure for the standards of cost accounting.
(b) to prepare the professionals of management and cost accountant through superior guide lines on
principles of cost accounting.
(c) to supports the members in groundwork of uniform cost accounts under numerous statutes.
(d) to deliver interpretations on standards of cost accounting from every time.
(e) to develop particular standard relating to application guidance.
(f) to spread the standards of cost accounting to convince the users to approve them in the presentation and
preparation of overall purpose statement of cost.
(g) to encourage the government and proper authorities to implement standards of cost accounting, to
simplify the acceptance thereof, by corporate entities and industry so as to realize the anticipated
objectives of standardized practices in cost accounting.
(h) to instruct the managers about the effectiveness and the prerequisite for compliance of standards in cost
accounting.
26
BCAS ISSUED BY ICMAB
The Bangladesh government has until now delivered record rules and audit report rules of cost accounting
with the aim of simplifying the cost accounting practice. Providing Cost Accounting Standards of Bangladesh
can advance the practice of cost accounting one phase ahead. With the intention of satisfy this requirement,
the Cost Accounting and Financial Reporting Standards Committee (CAFRSC) of ICMAB has engaged
this initial undertaking. These standards can assist as a guide for upkeep of prepare cost audit reports and
cost accounting records, for the areas where cost audit has been prepared compulsory. These can also aid
academicians and in other areas as a monitor. The Institute is trusted with The CAFRS Committee, among
others, the accountability to improve, update and issue Cost Accounting Standards of Bangladesh.
BCAS 1: Cost Concepts and Classifications
The aim of an efficient and effective cost accounting system is to record costs properly with a view to
identifying all the costs incurred in the process of producing a product or providing services. Cost accounting
is the process of tracking, recording and analysing costs associated with the products or activities of an
organization, where cost is defined as ‘required time or resources’. Cost accounting is also defined as
an inseparable part of management accounting, which translates the physical movement of products into
financial value in order to support decision-making and improve costs and cash flows.
This standard should be applied in ascertainment and assessment of the different cost elements which
go into the manufacturing of a product or the rendering of a service and the application of costing
techniques. It will also be useful to the management of such enterprises, as the standard will assist in the
decision making process.
BCAS 2: Estimation
The objective of the standard is to deliver guidance on the purpose nature and approaches to cost estimation.
The standard will guide the rational of selecting the suitable drivers of cost. The key characteristics are
pointed below:
 Selecting cost according to behavior.
 Differentiating capacity related, flexible and discretionary cost.
 Applying independent and dependent variables in constituting cost function
 Forecasting and cost prediction based on formula.
 Multiple regression application to generate the most suitable cost driver.
BCAS 3: Cost Allocation Base
Cost allocation base mainly deals with the nature and design of the bases used to allocate indirect cost
object.
 The primary purpose of the standard is to prescribe the cost allocation bases for indirect costs.
 The standard tries to standardize the methods of setting guidance on the nature and design of the bases
to allocate cost to cost objects.
 The standard will provide in taking different commercial and strategic management decisions such as
resource allocation, product and service mix optimization, make or buy decision etc.
 The standard aims at providing better disclosure requirement and transparency in the cost statement.
.
BCAS 4: Indirect Costs
This standard deals with the methods and principles of acquisition, allocation, proportion and absorption of
indirect costs of products or services and for the presentation and disclosure in cost statement.
 The main objective of the standard is to provide effective optimization of principles related to indirect
cost.
27
 This standard also provides methods of classification, distribution and determination of indirect cost
with reasonable accuracy.
 The standard is to be followed by all public limited companies where cost audit is mandatory through
Government gazette notification from time to time.
 The key features of this standard are identifying indirect costs relating to different resources used.
BCAS 5: Indirect Cost Rate
The standard deals with the methods, pooling, allocation and distribution of indirect cost for product and
services to identify total cost per unit.
The specific objective of this standard is to provide guidance on computing indirect cost rate that can be
used for charging cost object with the indirect cost most accurately.
However, the general objective are as follows:
 This standard focus on determination of indirect cost.
 The standard aims at providing ensuring better understanding on disclosure requirement and transparency
in the cost statement.
 This standard facilitate in taking commercial and strategic management decision such as resource
allocation, product and service mix optimization, make or buy decision.
BCAS 6: Support Department Costs
This standard deals with procedure and method of pooling, allocating and distributing department costs
over cost objects.
This standard shall be applied in allocating support departments costs over cost objects. More specifically,
the standard shall be applied in cost and management accounting practices relating to Cost of products, services or activities;
 Segment performance;
 Transfer pricing; and
 Cost statement by any other purpose.
The key features of this standard are Providing different cost with departmental attachment;
 Identifying different decision scenario;
 Single step and multistep approach; and
 Comparing direct, reciprocal and step cost allocation method.
BCAS 7: Job Order Costing
For product costing, job order costing is very important cost accumulation method.
The primary objective of this standard is to provide a guideline for determining the cost of any foods
produced or services rendered under job costing environment.
In addition to the primary objective, this standard also provides The basis of preparation and presentation of cost of goods sold(COGS) in the income statement under
job costing environment;
 The application of predetermined overhead; and
 The disposal of under applied and over applied factory overhead.
The key features are pointed below Recording different element of costs in the books of accounts;
 Identifying the elements of costs in delivering a job to customer;
28
 Prescribing the methodology of charging overheads to jobs; and
 Visualizing the flow of costs in books of accounts.
BCAS 8: Process Costing
The objective of this standard is to select the method and improve the relevance, reliability and comparability
with the standard reporting format of the process costing that a manufacturing entity applies in its cost
statement. To complete this standard establishes principles and requirements for how the entity:
 Select the costing system;
 Select the method of process costing; and
 Recognize normal and abnormal loss and its treatment in the cost statement.
The standard should be applied in manufacturing companies where cost audit is mandatory.
The key features of this standard are pointed out below:
 Introducing process costing;
 Presenting normal and abnormal spoilage; and
 Introduce a complete cost of production report.
29
BCAS 9: Joint Cost
The objective of this standard is to bring uniformity, consistency in the principles, methods of determining
and assigning Joint Costs with reasonable accuracy.
Joint costs are the cost of common resources used to produce two or more products or services simultaneously.
Joint cost incurred shall be assigned to joint products based on benefits received, which is measured using
any of the following methods:
(a) Physical Units Method.
(b) Net Realisable Value at split-off point.
BCAS 10: Target Costing
The aim of target costing is to keep cost control for ensuring the competitive edge in the market. Cost plus
pricing a broadly used pricing methodology, reined the product costing literature for long time although
lose its rationality in a highly competitive market. The most critical requirement is to set the selling price
by the market with a selective design and functionality requirement.
 The main purpose of target costing is to utilize estimated cost information during the product design
phase to reduce cost at product life cycle stage.
 Target costing is a comprehensive control and planning tool that is focused on market.
 Target costing cater to serve as an organizing, coordinating, and communication method among the
members of cross functional team charged with product development.
BCAS 11: Life Cycle Costing
Life Cycle Costing (LCC) is an advanced technique that can be used by the business organizations according
to their requirements. The main objective of this standard is to ensure that each element of cost of the
life cycle has been considered during planning stage. Planning and controlling costs requires not only an
understanding of the elements of the life-cycle cost but also the magnitude and timing of each element Each
element of the product lifecycle cost should be estimated using the principle of cause and effect. Product lifecycle cost components should not be estimated during the planning stage using allocations of existing costs.
BCAS 12: Kaizen Costing
Kaizen costing is a system of cost reduction via continuous improvement. The objective of this standard is
to provide guidance to the practitioners regarding the scope and methodology of applying kaizen costing
for establishing an environment of continuous improvement. It also tries to differentiate kaizen costing from
life cycle costing, target costing and standard costing so that practitioners can use it keeping its original
essence and zeal. It is important to get the maximum output from using kaizen costing.
Kaizen Costing is an ongoing process that strives to reduce costs by making improvements and removing
waste. Successful continuous improvement requires full commitment from senior managers, along with
effective, well-documented policies and procedures designed to log, examine and develop all new ideas.
The process of continual cost reduction that occurs after a product design has been completed and is now
in production. Cost reduction techniques can include working with suppliers to reduce the costs in their
processes, implementing less costly redesigns of the product, or reducing waste costs.
BCAS 13: Standard Costing
The purpose of this standard is to define the managerial role of variance reporting and the role played by
standard costs in identifying variances. The appropriate approach to choosing a cost standard will reflect
the organization’s unique circumstances. There is no single approach of choosing a cost standard that is
best in all settings.
30
The cost standard chosen should reflect the organization’s objectives for using that cost standard and the
variances that result from implementing it Since the organization is free to define standard cost to suit its
internal purposes, and since there is no commonly accepted or recommended method to derive a standard
cost, the label “standard cost” implies no authority in terms of using that cost for contracting purposes.
BCAS 14: Activity Based Costing (ABC)
Activity-based costing provides a more accurate method of product/service costing, leading to more
accurate pricing decisions. Under ABC, activities in an organization are identified, costs are accumulated
with reference to each identified activities and the cost of each activity is assigned to all products and
services according to their respective consumption. Charging direct material and direct labour costs are the
same under both traditional cost accounting method and ABC method. This standard acknowledges that
ABC results more pragmatic cost per unit to support strategic management decision.
BCAS 15: Product Mix Decisions
In the product mix decision, the organization identifies which products, i.e., goods or services; it will
produce and deliver to its customers. The purpose of this standard is to identify the role of cost information
in product mix decision.
Management should clearly identify capacity planning phase and operation phase with respective roles
to be played by designated personnel to align product mix related decisions properly. During the capacity
planning phase, planners compare the contribution margin expected to be provided by a production budget
with the cost of the capacity that enables that production budget. The capacity is acquired if the contribution
margin that it enables exceeds its cost.
During the operations phase, which takes the level and mix of capacity as given, it is imperative that the
costs used in choosing the optimal product mix do not include any capacity-related costs. Capacity-related
costs include the cost of any productive resource whose cost depends on the amount acquired rather than the
amount used. Generally, capacity-related costs will include the cost of machinery and equipment, the cost
of other general overhead resources, and, for some organizations, the cost of labour.
BCAS 16: Transfer Pricing
Transfer pricing mainly deals with the procedure and method of setting prices of the products (goods or
services) while transferred from one segment to another segment in a decentralized setting.
The primary purpose of the standard is to prescribe the ways and procedures of setting transfer prices of
goods or services. Specific objectives of the standard can be pointed as below:
(a) The standard tries to standardize the methods of setting transfer prices for the benefits of organizations
and practitioners as well.
(b) The standard facilitates management in evaluating financial performance of responsibility centers,
motivating responsibility centre to take decisions in the best interest of the organization as a whole,
facilitating inventory costing of the transferee etc.
(c) The standard helps fair practice in setting arm’s length transfer prices in international transactions, and,
hence, protects government interest.
BCAS 17: Performance Measurement
The standard provides a basic guideline of implementing performance measurement system in an
organization irrespective of nature, type, size and objectives of the organization.
31
This standard provides guidelines for implementing performance measurement system in organizations.
This standard is applicable to measure performance of individual units, segments, processes, individuals
and overall organizations.
This standard followed by companies and other business or non-business organizations where cost and
management accounting is in practice either as a statutory obligation or to support management decision
making process.
BCAS 18: Cash Flow
Cash flow in a company is a very important issue from managerial perspective. Forecasting cash flows are
very important for decision making purposes. Reporting cash flow related information for internal decision
making process receives extra attention along with external reporting. At the same time, management of
cash flows on a regular basis is an important task of treasury now-a days.
The standard provides a basic guideline on forecasting cash inflows and outflows, reporting of cash flow
related information, analysing cash flow data and using cash flow data in different typical situations. The
standard also highlights the importance of generating accurate cash flow information timely which is very
important for cash flow management.
BCAS 19: Budget and Pro Forma Financial Statements
This standard shall be applied in planning, formulating, and implementing budget in an
Organizational setup. More specifically, the standard shall be applied in cost and management accounting
practices relating a) To select budget philosophy;
b) To formulate different budget estimates;
c) To implement budget;
d) To follow up budget; and
e) To prepare and use pro forma financial statements.
This standard may be followed by companies and other business or non-business organizations where
cost and management accounting is in practice either as a statutory obligation or to support management
decision making process.
BCAS 20: Activity Based Management
Activity Based Management (ABM) deals with the procedures or phases of implementing ABM system in organization.
Each organization requires information to make decisions, set priorities, allocate resources and monitor the actions
taken. The standard focuses on the procedures of implementing Activity Based Management in organizations for
operational growth as well as improved decision making.
The key features of this standard are pointed below (a) Presenting activity based management system;
(b) Identifying different steps in implementing ABM system;
(c) Analysing both value added and non-value added activities for improving Performance;
(d) Applying benchmarking technique to ensure continuous improvement; and
(e) Listing some ratios, values and measures to trace the improvements caused by ABM.
BCAS 21: Capital Budgeting
The objective of this standard is to provide guidance on Capital Investment decision. To accomplish that this standard
establishes principles and requirements (a) To ensure the selection of the possible profitable capital projects;
(b) To ensure the effective control of capital expenditure by forecasting the long-term financial requirements;
32
This standard targets to provide guidance on capital expenditure decisions related to (a) Acquisition of long term assets;
(b) Identifying the mostly profitable investment from some alternatives;
(c) Presenting different techniques of capital budgeting;
(d) Using cash flow information in decision making; and
(e) Bringing some other issues used in long term investments like risk, cost of capital, financing etc.
BCAS 22: Enterprise Resource Planning
An Enterprise Resource Planning (ERP) is a complex set of computer applications designed to integrate the processes
and functions within the same company. This system is able to present a holistic vision of the company’s business by
sharing a common and integrated database. With the advent of information technology and its business application,
the pattern of business decision making has been changed significantly.
The standard provides a basic guideline for implementing ERP system in an organization with a view to increasing fast
and accurate decision making capability to remain competitive in an information era. More specifically, the standard
explicitly addresses (a) The usefulness of ERP system;
(b) The reasons for failure of ERP system;
(c) The step by step process of implementing ERP system; and
(d) The cost, maintenance, methods and team responsible for ERP system.
BCAS 23: Strategic Cost Management
Strategic cost management (SCM) deals with measuring and managing costs and aligning them to the
business strategy.
The main objective of this standard is to provide a basic guideline to those companies who plan to undergo
cost analysis as a part of strategic analysis. It tries to facilitate the practitioners to apply SCM as a driver
to ensure sustainable competitive advantage. The standard presents relevant analysis covering three core
components of SCM which are,
(a) Value chain analysis;
(b) Cost driver analysis and
(c) Strategic positioning.
BCAS 24: Material costs
This standard deals with the principles and methods of classification, measurement and assignment of
material cost, for determination of the Cost of product or service, and the presentation and disclosure in
cost statements.
The objective of this standard is to bring uniformity and consistency in the principles and methods of
determining the material cost with reasonable accuracy.
The Standard deals with the following issues.
 Assignment of material cost to cost objects
 Principle of Valuation of receipt of materials.
 Principle of Valuation of issue of materials.
BCAS 25: Employee Costs
This standard deals with the principles and methods of determining the Employee cost. The objective of this
standard is to bring uniformity and consistency in the principles and methods of determining the Employee
cost with reasonable accuracy.
33
This standard should be applied to cost statements which require classification,
measurement, assignment, presentation and disclosure of Employee cost including
those requiring attestation.
BCAS 26: Costs of Utility
The objective of this standard is to bring uniformity and consistency in the principles and methods of
determining the cost of utilities with reasonable accuracy.
 This standard shall be applied to cost statements which require classification, measurement, assignment,
presentation and disclosure of cost of utilities including those requiring attestation.
 For determining the cost of production to arrive at an assessable value of excisable utilities used for
captive consumption, Cost Accounting Standard on Cost of Production for Captive Consumption shall
apply.
 This standard shall not be applicable to the organizations primarily engaged in generation and sale of
utilities.
BCAS 27: Captive Consumption
The purpose of this standard is to bring uniformity in the principles and methods used for determining the
cost of production of excisable goods used for captive consumption.
The cost statement prepared based on standard will be used for determination of assessable value of
excisable goods used for captive consumption.
The standard and its disclosure requirement will provide better transparency in the valuation of excisable
goods used for captive consumption.
BCAS 28: Capacity Determination
Capacity shall be determined in terms of units of production or services or equivalent machine or man
hours. Installed capacity is usually determined based on:
i) Capacities of individual or interrelated production or operation Centres.
ii) Technical evaluation.
iii) Technical specifications of facility.
iv) Number of shifts or machine hours or man hours.
v) Operational constraints or capacity of critical machines or equipment.
This standard shall be applied to the cost statements, including those requiring attestation, which require
determination of capacity for assignment of overheads.
BCAS 29: Quality Costing
The standards shall be applied to cost statements which require classification, measurement, assignment,
presentation and disclosure of Quality Control cost including those requiring attestation.
The objective of this standard is to bring uniformity, consistency in the principles, methods of determining
and assigning Quality Control cost with reasonable accuracy.
The standard deals with the principles and methods of measurement and assignment of Quality Control cost
and the presentation and disclosure in cost statement.
34
BCAS 30: Service Costing
The objective of this standard is to bring uniformity and consistency in the principles and methods of determining the
Cost of Service with reasonable accuracy.
This standard deals with the principles and methods of classification, measurement and assignment of Cost of Service,
for determination of the Cost of product or service, and the presentation and disclosure in cost statements.
This standard should be applied to the preparation and presentation of cost statements, which require classification,
measurement and assignment of Service Cost Cost, including those requiring attestation.
BCAS 31: Construction Contract Costing
The objective of this standard is to provide guidance on cost and revenue of construction contract. To
accomplish that this standard establishes and applies ina) Accounting for construction contract in the financial statements of contractors.
b) Fixed asset register verification updating periodically.
c) Materials and equipment purchase in terms of –




Selection of vendors
Quotations invitations
Quotations evaluations
Goods receipts and issuance procedure.
The key features are:
a)
b)
c)
d)
Identifying the contract revenue and expenses over the periods;
Loss identification;
Allocating the contract revenue and expenses
Reporting relevant information
The Total 31 Bangladesh cost accounting standards (BCAS) are presented in the following table at a glance:
BCAS Number
Title
BCAS 1:
Cost Concepts and Classifications Cost
BCAS 2:
Estimation
BCAS 3:
Cost Allocation Base
BCAS4:
Indirect Costs
BCAS 5:
Indirect Cost Rate
BCAS 6:
Support Department Costs
BCAS 7:
Job Order Costing
BCAS 8:
Process Costing
BCAS 9:
Joint Cost
BCAS 10:
Target Costing
BCAS 11:
Life Cycle Costing
BCAS 12:
Kaizen Costing
BCAS 13:
Standard Costing
BCAS 14:
Activity Based Costing
35
BCAS 15:
Product Mix Decisions
BCAS 16:
Transfer Pricing
BCAS 17:
Performance Measurement
BCAS 18:
Cash Flows
BCAS 19:
Budget and Pro forma Financial Statements
BCAS 20:
Activity Based Management
BCAS 21:
Capital Budgeting
BCAS 22:
Enterprise Resource Planning
BCAS 23:
Strategic Cost Management
BCAS 24:
Material Cost
BCAS 25:
Employee Costs
BCAS 26:
Cost of Utilities
BCAS 27:
Captive Consumption
BCAS 28:
Capacity Determination
BCAS 29:
Quality Costing
BCAS 30:
Service Costing
BCAS 31:
Construction Contract Costing
Cost Hierarchy: The cost hierarchy is a classification system used in activity-based costing that designates
activities based on how easily they can be traced to a product.
Organization Sustaining Activities: Theses activities are carried out regardless of which customers are
served, which products are produced, how many batches are run, or how many units are made.
Development stages: The appraisal of costs is usually made with reference to all the development stages
of a product or service life which generally include design, introduction, growth, maturity, decline and
eventually abandonment.
Product: Product refers to goods or services since the general concept applies equally to both.
Responsibility centres: a responsibility centre is any part of an organization whose manager has control
over cost, revenue or investment of funds. Cost canters, profit centres, and investment centres all are known
as responsibility canters.
36
Cash Flows: There are two types of flows: inflows and outflows. If the increase in cash is the effect of
transactions, it is called inflows of cash; and if the result of transactions is decrease in cash, it is called
outflows of cash.
Free Cash Flow: Free cash flow represents the cash that a company is able to generate after spending the
money required to maintain or expand its asset base. It is calculated as operating cash flow minus capital
expenditures.
SELF-REVIEW QUESTIONS
1. What is the objective of BCAS -I named cost concept and classification?
2. What benefits derived from the application of cost concept and classification standard?
3. What are the key characteristics of cost estimation and cost allocation?
4. Distinguish between capacities related cost and discretionary cost.
5. Describe the recording and reporting procedure of cost allocation.
6. Identify the bases to be followed at the time of application of indirect cost.
7. What measurements and assignments should be recorded at the time of application of employee cost?
8. Identify the recording procedures of captive consumption.
9. What standards are maintained in transport, canteen and hotel service costing?
10. Define cost of contract. How do you recognize cost of revenues and expenses?
37
CHAPTER-A3
COST CONCEPTS, CLASSIFICATION, AND COST
STATEMENTS
CHAPTER OVERVIEW
This chapter elucidates several broadly recognised cost terms and concepts. They
will assist by validating the abundant determinations of cost accounting systems.
Various cost terms and concepts are valuable in many situations, including decision
making in the extents of analysis of value chain. They support managers to provide
choice about research, exploration as well as development. Understanding costs
is beneficial for defining ways of encompassing costs. This chapter also describes
the cost of goods sold (COGS) which is the cost of procuring or manufacturing
the goods or services that a company trades during a period, so the simply costs
comprised in the amount are those that are tied directly to the production of the
products, as well as the cost of materials, labour, and manufacturing overhead.
38
THE CONCEPTS OF COST AND EXPLAIN WHY THE CONCEPT OF
‘COST’ NEEDS TO BE DEFINED, IN ORDER TO BE MEANINGFUL.
Cost is the amount of resource given up in exchange for some goods or services. The resources given
upare money or money’s equivalent expressed in monetary units.
The Chartered Institute of Management Accountants, London defines cost as “the amount ofexpenditure
(actual or notional) incurred on, or attributable to a specified thing or activity”.
This activity of a firm may be the manufacture of a product or the rendering of a service which involves
expenditure under various heads, e.g., materials, labour, other expenses, etc. A manufacturing
organization is interested in ascertaining the cost per unit of the product manufactured while an
organization rendering service, e.g., transport undertaking, canteen, electricity company, municipality,
etc., is interested inascertaining the costs of the service it renders. In its simplest form, the cost per unit
is arrived at by dividingthe total expenditure incurred by the total units produced or the quantum of
service rendered. But this method is applicable if the manufacturer produces only one product. If the
manufacturer produces more than one product, it becomes imperative to split up the total expenditure
between the various products so that the cost of each product can be ascertained separately. Even if only
one product is manufactured, it may be necessary to analyse the cost per unit of each item of expenditure
that goes to make up the total cost. The problem becomes more complicated where a multiplicity of
products is produced and it is necessary to analyse the cost per unit of each product into various items
of expenditures that make up the total cost.
COST CLASSIFICATION FOR INVENTORY VALUATION AND PROFIT
MEASUREMENT
Classification by degree of nature or elements
There are three broad elements of costs:
1. Material: The substance from which the product is made is known as material. It can be direct
aswell as indirect.
Direct material: It refers to those materials which become a major part of the finished product andcan
be easily traceable to the units. Direct materials include:
 All materials specifically purchased for a particular job/process.
 All material acquired and latter requisitioned from stores.
 Components purchased or produced.
 Primary packing materials.
 Material passing from one process to another.
1. Indirect material: All material which is used for purposes ancillary to production and which can be
conveniently assigned to specific physical units is termed as indirect materials. Examples, oil,grease,
consumable stores, printing and stationary material etc.Labour: Labour cost can be classified into direct
labour and indirect labour.
2. Direct labor: It is defined as the wages paid to workers who are engaged in the production process whose
time can be conveniently and economically traceable to units of products. For example, wages paid to
compositors in a printing press or to workers in the foundry in cast iron works etc.
39
Indirect labor: Labor employed for the purpose of carrying tasks incidental to goods or services provided,
is indirect labor. It cannot be practically traced to specific units of output. Examples, wages of storekeepers, foreman, time-keepers, supervisors, inspectors etc.
4. Expenses: Expenses may be direct or indirect.
Direct expenses: These expenses are incurred on a specific cost unit and identifiable with the cost unit.
Examples are cost of special layout, design or drawings, hiring of a particular tool or equipment for a
job; fees paid to consultants in connection with a job etc.
Indirect expenses: These are expenses which cannot be directly, conveniently and wholly allocated
to cost center or cost units. Examples are rent, rates and taxes, insurance, power, lighting and heating,
depreciation etc.
It is to be noted that the term overheads has a wider meaning than the term indirect expenses.
Overheads include the cost of indirect material, indirect labour and indirect expenses. overheads may
be classified as
(a) production or manufacturing overheads, (b) administration overheads, (c) selling overheads, and (d)
distribution overheads.
The various elements of cost can be illustrated by the following chart:
Classification based on traceability to product
Cost can be distinguished as direct and indirect.
Direct Costs: The direct costs are those which can be easily traceable to a product or costing unit
or cost center or some specific activity, e.g. cost of wood for making furniture. It is also called traceable
cost.
40
Indirect Costs: The indirect costs are difficult to trace to a single product or it is uneconomic to do so.
They are common to several products, e.g. salary of a factory manager. It is also called common costs.
Costs may be direct or indirect with respect to a particular division or department. For example, all the
costs incurred in the Power House are indirect as far as the main product is concerned but as regards the
Power House itself, the fuel cost or supervisory salaries are direct. It is necessary to know the purpose
for which cost is being ascertained and whether it is being associated with a product, department or
some activity.
Direct cost can be allocated directly to costing unit or cost center. Whereas Indirect costs have to be
apportioned to different products, if appropriate measurement techniques are not available. These may
involve some formula or base which may not be totally correct or exact.
Classification based on time
Historical Costs: After the incurration of cost, these costs are determined. This type of costs are available
only at the time of production cost has already been completed.
Pre-determined Costs: These costs are calculated before they are incurred on the basis of a specification
of all factors affecting cost. Such costs may be:
Estimated costs: Costs are estimated before goods are produced; these are naturally less accurate than
standards.
Standard costs: This is a particular concept and technique. This method involves: setting up
predetermined standards for each element of cost and each product; comparison of actual with standard
to find variation; pin-pointing the causes of such variances and taking remedial action.
Classification based on product
Cost can be classified as product costs and period costs.
Product Costs: Product costs are those which are traceable to the product and included in inventory
values. In a manufacturing concern it comprises the cost of direct materials, direct labour and
manufacturingoverheads. Product cost is a full factory cost. Product costs are used for valuing inventories
which are shown in the balance sheet as asset till they are sold. The product cost of goods sold is
transferred to the cost ofgoods sold account.
Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., include many
selling and administrative costs essential to keep the business running. Though they are necessary
to generate revenue, they are not associated with production, therefore, they cannot be assigned to a
product. They are charged to the period in which they are incurred and are treated as expenses.
Selling and administrative costs are treated as period costs for the following reasons:
Most of these expenses are fixed in nature.
 It is difficult to apportion these costs to products.
 It is difficult to determine the relationship between such cost and the product.
 The benefits accruing from these expenses cannot be easily established.
 The net income of a concern is influenced by both product and period costs. Product costs are
41
included in the cost of the product and do not affect income till the product is sold. Period costs
are charged to the period in which they are incurred.
Classification based on volume or activity
Costs can be classified as fixed, variable and semi-variable cost.
Fixed Costs: The Chartered Institute of Management Accountants, London, defines fixed cost as “the cost
which is incurred for a period, and which, within certain output and turnover limits, tends to be unaffected
by fluctuations in the levels of activity (output or turnover)”.
It is wrong to say that fixed costs never change. These costs may vary depending on the circumstances.
The term fixed refer to non-variability related to the relevant range.
Variable Cost: Variable costs are those costs that vary directly and proportionately with the output e.g.
direct materials, direct labour. It should be kept in mind that the variable cost per unit is constant but the
total cost changes corresponding to the levels of output. It is always expressed in terms of units, not in
terms of time.
Management decisions can influence the cost behaviour patterns. The concept of variability is relative. If
the conditions upon which variability was determined changes, the variability will have to be determined
again.
Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. Because of the
variable element, they fluctuate with volume and because of the fixed element; they do not change in
direct proportion to output. Semi-variable costs change in the same direction as that of the output but
not in the same proportion. Depreciation is an example; for two shifts working the total depreciation
may be only 50% more than that for single shift working. They may change with comparatively small
changes in output but notin the same proportion.
Functional cost classification
A company performs a number of functions. Functional costs may be classified as follows:
Manufacturing/production Costs: It is the cost of operating the manufacturing division of anundertaking.
It includes the cost of direct materials, direct labor, direct expenses, packing (primary) cost and all
overhead expenses relating to production.
Administration Costs: They are indirect and covers all expenditure incurred in formulating the policy,
directing the organization and controlling the operation of a concern, which is not related to research,
development, production, distribution or selling functions.
Selling and Distribution Cost: Selling cost is the cost of seeking to create and stimulate demand e.g.
advertisements, market research etc. Distribution cost is the expenditure incurred which begins with
making the package produced available for dispatch and ends with making the reconditioned packages
available for re-use e.g. warehousing, cartage etc. It includes expenditure incurred i n transporting articles
to central or local storage. Expenditure incurred in moving articles to and fromprospective customers as in
the case of goods on sale or return basis is also distribution cost.
42
Research and Development Costs: They include the cost of discovering new ideas, process,products by
experiment and implementing such results on a commercial basis.
Pre-production Cost: When a new factory is started or when a new product is introduced, certainexpenses
are incurred. There are trial runs. Such costs are termed as pre-production costs and treated as
deferred revenue expenditure. They are charged to the cost of future production.
FINANCIAL, COST AND MANAGEMENT ACCOUNTING CONCEPTS
The American Accounting Association, committee on management accounting, defines management
accounting as “the application of appropriate techniques and concepts in processing the historical and
projected economic data of an entity to assist management in establishing a plan for reasonable economic
objectives and in the making of rational decisions with a view towards achieving these objectives”.
Though some number of differences can be identified between cost accounting and management accounting,
the line of difference is very thin. Because, cost accounting, at present, comprises of some of the advanced
techniques and systems of costing such as budgetary control, marginal costing, standard costing, etc. and
therefore, it tends to conform to management accounting. Consequently, not much difference can be found
between the two.
Financial accounting deals with the supply of information about the enterprise through P&L A/c and
balance sheet to outside parties -mainly for external use. It extends over the total performance of the firm in
general. The cost accounting is very closely-related to financial accounting. Few authorities of accounting
consider cost accounting to be the branch of financial accounting. But it may be said that cost accounting
is complementary to financial accounting. Financial accounting and cost accounting are both similar in
various ways. The main relationship between financial accounting and cost accounting are given as under:
 The fundamental principles of double entry system are applicable in financial accounting as well as cost
accounting.
 The results of business or organization are revealed by both the systems of accounts.
 The determination of future business activities and policy is guided by both accounting systems.
 A basis for comparison of expenditures is being provided by both the accounting systems.
 The invoices and vouchers constitute the common basis for recording transactions under both the
systems of accounting.
 The causes for losses and wastages of a business or industry are provided by financial and cost
accounting.
DESCRIBE HOW INFORMATION CAN BE USED TO IDENTIFY
PERFORMANCE WITHIN AN ORGANIZATION
Traditionally users in organization think about value in business in terms of assets—property, plants,
equipment, inventory and even human resources. The explosion of technology over the last decade has
made organization re-think what is valuable. In fact, what many businesses today consider to be their
most valuable asset cannot be held in user’s hand because it is the information generated by the collection
of billions of bits of data. In fact, the data that businesses gather about their customers is, to the most
progressive companies, invaluable.
At the most basic level, an information system (IS) is a set of components that work together to manage data
processing and storage. Its role is to support the key aspects of running an organization, such as communication,
43
record-keeping, decision making, data analysis and more. Organizations use this information to improve
their business operations, make strategic decisions and gain a competitive edge. Information systems
typically include a combination of software, hardware and telecommunication networks. For example, an
organization may use customer relationship management systems to gain a better understanding of its target
audience, acquire new customers and retain existing clients. This technology allows companies to gather
and analyse sales activity data, define the exact target group of customer satisfaction.
Modern technology can significantly boost company’s performance and productivity. Information systems
are no exception. Organizations worldwide rely on them to research and develop new ways to generate
revenue, engage customers and streamline time-consuming tasks. With an information system, businesses
can save time and money while making smarter decisions. A company’s internal departments, such as
marketing and sales, can communicate better and share information more easily. Since this technology is
automated and uses complex algorithms, it reduces human error. Furthermore, employees can focus on
the core aspects of a business rather than spending hours collecting data, filling out paperwork and doing
manual analysis.
INFORMATION AND PRIMARY BUSINESS ACTIVITIES
The primary activities are the functions that directly impact the creation of a product or service. The goal of
the primary activities is to add more value than they cost. The primary activities are:
•
Inbound logistics: These are the functions performed to bring in raw materials and other needed inputs.
Information can be used here to make these processes more efficient, such as with supply-chain
management systems, which allow the suppliers to manage their own inventory.
•
Operations: Any part of a business that is involved in converting the raw materials into the final products
or services is part of operations. From manufacturing to business process management, information can
be used to provide more efficient processes and increase innovation through flows of information.
•
Outbound logistics: These are the functions required to get the product out to the customer. As with
inbound logistics, information can be used here to improve processes, such as allowing for real-time
inventory checks.
•
Sales/Marketing: The functions that will entice buyers to purchase the products are part of sales and
marketing. Information is critical to every aspect of sales and marketing. From online advertising to
online surveys, information can be used to innovate product design and reach customers like never
before. The company website can be a sales channel itself as we have seen with Amazon.
INFORMATION AND SUPPORT ACTIVITIES
The support activities are the functions in an organization that support, and cut across, all of the primary
activities. The support activities are:
•
Procurement: The activities involved in acquiring the raw materials used in the creation of products
and services are called procurement. Business-to-business e-commerce can be used to improve the
acquisition of materials.
•
Human resource management: This activity consists of recruiting, hiring, and other services needed to
attract and retain employees. Using the Internet, HR departments can increase their reach when looking
for candidates. There is also the possibility of allowing employees to use technology for a more flexible
work environment.
44
•
Firm infrastructure: This includes organizational functions such as finance, accounting, and quality
control, all of which depend on information; the use of ERP systems is a good example of the impact
that information can have on these functions.
This brief analysis sheds some light onto how businesses can use information to gain a competitive
advantage. As you can see, the use of information cuts across the entire organization. Although the uses
may vary from area to area one thing that is consistent is that the use of accurate, timely information can
improve business processes and thereby enhance the customer experience. When the customer experience is
enhanced, revenues rise, profits rise and business flourishes. Information is quickly becoming the lifeblood
of business and its importance in the long-term success of an organization cannot be overstated.
EXPLAIN THE DIFFERENCES BETWEEN FINANCIAL INFORMATION
REQUIREMENTS FOR COMPANIES, PUBLIC BODIES AND SOCIETY.
Financial information plays a vital role in running a company because it helps to track income and
expenditures, ensure statutory compliance, and provide investors, management, and other users of company
with quantitative financial information which can be used in making business decisions. It helps in evaluating
the performance of business or company. It assists to understand what’s going on in business or company
financially. Not only will clean and up to date records help company by keeping track of expenses, gross
margin, and possible debt, but it will help to analyse current data with the previous accounting records and
allocate budget appropriately.
Financial information ensures statutory compliance by focusing proper accounting systems in the company.
The accounting information will ensure that liabilities such as sales tax, VAT, income tax, and pension funds,
are appropriately addressed. It helps to create budget and future projections for the company. Business
trends and projections are based on historical financial data to keep operations profitable in company. This
financial data is most appropriate when provided by well-structured accounting processes. Businesses are
required to file their financial statements with the registrar of companies. Listed entities are required to file
them with stock exchanges, as well as for direct and indirect tax filing purposes. Needless to say, financial
information plays a critical role in all these scenarios.
Financial information in public sector or body is particularly relevant and is the most important approach
for recording and reporting management acts, helping public managers to achieve their objectives
regarding internal and external reporting for accountability purposes. The main objectives of financial
information in public sector are to determine the legitimacy of transactions and their compliance with the
statues and accepted norms. Financial information in public sector accounting is the systematic process of
45
recording, communicating, summarizing, analysing and interpreting the financial statements and statistics
of government in aggregate and details. It deals with the receipts, custody, disbursement and rendering of
stewardship on public funds entrusted.
In early days, accounting was only to serve the interest of the owners. Under the changing business
environment, the financial information and the accountant both have to watch and protect the interests of
other people who are directly or indirectly linked with the operation of modern business. The society is
composed of people as customer, shareholders, creditors and investors. The accounting information/data
is to be used to solve the problems of the public at large such as determination and controlling of prices.
Therefore, safeguarding of public interest can better be facilitated with the help of proper, adequate and
reliable accounting information and as a result of it the society at large is benefited. Accounting also provides
jobs to the society. After regular study of accounting, human being can also learn to make budget and
every work is done by well-planned and according to resources of society. Accounting can help society by
handling corporate finance and money by recording it properly.
PREPARE THE STATEMENT OF COST OF GOODS SOLD
Cost of goods sold is a statement which is prepared periodically to provide detailed cost of a cost unit or cost
centre. A cost sheet not only shows the total cost but also the various components of the total cost. Period
covered by a cost sheet may be a year, a month or a week, etc. Cost sheet serves the following purposes:




It discloses various elements of cost,
It discloses the per unit cost as well as total cost of production,
It facilitates preparation of tender price, and
It facilitates comparison of total cost.
Cost of goods sold is one of the accounting techniques to present the cost of the products sold in detail
format to determine the selling price. During the preliminary stage of preparing the cost statement of the
product, there are two things to be borne in our mind at the moment of classification.
 Direct cost classification
 Indirect cost classification
The direct costs of the product or service are added together to know the volume of total direct cost. The
total volume of direct cost is known as “Prime Cost.”
Direct Materials + Direct Labour + Direct Expenses = Prime cost.
The factory overheads are nothing but the indirect costs incurred at the factory site. The total factory cost or
works cost incurred in the factory could be derived by adding the both direct cost and indirect cost incurred
during the factory process.
Manufacturing Cost = Prime cost + Factory Overheads.
.
46
Company Name
Cost of Goods Sold Statement or cost Sheet (Specimen)
Date: -----Particulars
TK
Beginning Raw Material
Add: New Purchase (adjust with purchase return, discount, freight in)
***
***
(1) Cost of material available for use
Less: Ending Raw Material
(2) Cost Material Consumed or Used
Add: Direct Labor
(3) Prime Cost
Add: Factory Overhead
(4) Manufacturing Cost
Add: Beginning Work in Process
(5) Cost of goods available for manufacture or production
Less: Ending Work in Process
***
***
***
***
***
***
***
***
***
***
(6) Cost of Goods Manufactured/produced
Add: Beginning Finished Goods
(7) Cost of Goods Available for sale
Less: Ending Finished Goods
(8) Cost of Goods Sold
***
***
***
***
***
Example: 1 (Basic level)
You have given the following ledger balances of Mierco Company for July, 2019:
Ledger a/cs balances
Finished goods inventory, beginning
Finished goods inventory, ending
Depreciation, factory
Administrative expense
Utilities, factory
Maintenance, factory
Supply, factory
Insurance, factory
Purchase of raw material
Purchase return
Freight in
Raw material inventory, beginning
Raw material inventory, ending
Direct labor/ production labor/direct wage
Indirect labor
TK
20,000
40,000
27,000
1,10,000
8,000
40,000
11,000
4,000
1,25,000
11,000
4,500
9,000
6,000
70,000
15,000
47
Work in process inventory – beginning
Work in process inventory – ending
Sale
Sale discount
Selling expense
Interest expense
Tax
17,000
30,000
5,00,000
20,000
80,000
14,000
25%
Requirements:
i. Prepare a cost of goods sold statement
ii. Prepare Classified Income statement
Solution: Basic level
Mierco Company
Cost of Goods Sold Statement
July, 2019
Particulars
Beginning Raw Material
Add: New Purchase
Less: Purchase return
Add: Freight in
(1) Cost of material available for use
Less: Ending Raw Material
(2) Cost Material Consumed or Used
Add: Direct Labor
(3) Prime Cost
Add: Factory Overhead
- Indirect labor
- Depreciation, factory
- Utilities, factory
- Maintenance, factory
- Supply, factory
- Insurance, factory
TK
TK
9000
125000
11000
4500
118500
6000
121500
70000
191500
15,000
27000
8000
40000
11000
4000
105000
(4) Manufacturing Cost
Add: Beginning Work in Process
(5) Cost of goods available for manufacture or production
Less: Ending Work in Process
(6) Cost of Goods Manufactured/produced
296500
17000
313500
30000
283500
Add: Beginning Finished Goods
20000
(7) Cost of Goods Available for sale
Less: Ending Finished Goods
(8) Cost of Goods Sold
303500
40000
263500
48
(ii)
Mierco Company
Classified Income Statement
July, 2019
Particulars
Sale
Less: Sale Discount
(1)Net sale
Less: Cost of goods sold
(2)Gross profit
Less: operating expense
- Administrative
- Selling
(3)Operating income
Less: non operating expense
- Interest expense
(4)Income before tax
Less: tax @ 25%
(5)Net income
Example 2: (Intermediate level)
Prepare the cost sheet and income statement from the following information:
Account titles from the ledgers
Sale
Advertisement
Sale return
Entertainment
Interest expense
Direct labor
Indirect labor
Gain on sale of an equipment
Building rent (80% is used in factory space and rest one has been used by office)
Depreciation on office equipment
Bad debt
Utilities, factory
Raw material purchased
Royalty, factory
Maintenance, factory
Selling & administrative expense
Other factory overhead
Tax
TK
TK
500000
20000
480000
263500
216500
110000
80000
190000
26500
14000
12500
3125
9375
TK
13,00,000
1,05,000
50,000
40,000
36,000
90,000
85,000
45,000
40,000
45,000
35,000
1,08,000
4,80,000
13,000
9,000
10,000
6,800
55,000
49
Inventory schedule
Beginning
20,000
50,000
45,000
Raw material
Work in process
Finished goods
ending
30,000
40,000
65,000
Solution : Intermediate level
Company name
Cost of Goods Sold Statement
Date:
Particulars
TK
TK
Beginning Raw Material
20000
Add: New Purchase
(1)Cost of material available for use
480000
500000
Less: Ending Raw Material
(2)Cost Material Consumed or Used
Add: Direct Labor
30000
470000
90000
(3)Prime Cost
560000
Add: Factory Overhead
- Indirect labor
- Building rent, factory (80%)
- Utilities, factory
- Royalty
- Maintenance, factory
- Other factory overhead
(4) Manufacturing Cost
Add: Beginning Work in Process
(5)Cost of goods available for manufacture or production
85000
32000
108000
13000
9000
6800
253800
Less: Ending Work in Process
(6)Cost of Goods Manufactured/produced
813800
50000
863800
40000
823800
Add: Beginning Finished Goods
45000
(7)Cost of Goods Available for sale
868800
Less: Ending Finished Goods
65000
(8) Cost of Goods Sold
50
8,03,800
Company name
Income Statement
Date:
Particulars
Sale
Less: Sale return
(1)Net sale
Less: Cost of goods sold
(2)Gross profit
Less: Operating exp
- Advertisement
- Entertainment
- Building rent (20%)
- Depreciation on office equipment
- Bad debt
- Selling & administrative expense
(3)Operating income
Add: non-operating income
- Gain on sale of an equipment
Less: non-operating expense
- Interest expense
(4)Income before tax
Less: Tax
(5)Net income
TK
TK
1300000
50000
1250000
803800
4,46,200
105000
40000
8000
45000
35000
10000
243000
203200
45000
36000
284200
55,000
229200
51
Example: 3 (Advanced level)
The following figures were extracted from the Trial Balance of a company as on 31st December 2020.
Particulars
Inventories
Raw Material
WIP
FG
Office Appliances
Plant and Machinery
Buildings
Sales
Sales Returns
Material purchased
Freight on materials
Purchase returns
Direct labour
Indirect labour
Factory supervision
Factory repairs & upkeep
Heat, light & power
Rates & taxes
Misc factory expenses
Sales commission
Sales travelling
Sales Promotion
Distribution department salaries & wages
Office salaries
Interest on borrowed funds
TK
1,40,000
2,00,000
80,000
17,400
4,60,500
2,00,000
7,68,000
14,000
3,20,000
16,000
4,800
1,60,000
18,000
10,000
14,000
65,000
6,300
18,700
33,600
11,000
22,500
18,000
8,600
2,000
Further details are given as follows:
Closing inventories are Material TK 180000, WIP TK 192000 & FG TK 115000.
Accrued expenses are Direct Labour TK 8000, Indirect Labour TK 1200 & interest TK 2000.
Depreciation should be provided as 5% on Office Appliances, 10% on Machinery and 4% on Buildings.
Heat, light and power are to be distributed in the ratio of 8:1:1 among factory, office and distribution
respectively.
 Rates & taxes apply as 2/3rd to the factory and 1/3rd to office.
 Depreciation on building to be distributed in the ratio of 8:1:1 among factory, office and distribution
respectively.




Required: Prepare a Cost Sheet showing all important components and also a condensed P & L Account
for the year.
52
Solution: 3 (Advanced level)
Particulars
Direct Materials
Opening stock
Add: Purchases
Add: Freight
Less: Returns
Less: Closing Stock
Direct Labour
Add: Accrued
Prime Cost
Factory Overheads:
Indirect labour
Accrued indirect labour
Factory supervision
Repairs & upkeep
Heat, Light & power
Rates & taxes
Misc. Factory expenses
Depreciation on plant & machinery
Depreciation on buildings
Add: Opening WIP
Less: Closing WIP
Factory Cost
Administration Overheads
Heat Light & power
Rates & taxes
Depreciation on buildings
Depreciation on office appliances
Office salaries
Add: Opening FG stock
Less: Closing FG Stock
Cost of goods sold
Selling & Distribution overheads
Heat & light
Depreciation on buildings
Sales commission
Sales travelling
Sales promotion
Distribution department expenses
Amount (TK)
1,40,000
3,20,000
16,000
(4,800)
(1,80,000)
1,60,000
8,000
18,000
1,200
10,000
14,000
52,000
4,200
18,700
46,050
6,400
1,70,550
2,00,000
(1,92,000)
Amount (TK)
2,91,200
1,68,000
4,59,200
1,78,550
6,37,750
6,500
2,100
800
870
8,600
18,870
80,000
(1,15,000)
6,500
800
33,600
11,000
22,500
18,000
(16,130)
6,21,620
92,400
53
Cost of Sales
Condensed P & L Account for the year ended 31-12-2020
Sales Income
Less: Returns
Cost of Sales as above
Interest on borrowings (2,000 + 2,000)
Net Profit
7,14,020
7,68,000
(14,000)
7,54,000
7,14,020
4,000
35,980
Costs have been classified by - time, nature or elements, degree of traceability to the product,
association with the product, changes in activity or volume, function, relationship with accounting period,
controllability, cost for analytical and decision-making purposes, etc.
Methods of costing covers - job costing, contract costing, batch costing, terminal costing, operation
costing, process costing, unit costing, operating costing, multiple or composite costing, departmental
costing, etc.
Techniques of costing includes - historical or conventional costing, standard costing marginal costing,
uniform costing, direct costing, absorption costing, and activity based costing.
Financial information ensures statutory compliance by focusing proper accounting systems in the
company.
Direct material refers to those materials which become a major part of the finished product and can
be easily traceable to the units.
Direct labor is defined as the wages paid to workers who are engaged in the production process whose
time can be conveniently and economically traceable to units of products.
SELF-ASSESSMENT QUESTIONS
State whether the following statement is True (or) False:
1. Differential Cost is the change in the cost due to change in activity from one level to another.
2. Direct Expenses are expenses related to manufacture of a product or rendering of services
3. Cost unit of Hotel industry is student per year.
4. Profit is result of two varying factors sales and variable cost.
5. Multiple Costing is suitable for the banking Industry.
[Ans: T, T F, F, F]
54
MULTIPLE CHOICE QUESTIONS
1.
The most important element of cost is:
A. Material
B. Labour
C. Overheads
D. All the above.
2. Depreciation is an example of:
A. Fixed cost
B. Variable cost
C. Semi variable cost D. None of the above.
3. Batch Costing is suitable forA. Sugar Industry
B. Chemical Industry C. Pharma Industry
D. Oil Industry
4. Joint Cost is suitable forA. Infrastructure Industry
B. Ornament Industry.
C. Oil Industry
D. Fertilizer Industry
5. Cost units of Hospital Industry isA. Tonne
B. Student per year
C. Kilowatt Hour
D. Patient Day
6. Cost units of Automobile Industry isA. Cubic meter
B. Bed Night
C. Number of Call
D. Number of vehicle
7. Depreciation is a example ofA. Fixed Cost
B. Variable Cost
C. Semi Variable Cost D. None of these
8. Selling price is the summation ofA. Direct and indirect costs B. Product and administrative costs C. Cost of sales and profit margin
D. Direct materials, direct labour and direct expenses
9. Production cost is the summation of
A. Direct and indirect costs B. Product and administrative costs C. Cost of sales and profit margin
D. Direct materials, direct labour and direct expenses
10. The statement prepared for the computation of a product/service cost is known as
A. Standard Costing
B. Marginal Costing C. Prime Costing
D. None of these
[Ans: A, A, C, C, D, D, A, C, B, D]
SELF-REVIEW QUESTIONS
1. Cost may be classified in a variety of ways according to their nature and the information needs of the
management” Discuss.
2. Why financial information is necessary for the company and society?
3. What is product cost and period cost?
4. The term ‘cost’ must be qualified according to its context”. Discuss this statement referring to important
concepts of cost.
5. Write short notes on the following:
(a) Out of Pocket Cost.
(b) Sunk Cost
(c) Opportunity Cost
6. ‘Per unit variable cost is fixed’ Do you agree or not?
7. Exercise: (Basic level)
The Mintex Manufacturing Company submits the following information on 31st March, 2021 as per the
account records:
55
Inventories at the beginning of the year:
Materials
TK 3,000
Finished goods
7,000
Work-in-process
4,000
Raw materials purchase for the year
110,000
Direct labor
65,000
Factory supervision
35,000
Transportation in
12,000
Depreciation of factory machinery
27,000
Purchase return and discount
3,500
Factory insurance
15,000
Factory rent
50,000
Inventories at the end of the year:
Materials
4,000
Finished goods
8,000
Work-in-process
6,000
You are required to prepare a statement of cost of goods sold for the year ended 31st March, 2021.
8. Exercise: (Intermediate level)
The Sun Company makes art prints. The following details are available for the year ended 30th June, 2021:
TK
Opening Stocks:
Direct materials
26,000
Work-in-process
74,000
Finished goods
120,000
Direct materials purchased
436,000
Transportation in
20,000
Purchase returns and allowances
5,000
Direct labour
120,000
Factory supervision
44,000
Factory oil and gas expenses
160,000
Factory rent, rates and insurance
94,000
Depreciation of factory equipment
70,000
Other factory related expenses
140,000
Factory power, heat and light
20,000
Factory overheads charges
12,000
Factory charges
120,000
Closing Stocks:
Direct materials
42,000
Work-in-process
54,000
Finished goods
80,000
You are required to prepare a statement of cost of goods sold for the year ended 30th June, 2021.
56
9. Exercise: (Advanced level)
The following data has been taken from the records of Maxwale Company:
Inventories:
January 1
Finished goods
TK 5,000
Work in process
15,000
Materials
10,000
Other information is as follows:
Materials purchase
Direct labor
Transportation in
Factory expenses
Factory insurance
Depreciation-factory equipment
Purchase discount and allowances
Purchase return
December 31
TK 7,000
9,000
12,000
TK 100,000
200,000
3,000
4,000
12,500
40,000
5,000
800
You are required to prepare a statement of cost of goods sold for the year ended December 31, 2020.
57
COST ACCOUNTING (COA)
PART-B
Elements of Costs
[WEIGHT 20%]
58
CHAPTER-B1
COSTING OF MATERIALS
CHAPTER OVERVIEW
The success of any industry or enterprise depends, to a greater extent, upon
the successful control of material. Further, this input provides a number
of avenues and wide scope for improvement of overall performance of
the industry. Material is any substance (Physics term) that forms part of
or composed of a finished product. i.e material refers to the commodities
supplied to an undertaking for the purpose of consumption in the process
of manufacturing or of rendering service or for transformation into
products. Good inventory management is essential since it is responsible
for planning and controlling inventory from the raw material stage at a
company to the inventory of delivered finished goods.
59
Chapter Learning Outcomes (CpLOs)
Decide material costs to be reported in the cost statements
Manage material costs adopting different techniques and
relevant BCAS
This Study Note Covers (Subtopics)
Classification of Materials
Objectives of materials management and control
Accounting for materials
Stock control in Advanced Manufacturing Environment
Inventory System – Periodic System & Perpetual System
Maintenance of General Ledger and Subsidiary Ledger
Methods of Pricing issues FIFO, LIFO, Weighted / Moving Average
Valuation of closing / inventory for Balance sheet
Pricing of returns – selection of pricing method Recording.
Corresponding BCAS
Level of Study Required
AP, AN, E, D
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
CLASSIFICATION OF MATERIALS
Material is the cost of material of any nature provided for the intend of the production of a particular
service or a product. It comprises materials cost, duties & taxes, freight inwards, insurance etc. straightly
attributable to acquirement, but exclusive of the duty drawbacks, trade discounts, and refunds on excise
duty on credit and vat.
Materials items may be classified as expensive, inexpensive or in a middle-cost range. Because of the
practical advantages of simplifying stores control procedures without incurring unnecessary high costs, it
may be possible to segregate materials for selective stores control.
 Expensive and medium-cost materials are subject to careful stores control procedures to minimize cost.
 Inexpensive materials can be stored in large quantities because the cost savings from careful stores
control do not justify the administrative effort required to implement the control.
This selective approach to stores control is sometimes called the ABC method whereby materials are
classified A, B or C according to their expense-group A being the expensive, group B the medium-cost and
group C the inexpensive materials.
60
OBJECTIVES OF MATERIALS MANAGEMENT AND CONTROL
Materials management and control should assist the following objectives:
(i)
To afford constant flow of prerequisite materials, components and parts for competent and endless
production flow.
(ii)
To reduce investment in inventories by caring in view functioning requirements.
(iii) To offer for effective materials store so that inventories can be preserved from theft, handling time and
loss by fire and also cost can be retained at a minimum.
(iv) To provide obsolete and surplus items to lowest.
It might look apparent that inventory control is effective providing going down the material level. Materials
should decrease or increase on time and amount which is related to schedules of production and requirements
of sales.
ACCOUNTING FOR MATERIALS
We will use an example to illustrate how to account for the purchase and issue of raw materials.
Example – material control account
 B Co manufactures a single product and has the following transactions for material during a particular
period:
 Raw materials of $500,000 were purchased on credit from a supplier (T Co).
 Raw materials costing $10,000 were returned to the same supplier due to defects.
 The total stores requisitions for direct material for the period were $400,000.
 Total issues for indirect materials during the period were $15,000.
 $5,000 of unused material was returned to stores from production.
Required: Prepare the material control account for the period, showing clearly how each transaction is
treated.
Solutions
Notes on transactions:
 All raw material purchases are entered into the material control account as a debit entry – the corresponding
credit goes to the payables control account.
 Any returns of material are treated in the opposite way to purchases of material.
 Direct material is directly related to production. The material control account will be reduced (credited) by
the amount of material being issued. On-going production is represented by a Work in Progress account in the
ledger system.
 Indirect materials are not directly related to production so will not affect the Work in Progress account. Such
materials are classed as factory overheads and will therefore be entered into a Factory Overheads account.
 The unused material returned to stores (inventory) will increase materials inventory and will therefore be a
debit entry in the material control account. As it is being returned from production, the corresponding credit
entry will be in the Work in Progress account.
61
MATERIAL CONTROL ACCOUNT
Payables control account
Work in Progress account
TK
500,000 Payables control account
5,000 Work in Progress account
Factory Overheads account
Closing inventory (bal. fig.)
505,000
TK
10,000
400,000
15,000
80,000
505,000
Any increases in materials inventory will result in a debit entry in the material control account
whilst any reductions in materials inventory will be shown as a credit entry in the material control
account.
Multiple Choice Question
Doodaa Co issued Tk100,000 of material from stores, 25% of which did not relate directly to production.
How would the transaction be recorded in Doodaa’s ledger accounts?
A
B
Debit: Work in Progress
Debit: Material Control Account
C
Debit: Work in Progress
Debit: Factory Overheads
D
Debit: Material Control Account
TK100,000
TK100,000
Credit: Material Control Account TK100,000
Credit: Work in Progress
TK100,000
75,000
25,000
100,000
Credit: Material Control Account 100,000
Credit: Work in Progress
75,000
Credit: Factory Overheads
25,000
The correct answer is C.
Materials inventory is being reduced as materials are being issued therefore the Material Control Account
is credited with Tk. 100,000. 25% of the total (Tk. 25,000) did not relate to production and should therefore
be debited to Factory Overheads. The remaining TK 75,000 which relates directly to production should be
debited to Work in Progress. The total debit entries equal the total credit entries, which should always be
the case.
STOCK CONTROL IN ADVANCED MANUFACTURING ENVIRONMENT
A stock control system which is also known as an inventory control system, incorporates all the functions
are associated with inventory management and maintenance in advanced manufacturing environment. It
should encompass everything from purchasing, product tracking, and product turnover, to storage inputs,
shipping and receiving and re-ordering products. The purpose of stock control is to reduce the costs of
holding stock, while ensuring to meet customer demand and making sure that there’s enough material for
production. Advanced manufacturing environment should always have a ‘safe’ amount of stock so that
they›re able to react and cover any unforeseen issues.
There are several methods to stock control in advanced manufacturing environment. Most important stock
controlling methods are as follows:
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1. Economic order quantity (EOQ)
EOQ is the ideal order quantity a company should purchase to minimize inventory costs such as holding
costs, shortage costs, and order costs. This production-scheduling model was developed in 1913 by Ford W.
Harris and has been refined over time.
Economic order quantity
The optimum ordering quantity, i.e., the quantity for which the cost of holding plus the cost of purchasing
is the minimum is known as Economic Ordering Quantity and is calculated by the following formula:
EOQ =
2xAO
c
Where
E.O.Q. = Economic Ordering Quantity
A = Annual consumption (units) during the year
O = Cost of placing an order
C = Annual cost of storage of one unit.
Example: Economic order quantity
Suppose a company purchases raw material at a cost of TK 16 per unit. The annual demand for the raw
material is 25,000 units. The holding cost per unit is TK 6.40 and the cost of placing an order is TK 32.
We can tabulate the annual relevant costs for various order quantities as follows.
Order quantity (units)
Average inventory
(units)
Number of orders
Annual holding cost
Annual order cost
Total relevant cost
100
50
200
100
300
150
400
200
500
250
600
300
800
400
1,000
500
(b)
250
TK
125
TK
83
TK
63
TK
50
TK
42
TK
31
TK
25
TK
(c)
(d)
320
8,000
8,320
640
4,000
4,640
960
2,656
3,616
1,280
2,016
3,296
1,600
1,600
3,200
1,920
1,344
3,264
2,560
992
3,552
3,200
800
4,000
(a)
Notes:
Average inventory = Order quantity 2 (i.e. assuming no safety inventory)
63
Number of orders = annual demand order quantity
Annual holding cost = Average inventory TK 6.40
Annual order cost = Number of orders TK 32
You will see that the economic order quantity is 500 units. At this point the total annual relevant costs are
at a minimum.
2. Various stock level identification
Normally, the organisation fixes levels of stock as follows:
a)
Maximum Level: This represents the minimum quantity above which stocks should not be held at
any time.
(b) Minimum Level: This represents the minimum quantity of stock that should be held at all times.
(c) Danger Level: Normal issues of stock are usually stopped at this level and made only under specific
instructions.
(d) Ordering Level: It is the level at which indents should be placed for replenishing stocks.
(e) Ordering Quantity: It is the quantity that is ordered.
Formulas for stock level
Maximum stock level = Re-order level + Re-ordering quantity – (Minimum
consumption x Minimum re-order period).
Minimum level = Re-order level - (Normal consumption x Normal re-order period).
Safety stock level = Ordering level – (Average rate of consumption × Re-order period) OR
(Maximum rate of consumption - Average rate of consumption) × Lead time
Ordering level = Minimum level + Consumption during time lag period. OR
Maximum consumption x Maximum re-order period. OR
Maximum consumption x Lead time + Safety Stock
Example 1 (Basic level)
Materials A and B are used as follows:
Minimum usage − 50 units each per week
Maximum usage − 150 units each per week
Normal usage − 100 units each per week
Ordering quantities A = 600 units
B = 1,000 units
Delivery period A = 4 − 6 weeks
B = 2 − 4 weeks
Calculate for each material (i) Maximum level (ii) Minimum level and (iii) Ordering level.
Solution 1 (Basic level)
Material A
Ordering level = Maximum usage x Maximum delivery period = 150 x 6 = 900 units.
Minimum level = Ordering level - (Normal usage x Normal delivery period) = 900 − (100 x 5) = 400 units.
Maximum level = (Ordering level + Ordering quantity) − (Minimum usage x Minimum delivery period) =
900 + 600 − (50 x 4) = 1,500 – 200 = 1,300 units
Material B
Ordering Level = Maximum usage x Maximum delivery period = 150 x 4 = 600 units
Minimum Level = Ordering level − (Normal usage x Normal delivery period)
64
= 600 − (100 x 3) = 300 units.
Maximum Level = (Ordinary level + Ordering quantity) - (Minimum usage x Minimum delivery period) =
600 + 1,000 − (50 x 2) = 1,600 − 100 = 1,500 units.
Normal delivery period has been computed as follows:
Material A
= 4+ 6
2
= 5 weeks
Material B =
2+ 4
2
= 3 weeks
Example: 2 (Intermediate level)
A company uses three raw materials X, Y and Z for a particular product for which the following data
apply: –
Raw Material
Usage per
unit of
product
(Kg.)
Re- order
Quantity
(Kg.)
Price per
(Kg.)
X
10
10,000
Y
4
Z
6
Delivery period (in weeks)
Minimum
Average
Maximum
Re- order level
(Kg.)
Minimum
level (Kg.)
0.10
1
2
3
8,000
?
5,000
0.30
3
4
5
4,750
?
10,000
0.15
2
3
4
?
2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the said product. What would be
the following quantities: –
(i) Minimum Stock of X?
(ii) Maximum Stock of Y?
(iii) Re-order level of Z?
Solution: 2 (Intermediate level)
(i) Minimum stock of X
Re-order level – (Average consumption × Average time required to obtain delivery)
=
8,000 kg. – (200 units × 10 kg. × 2 weeks) = 4,000 kg.
(ii) Maximum stock of Y
Re-order level – (Min. Consumption × Min. Re-order period) + Re-order quantity
=
4,750 kg. – (175 units × 4 kg. × 3 weeks) + 5,000 kg.
=
9,750 - 2,100 = 7,650 kg.
(iii) Re-order level of Z
Maximum re-order period × Maximum Usage
=
4 weeks × (225 units × 6 kg.) = 5,400 kg.
OR
=
Minimum stock of Z+ (Average consumption × Average delivery time)
=
2,000 kg. + [(200 units × 6 kg.) × 3 weeks] = 5,600 kg.
Example: 3 (Advanced level)
BPL Limited uses a small casting in one of its finished products. The castings are purchased from a foundry.
65
BPL Limited purchases 54,000 castings per year at a cost of TK 800 per casting.
The castings are used evenly throughout the year in the production process on a 360-days-per-year basis.
The company estimates that it costs TK 9,000 to place a single purchase order and about TK 300 to carry
one casting in inventory for a year. The high carrying costs result from the need to keep the castings in
carefully controlled temperature and humidity conditions, and from the high cost of insurance.
Delivery from the foundry generally takes 6 days, but it can take as much as 10 days. The days of delivery
time and percentage of their occurrence are shown in the following tabulation:
Delivery time (days) :
6
7
8
9
10
Percentage of occurrence:
75
10
5
5
5
Requirements:
(i)
(ii)
Compute the economic order quantity (EOQ).
Assume the company is willing to assume a 15% risk of being out of stock. What would be the safety
stock? The re-order point?
(iii) Assume the company is willing to assume a 5% risk of being out of stock. What would be the safety
stock? The re-order point?
(iv) Assume 5% stock-out risk. What would be the total cost of ordering and carrying inventory for one
year?
(v) Refer to the original data. Assume that using process re-engineering the company reduces its cost of
placing a purchase order to only TK 600. In addition, company estimates that when the waste and
inefficiency caused by inventories are considered, the true cost of carrying a unit in stock is TK 720
per year. How frequently would the company be placing an order, as compared to the old purchasing
policy?
66
Solution: 3 (Advanced level)
Computation of economic order quantity (EOQ)
Annual requirement (A) =
54,000 castings
Cost per casting (C)
=
TK 800
Ordering cost (O)
=
9,000 per order
Carrying cost per casting p.a. (C × i)
=
TK 300
EOQ =
=
=
`300
1,800 castings
(ii) Safety stock (Assuming a 15% risk of being out of stock)
=
Safety stock
=
Re-order point (level)
Annual demand
360 days
54,000units
×(Max.lead time - Avg.lead time)
X
( 7days - 6days)
=
360 days
150 castings
=
Safety Stock + Average lead time consumption
=
150 units + (6 days ×
150 units) = 1,050 castings.
(iii) Safety stocks (Assuming a 5% risk of being out of stock)
=
Safety stock
Annual demand
360days
54,000units
=
Re-order point (level)
=
×(Max.lead time - Avg.lead time)
× (9days - 6days) = 450 castings
360 days
Safety Stock + Average lead time consumption
= 450 units + (6 days × 150 units) = 1,350 castings.
(iv)
At 5% stock -out risk the total cost of
Total cost of ordering
ordering and carrying cost is as follows:
=
Annual demand ×Cost per order
=
EOQ
54,000units × 9,000
1,800units
=
Total cost of carrying
(v)
=
=
=
2,70,000
(Safety Stock + ½ EO Q) × Carrying cost per unit
(450 units + ½ × 1,800 units)
300
4,05,000
Total number of orders to be placed in a year are 54,000units
300units
= 180 times
67
PERIODIC INVENTORY SYSTEM – PERIODIC SYSTEM & PERPETUAL SYSTEM
A periodic inventory system is a form of inventory valuation where the inventory account is updated at the
end of an accounting period rather than after every sale and purchase.
The method allows a business to track its beginning inventory and ending inventory within an accounting
period.
This system visualizes physical stock verification at a fixed date/period during the year. Generally, under
this system the activity takes place at the end of the accounting period or a date close to such date. Usually
the system is opened in the following manner: (a)
A period of 5/7 days, depending on the magnitude of the work is chosen during which all the items
under stock are verified physically and such period is known as ‘cut-off’ period. During this period
there are no movements of stock items and neither ‘receipts’ nor are ‘issues permitted.
(b)
The items are physically counted/measured depending on their nature and are noted down in records
which are signed by the auditors if they are present in stock verification.
(c)
The bin cards balances are also checked and initiated. Generally, the physical balances and bin
card balances of various items should be same unless shortage/excesses are there or the recording/
balancing in the cards are incorrect.
(d)
After the physical verification is completed work sheets are countersigned by the go down supervisors
and the stock verified.
(e)
Thereafter reconciliation statement is prepared item wise where the physical balances and bin
card balances are different.
(f)
Then the balance as per bin cards and as per stores ledger is also compared and necessary adjustments
are made to show the correct position of stock at the year end.
(g)
Finally the shortages/excess statement is prepared by the concerned departments and are placed before
the higher management for their approval for adjustments. The periodic inventory system is ideal for
smaller businesses that maintain minimum amounts of inventory. The physical inventory count is
easy to complete, small businesses can estimate the cost of goods sold figures for temporary periods.
Perpetual Inventory: It represents a system of records maintained by the stores in department. It in
fact comprises of: Bin Cards, and Stores Ledger.
Bin Card maintains a quantitative record of receipts, issues and closing balances of each item of stores.
Separate bin cards are maintained for each item. Each card is filled up with the physical movement of
goods i.e. on its receipt and issue. Like bin cards, the Stores Ledger is maintained to record all receipt and
issue transactions in respect of materials. It is filled up with the help of goods received note and material
requisitions.
A perpetual inventory is usually checked by a programme of continuous stock taking. Continuous stock
taking means the physical checking of those records (which are maintained under perpetual inventory)
with actual stock. Perpetual inventory is essentially necessary for material control. It incidentally helps
continuous stock taking.
The main advantages of perpetual inventory are as follows:
68
(1) Fixation of the various levels and check of actual balances in hand with these levels assist the
Storekeeper in maintaining stocks within limits and in initiating purchase requisitions for correct
quantity at the proper time.
(2) A systematic review of the perpetual inventory reveals the existence of surplus, dormant, obsolete
and slow-moving materials, so that remedial measures may be taken in time.
(3) Physical stocks can be counted and book balances adjusted as and when desired without waiting for
the entire stock-taking to be done.
(4) Discrepancies are easily located and thus corrective action can be promptly taken to avoid their
recurrence.
(5) Quick compilation of Profit and Loss Accounts (for interim period) due to prompt availability of
stock figures.
MAINTENANCE OF GENERAL LEDGER AND SUBSIDIARY LEDGER
The general ledger is the ledger account that aggregates the balances of all the related subsidiary ledger
accounts. It is akin to a master account. Journal entries are first posed to subsidiary ledger accounts. From
here, the balances of the related subsidiary ledgers are totalled and transferred to the general ledger account.
Example
A merchandising company, M/s P sells its products to several different customers, such as Customer A,
Customer B, Customer C and so on. When M/s P records its sales transactions, it would do so by debiting
the customer account and crediting sales account. At the end of the accounting period, the balances in all
the customer accounts are aggregated and transferred into the ‘Accounts receivable’ account. The ‘accounts
receivable’ is the general ledger account that is a sum total of the balances of all the individual customer
accounts.
Subsidiary ledger is essentially a sub-set of the general ledger. It is the ledger account to which journal
entries are first posted. Subsidiary ledgers are created for those account categories in which there are high
volume of transactions. In such cases, individual subsidiary ledger accounts are created within a broader
general ledger account.
Once all journal entries are posted to the subsidiary ledger accounts, the related accounts are consolidated
and their cumulative balances transferred to the relevant general ledger account.
Example
The individual customer accounts, Customer A, Customer B, customer C and so on are the subsidiary ledger
accounts. Each customer account will contain all the important financial data related to the transactions
between it and the company. For example, the subsidiary ledger will record all sales to the customers, any
sales returns, advances received, remittances received against invoices etc.
69
METHODS OF PRICING ISSUES FIFO, LIFO, WEIGHTED / MOVING AVERAGE
The important operation of the inventory management is inventory valuation through stores register.
Inventory valuation under-pricing is being executed through the following various
methodologies:
1. First in First out (FIFO)
2. Last in First out (LIFO)
3. Weighted Average Method (WAM)
1. First in First out (FIFO)
The material which is first issued from the earliest consignment on hand and priced at the cost at which that
consignment was placed in stores. The materials which are received at first to be issued first. This is the
method suitable for the trend of falling prices in the market.
Advantages
It is very simple to understand.
It is issued on the basis of purchases.
The materials are issued at purchase price.
It is most advantageous during the moment of falling prices due to lower cost of replacement through
purchases against the issues.
 The closing stock reflects the market price due to recent purchase of materials.




70
Disadvantages
 There may be the possibility of clerical errors at the moment of maintaining the stock register due to
price fluctuations.
 The comparison between the jobs cannot be made possible due to various prices involved. The
materials issued for one job is at earlier prices which do not agree with the materials issued for
another job at later prices. When the price of materials do not agree with each other, they will not be
considered for comparison.
 The issue prices do not reflect the market price due to upward price trend. The main reason is that the
issues are only due to earliest consignments.
Example 1
2-4-2021
6-4-2021
Received 100 units @ 55 per unit
Issued 400 units
10-4-2021
Received 600 units @ 55 per unit
13-4-2021
Issued 400 units
20-4-2021
Received 500 units @ 65 per unit.
25-4-2021
Issued 600 units
10-5-2021
Received 800 units @ 70 per unit
12-5-2021
Issued 500 units
13-5-2021
Issued 200 units
15-5-2021
Received 500 units @ 75 per unit
12-6-2021
Issued 400 units
15-6-2021
Received 300 units @ 80 per unit
The following receipts and issues wererecorded and the stock of material held on 1-4-2021 was 400 units @
50 per unit. You are required to prepare the Stores Ledger Account, showing how the values of issues would
be calculated under FIFO base being 100 units.
71
Solution 1
Store ledger account [FIFO method]
Date
Qty.
Receipts
Price
Value
Issue
Price
Qty.
Value
Qty.
1-4-2021
--
--
--
--
--
--
2-4-2021
100
55
5,500
--
--
--
6-4-2021
--
--
--
50
55
--
15,000
5,500
--
10-4-2021
600
55
33,000
300
100
--
13-4-2021
--
--
--
400
55
22,000
20-4-2021
500
65
32,500
--
--
--
25-4-2021
--
--
--
10-5-2021
800
70
56,000
200
400
--
55
65
--
11,000
26,000
--
12-5-2021
--
--
--
13-5-2021
--
--
--
100
400
200
65
70
70
6,500
28,000
14,000
15-5-2021
500
75
37,500
--
--
--
12-6-2021
--
--
--
15-6-2021
300
80
24,000
200
200
--
70
75
--
14,000
15,000
--
Balance
Price
Value
100
300
100
300
100
50
50
50
50
55
5,000
15,000
5,000
15,000
5,500
100
100
600
100
200
100
200
500
100
100
100
100
800
100
400
100
200
100
200
500
100
300
100
300
300
50
50
55
50
55
50
55
65
50
65
50
65
70
50
70
50
70
50
70
75
50
75
50
75
80
5,000
5,000
33,000
5,000
11,000
5,000
11,000
32,500
5,000
6,500
5,000
6,500
56,000
5,000
28,000
5,000
14,000
5,000
14,000
37,500
5,000
22,500
5,000
22,500
24,000
2. Last in First out (LIFO)
Under this method, the issues are made at the price of latest consignment. The current cost of the jobs/work
orders are denominated only in terms of the price of the latest consignment. During the rising prices, this is
considered to be a most suitable method.
72
Advantages
 The recent purchase through the latest consignment reflects the current market prices in the cost of sales
of the fi rm.
 The issue of materials through latest consignments are denominated in terms of higher prices; led to
illustrate lesser profits due to higher charge during the production and lessens the income tax burden.
 It has greater applicability only when the transactions are very minimal and prices are steady in the
environment.
Disadvantages
 There may be a possibility of either overstating or understating the value of the stock in the balance
sheet.
 Greater possibility for more number of clerical errors.
 This method also helps to compare the jobs or works.
Example 1
From the following information, you are required to prepare a statement showing how theissues would
be priced if LIFO method is followed.
2021
Feb:
1.
2.
Opening Balance 100 units at 10 each.
Purchased 200 units at 10.50 each.
3.
Purchased 300 units at 10.60 each.
4.
Issued 400 units to Job X.
6.
Issued 120 to Job Y.
7.
Purchased 400 units at 11 each.
8.
Issued 200 units to Job Y
12.
Purchased 300 units at 11.40 each.
13.
Purchased 200 units at 11.50 each.
17.
Issued 400 units to Job Z.
Solution:
Date
Stores Ledger Account [LIFO Method]
Qty.
Receipts
Price
Value
Issue
Qty
Price
Balance
Qty.
Price
Value
2016
Feb 1
Feb 2
-200
-10.50
-2,100
---
---
---
Feb 3
300
10.60
3,180
--
--
--
100
100
200
100
200
300
10.00
10.00
10.50
10.00
10.50
10.60
Value
1,000
1,000
2,100
1,000
2,100
3,180
73
Feb 4
--
--
--
4,400
300
100
100
20
--
10.6
10.50
10.50
10.00
--
3,180
1,050
1050
200
--
Feb 6
--
--
--
Feb 7
400
11.00
Feb 8
--
--
--
200
11.00
2200
Feb 12
300
11.40
3,420
--
--
--
Feb 13
200
11.50
2,300
--
--
--
Feb 17
--
--
--
200
200
11.50
11.40
2300
2280
100
100
-80
80
400
80
200
80
200
300
80
200
300
200
80
200
100
10.00
10.5
-10.00
10.00
11.00
10.00
11.00
10.00
11.00
11.40
10.00
11.00
11.40
11.50
10.00
11.00
11.40
1,000
1,050
-800
800
4,400
800
2,200
800
2,200
3,420
800
2,200
3,420
2,300
800
2,200
1,140
3. Weighted average method
While computing the average price in this method, the total costs and total quantities are taken into
consideration.After each purchase it is considered by summing the cost of this purchase to the cost of stock
in hand and quantity received to the stock in hand. To reach at the value the total cost is divided by the total
quantity. This method reduces the number of calculations and avoids price fluctuations and gives an
acceptable figure for stock.
Advantages:
 The values reproduce actual costs.
 Prices changes do not move inventory and issues.
 It is consistent and logical.
Disadvantages
 It is complex and inconvenient when frequently changes price.
 It includes substantial extent of secretarial work.
 It is not convincing as it does not show the real price.
Example
Prepare a statement showing the pricing of issues, on the basis of Weighted Average methods from the
following information:
2021
74
March
1.
2.
Received 100 units @ TK 10 each
Received 200 units @ TK 10.2 each.
3.
Received 300 units at 10.60 each.
Solution
Date
5.
Issued 250 units to Job A
7.
Purchased 200 units @ 10.50 each
10.
Purchased 300 units @ 10.80 each
13.
Issued 200 units to Job B
18.
Issued 200 units to Job C
20.
25.
Purchased 100 units @ 11 each
Issued 150 units to Job D
Stores Ledger Account [WEIGHTED AVERAGE Method]
Receipts
Issue
Balance
Qty.
Price
TK
Value
TK
Qty.
Price
TK
Value
TK
Qty.
Value
TK
2021
March 1
100
10
1000
--
--
--
100
1000
March 2
200
10.2
2040
--
--
--
300
3040
March 5
--
--
--
250
10.13 (1)
2533
50
507
March 7
200
10.5
2100
--
--
--
250
2607
March 10
300
10.8
3240
--
--
--
550
5847
March 13
--
--
--
200
10.63 (2)
2126
350
3721
March 18
--
--
--
200
10.63 (3)
2126
150
1595
March 20
100
11
1100
--
--
--
250
2695
March 25
--
--
--
150
10.78 (4)
1617
100
1078
Workings:
1.Calculation of price for Issue on March 5th
= 3040/300 = 10.13
2.Calculation of price for Issue on March 13th
= 5847/550 = 10.63
3.Calculation of price for Issue on March 18th
= 3721/350 = 10.63
4.Calculation of price for Issue on March 25th
= 2695/250 = 10.78
75
VALUATION OF CLOSING / INVENTORY FOR BALANCE SHEET
Ending inventory is the value of goods available for sale at the end of an accounting period. It is the
beginning inventory plus net purchases minus cost of goods sold. Net purchases refer to inventory purchases
after returns or discounts have been taken out.
While the number of inventory units remains the same at the end of an accounting period, the value of ending
inventory is affected by the inventory valuation method selected. FIFO (first in, first out) method is used
during a period of rising prices or inflationary pressures as it generates a higher ending inventory valuation
than LIFO (last in, first out). As such, certain businesses strategically select LIFO or FIFO methods based
on different business environments.
Example
Using the following data, compute (i) Closing Inventory and (ii) Cost of sales under ‘current purchasing
power’ (CPP) method assuming that the firm is following LIFO method of inventory valuation:
Inventory as on 1/04/2020:
Purchases during 2020:
TK 2,40,000
14,40,000
Inventory as on 31/03/2021:
3,60,000
Price index as on 01/04/2020:
100
Price index as on 31/03/2021:
130
Average price Index for 2020:
120
The converted amount of closing stock under CPP considering LIFO method:
Value of Closing Stock = TK 3,60,000
Out of the above, 2,40,000 is deemed to be from the opening stock and the balance 1,20,000 from
thecurrent purchases since LIFO method is being followed.
Relevant conversion factor for 2,40,000
= 2,40,000 x 130/100 = 3,12,000
The conversion factor for the balance 1,20,000
= 1,20,000 x 130/120= 1,30,000
Value of closing Stock under CPP = 3,12,000 + 1,30,000 = 4,42,000
Calculation of Cost of Sales under CPP when LIFO method of inventory valuation is used:
Historical Cost Basis
ConversionFactor
Converted Amount
Inventory as on 01/04/2020
2,40,000
130/100
3,12,000
Add: Purchases
Total
14,40,000
16,80,000
130/120
15,60,000
18,72,000
Less: Closing Inventory as
calculated above
76
3,60,000
4,42,000
13,20,000
14,30,000
Pricing of returns – selection of pricing method Recording
Valuation of Materials Returned to the Vendor: Materials which do not meet quantity, dimensional and
other specifications and are considered to be unfit for production are usually returned to the vendor. These
materials can be returned to the vendor before they are sent to the stores. In case materials reach store and
are noticed to be of sub-standard quality, then also they can be returned to vendor. The price of the materials
to be returned to vendor should include its invoice price plus freight, receiving and handling charges etc.
Strictly speaking, the materials returned to vendor should be returned at the stores ledger price and not at
invoice price. But in practice invoice price is only considered, the gap between the invoice price and stores
ledger price is charged as overhead. In Stores ledger the defective or sub-standard materials are shown in
the issue column at the rate shown in the ledger, and the difference between issue price and invoice cost is
debited to an inventory adjustment account.
Valuation of Materials Returned to Stores: When materials requisitioned for a specific job or work-in
progress are found to be in excess of the requirement or are unsuitable for the purpose, they are returned to
the stores. There are two ways of treating such returns.
(1)
Such returns are entered in the receipt column at the price at which they were originally issued,
and the materials are kept in suspense, to be issued at the same price against the next requisition.
(2)
Include the materials in stock as if they were fresh purchases at the original issue price.
Valuation of Shortages during Physical Verification: Materials found short during physical verification
should be entered in the issue column and valued at the rate as per the method adopted, i.e., FIFO or any
other recorded at the original price but a new price has to be calculated for further issues.
Example 1
Prepare a Stores Ledger Account from the following information adopting FIFO method of pricing of issues
of materials.
2021
March
1.
3.
4.
5.
13.
14.
16.
20.
24.
25.
26.
27.
28.
Opening Balance 500 tons @ 200
Issue 70 tons
Issue 100 tons
Issue 80 tons
Purchased from suppliers 200 tons @ 190
Returned from Department X 15 tons.
Issued 180 tons
Purchased 240 tons @195
Issue 300 tons
Purchased from supplier 320 tons @ 200
Issue 115 tons
Returned from Department Y 35 tons
Purchased from supplier 100 tons @ 200
77
Solution 1
Date
Receipts
Issue
Qty
Price
Value
March 3
March 4
March 5
March 13
----200
----190
----38,000
March 14
15
200
3,000
2021
March 1
March 16
March 20
March 24
--
240
320
March 26
--
March 27
35
78
195
--
March 25
March 28
--
100
--
46,800
--
200
195
200
Qty
Price
Value
-70
100
80
--
-200
200
200
--
-14,000
20,000
16,000
--
500
430
330
250
250
200
200
200
200
200
200
190
1,00,000
86,000
66,000
50,000
50,000
38,000
--
--
--
250
200
200
190
50,000
38,000
15
200
3,000
70
200
200
190
14,000
38,000
15
200
3,000
70
200
200
190
14,000
38,000
15
200
3,000
240
195
46,800
180
200
--
36,000
--
Qty
Price
Value
70
200
200
190
14,000
38,000
---
---
15
200
3,000
--
--
15
195
2,925
225
195
43,875
--
225
320
195
200
43,875
64,000
22,425
110
320
195
200
21,450
64,000
--
110
320
195
200
21,450
64,000
35
195
6,825
110
320
195
200
21,450
64,000
35
195
6,825
100
200
20,000
64,000
--
--
115
6,825
--
20,000
Balance
--
195
--
Example 2
On 1 January Mr P started a small business selling a special yarn. He invested his savings of TK 40 000 in
the business and during the next six months the following transactions occurred:
Date of
receipt
Yarn purchases
quantity (box)
Total cost
(TK)
Date of issue
Yarn sales
quantity (box)
Total value
(TK)
13 Jan
8 Feb
11 Mar
12 Apr
15 June
200
400
600
400
500
7 200
15 200
24 000
14 000
14 000
10 Feb
500
25 000
20 Apr
600
27 000
25 June
400
15 200
The yarn is stored in premises Mr P has rented, and the closing stock of yarn, counted on 30 June, was
500 boxes. Other expenses incurred, and paid in cash, during the six-month period amounted to TK
2300.
Required:
a) Calculate the value of the material issues during the six-month period, and the value of the
closing stock at the end of June, using the following methods of pricing:
i) first in, first out;
ii) last in, last out;
iii) weighted average (calculations to two decimal places only).
b) Calculate and discuss the effect each of the three methods of material pricing will have on the
reported profit of the business, and examine the performance of the business during the first sixmonth period. (Adapted from ACCA).
Solution 2
(a) (i) FIFO: 2100 boxes were purchased and 1500 boxes were issued to production, leaving a balance of
600 boxes. Actual closing stock is 500 boxes, resulting in a stock loss of 100 boxes. The closing stock will
be valued at the latest purchase price: TK 28 per unit (TK 14 000/500). Closing stock valuation = TK 14 000
(500 × TK 28) Cost of sales (including stock loss) = TK 60 400 (Total purchase cost (74 400) – (14000).
(ii) LIFO:
Date
Issue
10/2
400 units
100 units at TK 7200/200
20/4
400 units
200 units at TK 24 000/600
25/6
30/6
400 units at TK 14 000/500
100 units (stock loss) at TK 14 000/500
Total cost of issues
Cost (TK)
15 200
3 600
18 800
14 000
8 000
22 000
11 200
2 800
800
79
Note
If the question does not require you to prepare a stores ledger account, you are recommended for the
FIFO method to follow the approach shown in this answer. First calculate the closing stock in units.
With the FIFO method the closing stock will be valued at the latest purchase prices. You can calculate
the cost of sales as follows:
Cost of sales = Opening stock + Purchases – Closing stock
(iii)
Weighted average method
Receipts
Date
Quantity
(boxes)
13/1
8/2
200
400
Total
cost
(TK)
7 200
15 200
Date
10/2
11/3
12/4
600
400
500
Cost
(TK)
18 665
200
600
100
7 200
22 400
3 735
22.764
700
1 100
500
27 735
41 735
18 971
39.62
37.94
37.94
13 188
1 000
600
32 971
19 783
32.97
32.97
3 297
500
16 486
32.97
Closing balance
Quantity
(boxes)
500 at
TK 37.33
Total
cost
(TK)
24000
14 000
20/4
15/6
Quantity
(boxes)
Weighted
Average
issue
price
(TK)
36.00
37.33
37.33
Issues
600 at
TK 37.94
14 000
25/6
30/6
400 at
TK 32.97
100 at
TK 32.97
57 914
(b) Profit calculations
Sales
Cost of sales and stock loss
Other expenses
Profit
FIFO
(TK)
67 200
(60 400)
(2 300)
4 500
LIFO
(TK)
67 200
(54 800)
(2 300)
10 100
Weighted
average (TK)
67 200
(57 914)
(2 300)
6 986
The purchase cost per box is TK 36 (Jan.), TK 38 (Feb.), TK 40 (March), TK 35 (April) and TK 28 (June).
The use of FIFO results in the lowest profit because prices are falling and the higher earlier prices are
charged to production, whereas with LIFO the later and lower prices are charged to production. The use
of the weighted average method results in a profit calculation between these two extremes. There are
two items of concern regarding the performance of the business:
80
There was a large purchase at the highest purchase price in March. This purchase could have been
delayed until April so as to take advantage of the lower price. The stock loss has cost over TK 3000.
This should be investigated. A materials control procedure should be implemented.
CORRESPONDING BCAS
BCAS: 24-Material costs deals with the principles and methods of classification, measurement and
assignment of material cost, for determination of the cost of product or service, and the presentation and
disclosure in cost statements. The objective of this standard is to bring uniformity and consistency in the
principles and methods of determining the material cost with reasonable accuracy.
The Standard deals with the following issues:
 Principle of Valuation of receipt of materials.
 Principle of Valuation of issue of materials.
 Assignment of material cost to cost objects.
Principle of valuation of receipt of materials:
 The material receipt should be valued at purchase price including duties and taxes, freight inwards,
insurance, and other expenditure directly attributable to procurement (net of trade discounts, rebates,
taxes and duties refundable or to be credited by the taxing authorities) that can be quantified with
reasonable accuracy at the time of acquisition.
 Finance costs incurred in connection with the acquisition of materials shall not form part of
material cost.
 Self-manufactured materials shall be valued including direct material cost, direct employee cost, direct
expenses, factory overheads, share of administrative overheads relating to production but excluding
share of other administrative overheads, finance cost and marketing overheads. In case of captive
consumption, the valuation shall be in accordance with Cost Accounting Standard 27.
 Spares which are specific to an item of equipment shall not be taken to inventory, but shall be capitalized
with the cost of the specific equipment. Cost of capital spares and/or insurance spares, whether procured
with the equipment or subsequently, shall be amortized over a period, not exceeding the useful life of
the equipment.
Principle of valuation of issue of material
 Issues shall be valued using appropriate assumptions on cost flow e.g. First In First Out, Last In First
Out, Weighted Average Rate. The method of valuation shall be followed on a consistent basis.
 Where materials are accounted at standard cost, the price variances related to materials shall be treated
as part of material cost.
 Any abnormal cost shall be excluded from the material cost.
 Material cost may include imputed costs not considered in financial accounts. Such costs which are not
recognized in financial accounts may be determined by imputing a cost to the usage or by measuring
the benefit from an alternate use of the resource.
 The material cost of normal scrap/ defectives which are rejects shall be included in the material cost of
goods manufactured. The material cost of actual scrap / defectives, not exceeding the normal shall be
adjusted in the material cost of good production. Material Cost of abnormal scrap /defectives should not
be included in material cost but treated as loss after giving credit to the realizable value of such scrap
/ defectives.
81
Assignment of costs – Materials
Assignment of material costs to cost objects: Material costs shall be directly traced to a Cost object to the
extent it is economically feasible and /or shall be assigned to the cost object on the basis of material quantity
consumed or similar identifiable measure and valued.
Where the material costs are not directly traceable to the cost object, these may be assigned on a suitable
basis like technical estimates.
Assignment of costs – Direct Expenses
Where a material is processed or part manufactured by a third party according to specifications provided
by the buyer, the processing/ manufacturing charges payable to the third party shall be treated as part of the
material cost.
Wherever part of the manufacturing operations / activity is subcontracted, the subcontract charges related
to materials shall be treated as direct expenses and assigned directly to the cost object.
Assignment of costs– Indirect materials
The cost of indirect materials shall be assigned to the various Cost objects based on a suitable basis such as
actual usage or technical norms or a similar identifiable measure.
Recording and reporting
 Direct Materials shall be classified in the cost statement under suitable heads. E.g. Raw materials,
Components, Semi finished goods and Sub-assemblies.
 Direct Materials shall be classified as Purchased - indigenous, imported and self-manufactured.
 Indirect Materials shall be classified in the cost statement under suitable heads.
 Indirect materials may be grouped under major heads like tools, stores and spares, machinery spares,
jigs and fixtures, consumable stores, etc., if they are significant.
82
Inventory control: It includes the functions of inventory ordering and purchasing, receiving goods into
store, storing and issuing inventory and controlling the level of inventories.
 Every movement of material in a business should be documented using the following as appropriate:
purchase requisition, purchase order, GRN, materials requisition note, materials transfer note and
materials returned note.
 The inventory count (stock take) involves counting the physical inventory on hand at a certain date,
and then checking this against the balance shown in the inventory records. The inventory count can
be carried out on a continuous or periodic basis.
Perpetual inventory: It refers to a inventory recording system whereby the records (bin cards and stores
ledger accounts) are updated for each receipt and issue of inventory as it occurs.
Stores Ledger: A ledger containing a separate account for each item of material and component stocked
in store giving details of the receipts, issues and balance both in terms of quantity and value.
The important operation of the inventory management is inventory valuation through stores register.
Inventory valuation under-pricing is being executed through the following various methodologies:
 First in First out (FIFO)
 Last in First out (LIFO)
 Weighted Average Method (WAM)
Carrying Cost: Cost incurred for carrying the materials from the place of purchase to place of production
centre/profit centre.
E.O.Q: Economic Order Quantity of materials to be ordered/procured.
Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods and Stock of
Spares, but not Stock of Loose tools.
Ordering Cost: Cost incurred at the moment of placing the order of goods or materials, administration
costs, cost of communication and so on.
83
SELF-REVIEW QUESTIONS
1.
2.
Define inventory control. Why is inventory control necessary?
Explain what is maximum level, minimum level, and ordering level quantity. How are they determined?
Perpetual inventory is a method of maintaining records, whereas continuous stock taking involves
physical checking of those records with actual stock. Comment.
Critically evaluate the roles of carrying costs and ordering costs on the economic order quantity.
What is Economic Order Quantity? How is it calculated?
Find out the Economic order quantity from the following information’s: Annual usage: 3,000 units;
Cost of material per unit: TK 10; Cost of placing and receiving one order TK 60; and Annual carrying
cost per unit: 10% of inventory value
Two components P and Q are used as follows:
Normal usage 50 units each per week
Minimum usage 25 units each per week
Maximum usage 75 units each per week
Re-order quantity P: 400 units; Q: 600 units
Re-order period P: 4 to 6 weeks; Q: 2 to 4 weeks.
Calculate for each component: (1) the re-order level, (2) the minimum level, (3) the maximum level,
and (4) the average stock level.
From the following records regarding material calculate (i) the re-order level, (ii) the maximum
stock level, and (iii) the minimum stock level. Re-order quantity 6,000 units, Minimum stock (for
emergencies) 4 weeks
Average delivery time 5 weeks
Maximum stock level 20 weeks
Average consumption per week 400 units
Minimum consumption in 4 weeks 1,200 units
From the following transactions, prepare separately the Stores Ledger Accounts, using the following
pricing methods: (i) the FIFO, (ii) the LIFO.
January 1 Opening balance 100 units @ TK 5 each
January 5 Received 500 units @ TK 6 each
January 20 Issued 300 units
February 5 Issued 200 units
February 6 Received 600 units @ TK 5 each
March 10 Issued 300 units
March 12 Issued 250 units
X Ltd. has purchased and issued the materials in the following order:
Unit
Cost (TK)
1st January Purchased
300
3
4th January Purchased
600
4
6th January Issued
500
10th January Purchased
700
4
15th January Issued
800
20th January Purchased
300
5
23rd January Issued
100
Ascertain the quantity of closing stock as on 31st January and state what would be its value (in each
case) if issues were made under the following methods:
(i) Weighted Average cost.
(ii) First-in First-out.
(iii) Last-in First-out.
3.
1.
2.
3.
4.
5.
6.
7.
84
CHAPTER-B2
COSTING OF LABOUR
CHAPTER OVERVIEW
Labour cost is a significant element of cost specially in an organisation
using more manual operations. It is the cost of human endeavour in the
product and requires coordinated efforts for its control. The management
objective of keeping labour cost as low as possible is achieved by
balancing productivity with wages. Low wages do not necessarily mean
low labour cost. Low labour cost is possible by giving substantial increase
in wages against corresponding increase in productivity. Labour Cost is
of paramount importance. Labour cost is also called as employee cost.
However, for control and reduction of labour cost, it is essential to compute
the labour cost in a scientific manner and hence there should be proper
systems and processes and documentation, which will help computation
of labour cost in a scientific manner.
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Chapter Learning Outcomes (CpLOs)
Design labor pay scheme in a given context
Control labor costs through proper recording and reporting
This Study Note Covers (Subtopics)
Productivity and Labor Costs
Remuneration methods
Recording labor costs
Employee cost reporting and measurement of efficiency
Corresponding BCAS
Level of Study Required
AP, AN, C
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
PRODUCTIVITY AND LABOR COSTS
Productivity is a measure of the efficiency with which output has been produced. Production is the quantity
or volume of output produced. An increase in production without an increase in productivity will not reduce
unit costs.
Example:
Suppose that an employee is expected to produce three units in every hour that he works. The standard rate
of productivity is three units per hour, and one unit is valued at 1/3 of a standard hour of output. If, during
one week, the employee makes 126 units in 40 hours of work the following comments can be made.
Production in the week is 126 units.
Productivity is a relative measure of the hours actually taken and the hours that should have been taken to
make the output.
(i)Either, 126 units should take
42 hours
But did take
40 hours
Productivity ratio = 42/40 100% =
105%
120 units
(ii) Or alternatively, in 40 hours, he should make (3)
But did make
126 units
Productivity ratio = 126/120 100% =
105%
A productivity ratio greater than 100% indicates that actual efficiency is better than the expected or ‘standard’
level of efficiency.
Management will wish to plan and control both production levels and labour productivity.
Production levels can be raised as follows.
 Working overtime
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 Hiring extra staff
 Sub-contracting some work to an outside firm
 Managing the work force so as to achieve more output.
Production levels can be reduced as follows.
 Cancelling overtime
 Laying off staff
Productivity, if improved, will enable a company to achieve its production targets in fewer hours of work,
and therefore at a lower cost.
Productivity and its effect on cost
Improved productivity is an important means of reducing total unit costs. In order to make this pointclear, a
simple example will be used.
Example:
ABC Co has a production department in its factory consisting of a work team of just two men, Karim and
Rahim. Karim and Rahim each works a 40 hour week and refuse to do any overtime. They are each paid
Tk. 100 per week and production overheads of TK. 400 per week are charged to their work.
a) In week one, they produce 160 units of output between them. Productivity is measured in units of output
per man hour.
Production
Productivity (80 man hours)
Total cost
Cost per man hour
Cost per unit
160 units
2 units per man hour
Tk. 600 (labour plus overhead)
TK 7.50
TK 3.75
b) In week two, management pressure is exerted on Karim and Rahim to increase output and theyproduce
200 units in normal time.
Production
200 units (up by 25%)
Productivity
2.5 units per man hour (up by 25%)
Total cost
TK 600
Cost per man hour
TK 7.50 (no change)
Cost per unit
TK 3.00 (a saving of 20% on the previous cost;
25% on the new cost)
c) In week three, Karim and Rahim to work a total of 20 hours of overtime for an additional TK 50 wages.
Output is again 200 units and overhead charges are increased by TK 100.
Production
200 units (up 25% on week one)
Productivity (100 man hours)
2 units per hour (no change on week one)
Total cost (Tk. 600 + Tk. 50 + Tk. 100)
TK 750
Cost per unit
TK 3.75
d) Conclusions
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An increase in production without an increase in productivity will not reduce unit costs(week one compared
with week three).
An increase in productivity will reduce unit costs (week one compared with week two).
1. Automation
Labour cost control is largely concerned with productivity. Rising wage rates have increased automation,
which in turn has improved productivity and reduced costs.
Where automation is introduced, productivity is often, but misleadingly, measured in terms of output per
man-hour.
Example: Automation
Suppose, for example, that a work-team of six men (240 hours per week) is replaced by one machine (40
hours per week) and a team of four men (160 hours per week), and as a result output is increased from 1,200
units per week to 1,600 units.
Before the machine
After the machine
Production
1,200 units
1,600 units
Man hours
240
160
Productivity
5 units per man hour
10 units per man hour
Labour productivity has doubled because of the machine, and employees would probably
expect extra pay for this success. For control purposes, however, it is likely that a new measure of
productivity is required, output per machine hour, which may then be measured against a standard output
for performance reporting.
REMUNERATION METHODS
There are three basic groups of remuneration method: time work; piecework schemes; bonus/incentive
schemes.
Labour remuneration methods have an effect on the following.


The cost of finished products and services.
The morale and efficiency of employees.
1. Time work
The most common form of time work is a day-rate system in which wages are calculated by the following
formula.
Wages = Hours worked x rate of pay per hour
a) Overtime premium:
If an employee works for more hours than the basic daily requirement, he/she may be entitled to an
overtime payment. Hours of overtime are usually paid at a premium rate. For instance, if the basic dayrate is TK 4 per hour and overtime is paid at time-and-a-quarter, eight hours of overtime would be paid
the following amount.
Basic pay (8 x TK 4)
32
Overtime premium (8 x TK 1)
8
Total (8 x TK 5)
40
The overtime premium is the extra rate per hour which is paid, not the whole of the payment for the
overtime hours.
88
If employees work unsocial hours, for instance overnight, they may be entitled to a shift premium. The extra
amount paid per hour, above the basic hourly rate, is the shift premium.
Characteristics of day-rate systems
(a) They are easy to understand.
(b) They do not lead to very complex negotiations when they are being revised.
(c) They are most appropriate when the quality of output is more important than the quantity, or where
there is no basis for payment by performance.
(d) There is no incentive for employees who are paid on a day-rate basis to improve their performance.
Example 1:
Calculate total weekly wages paid to Mohan, from the following information:
Per week
Standard Hours even to him
40 Hours
Actual Hours worked
30 Hours
Rate per Hour
TK 20
Solution 1:
The total weekly wages paid to Mohan will be calculated as follows:
Formula:
Wages = Hours Worked x Rate Per Hour = 30 x TK 20 = TK 600
Thus, weekly wages paid to Mohan is TK 600
Example 2:
From the following information, calculate total wages by time rate method.
Standard Hours 60
Actual Hours Worked 50
No. of Unit Produced 500
Rate per Hour TK 20
Rate per unit produced TK 5
Solution 2:
The total wages paid to workers is calculated as follows:
Time Rate Method Formula = Actual Hours Worked x Rate per Hour = 50 x TK 20 = TK 1,000
2. Piecework scheme
In a piecework scheme, wages are calculated by the following formula. Wages = Units produced x Rate of
pay per unit.
Suppose for example, an employee is paid TK 1 for each unit produced and works a 40 hour week. Production
overhead is added at the rate of TK 2per direct labour hour.
Weekly production
Pay (40 hours) Overhead Conversion cost Conversion cost per unit
Units
TK
TK
TK
TK
40
50
60
70
40
50
60
70
80
80
80
80
120
130
140
150
3.00
2.60
2.33
2.14
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As his output increases, his wage increases and at the same time unit costs of output are reduced. It is normal
for pieceworkers to be offered a guaranteed minimum wage, so that they do not suffer loss of earnings when
production is low through no fault of their own.
If an employee makes several different types of product, it may not be possible to add up the units for
payment purposes. Instead, a standard time allowance is given for each unit to arrive at a total of piecework
hours for payment.
Example:
Penny Pincher is paid 50c for each towel she weaves, but she is guaranteed a minimum wage of TK 60 for
a 40-hour week. In a series of four weeks, she makes 100, 120, 140 and 160 towels.
Requirement:
Calculate her pay each week, and the conversion cost per towel if production overhead is added at the rate
of TK 2.50 per direct labour hour.
Solution:
Week Output Units
1
2
3
4
100 (minimum)
120
140
160
Pay TK Production overhead TK Conversion cost TK Unit conversion cost TK
60
60
70
80
100
100
100
100
160
160
170
180
1.60
1.33
1.21
1.13
There is no incentive to Penny Pincher to produce more output unless she can exceed 120 units in a week.
The guaranteed minimum wage in this case is too high to provide an incentive.
a) Differential piecework scheme
Differential piecework schemes offer an incentive to employees to increase their output by paying higher
rates for increased levels of production. For example:
up to 80 units per week, rate of pay per unit
80 to 90 units per week, rate of pay per unit
above 90 units per week, rate of pay per unit
=
=
=
TK1.00
TK1.20
TK1.30
Employers should obviously be careful to make it clear whether they intend to pay the increased rate on all
units produced, or on the extra output only.
Summary of piecework schemes
 They enjoy fluctuating popularity.
 They are occasionally used by employers as a means of increasing pay levels.
 They are often seen to drive employees to work too hard to earn a satisfactory wage. Careful
inspection of output is necessary to ensure that quality doesn’t fall as production increases.
3. Bonus/incentive schemes
In general, bonus schemes were introduced to compensate workers paid under a time-based system for their
inability to increase earnings by working more efficiently. Various types of incentive and bonus schemes
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have been devised which encourage greater productivity. The characteristics of such schemes are as follows.
 Employees are paid more for their efficiency.
 Morale of employees is likely to improve since they are seen to receive extra reward for extra effort.
A bonus scheme must satisfy certain conditions to operate successfully.
 It must win the full acceptance of everyone concerned.
 Its objectives should be clearly stated and attainable by the employees.
 It should be seen to be fair to employees and employers.
 The profits arising from productivity improvements are shared between employer and employee.
 Only those employees who make the extra effort should be rewarded.
 Allowances should be made for external factors outside the employees’ control which reduce their
productivity (machine breakdowns, material shortages).
 The rules and conditions of the scheme should be easy to understand.
 The bonus should ideally be paid soon after the extra effort has been made by the employees.
 The scheme must be properly communicated to employees.
RECORDING LABOR COSTS
Labour attendance time is recorded on, for example, an attendance record or clock card. Job time may be
recorded on daily time sheets, weekly time sheets or job cards depending on the circumstances. The manual
recording of times on time sheets or job cards is, however, liable to error or even deliberate deception and
may be unreliable. The labour cost of pieceworkers is recorded on a piecework ticket/operation card.
Controlling measurement of labour costs
Several departments and management groups are involved in the collection, recording and costing of labour.
These include the following.
Personnel
Production planning
Timekeeping
Wages
Cost accounting
1. Personnel department
The personnel department is responsible for the following:
 Engagement, transfer and discharge of employees.
 Classification and method of remuneration.
The department is headed by a professional personnel officer trained in personnel management, labour
laws, company personnel policy and industry conditions who should have an understanding of the needs
and problems of the employees.
When a person is engaged a personnel record card should be prepared showing full personal particulars,
previous employment, medical category and wage rate. Other details to be included are social security
number, address, telephone number, transfers, promotions, changes in wage rates, sickness and accidents
and, when an employee leaves, the reason for leaving.
Personnel departments sometimes maintain records of overtime and shift working. Overtime has to be
sanctioned by the works manager or personnel office who advise the time-keepers who control the time
booked.
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The personnel department is responsible for issuing reports to management on normal and overtime hours
worked, absenteeism and sickness, lateness, labour turnover and disciplinary action.
2. Production planning department
This department is responsible for the following.
 Scheduling work
 Issuing job orders to production departments
 Chasing up jobs when they run late
Timekeeping department
The timekeeping department is responsible for recording the attendance time and job time of the following.
 The time spent in the factory by each worker
 The time spent by each worker on each job
Such timekeeping provides basic data for statutory records, payroll preparation, labour costs of an operation
or overhead distribution (where based on wages or labour hours) and statistical analysis of labour records
for determining productivity and control of labour costs
Attendance time
The bare minimum record of employees’ time is a simple attendance record showing days absent because
of holiday, sickness or other reason. It is also necessary to have a record of the following.
Time of arrival
Time of departure
Time of breaks
These may be recorded as follows.
 In a signing-in book
 By using a time recording clock which stamps the time on a clock card
 By using swipe cards (which make a computer record)
30. Wages department
Responsibilities of the payroll department include the following.
 Preparation of the payroll and payment of wages.
 Maintenance of employee records.
 Summarizing wages cost for each cost centre.
 Summarizing the hours worked for each cost centre.
 Summarizing other payroll information e. g bonus payment, pensions etc.
Providing an internal check for the preparation and payout of wages.
Internal checks are necessary to prevent fraud. One method is to distribute the payroll work so that no
person deals completely with any transaction. All calculations should be checked on an adding machine
where possible. Makeup of envelopes should not be done by persons who prepare the payroll. The cashier
should reconcile his analysis with the payroll summary.
31. Cost accounting department
The cost accounting department has the following responsibilities.
 The accumulation and classification of all cost data (which includes labour costs).
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 Preparation of cost data reports for management.
 Analyzing labour information on time cards and payroll.
In order to establish the labour cost involved in products, operations, jobs and cost centres, the following
documents are used.
Clock cards
Idle time cards
Job cards
Payroll
Analyses of labour costs are used for the following.




Charging wages directly attributable to production to the appropriate job or operation.
Charging wages which are not directly attributable to production as follows.
Idle time of production workers is charged to indirect costs as part of the overheads.
Wages costs of supervisors, or store assistants are charged to the overhead costs of the relevant
department.
Example:
The following details were extracted from a weekly payroll for 750 employees at a factory.
Direct workers
Ordinary time
Overtime: basic wage
premium
Shift allowance
Sick pay
Idle time
Net wages paid to employees
TK
36,000
8,700
4,350
3,465
950
3,200
56,665
Tk. 45,605
Indirect workers
(TK)
Total TK
22,000
5,430
2,715
1,830
500
–
32,475
58,000
14,130
7,065
5,295
1,450
3,200
89,140
Tk. 24,220
Tk. 69,825
Requirement: Prepare the wages control account
Solutions
 The wages control account acts as a sort of ‘collecting place’ for net wages paid and deductions made
from gross pay. The gross pay is then analysed between direct and indirect wages.
 The first step is to determine which wage costs are direct and which are indirect. The direct wages
will be debited to the work in progress account and the indirect wages will be debited to the production
overhead account.
 There are in fact only two items of direct wages cost in this example, the ordinary time (TK 36,000) and
the basic overtime wage (TK 8,700) paid to direct workers. All other payments (including the overtime
premium) are indirect wages.
 The net wages paid are debited to the control account, and the balance then represents the deductions
which have been made for tax, social insurance, and so on.
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WAGES CONTROL ACCOUNT
TK
TK
Bank: net wages paid
Deductions control accounts*
69,825 Work in progress – direct labour
Production overhead control:
44,700
($89,140 - $69,825)
19,315 Indirect labour
Overtime premium
27,430
7,065
89,140
Shift allowance
5,295
Sick pay
1,450
Idle time
3,200
89,140
* In practice there would be a separate deductions control account for each type of deduction made (for
example, tax and social insurance).
EMPLOYEE COST REPORTING AND MEASUREMENT OF EFFICIENCY
Employee cost reporting
1. Direct Employee costs shall be presented as a separate cost head in the cost statement: Direct employees
are those who work on a product directly, either manually or by using machines. They are directly involved
in the production of a finished product, that can be easily traced to the product. Examples are assemblyline workers in an automobile factory or employee working on spindle / loom in the textile industry. Direct
Employee cost is to be presented as a separate item in the cost statement.
2. Indirect Employee costs shall be presented in cost statements as a part of overheads relating to respective
functions e.g. manufacturing, administration, marketing, etc: Indirect employee cost is not directly traceable
to a cost object/product and forms part of overheads. The word ‘overheads’ is used for a type of cost that
cannot be directly allocated to a cost object or product but can be assigned to cost objects. Employees whose
services are indirectly related to production include product designers, job supervisors, foremen, product
inspectors, and the like. Employee cost of such employees is considered part of Production overheads.
Salaries of employees working on administrative activities such as administration, personnel, accounts,
and the like are classified as part of administrative overheads. Similarly, salaries of employees engaged in
marketing/selling activities and distribution activities are part of Selling and Distribution Overheads.
3. The cost statement shall furnish the resources consumed on account of employee cost, category wise
such as wages salaries to permanent, temporary, part-time, and contract employees piece-rate payments,
overtime payments, employee benefits (category wise), etc wherever such items form a material part of the
total employee cost: Direct employee cost is to be exhibited as a separate item in the cost statement as per
CAS 1.
Measuring Productivity
Productivity is simply the number of units of a product or service that an employee handles in a defined
time frame. An employee who makes mechanical devices might make 20 mechanical devices per hour, or
an employee at a coffee shop might service 15 customers per hour. Simple productivity is neither good nor
bad, and in in-service industries, it might vary according to factors beyond the employee’s control, like the
number of customers who present for service. Productivity is the basic measure of employee work output.
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Determining Unit of Service (UOS)
Productivity and efficiency require a defined unit of service. UOS analysis is usually job-specific and is
most relevant to employees who have jobs that are repetitive. For example, a spot welder might have “welds
completed” or “parts completed” as his UOS, whereas a housekeeper in a hotel might have “rooms cleaned
per shift” as her UOS. Some jobs, particularly professional jobs that have variable output, defy reasonable
UOS measurements.
Measuring Efficiency
Efficiency is a ratio of an employee’s actual time to perform each UOS against the theoretical time needed
to complete it. For example, an employee who packages DVDs might put together 80 DVDs in one hour. If
the best-practice target is 100 DVDs in an hour--measured by a time study--then the employee is 80 percent
effective and has the capacity to produce 20 more units per hour. It is usually helpful to report separately
the percentage of an employee’s paid time that is actually spent performing direct work. For example, an
employee who is paid for working 8.0 hours but because of meetings and lunch breaks only works 6.0 hours
only spends 75 percent of her time being “productive” in terms of UOS analysis. Only the six hours spent
working should be factored into efficiency scoring.
Benchmarks and Targets
Some industries have basic benchmarks already established. For example, telephone call centres have service
levels that identify the ideal amount of time that common transactions should take, that are consistent across
industries. However, most companies will have to establish for themselves how long basic tasks should
take, and set performance targets accordingly.
Longitudinal Reporting
The real benefit to measuring employee efficiency is in longitudinal reporting. Calculating efficiency over
a period of time can identify opportunities to reorganize staffing, or add or remove employees based on the
company’s volume of business, and an individual employee’s long-term productivity can factor into merit
increases and bonuses. Efficiency scoring can also help with predictive modeling. If it takes 90 seconds
to produce a mechanical device, and employees are operating at 75 percent efficiency, then instead of
producing 40 widgets per hour, only 30 will be produced.
CORRESPONDING BCAS
This standard covenants with the methods and principles of measurement classification, and assignment of
cost of employee, for identification of the of product cost or service cost, and the disclosure and presentation
in the cost statements.
 Employee cost shall be determined taking into account the gross pay including all allowances payable
along with the cost to the employer of all the benefits.
 Remuneration payable to Executive Directors on the Board and other officers of a corporate body under
a statute will be considered as part of the employee cost of the year under reference whether the whole
or part of the remuneration is computed as a percentage of profits.
 Separation costs related to voluntary retirement, retrenchment, termination etc. shall be amortized over
the period benefitting from such costs.
 Employee cost shall not include imputed costs.
 Cost of idle time is ascertained by the idle hours multiplied by the hourly rate applicable to the idle
employee or a group of employees.
 Where employee cost is accounted at standard cost, variances due to normal reasons related to employee
95





cost shall be treated as part of employee cost. Variances due to abnormal reasons shall be treated as part
of abnormal cost.
Any subsidy, grant, incentive or any such payment received or receivable with respect to any employee
cost shall be reduced for ascertainment of cost of the cost object to which such amounts are related.
Any abnormal cost where it is material and quantifiable shall not form part of the employee cost.
Penalties, damages paid to statutory authorities or other third parties shall not form part of the employee
cost.
The cost of free housing, free conveyance and any other similar benefits provided to an employee shall
be determined at the total cost of all resources consumed in providing such benefits.
Any recovery from the employee towards any benefit provided e.g. housing shall be reduced from the
employee cost.
Costs assignment procedure
 Where the Employee services are traceable to a cost object, such employees’ cost shall be assigned
to the cost object on the basis such as time consumed or number of employees engaged etc or similar
identifiable measure.
 While determining whether a particular employee cost is chargeable to a separate cost object, the
principle of materiality shall be adhered to.
 Where the employee costs are not directly traceable to the cost object, these may be assigned on suitable
basis like estimates of time based on time study.
 The amortised separation costs related to voluntary retirement, retrenchment, and termination etc. for
the period shall be treated as indirect cost and assigned to the cost objects in an appropriate manner.
However, unamortised amount related to discontinued operations, shall not be treated as employee cost.
 Recruitment costs, training cost and other such costs shall be treated as overheads and dealt with
accordingly.
 Overtime premium shall be assigned directly to the cost object or treated as overheads depending on the
economic feasibility and the specific circumstance requiring such overtime.
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Incentive wage plans is a compromise between time rate and piece rate systems and incentives are
provided to workers to work hard. The employer as well as the workers share the benefit of time saved
and both labour and overhead costs are reduced.
Production is the quantity or volume of output produced. Productivity is a measure of the efficiency with
which output has been produced. An increase in production without an increase in productivity will not
reduce unit costs.
The term remuneration is used to cover the total monetary earnings of employees which includes wages
according to time or piece basis and other financial incentives.
There are three basic groups of remuneration method: time work; piecework schemes; and
bonus/incentive schemes.
Labour attendance time is recorded on, for example, an attendance record or clock card. Job time may
be recorded on daily time sheets, weekly time sheets or job cards depending on the circumstances. The
manual recording of times on time sheets or job cards, is however, liable to error or even deliberate
deception and may be unreliable. The labour cost of pieceworkers is recorded on a piecework ticket/
operation card.
Idle time has a cost because employees will still be paid their basic wage or salary for these unproductive
hours and so there should be a record of idle time.
Abnormal Idle Time: It is that time wastage which can be avoided if proper precautions are taken.
Normal Idle Time: This represents the time wastage that cannot be avoided and, therefore, the employer
must bear the labour cost of this time.
SELF-ASSESSMENT QUESTIONS
1. Guaranteed Time Rates is a payment of a fixed sum per fixed unit produced without regard to time taken.
2. Time saved is the difference between Time Allowed (Standard Time) and Time Taken.
3. Normal wages may be ascertained and bonus may be added to arrive at total earnings.
4. The difference between Halsey plan and Rowan plan is only in the calculation of the bonus.
5. Straight Piece Rates takes the form of wage rate which varies with changes in the local cost of living
index.
Answers: 1. False 2. True 13. True 4. True 5. False
SELF-REVIEW QUESTIONS
1. Do you think that there is a direct relationship of the labour to a particular production unit or process?
2. Explain the different methods of time recording for workers.
3. What are the factors that you will take into account before adopting a particular system of wage payment?
4. Under Time Rate method payment is made at a rate on attendance by hour, day, week or a month regardless of output. What are the key significance and drawbacks of time rate method?
5. Discuss the advantages and disadvantages of the piece rate method of payment of wages. Do you con-
97
sider that workers remunerated by reference to this method should be required to maintain time records?
6. Explain the term “efficiency of labor”.
7. Calculate the normal and overtime wages payable to a workman from the following data:
Days
Hours worked
Monday
8 hrs.
Tuesday
10 hrs.
Wednesday
9 hrs.
Thursday
11 hrs.
Friday
9 hrs.
Saturday
4 hrs.
Normal rate Normal working hours -
5.00 per hour
8 hours per day.
Overtime rate - Upto 9 hours in a day at single rate and over 9 hours in a day at double rate.
8. X, the proprietor of a small engineering workshop producing speciality product by employing 5 skilled
workers is considering the introduction of some incentive scheme-either Halsey scheme or Rowan
scheme-of wage payment for increasing the labour productivity to cope with the increased demand for
the product by about 25%. He feels that if the proposed incentive scheme could bring about an average
20% increase over the present earnings of the workers, it would act as a sufficient incentive for them to
produce more and he has accordingly given this assurance to the workers. As a result of this assurance,
an increase in productivity has been observed as revealed from the following figures for the current
month:
Hourly rate of wages (guaranteed) 5.00 Average time for producing 1 piece by one worker as per the
previous performance (X desires that this time be considered as time allowed for the purpose of incentive
scheme) 2 hours
No. of working days in the month 25 No. of working hours per day for each worker 8 Actual production
during the month 625 pieces
You are required to:
(a) Calculate effective rate of earnings per hour under Halsey scheme and Rowan scheme.
(b) Calculate the savings to X in terms of direct labour cost per piece under the above schemes.
(c) Advise X about the selection of the scheme to fulfill his assurance.
9. During audit of account of G Company, your assistant found errors in the calculation of the wages of
factory workers and he wants you to verify his work. He has extracted the following information:
The contract provides that the minimum wage for a worker is his base rate. It is also paid for downtimes
i.e., the machine is under repair or the worker is without work. The standard work week is 40 hours. For
overtime production, workers are paid 150 percent of base rates.
Straight Piece Work – The worker is paid at the rate of 20 paise per piece.
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Percentage Bonus Plan – Standard quantities of production per hour are established by the engineering
department. The workers’ average hourly production, determined from his total hours worked and his
production, is divided by the standard quantity of production to determine his efficiency ratio. The efficiency ratio is then applied to his base rate to determine his hourly earnings for the period.
Emerson Efficiency Plan – A minimum wages is paid for production upto 66-2/3% of standard output
or efficiency. When the workers production exceeds 66-2/3% of the standard output, he is paid bonus
as per the following table:
Efficiency Level
2
Upto 66 %
3
Bonus
⁄
66
2
Nil
⁄3% to 79 %
10%
80% – 99%
20%
100% – 125%
45%
Your assistant has produced the following schedule pertaining to certain workers of aweekly pay roll:
Workers
R
Wage Incentive Total
Plan
Hours
Straight piece
work
M*
Straight piece
work
J
Straight piece
work
Harish Percentage bonus plan
p
Emerson
A
Emerson
(40 hours
productio)
Down
Time
Hours
Units
Produced
40
46
5
—
44
40
40
40
Standard
Units
Base
Rate
400
455
—
—
`
1.80
1.80
Gross Wages
as per
Book
`
85
95
—
425
—
1.80
85
4
—
—
250
240
600
200
300
500
2.20
2.10
2.00
120
93
126
* Total hours of M include 6 overtime hours.
Prepare a schedule showing whether the above computation of workers’ wages are correct or not. Give
details.
99
CHAPTER-B3
COSTING OF OVERHEAD
CHAPTER OVERVIEW
In earlier days, overheads were not given much importance, because the
prime cost constitutes 50-80% of the total cost. However, with the modern
trend towards the mechanization, automation, and mass production,
overhead costs have grown considerably in size and in many undertakings
the proportion of overhead costs to the total costs of products is appreciably
high. In modern industrial undertakings, overheads are a very large
proportion of the total cost and, therefore, good deal of attention has to be
paid to them. It will be a big mistake to pay attention only to direct cost.
The problem in respect of overheads arises from the facts that the amount
of overheads has to be estimated and that too before the concerned period
begins (since it is only continuous costing that is found useful) and that,
the amount has to be distributed over the various cost units, again on an
estimated basis.
100
Chapter Learning Outcomes (CpLOs)
1. Illustrate the process of identifying and applying predetermined overhead rates
2. Report overhead costs after necessary adjustments
This Study Note Covers (Subtopics)
Define Overheads; Overhead allocation, apportionment of overhead
Absorption of factory overhead
Absorption and treatment of over or under absorption of overheads
Accounting for specific items of production overheads
Treatment of Non – Manufacturing Overheads
Corresponding BCAS
Level of Study Required
AP, AN,
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
Define Overheads; Overhead allocation, apportionment of overhead
Overhead may be defined as the cost of indirect material, indirect labour and such other expenses, including
services, as cannot be conveniently charged direct to specific cost centres or cost units. It should be noted
that direct costs (materials, labour, etc.) are associated with individual jobs or products. Indirect expenses
or overheads are not associated with individual jobs or products; they represent the cost of the facilities
required for carrying on the operations.
CIMA, London defines overhead as “Expenditure on labour, materials or services which cannot be
economically identified with a specific saleable cost unit”.
Overhead allocation has started after having collected the overheads under proper standing order numbers
the next step is to arrive at the amount for each department or cost centre. According to the Chartered
Institute of Management Accountants, London, cost allocation is “that part of cost attribution which charges
a specific cost to a cost centre or cost unit”. Thus, the wages paid to maintenance workers as obtained
from wages analysis book can be allocated directly to maintenance service cost centre. Similarly, indirect
material cost can also be allocated to different cost centres according to use by pricing stores requisitions.
Apportionment of overhead stands to the distribution of overheads among departments or cost centres on an
equitable basis. In other words, apportionment involves charging a share of the overheads to a cost centre
or cost unit.
CIMA, London has defined it as “that part of cost attribution which shares costs among two or more cost
centres or cost units in proportion to the estimated benefit received, using a proxy”.
101
Absorption of factory overhead
The absorption of overhead enables a cost accountant to recover the overhead cost spent on each product
department through each unit produced. Overhead absorption is also known as levy or recovery of overheads.
The following are the main methods of absorbing factory overheads:
1. Percentage on direct material cost
2. Percentage on prime cost
3. Percentage on direct wages
4. Machine hour rate
5. Direct labour hour rate
6. Rate per unit of output
Example-1
In a factory the following information has been taken from the budgeted amount:
Budgeted amounts for the year:
Estimated
Factory overheads
Direct labour hours
Direct labour cost
Machine-hours
Req.-1
TK
58,000
1,34,600
97,800
50,500
(i) Prepare Normal Overhead Application Rates using the:
(a) Direct Labour Rate Method
(b) Direct Labour Cost Method, and
(c) Machine Hours Rate Method
(ii) Prepare a comparative statement of cost showing the result of the application of each of the
rates of Batch No. 400 from the data given below:
Direct materials consumed
Direct labour
Direct labour hours
Machine hours
TK z42
45
30
20
Solutions
1.
Computation of Normal Overhead Application Rates from the following Methods:
(a)
Direct Labour Hour Rate Method:
Estimated Factory Overheads TK 58,000
Estimated Direct Labour Hours 1,34,600
Overhead Application Rate = 58,000 = TK 0.431
1,34,600
(b)
102
Direct Labour Cost Method:
Estimated Factory Overheads TK 58,000
Estimated Labour Cost TK 97,800
above
Overhead Application Rate = 58,000
97,800 × 100 = 59.3%
(c)
Machine Hour Rate Method:
Estimated Factory Overheads TK 58,000
Estimated Machine Hours
50,500, Overhead Application Rate = TK 1.149
2.
Comparative Statement of Cost of Batch No. 400
Particulars
Direct Materials Consumed
Direct Labour
Prime Cost
Factory Overhead
Direct Labour
Rate
42
45
87
12.93
99.93
Direct Labour
Cost
42
45
87
26.68
113.68
Machine Hour Rate
Method
42
45
87
22.98
109.98
Example-2
The production department of a factory furnishes the following information for the month of June, 2021.
Material
TK 54,000
45,000
Director Wages
Labour-hours worked
36,000
Hours of machine operation
30,000
Overheads chargeable to the department
36,000
For an order executed by the department during the period, the relevant information was as under:
Material used
Direct wages
TK 6,000
3,200
Labour hours worked
3,200
Hours of machine operation
2,400
Calculate the overhead charges chargeable to the job by the following methods: (a) Direct materials cost
percentage rate, (b) Labour hour rate, and (c) Machine hour rate.
Solutions
a.
Direct Material Cost Percentage Rate: = Overhead expenses
Direct material cost
× 100
= 36,000
54,000
× 100 = 66.67%
Overhead charges @ 66.67% chargeable to the job for which materials used
accounted for 6,000.
= 6,000
× 66.67
100
= 4,000
103
b.
Labour Hour Rate:
Overhead expenses
=Direct labour hour
= 36,000
36,000
= TK 1
Overhead for the job @ TK 1 for 3,200 hours
= TK 3,200
c.
Machine Hour Rate:
= Overhead expenses
Machine hours
= 36,000
30,000
= 1.20
Overhead for the job @ TK 1.20 for 2,400 hours
ABSORPTION AND TREATMENT OF OVER OR UNDER ABSORPTION
OF OVERHEADS
The absorption of overheads is based on some pre-determined rates. The actual overheads incurred
may or may not be equal to the overheads absorbed. Predetermined overhead rates are those which
are established well in advance before commencement of production. Predetermined overhead rate is
computed by dividing the budgeted overhead expenses by the budgeted base.
Under absorption of overheads
The overheads are under absorbed if the actual overheads incurred are more than the overheads absorbed.
Actual overhead rate is determined by dividing the overhead expenses incurred during the accounting
period by the actual quantum of the base selected, such as unit of products, direct wages, direct material
cost, labour hours, or machine hours. The basic principle in costing is that the recovery of overhead should
be made on actual basis, as for as possible, so that overheads may be directly charged to jobs, processes,
operations, or products.
Over absorption of overheads
The overheads are over absorbed if the actual overheads incurred are less than the overheads absorbed.
Over-absorbed overhead = Absorbed overhead – Incurred overhead
Example-1
The budgeted and actual data for River Arrow Products Co for the year to 31 March 2021 are as follows.
Direct labour hours
Direct wages
104
Budgeted
9,000
TK 34,000
Actual
9,900
TK 35,500
Machine hours
Direct materials
Units produced
Overheads
10,100
TK 55,000
120,000
TK 63,000
9,750
TK 53,900
122,970
TK 61,500
The cost accountant of River Arrow Products Co has decided that overheads should be absorbed on the
basis of labour hours.
Requirement
Calculate the amount of under– or over-absorbed overheads for River Arrow Products Co for the year
to 31 March 2021.
Solutions
Overhead absorption rate TK 63,000
TK 7 per hour
= 9,000
Overheads absorbed by production = 9,900 x TK 7 = TK 69,300
TK
Actual overheads
61,500
Overheads absorbed
69,300
Over-absorbed overheads
7,800
You can always work out whether overheads are under– or over-absorbed by using the following rule.
If Actual overhead incurred – Absorbed overhead = NEGATIVE (N), then overheads are over- absorbed
(O) (NO)
If Actual overhead incurred – Absorbed overhead = POSITIVE (P), then overheads are under- absorbed
(U) (PU)
So, remember the NOPU rule when you go into your examination and you won’t have any trouble in
deciding whether overheads are under– or over-absorbed!
Example-2
MM Company absorbs production overheads at the rate of TK 0.50 per operating hour and administration
overheads at 20% of the production cost of sales. Actual data for one month was as follows.
Administration overheads
Production overheads
Operating hours
Production cost of sales
TK 32,000
TK 46,500
90,000
TK 180,000
Requirements:
What entries need to be made for overheads in the ledgers?
105
Solutions
Cash
DR
CR
TK
46,500
TK
45,000
Absorbed into WIP (90,000x TK
0.50)
Under absorbed overhead
46,500
ADMINISTRATION OVERHEADS
Cash
Over-absorbed overhead
DR
TK
32,000
To cost of sales (180,000x 0.2)
4,000
36,000
UNDER-/OVER-ABSORBED OVERHEADS
Production overhead
Balance to profit and loss account
DR
TK
1,500
2,500
4,000
Administration overhead
1,500
46,500
CR
TK
36,000
36,000
CR
TK 4,000
4,000
Less production overhead has been absorbed than has been spent so there is under-absorbed overhead of
TK 1,500. More administration overhead has been absorbed (into cost of sales, note, not into WIP) and so
there is over-absorbed overhead of TK 4,000. The net over-absorbed overhead of TK 2,500 is a credit in
the income statement.
ACCOUNTING FOR SPECIFIC ITEMS OF PRODUCTION OVERHEADS
Generally, factory overheads form a substantial portion of the total overheads. It is very important therefore,
that such overheads are properly absorbed over the cost of production.
The following are the steps involved in accounting of overheads:
(i)
The overhead expenses incurred by various departments are collected and accumulated under
appropriate standing order numbers in the overhead expenses ledger.
(ii) Allocation of overheads to production and service departments.
(iii) Apportionment of such overheads which cannot be allocated.
(iv) Re-appointment of service department expenses to production departments.
(v) The total overhead expenses incurred by steps (i) to (iv) above represents the total
overhead cost of production departments.
(vi) An overhead rate is to be computed for each department on the basis of estimated,
actual or normal expenses and normal rate of working. The departmental overheads
are applied or charged to the cost of products manufactured by different
departments at a rate determined in the foregoing manner.
(viii) Periodical comparison of actuals with absorbed expenses to find out under or over
absorption of overheads.
106
Example
In a Factory, the following particulars have been extracted for the quarter ended 31st December, 2020.
Compute the departmental overhead rate for each of the production departments, assuming that overheads
are recovered as a percentage of direct wages.
Production Depts.
Service Depts.
Direct Wages (TK)
30,000
45,000
60,000
15,000
30,000
Direct Material
15,000
30,000
30,000
22,500
22,500
No. of workers
Electricity KWH
1,500
6,000
2,250
4,500
2,250
3,000
750
1,500
750
1,500
Assets Value
No. of Light points
60,000
10
40,000
16
30,000
4
10,000
6
10,000
4
Area Sq. Yards
150
250
50
50
50
A
B
C
X
Y
The expenses for the period were:
TK
Power
Lighting
1,100
200
Stores Overhead
800
Welfare of Staff
3,000
Depreciation
30,000
Repairs
6,000
General Overheads
12,000
Rent and Taxes
550
Apportion the expenses of Service Dept. Y according to direct wages and those of Service Department X
in the ratio of 5: 3: 2 to the production departments.
Solutions
Statement showing apportionment of overheads and computation of OH rates:
Particulars
Basis
Material
Wages
Actual
Actual
Total
(TK)
45,000
45,000
A (TK)
—
—
B
(TK)
—
—
C
(TK)
—
—
X (TK)
Y (TK)
22,500
15,000
22,500
30,000
107
Power
KWH (4:3:2:1:1)
Lighting
Rent & Taxes
Light Points
(5:8:2:3:2)
Materials
(2:4:4:3:3)
No. of workers
(2:3:3:1:1)
Assets Value
(6:4:3:1:1)
Assets Value
(6:4:3:1:1)
Direct Wages
(2:3:4:1:2)
Area (3:5:1:1:1)
Costs of ‘X’
Costs of ‘Y’
5:3:2
2:3:4
Stores overhead
Welfare of staff
Depreciation
Repair
General Over- heads
Overhead Rate as % on direct wages
1,100
400
300
200
100
100
200
50
80
20
30
20
800
100
200
200
150
150
3,000
600
900
900
300
300
30,000
12,000
8,000
6,000
2,000
2,000
6,000
2,400
1,600
1,200
400
400
12,000
2,000
3,000
4,000
1,000
2,000
550
1,43,650
150
17,700
20,765
12,782
51,247
250
50
50
50
14,330 12,570 41,530
57,520
12,459 8,306 (41,530)
—
19,173 25,565
—
(57,520)
45,962 46,441
—
—
A
B
C
[51,247/30,000] x 100 = 170.82%
[45,962/45,000] x 100 = 102.14%
[46,441/60,000] x 100 = 77.40%
=
=
=
Example
The New Enterprises Ltd. has three producing departments A,B and C two service Departments D and E.
The following figures are extracted from the records of the Co.
Rent and Rates
General Lighting
5,000
600
Indirect Wages
1,500
Power
1,500
Depreciation on Machinery
10,000
Sundries
10,000
The following further details are available:
Floor Space (Sq.Mts.)
A
2,000
B
2,500
C
3,000
D
2,000
E
500
Light Points
10
15
20
10
5
Direct Wages
3,000
2,000
3,000
1,500
500
H.P. of machines
60
30
50
10
--
Working hours
6,226
4,028
4,066
--
--
108
Value of Material
--
--
1,20,000
1,60,000
2,00,000
The expenses of D and E are allocated as follows:
10,000
10,000
A
B
C
D
E
D
20%
30%
40%
--
10%
E
40%
20%
30%
10%
--
Value of Assets
60,000
80,000
1,00,000
What is the factory cost of an article if its raw material cost is TK 50, labour cost TK 30 and it passes
through Departments A, B and C. For 4, 5 & 3 hours respectively.
Solutions
Statement showing apportionment of overheads to departments
Particulars
Basis
Rent & Rates
Space
(4:5:6:4:1)
Light Points
(2:3:4:2:1)
Direct wages
(6:4:6:3:1)
Horse Power
(6:3:5:1)
Value of Asset
(12:16:20:1:1)
Direct wages
(6:4:6:3:1)
Actual
Lighting
Indirect wages
Power
Depreciation
Sundries
Wages
Total (TK) A (TK)
B
(TK)
C
(TK)
D (TK)
E (TK)
5,000
1,000
1,250
1,500
1,000
250
600
100
150
200
100
50
1,500
450
300
450
225
75
1,500
600
300
500
100
--
10,000
2,400
3,200
4,000
200
200
10,000
2,000
30,600
3,000
-7,550
2,000
-7,200
3,000
-9,650
1,500
1,500
4,625
500
500
1,575
D
4,625
(4,625)
-204
204
(204)
-2
2
(2)
E
1,575
463
2,038
(2,038)
-20
20
(20)
---
Repetitive Distribution Method
Particulars
Totals
Cost of D (2:3:4:1)
Cost of E (4:2:3:1)
Cost of D (2:3:4:1)
Cost of E (4:2:3:1)
Cost of D (2:3:4:1)
A
7,550
925
8,475
815
9,290
41
9,331
8
9,339
--
B
7,200
1,387
8,587
408
8,995
61
9,056
4
9,060
1
C
9,650
1,850
11,500
611
12,111
82
12,193
6
12,199
1
109
9,339
6,226
1.5
Working Hours
Rate per hour
9,061
4,028
2.25
12,200
4,066
3.00
--
--
Computation of Factory Cost
Particulars
Amount
50.00
30.00
Material
Labor
Overheads
Dept A (4 x 1.5)
Dept B (5 x 2.25)
Dept C (3 x 3)
Factory Cost
6.00
11.25
9.00
106.25
Simultaneous Equation Method
Let total cost of Service Department D be ‘d’. Let total cost of Service Department E be ‘e’.
d = 4625 + 10/100 e
e = 1575 + 10/100 d
100 d = 462500 + 10 e
100 d – 10e = 462500…………….(1)
100 e = 157500 + 10 d
-10 d + 100 e = 157500…………. (2)
Equ. (1)
100 d – 10e
=
462500
Equ. (2) x 10
- 100 d + 1000e
=
1575000
990e
=
2037500
e
= 2037500 / 990
=
2,058
Substituting the value of ‘e’ in Equation (1), we get
100 d – 10 (2058) = 462500
d = 483080 / 100
d = 4831
Particulars
Totals
Costs of D (2:3:4:1) (4831)
Costs of E (4:2:3:1) (2,058)
110
A
7,550
966
823
9,339
B
7,200
1,450
412
9,062
C
9,650
1,932
617
12,199
D
4,625
(4,831)
206
--
E
1,575
483
(2058)
--
TREATMENT OF NON – MANUFACTURING OVERHEADS
Non-manufacturing overheads may be allocated by choosing a basis for the overhead absorption rate which
most closely matches the non-production overhead, or on the basis of a product’s ability to bear the costs.
Two possible methods of allocating such non-manufacturing overheads are as follows.
Method 1: Choose a basis for the overhead absorption rate which most closely matches the nonmanufacturing overhead such as direct labour hours, direct machine hours and so on.
Method 2: Allocate non-manufacturing overheads on the ability of the products to bear such costs. One
possible approach is to use the manufacturing cost as the basis for allocating non-manufacturing costs to
products.
If, for example, budgeted distribution overheads are TK 200,000 and budgeted manufacturing costs are TK
800,000, the predetermined distribution overhead absorption rate will be 25% of manufacturing cost. Other
bases for absorbing overheads are as follows.
Types of overhead
Selling and marketing
Research and development
Distribution
Administration
Possible absorption base
Sales value
Consumer cost (= production cost minus cost of direct materials) or
added value (= sales value of product minus cost of bought in materials and services)
Sales values
Consumer cost or added value
CORRESPONDING BCAS
Overheads: Overheads comprise costs of indirect materials, indirect employees and indirect expenses.
Manufacturing overheads shall include administration cost relating to production, factory, works or
manufacturing and depot. Manufacturing Overheads shall be classified on the basis of behavior as Variable
Manufacturing Overheads and Fixed Manufacturing Overheads. Variable Manufacturing Overheads
comprise of expenses which vary in proportion to the change in volume of production. For example, cost
of utilities etc.
Fixed Manufacturing overheads comprise of expenses which does not change with the change in volume
of production. For example, salaries, rent, repairs & maintenance, etc. The fixed manufacturing/production
overheads and other similar item of fixed costs such as quality control cost, research and development costs
and administrative overheads relating to manufacturing shall be absorbed in the manufacturing cost on the
basis of the normal capacity or actual capacity utilization of the plant, whichever is higher.
Administrative overheads shall be the aggregate of cost of resources consumed in activities relating to
general management and administration of an organization. Administrative overheads shall not include
any abnormal administrative cost. Example: Expense incurred in a situation of natural calamity. Selling
and Distribution Overheads shall be the aggregate of the cost of resources consumed in the selling and
distribution activities of the entity. Selling and Distribution Overheads, the benefits of which are expected
to be derived over a long period, shall be amortized on a rational basis.
111
Overhead is the expenditure on labour, materials or services which cannot be economically identified
with a specific saleable cost unit.
Apportionment of overheads refers to the allotment of proportions of items of cost to cost canters or
cost units.
Cost allocation- The term ‘allocation’ refers to assignment or allotment of an entire item of cost to a
particular cost center or cost unit.
Primary distribution of overhead involves allocation or apportionment of different items of overhead to
all departments of a factory. This is also known as departmentalization of overheads.
Secondary distribution of overheads is the process of apportionment of service department overheads
among the production departments.
Re-apportionment- The process of assigning service department overheads to production departments
is called reassignment or re-apportionment.
Cost apportionment- Apportionment implies the allotment of proportions of items of cost to cost centers
or departments.
Pre-determined overhead rate is the rate calculated by dividing the budgeted overheads for an accounting period by the budgeted base for the period.
Machine hour rate is the overhead cost for operating the machine for one hour.
Non-manufacturing overheads may be allocated by choosing a basis for the overhead absorption rate
which most closely matches the non-production overhead, or on the basis of a product’s ability to bear
the costs.
112
SELF-ASSESSMENT QUESTIONS
1.
2.
3.
4.
5.
6.
7.
Departments that assist producing Department indirectly are called service departments.
Factory overhead cost applied to a job is usually based on a per-determined rate.
Variable overhead very with time.
When actual overhead are more than absorbed overheads, it is known as over-absorption.
Cost of indirect materials is apportioned to various departments.
Under-absorption of overhead means that actual overhead are more than absorbed overhead
Allocation, for overhead implies the identification of overhead cost centres to which they relate
Answers: 1 True 2. True 3 False. 4. False 5. False 6. False 7. True.
SELF-REVIEW QUESTIONS
1. What are overheads? How should overheads be classified? To what extent will you include overhead
charges in your valuation of (a) work-in-progress, and (b) finished goods?
2. What is allocation?
3. Name the three stages in charging overheads to units of output.
4. What is the problem with using a single factory overhead absorption rate?
5. How is under-/over-absorbed overhead accounted for?
6. Why does under– or over-absorbed overhead occur?
7. Distinguish between allocation, apportionment and absorption in connection with
factory overhead expenses.
8. Explain the nature of administration overheads. How they are apportioned?
9. The budgeted working conditions of a cost centre are as follows:
Normal working per week
42 hours
No. of machines
14
Normal weekly loss of hours on maintenance etc.
5 hours per machine
No. of weeks worked per year
48
Estimated annual overheads
TK 2,48,640
Estimated direct wage rate
TK 8 per hour
Actual results in respect of a week period are:
Wages incurred
Overheads incurred
Machine hours produced
TK 18,000
TK 20,400
2,000
You are required to calculate:
(i) The overhead rate per machine hour; and
(ii) The amount of under or over absorption of wages and overheads
10. In a factory, there are two service departments P and Q and three production departments A, B and C.
In April 2021, the departmental expenses were:
113
Departments
A
B
C
P
Q
TK
6,50,000
6,00,000
5,00,000
1,20,000
1,00,000
The service department expenses are allotted on a percentage basis as follows:
Service Departments
Production Departs.
Service Departs.
A
B
C
P
Q
P
30
40
15
15
Q
40
30
25
5
Prepare a statement showing the distribution of the two service departments’ expenses to the three
departments by a) Simultaneous Equation Method b) Repeated Distribution Method.
11. The following particulars were extracted from the records of Epilon Ltd. on 31st December:
Dept. A
Dept. B
Dept. C
Tk
Tk
Tk
Overhead incurred
2,000
1,500
2,500
Overhead absorbed
2,200
1,400
2,250
The departmental loads during the three months to 31st December averaged:
Dept. A
100% of Normal Capacity
Dept. B
75% of Normal Capacity
Dept. C
50% of Normal Capacity
How would you deal with the balances under or over-absorbed? What preliminaries enquiries would you
make?
114
CHAPTER-B4
COST ACCOUNTING RECORDS AS PER BCAS
CHAPTER OVERVIEW
“Cost records” means books of accounts relating to utilization of materials,
labor and other items of cost as applicable to the production, processing,
manufacturing or mining activities of the company. The objective of cost
record is to ensure companies keep proper records, to instruct a culture
of cost consciousness among industries for better resource management,
to make the efficiency audit possible; and to make cost data available
with the Government. These Rules instruct a system so that such records
are maintained under generally accepted cost accounting principles in
the systematic way and on uniform basis among the various companies
of the industries. This ensure the availability of uniform and authentic
database with industries, which can be helpful to the Government in
taking appropriate decision, whenever required.
115
Chapter Learning Outcomes (CpLOs)
Maintain proper cost accounting records as per BCAS
This Study Note Covers (Subtopics)
Maintaining Cost Accounting Records (CARs)
Learn how CARs are maintained for different sectors/Industries
Total Cost Management and Framework process
Level of Study Required
U, AP
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1
CLO1
CLO1
CLO 1
CLO1
CLO1
MAINTAINING COST ACCOUNTING RECORDS (CARS)
As per notification, issued the Companies (Cost Accounting Records) shall apply to every company,
including a foreign company, which is engaged ina)
Manufacturing
b)
Production
c)
Processing
“Manufacturing Activity” includes any act, process or method employed in relation to –
a)
Transformation of raw materials, components, sub-assemblies, or parts into semi-finished or finished
products; or
b) Making, altering, repairing, fabricating, generating, composing, ornamenting, furnishing, finishing,
packing, re-packing, oiling, washing, cleaning, breaking-up, demolishing, or otherwise treating or
adapting any product with a view to its use, sale, transport, delivery or disposal; or
c)
Constructing, reconstructing, reconditioning, servicing, refitting, repairing, finishing or breaking up
of any products.
“Production Activity” includes any act, process, or method employed in relation to –
a)
Transformation of tangible inputs (raw materials, semi-finished goods, or sub-assemblies) and
intangible inputs (ideas, information, know how) into goods or services; or
b) Manufacturing or processing or mining or growing a product for use, consumption, sale, transport,
delivery or disposal; or
c)
Creation of value or wealth by producing goods or services.
“Processing Activity” includes any act, process, procedure, function, operation, technique, treatment or
method employed in relation to
a)
Altering the condition or properties of inputs for their use, consumption, sale, transport, delivery or
disposal; or
b) Accessioning, arranging, describing, or storing products; or
116
c)
d)
Developing, fixing, and washing exposed photographic or cinematographic film or paper to produce
either a negative image or a positive image; or
Printing, publishing, finishing, perforation, trimming, cutting, or packaging; o
For cost records maintenancea)
The cost records shall be kept on regular basis in such manner so as to make it possible to calculate
per unit cost of production or cost of operations, cost of sales and margin for each of its products and
activities for every financial year on monthly/quarterly/half-yearly/annual basis.
b) The cost records shall be maintained in accordance with the Bangladesh Cost Accounting Standards
(BCAS) issued by the institute of cost and management accountant of Bangladesh; to the extent these
are found to be relevant and applicable.
c)
All such cost records and cost statements, shall be reconciled with the audited financial statements
for the financial year specifically indicating expenses or incomes not considered in the cost records or
statements so as to ensure accuracy and to reconcile the profit of all product groups with the overall
profit of the company. The variations, if any, shall be clearly indicated and explained.
LEARN HOW CARS ARE MAINTAINED FOR DIFFERENT SECTORS/
INDUSTRIES
Cost accounting records are required to be maintained on continuous basis from the basic stage of inputs to
the final output. These rules also require that the records should be maintained in such a manner so that they
are able to provide necessary data which is required to be furnished.
Cost accounting records maintain for sugar industry
 Proper records shall be maintained showing separately, all receipts, issues and balances both in
quantities and cost of sugarcane procured at the gate and other locations.
 Proper records shall be maintained to show the attendance and earnings of all employees of the cost
centers/departments and the work on which they are employed. Such records shall contain the salaries
&wages, pertaining to the season and off-season separately.
 Where Sugarcane is grown in farms owned or taken on lease by the company detailed records shall be
maintained so as to enable computation of such sugarcane. The State advisory price/ controlled rate will
be adopted for pricing the sugarcane supplied by the farm to the sugar factory in cost records.
 Detailed records shall be maintained to indicate expenses incurred in respect of
each service department or cost center like laboratory, welfare, transport etc.
 Proper records showing the quantity and cost of treated/cooling water produced and consumed.
 The basis on which depreciation is calculated and allocated apportioned to the various cost centers/
departments and absorbed on the products shall be clearly indicated in the cost records.
Cost accounting records maintain for fertilizer industry
 Proper records shall be maintained showing separately all receipts, issues and balances both in quantities
and cost of each item of process material, chemical and catalyst, tower packing, services and molecular
and other items.
 If the wages and salaries are charged to production on any basis other than actuals, the method adopted
shall be indicated in the cost records.
 Proper records showing the quantity and cost of treated/cooling/dematerialized water produced and
consumed for the manufacture of fertilizers in different cost centers or departments shall be maintained
in such details as may enable the company to furnish the necessary particulars.
117
 Records shall be maintained showing the cost and other particulars of fixed assets in respect of which
depreciation is to be provided for.
Cost accounting records maintain for cotton yarn/ textile industry
 Proper records shall be maintained showing all the receipts, issues and balances, both in quantities and
cost, of cotton, manmade fibers and filament yarn from man-made fibers used in the manufacture of
cotton textiles.
 Any wages and salaries allocable to capital works such as addition or heavy repair works to plant and
machinery, buildings or other fixed assets shall be accounted for under the relevant capital heads.
 Expenditure on major repair works, from which benefit is likely to accrue for more than one financial
year shall be shown separately in the cost records indicating the method of accounting in determining
the cost of various product manufactured during the relevant period.
 The basis on which depreciation is calculated. and allocated. to the various cost centers aid departments
and to the products shall be clearly indicated in the records.
Cost accounting records maintain for vegetable oil industry
 Where raw company or by its Where of oil from seeds the company to fill any form as near the Cost of
oil produced be maintained separate to the manufacture where material the produced or major cost of
manufacture consumed for their such details as may be in a scientific manner.
 The cost of consumable stores, small tools and machinery spares consumed shall be charged to the
relevant heads of account such as manufacture, repairs to plant and machinery, repairs to buildings,
maintenance of township, maintenance of vehicles, etc.
 Where power is purchased, the records shall show separately the cost of power purchased fixed charges
and duties, if any, payable by the consumer.
 Direct expenses of service department shall be apportioned to the production department and the basic
of service rendered.
 The basis on which depreciation is calculated and allocated to the various departments and products
shall be clearly indicated in records.
Cost accounting records maintain for Drug/ Pharmaceutical industry
 “pharmaceutical activities” means production, processing, or manufacturing of bulk drugs or
formulations and includes the meaning assigned to them.
 The cost records shall be kept on regular basis in such manner so as to make it possible to calculate
per unit cost of production or cost of operations, cost of sales and margin for each of its products and
activities for every financial year on monthly or quarterly or half‐yearly or annual basis.
 The cost records shall be maintained in such manner so as to enable the company to exercise, as far
as possible, control over the various operations and costs with a view to achieve optimum economies
in utilization of resources and these records shall also provide necessary data which is required to be
furnished.
TOTAL COST MANAGEMENT AND FRAMEWORK PROCESS
Total Cost Management and Framework process (TCM) is a systematic approach to managing cost
throughout the life cycle of any enterprise, program, facility, project, product or service.
It is a process map that explains each practice area of the cost engineering field in the context of its
relationship to the other practice areas including allied professions. It is a process for applying the skills
and knowledge of cost engineering
For example, a real estate developer may build, maintain, renovate, and then demolish an office building
118
during its life cycle—at each phase of the building life cycle the developer makes significant investments.
To manage these investments, the building developer monitors building operating costs and profitability;
evaluates alternative investment opportunities; and initiates, plans, and controls improvement projects.
These activities are all within the scope of the TCM process.
TCM Starts with a Concept of
PLAN
(plan activities)
ACT
DO
(evaluate
measures, act
upon variances)
(perform
activities)
CHECK
(measure
performance of
activities)
PDCA Cycle
The PDCA cycle in TCM includes the following steps:




Plan - plan asset solutions or project activities
Do (i.e., execute) - initiate and perform the project or project activities in accordance with the plan
Check (i.e., measure) - making measurements of asset, project, or activity performance, and
Act (i.e., assess) - assessing performance variances from the plan and taking action to correct or
improve performance to bring it in line with the plan or to improve the plan.
Outputs from Total Cost Management are
Managed Asset Portfolio - The end products of the TCM process are new, modified, maintained, or retired
assets that achieve the enterprise’s strategic performance objectives and requirements.
Managed Project Portfolio - For larger enterprises, projects will be in progress at all times. While
individual projects have a beginning and end, the enterprise must consistently manage the project process
to assure that all projects achieve the enterprise’s objectives and requirements.
119
Total Cost Management - The sum of the practices and processes that an enterprise uses to manage the
total life cycle cost investment in its portfolio of strategic assets. Describes the process employed in the
profession of cost engineering.
Strategic Asset - Any unique physical or intellectual property of some scope that is of long term or
ongoing value to the enterprise.
Process - A series of actions bringing about a result.
Business Processes - There are various types of business processes including governing, asset creating,
value adding, and enabling.
PDCA Cycle (Shewhart or Deming cycle) - A basic management process first described in the 1930s. It
is conducive to process management and control by inherently incorporating continuous improvement
and measurement.
Tools, Techniques, and Sub-processes - These are the transforming mechanisms and technologies that
convert the inputs to outputs.
SELF-REVIEW QUESTIONS
1. Which Rules govern maintenance of cost accounting records?
2. What is total cost management and framework process?
3. How PDCA cycle work in TCM?
4. What are the implications of cost accounting rules?
5. How Cost accounting records maintain for sugar industry?
6. How Cost accounting records maintain for fertilizer industry?
120
121
CHAPTER-C1
JOB, BATCH AND CONTRACT COSTING
CHAPTER OVERVIEW
Today different business and industry needs different costing methods
and techniques to meet their individual requirements. It is not possible
to devise a single costing methods and techniques to fulfil everybody’s
needs. Different methods of costing for different industries depending upon
the type of manufacture and their nature have been developed. The first
costing method that this chapter will provide at this stage is job costing.
This chapter will also deliver the circumstances in which job costing
should be used and how the costs of jobs are calculated. The chapter will
look at how the costing of individual jobs fits in with the recording of
total costs in control accounts and then we will move on to batch costing,
the procedure for which is similar to job costing. Contract Costing is a
variant of the job costing system, which is applied in businesses engaged
in building or other construction work.
122
Chapter Learning Outcomes (CpLOs)
Determine cost of products under different methods
This Study Note Covers (Subtopics)
Nature of job costing
Job Cost sheet and job ledger
Recording costs on Jobs
Recording completed jobs & Batch costing
Economic Batch quantity
Differences between job and contract costing
Calculating the percentage of completion
Calculating the profit based on the percentage of completion.
Level of Study Required
R, U, AP
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1
CLO1
CLO1
CLO 1
CLO1
CLO1
NATURE OF JOB COSTING
Job costing may be defined as a system of costing in which the elements of cost are accumulated separately
for each job or work order undertaken by an organisation. Industries which manufacture products or render
services against specific orders use job costing or job order method of cost accounting. In the job costing
system, an order or a unit, lot or batch of product may be taken as a cost unit, i.e. a job. Job costing is a
method of costing in which cost units can be separately identified and need to be separately costed. The
primary purpose of job costing is to bring together all the costs incurred for completing a job.
The following are the natures of job costing.
 It is a specific order costing
 A job is carried out or a product is produced is produced to meet the specific requirements of the order.
 Job costing enables a business to ascertain the cost of a job on the basis of which quotation for the job
may be given.
 While computing the cost, direct costs are charged to the job directly as they are traceable to the job.
 Indirect expenses i.e. overheads are charged to the job on some suitable basis.
 Each job completed may be different from other jobs and hence it is difficult to have standardization of
controls and therefore more detailed supervision and control is necessary.
 At the end of the accounting period, work in progress may or may not exist.
JOB COST SHEET AND JOB LEDGER
Job cost sheet is a document which provides for the assembly of the detailed cost of a cost center or cost
unit. It is a periodical statement of cost designed to show in detail the various components of cost of
goods produced like prime cost, factory cost, cost of production, total cost and cost per unit. It uses for the
following purposes:
123
 It gives total cost and cost per unit for a particular period.
 It gives information to management for cost control.
 It provides comparative study of actual current costs with the cost of corresponding periods, thus causes
of inefficiencies and wastage can be known and suitably corrected by management.
 It acts as a guide to manufacture in formulation of suitable and definite policies and in fixing up the
selling price.
The Job Ledger report lists all transactions that have been assigned to a job and including subtotals by phase
and job. It also includes hours allocated in payroll to jobs, if desired.
The Job Ledger contains revenues, receipts, and direct costs related to jobs. Factories require both accounting
and non-accounting Job Charge (JC) documents after overhead rates have been applied and full costs have
been calculated. It is at the same level of detail as the Job Ledger and contains both direct and full costs.
Example
A small factory named KL presented the following cost for Job no.3333 to determine selling price.
Particulars
Materials
Direct Wages 18 hours at 2.5
Dept. X-8 hours
Dept. Y-6 hours
Dept. Z-4 hours
Chargeable expenses (special stores items)
Plus 33% Overheads
124
Per unit (TK)
70
45
5
120
40
160
Analysis of the Profit/Loss Account for 2021 shows the following:
Particulars
Materials
Direct Wages:
Dept. X
Dept. Y
Dept. Z
Special stores items
Overheads:
Dept. X
Dept. Y
Dept. Z
TK
10,000
12,000
8,000
5,000
9,000
2,000
Gross profit c/d
Selling expenses
Net profit c/d
TK
1,50,000
Particulars
Sales
TK
TK
2,50,000
30,000
4,000
16,000
2,00,000
50,000
2,50,000
20,000
30,000
50,000
Gross profit b/d
2,50,000
50,000
50,000
It is also noted that average hourly rates for the 3 departments, X, Y and Z are similar.
Requirements:
(a) Draw up a job cost sheet;
(b) Calculate the entire revised cost using 2021 actual figures as basis;
(c) Add 20% to total cost to determine selling price.
Solutions:
Calculation of Departmental Overhead Rates
Particulars
(i) Direct Wages
(ii) Rate of wages per hour
(iii) Hours
(iv) Actual Overheads in 8%
(v) Department Overhead Rates per hour
X
TK
10,000
2.5
4000
5000
1.250
Departments
Y
TK
12,000
2.5
4800
9000
1.875
Z
TK
8,000
2.5
3200
2000
0.625
(iv / iii)
125
Job cost sheet
Particulars
Materials
Labour:
Dept. X
Dept. Y
Dept. Z
Direct Expenses
Prime Costs
Overheads:
Dept. X
Dept. Y
Dept. Z
Total Cost
Add: Profit 20%
Selling Price
TK
70
8 x 2.5
6 x 2.5
4 x 2.5
20
15
10
8 x 1.250
6 x 1.875
4 x 0.625
10.00
11.25
2.50
45
5
120
23.75
143.75
28.75
172.50
RECORDING COSTS ON JOBS
A job cost record is used to aggregate the costs of direct materials, direct labor, and the overhead to be
applied to a specific job. As such, it is a source document for a job costing system, in which costs are
accumulated for batches of units.
Material Costs
An essential requirement of job order cost accounting is that direct materials and their cost must be traced
to and identified with specific jobs or work orders. On receipt of a production order, the shop draws the
requisite materials from stores. The withdrawals of material are made on materials requisitions on the
authority of the bill of materials. The particular job order number for which material is drawn is indicated
in each requisition. Surplus, excess or incorrect materials are returned from the shops to the stores with
materials return note.
A daily or weekly analysis of materials requisitions, materials return notes and bills of materials is made and
posted in the materials requisition journal. For cost accounting purposes, a materials issue analysis sheet is
prepared showing the cost of materials issued against the various job order numbers. Direct material cost is
posted on the cost sheet relating to the particular production order while, indirect materials cost is treated
as overhead costs.
Labour Costs
All direct labour costs must be analysed according to individual jobs or work orders. On the authority of
operation schedule, time is booked on time sheets, job cards, time tickets or piece-work cards. The job
cards are valued by the costing department; the wages paid are classified into direct and indirect labour and
booked to production order and standing order numbers respectively. Labour summaries or wages analysis
sheets are prepared for each accounting period; say a week. Amounts on account of overtime, idle time,
shift-differential and fringe benefits may also be included in the wages analysis sheet. Direct labour costs
are posted on the respective cost-sheets and indirect labour is treated as overhead costs.
126
Manufacturing Overheads
Overhead costs are accumulated against standing order numbers and against cost centres. Overhead rates,
predetermined or actuals as the case may be, are worked out for each centre. The amount of overhead cost
recoverable on each job order is summarised in an Overhead Absorption or Applied Overhead AnalysisSheet and is posted on the relevant cost-sheets. Usually, overheads are added only when the job is complete
but, at the end of the accounting period, the amount of overheads which could be applied to incomplete jobs
is ascertained for the purpose of establishing the extent of over or under absorption of overheads.
Completion of Jobs
Postings of direct material, direct labour and manufacturing overhead costs to the cost-sheet for a job
or production order are made throughout the run of the job or order. On the completion of a job, a job
completion report is sent by the production shop to the Production and Planning Department, with a copy
to the Cost Office.
Work-in-Progress
The cost of an incomplete job i.e., a job on which some manufacturing processes or operations are still
due before it can be made into the finished product is termed Work-in-Progress or Work-in-Process. If a
production order has been only partly completed by the end of an accounting period, it is essential that the
closing stock of the work-in-progress be determined.
RECORDING COMPLETED JOBS & BATCH COSTING
Completed Job costing refers to costing of jobs that are executed against specific orders in fully whereas in
batch costing items are manufactured for stock. A finished product may require different components for
assembly and may be manufactured in economical batch lots.
When orders are received from different customers, there are common products among orders; then
production orders may be issued for batches, consisting of a predetermined quantity of each type of product.
Batch costing method is adopted in such cases to calculate the cost of each such batch. Cost per unit is
ascertained by dividing the total cost of a batch by number of items produced in that batch. In order to do
that a Batch Cost Sheet is prepared.
Example:
FM is a jobbing company. On 1 June 2021, there was one uncompleted job in the factory. The job card for
this work is summarised as follows.
Costs to date
TK
Direct materials
630
Direct labour (120 hours)
350
240
Factory overhead (TK 2 per direct labour hour)
1,220
Factory cost to date
During June, three new jobs were started in the factory, and costs of production were as follows.
Issued to:
Direct materials
TK
Job 6832
Job 6833
Job 6834
2,390
1,680
3,950
127
Job 6835
Damaged inventory written off from stores
Material transfers
Job 6834 to Job 6833
Job 6832 to 6834
Materials returned to store
From Job 6832
From Job 6835
Direct labour hours recorded:
Job 6832
Job 6833
Job 6834
Job 6835
4,420
2,300
TK
250
620
TK
870
170
430 hrs
650 hrs
280 hrs
410 hrs
The cost of labour hours during June 2021 was TK 3 per hour, and production overhead is absorbed at the
rate of TK 2 per direct labour hour. Production overheads incurred during the month amounted to TK 3,800.
Completed jobs were delivered to customers as soon as they were completed, and the invoiced amounts
were as follows:
Job 6832
Job 6834
Job 6835
TK 5,500
TK 8,000
TK 7,500
Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory cost.
Actual costs incurred during June 2021 amounted to TK 3,200.
Requirements:
(a) Prepare the job accounts for each individual job during June 2021; (the accounts
should only show the cost of production, and not the full cost of sale).
(b) Prepare the summarized job cost cards for each job, and calculate the profit on each completed job.
Solutions:
(a)Job accounts
Balance b/f
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o’hd a/c)
JOB 6832
TK 1,220
Job 6834 a/c
2,390
(materials transfer)
1,290 Stores a/c (materials returned)
860
Cost of sales a/c (balance)
5,760
TK620
870
4,270
5,760
JOB 6833
TK
Materials (stores a/c)
Labour (wages a/c)
128
1,680
1,950
TK
Balance c/f
5,180
Production overhead (o’hd a/c)
Job 6834 a/c (materials transfer)
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o’hd a/c)
Job 6832 a/c (materials transfer)
1,300
250
5,180
JOB 6834
TK3,950 Job 6833 a/c (materials transfer)
840
560 Cost of sales a/c (balance)
620
5,970
5,180
TK 250
5,720
5,970
JOB 6835
Materials (stores a/c)
Labour (wages a/c)
4,420 Stores a/c (materials returned)
1,230
Production overhead (o’hd a/c)
820 Cost of sales a/c (balance)
6,470
(b)
170
6,300
6,470
Job cards, summarized
Materials
Labour
Production overhead
Factory cost
Admin & marketing o’hd (20%)
Cost of sale
Invoice value
Profit/(loss) on job
Job 6832
Job 6833
Job 6834
Job 6835
TK 1,530*
1,640
1,100
4,270
854
5,124
5,500
376
TK 1,930
1,950
1,300
5,180 (c/f)
TK 4,320**
840
560
5,720
1,144
6,864
8,000
1,136
TK 4,250
1,230
820
6,300
1,260
7,560
7,500
(60)
*$(630 + 2,390 – 620 – 870)
**$(3,950 + 620 – 250)
ECONOMIC BATCH QUANTITY
Economic Batch Quantity refers to the optimum quantity batch which should be produced at a point of time
so that the set up & processing costs and carrying costs are together optimized.
The setting up and processing costs refer to the costs incurred for setting up and processing operations
before the start of production of a batch. There is an inverse relationship between batch size and set up &
processing costs.
The carrying costs refer to the costs incurred in maintaining a given level of inventory. There is positive
relationship between batch size and carrying costs.
129
E.B.Q =
2AS
C
Where, E.B. Q = Economic Batch Quantity
A = Annual Demand
S = Set up Cost per batch
C = Carrying Costs per unit per year
Example:
PQ Ltd is committed to supply 24,000 bearings per annum to AB Ltd. It is estimated that it costs 10 paise
as inventory holding cost per bearing per month and that the set-up cost per run of bearing manufacture is
TK 324.
a)
b)
c)
What would be the optimum run size for bearing manufacture?
What is the minimum inventory holding cost at optimum run size?
Assuming that the company has a police of manufacturing 6000 bearing per run, how much extra
costs would the company be incurring as compared to the optimum run suggested in (a)?
Solutions:
(a) Optimum production Run Size (Q) = √
2AS
C
Where, A = No. of units to be produced within one year = 24,000 (units) bearing
O = Set-up cost per production run = TK 324
C = Carrying cost per unit per annum = 0.10 × 12 = TK 1.2
=
√ 2 × 24,000 (units) × TK 324
TK 1.2
= 3,600 units (bearing)
(b) Minimum inventory Holding Cost, if run size is 3600 bearings
= Average inventory x carrying cost per unit
= (3600/2) x (.10 x 12) = TK 2160
(c) Statement showing Total Cost at Production Run sizes of 3600 and 6000 bearings
A.
B.
C.
D.
E.
F.
G.
H.
I.
Annual requirements
Run size
No. of runs (A/B)
Set up cost per run
Total set up cost (C X D)
Average inventory( B/2)
Carrying cost per unit p.a.
Total carrying cost ( F x G)
Total cost (E + H)
24000
3600
6.667
TK 324
TK 2160
1800
1.20
2160
4320
Extra cost incurred, if run size is of 6000 = TK 4896 – TK 4320 = TK 576
130
24000
6000
4
TK 324
TK 1296
3000
1.20
3600
4896
DIFFERENCES BETWEEN JOB AND CONTRACT COSTING
Contract jobs, while they resemble jobs, have a few distinctive features:
 Under job costing, the cost is first allocated to cost centres and then to individual jobs. In contract
costing, most of the expenses are of direct nature, overhead forms only a small percentage of total
expenditure and it represents expenses like share of head office expenses, share of central storage cost
etc.
 Under job costing pricing is influenced by individual conditions and general policy of the organisation.
Under contract costing, pricing is influenced by specific clauses of the contract.
 Unlike job costing, each contract is a cost unit in contract costing.
 Under contract costing, the work is usually carried out at a site other than contractee’s own premises.
Job costing is often applied where jobs are carried out at the contractee’s own premises.
CALCULATING THE PERCENTAGE OF COMPLETION
To estimate the percentage of completion, it needs to divide the total expenditure incurred from inception to
date with the total estimated costs of the contract. This value is then applied to determining the total revenue
associated with the project. The percentage of completion method is a revenue recognition accounting
concept that evaluates how to realize revenue periodically over a long-term project or contract. Revenue,
expenses, and gross profit are recognized each period based on the percentage of work completed or costs
incurred.
Methods for Calculating the Percentage of Completion
 Cost-to-cost method. This is a comparison of the contract cost incurred to date to the total expected
contract cost.
 Efforts-expended method. This is the proportion of effort expended to date in comparison to the total
effort expected to be expended for the contract. For example, the percentage of completion might be
based on direct labor hours, or machine hours, or material quantities.
 Units-of-delivery method. This is the percentage of units delivered to the buyer to the total number of
units to be delivered under the terms of a contract. It should only be used when the contractor produces
a number of units to the specifications of a buyer.
Example
The following balances were extracted from the books of a building contract on 31st March, 2021 regarding
Contract No. 1231:
Particulars
Materials issued to site
Wages Paid
Wages outstanding on 31.3.2021
Plant issued to site
Direct charges paid
Direct charges outstanding on 31.3.2021
Establishment charges
Stock of materials at site on 31.3.2021
Value of work certified on 31.3.2021
Cost of work not yet certified
TK
6,27,200
7,34,550
7,200
60,000
25,150
2,100
56,500
12,000
16,50,000
35,000
131
Cash received on account of architect’s certificate after deduction by
customer of 5 percent retention money
14,10,750
The work was commenced on April 1, 2021 and the contract price agreed at TK 24,50,000.
Requirements:
Prepare contract account for the year providing for depreciation of plant of 25 per cent. Calculate the Profit
or Loss in the contract to date and make such provision in the contract account as you consider desirable.
Set out also contractor’s balance sheet so far as it relates to the contract.
Solution
Contract Account
Dr.
Particulars
Cr.
TK
TK Particulars
To
Materials to site
6,27,200 By Stock of material at site
To
To
To
To
To
To
To
Wages paid
Wages outstanding
Direct charges
Direct charges outstanding
Establishment charges
Depreciation-Plant
National Profit c/d
7,34,550 By Work-in-Progress:
7,200 Work certified
25,150 Work uncertified
2,100
56,500
15,000
2,29,300
16,97,000
_
16,97,000
To
Profit and Loss A/c
1,30,700 By Notional Profit
2,29,300
Balance Sheet as on 31st March, 2021
TK Assets
TK
Liabilities
12,000
16,50,000
35,000
Wages outstanding
7,200 Stocks of material at site
12,000
Direct charges
Outstanding
P&L A/c:
Plant at site
2,100 Work-in-Progress:
Work certified
45,000
Profit transferred
from Contract A/c
Work uncertified
1,30,700
Less: Reserve
Less: Cash received
132
16,50,000
35,000
16,85,000
98,600
15,86,400
14,10,750
1,75,650
CALCULATING THE PROFIT BASED ON THE PERCENTAGE OF
COMPLETION.
At the end of an accounting period it may be found that certain contracts which have been completed while
others are still in process and will be completed in the coming years. The profit on completed contracts
may be safely taken to the credit of the profit and loss account. In the case of uncompleted contracts there
are unforeseen contingencies which may lead to heavy fluctuations in costs and profit. At the same time,
it does not also seem desirable to consider the profits only on completed contracts and ignore completely
incomplete ones as this may result in heavy fluctuations in the future for profit from year to year.
If profit or loss is not shown in the intermittent years for the work in progress, contract will show high
figure of profit in the year of completion and reverse may be the case in the year in which a large number
of contracts remain incomplete. Therefore, profits on incomplete contracts should be considered, of course,
after providing adequate sums for meeting unknown contingencies. There are no hard and fast rule regarding
calculation of the figures for profit to be taken to the credit of profit and loss account.
Example (Basic Level)
If the total profit on a contract for TK 3,00,000 is TK 60,000 and the contract is 60% complete and has been
certified accordingly. The retention money is 20% of the certified value, then the amount of profit that can
be prudently credited to Profit and Loss Account may be calculated as follows:
(1) Apparent profit TK 60,000.
(2) 2/3rd of this is ordinarily suitable for transfer to Profit and Loss Account
(Since the Work certified is more than 50%) TK 40,000.
(3) The percentage of cash received to certified value 80%.
(4) The amount of profit determined on cash basis being suitable for transfer to
Profit and Loss Account (80% of TK 40,000) TK 32,000.
Example (Advance level)
ABC contractors obtained a contract to construct a house for TK 8,00,000. Work was started on 1st January,
2021 and it was estimated that contract would take 15 months to complete. Work is proceeding as per
schedule and the details up to 31st December 2021 are as follows:
Materials and stores
Wages Paid
Plant hire charges and other expenses
Establishment charges
Material unused
Work Certified
Cash received
Work not yet certified (at cost)
TK 1,87,000
2,70,000
60,000
54,000
11,000
6,00,000
5,40,000
20,000
It is further estimated that the following further expenses will be required to complete the work: Additional
material: TK 25,000; Wages: TK 20,000; Sub Contract cost: TK 50,000; Plant hire charges: TK 10,000;
Establishment Expenses: TK 11,800; and provision for contingencies: 5% of total cost.
You are required to calculate the value of Work in Progress as on 31st December 2021 taking credit for a
reasonable profit and also show the contract account.
133
Solution
Dr.
Contract Account as on 31st December, 2021
Particulars
To Material and
Stores
To Wages
To Plant hire charges expenses
&
To Establishment expenses
To Notional Profit c/d
To Profit & Loss Account
To Work in progress (balancing
figure)
Cr.
TK Particulars
1,87,000 By Material and stores
TK
11,000
2,70,000 By Work in Progress :
60,000 (a) Work uncertified at cost
20,000
54,000 (b) Value of work certified
60,000
6,31,000
57,000 By Notional Profit b/d
3,000
60,000
6,00,000
6,31,000
60,000
60,000
Statement of Estimated Cost and Estimated Profit
Cost incurred up to 31st December, 2021
(TK 1,87,000 + TK 2,70,000 + TK 60,000 + TK 54,000) – TK 1 1,000
Add: Additional Estimated Cost
TK
5,60,000
Material (TK 11,000 + 25,000)
Wages
Sub-contract cost
Plant hire charges
Establishment charges
Estimated cost before provision
Add: Provision for Contingencies = (5/95) x 6,87,800
36,000
20,000
50,000
10,000
11,800
6,87,800
36,200
Estimated total cost
7,24,000
Estimated profit
Profit to P&L Account
=
=
=
Alternatively,
Profit to P&L Account
=
=
=
=
134
TK 8, 00,000 – 7, 24,000 = TK 76, 000
Estimated Profit x Work certified
Contract price
76,000 x 6,00,000
8,00,000
TK 57,000
Estimated Profit x Cash Received
Contract price
76,000 x 5,40,000
8,00,000
TK 51,300
Value of Work in Progress as on 31st December, 2021 to be shown in Balance Sheet
Particulars
TK
Work in progress:
Value of work certified
6,00,000
Cost of work uncertified
20,000
6,20,000
Less : Reserve for unrealised profit : 3,000
Amount received from contractee
5,40,000
5,43,000
77,000
Job costing: It is a costing method applied where work is undertaken to customers’ special requirements
and each order is of comparatively short duration.
Batch costing: It is similar to job costing in that each batch of similar articles is separately identifiable.
The cost per unit manufactured in a batch is the total batch cost divided by the number of units in the
batch.
Job Ledger: It report lists all transactions that have been assigned to a job and including subtotals by
phase and job. It also includes hours allocated in payroll to jobs, if desired.
Economic Batch Quantity: It refers to the optimum quantity batch which should be produced at a point
of time so that the set up & processing costs and carrying costs are together optimized.
Contract costing: It is that form of specific order costing which applies where work is undertaken as per
customer’s special requirements and each order is of long duration.
Work certified: It is the work approved by the contractee or his nominee on a specific date.
Work uncertified: It is which has not been so far approved by the contractee or his nominee is known
as work uncertified.
SELF-REVIEW QUESTIONS
1.
2.
3.
4.
5.
6.
7.
How are the material costs for each job determined?
What is a batch? How would you calculate the cost per unit of a completed batch?
What is Job Costing?
What is cost sheet? In what respect it differs from production account?
Distinguish between ‘Job Costing’ and ‘Contract Costing’.
Discuss the nature of contract costing and explain how costs are recorded in contracts.
The information given under has been extracted from the books of a contractor relating to contract for
TK 3,75,000.
135
1st Year
2nd Year
3rd Year
TK
TK
TK
Materials
45,000
55,000
31,500
Direct Expenses
1,750
6,250
2,250
Indirect expenses
750
1,000
---
Wages
42,500
57,500
42,500
Total work certified
87,500
2,82,500
3,75,000
---
5,000
---
5,000
---
---
Uncertified work
Plant
The value of plant at the end of Ist year was TK 4,000 at the end of 2nd year TK 2,500 and at the end of
3rd year it was TK 1,000. It is customary to pay 90% in cash of the amount of work certified. Prepare
the contract Account and show how the figures would appear in the balance sheet.
8. A company of builders took to a multi-storied structure for TK 40,00,000 estimating the cost to be TK
36,80,000. At the end of the year, the company had received TK 14,40,000 being 90% of the work
certified; work done but not certified was TK 40,000. Following expenditure were incurred.
Particular
Materials
Labour
Plant
TK
4,00,000
10,00,000
80,000
Materials costing TK 20,000 were damaged. Plant is considered as having depreciated at 25%. Prepare
Contract Account and show all the possible figures that can reasonably be credited to Profit and Loss
Account.
9. A customer has been ordering 90,000 special design metal columns at the columns at the rate of 18,000
per order during the past years. The production cost comprises TK 120 for material, TK 60 for labour
and TK 20 for fixed overheads. It costs TK 1,500 to set up for one run of 18,000 column and inventory
carrying cost is 15% since this customer may buy at least 5000 columns this year, the company would
like to avoid making five different production runs. Find the most economic production run.
10. A manufacturing company is divided into three production departments – A, B and C. All production
is to customers’ orders. All orders are dissimilar and they go through all the three departments.
Manufacturing Costs for a given period were as follows:
136
Particulars
Dept A
Dept B
Dept C
Total
TK
TK
TK
TK
Direct material
1,80,000
Direct labour
40,000
20,000
30,000
90,000
Indirect manufacturing costs
20,000
40,000
30,000
90,000
The cost of producing a particular order was determined as follows:
Particulars
TK
Direct material
TK
1,000
Direct Labour:
Department A
120
Department B
Department C
280
200
Indirect manufacturing Costs
600
600
2,200
The General Manager had a hazy idea that the jobs executed on orders of this nature are underpriced. So,
the services of a firm of cost accountants, of which you are a member, have been acquired for a thorough
investigation. Can you detect, after a careful perusal of the limited available information, the fundamental
fallacy of the company’s method assuming that the direct labor cost is an acceptable basis for distributing
indirect manufacturing costs?
Prepare a revised cost for order distributing indirect manufacturing costs in a manner you consider more
correct than the company’s procedure.
137
CHAPTER-C2
PROCESS COSTING
CHAPTER OVERVIEW
This chapter contemplate the issue from basics, considering at how to
account for the simplest of processes. This chapter then move on to FIFO,
LIFO and Weighted average cost flow methods, how to account for any
losses which might occur, as well as what to do with any scrapped units
which are sold. This chapter also consider how to deal with treatment
of normal loss, abnormal loss, normal and abnormal losses with scrap
value and waste with disposal cost, addition of units and effect on cost,
treatment of abnormal gain in process costing which will be explained in
detail. Process costing is a form of operations costing which is used where
standardized homogeneous goods are produced. Process costing is also
used in the assembly type of industries. In process costing, it is assumed
that the average cost presents the cost per unit. Cost of production during
a particular period is divided by the number of units produced during that
period to arrive at the cost per unit.
138
Chapter Learning Outcomes (CpLOs)
32. Determine cost in a process costing environment
33. Explain treatment for normal and abnormal losses
This Study Note Covers (Subtopics)
The basics of process costing
Objective of Process Cost System
Characteristics of a Process Cost System
Comparison of Job Order and Process Cost Accumulation System
FIFO, LIFO and Weighted average cost flow methods
Treatment of Normal loss, abnormal loss, Normal and abnormal losses with scrap value and waste with
Disposal Cost, Addition of units and effect on cost, Treatment of Abnormal gain in process costing
Level of Study Required
U, AP
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
THE BASICS OF PROCESS COSTING
Process costing is a costing method used where it is not possible to identify separate units of production,
or jobs, usually because of the continuous nature of the production processes involved. It is common to
identify process costing with continuous production such as the following:
 Foods and drinks
 Oil refining
 Paper
 Chemicals
Process costing may also be associated with the continuous production of large volumes of low-cost items,
such as cans or tins.
Process costing is centred around four key steps. The exact work done at each step will depend on whether
there are normal losses, scrap, opening and closing work in progress.
 Determine output and losses
 Calculate cost per unit of output, losses and work in process (WIP)
 Calculate total cost of output, losses and WIP
 Complete accounts
OBJECTIVE OF PROCESS COST SYSTEM
The aim of process cost system is to describe how cost accountants keep a set of accounts to record the costs
of production in a processing industry. The purpose of the set of accounts is to derive a cost, or valuation,
for output and closing inventory. The major objectives are listed below:
 To determine the unit cost.
 To allocate the accumulated materials, labour and factory overhead costs to process cost centers.
139
 To express incomplete units in terms of completed units.
 To give accounting treatment to process losses such as waste, scrap, defective goods and spoiled
goods.
 To differentiate the main product from by-product and joint product.
 To give accounting treatment to joint product and by-product.
 To calculate the cost of main product accurately.
CHARACTERISTICS OF A PROCESS COST SYSTEM
The basic characteristics of a process cost systems are given below:
 The output of one process becomes the input to the next until the finished product is made in the final
process.
 The production is continuous.
 The product is homogeneous.
 The process is standardized.
 There is often a loss in process due to spoilage, wastage, evaporation and so on Clearly defined
process cost centres and the accumulation of all costs by the cost centres.
 The maintenance of accurate records of units and part units produced and cost incurred by each
process.
 The finished product of one process becomes the raw material of the next process or operation and so
on until the final product is obtained.
 Avoidable and unavoidable losses usually arise at different stages of manufacture for various reasons.
 Output from production may be a single product, but there may also be a by-product (or by- products)
and/or joint products.
COMPARISON OF JOB ORDER AND PROCESS COST ACCUMULATION
SYSTEM
The main points of distinction between job order costing and process cost accumulation systems are
summarised below:
Job costing
Process costing
Goods are manufactured against specific order
Production is of like units in continuous flow.
Costs are accumulated and applied to specific jobs. Costs are accumulated and applied process-wise or
department-wise.
It requires more forms and details
It requires few forms and less details.
Joint products / By-products do not usually arise in Joint products/By-products do arise and joint cost
jobbing work.
apportionment is necessary.
Different jobs are independent of each other.
Production being in a continuous flow, products
are intermingled in such a manner that lots are not
distinguishable.
Products are normally not transferred from one job Costs are normally transferred from one process
to another except in the case of surplus work or
to another. Generally the finished product of the
excess production.
process becomes the raw material of the next process
until the goods are completely manufactured.
140
Different jobs may or may not have opening or
closing work-in-progress.
Losses are generally not segregated.
As the production is in continuous flow there is
always an opening and closing balance of work-inprogress.
Normal losses are carefully predetermined and
abnormal losses are segregated.
FIFO, LIFO AND WEIGHTED AVERAGE COST FLOW METHODS
The FIFO method of costing is based on the assumption of that the opening work-in- progress units are
the first to be completed. Equivalent production of opening work-in-progress can be calculated as follows:
Equivalent Production = Units of Opening WIP x Percentage of work needed to finish the units.
In LIFO method the assumption is that the units entering into the process is the last one first to be completed.
The cost of opening work-in-progress is charged to the closing work-in- progress and thus the closing workin progress appears cost of opening work-in-progress. The completed units are at their current cost.
In weighted average cost method, no distinction is made between completed units from opening inventory
and completed units from new production. All units finished during the current accounting period are treated
as if they were started and finished during that period. The weighted average cost per unit is determined by
dividing the total cost (opening work-in-progress cost + current cost) by equivalent production.
Example 1
Particulars
TK
Units introduced during the period 10,000 units
19,300
Opening work-in-process - 1,000 units (60% complete)
1,100
Scrap realised
1.00 per unit.
Transferred to next process 9,000 units
Closing work-in-process - 800 units (75% complete)
Scrapped units are 100% complete
Normal loss estimated at 10% of total input including units in process at the beginning.
Requirement:
Compute equivalent production and cost per equivalent unit according to FIFO and average cost method.
Also evaluate the output.
Solution 1
Particulars
Op. work-inprocess
Units
Introduced
FIFO Method
Statement of equivalent production and cost per unit
Input Units
1,000
10,000
Particulars
Op. WIP
completed
Completed
Normal loss
Output
units
1,000
8,000
1,100
Equivalent
Percentage of
work done
Production
Equivalent units
40
100
-
400
8,000
-
141
Closing workin-process
800
Abnormal loss
100
11,000
11,000
Cost of the process (for the period)
TK 19,300
Less: Scrap value of normal loss
1,100
TK 18,200
Cost per equivalent unit
TK 18,200 /9,100 = TK 2
75
100
600
100
9,100
Evaluation Statement
Particulars
Opening WIP completed
Add: Cost of Opening WIP
(Complete Cost of 1,000 units of
opening WIP
Completely processed units
Abnormal loss
Closing WIP
Equivalent
units
400
–
1,000
Cost per equivalent
units
2.00
–
1.90
8,000
2.00
100
2.00
600
2.00
Average Cost Method
Statement of equivalent production and cost per unit
Output
Units
Equivalent percentage
Transferred to next process
Normal loss
Abnormal loss
Closing WIP
9,000
1,100
100
800
Opening work-in-process
Costs of units introduced
Costs
Less: Scrap value realized on normal loss
Cost per equivalent unit
Amount TK
800
1,100
(1,900)
16,000
200
1,200
Production units
100
100
75
9,000
100
600
9,700
1,100
19,300
20,400
1,100
TK 19,300
TK 19,300 /9,700 = TK 1.99 (approx).
Statement of Evaluation
Particulars
Transferred to next process
Abnormal loss
Closing work-in-process
142
Equivalent units
9,000
100
600
Cost per equivalent unit
1.99
1.99
1.99
Amount TK
17,910
199
1,191
19,300
Example 2
Pie produces an item which is manufactured in two consecutive processes. Information relating to process
2 during September 2020 is as follows.
Opening inventory 800 units.
Degree of completion:
process 1 materials
added materials
conversion costs
TK
4,700
600
1,000
6,300
100%
40%
30%
During September 2020, 3,000 units were transferred from process 1 at a valuation of TK 18,100. Added
materials cost TK 9,600 and conversion costs were TK 11,800.
Closing inventory at 30 September 2020 amounted to 1,000 units which were 100% complete with respect
to process 1 materials and 60% complete with respect to added materials. Conversion cost work was 40%
complete.
Pie uses a weighted average cost system for the valuation of output and closing inventory.
Requirements:
Prepare the process 2 account for September 2020.
Solution 2
Opening inventory
Fully worked units*
Output to finished
goods
Closing inventory
EQUIVALENT UNITS STATEMENT
Total
units
800 (100%)
2,000 (100%)
800
2,000
2,800
1,000 (100%)
3,800
2,800
1,000
3,800
Added
material
(60%)
800
2,000
Equivalent units
Conversion
costs
800
2,000
2,800
600
3,400
2,800
400
3,200
(40%)
(*3,000 units from process 1 minus closing inventory of 1,000 units)
COSTS PER EQUIVALENT UNIT STATEMENT
Process 1 material
TK
Opening inventory
Added in September 2020
Total cost
Equivalent units
Cost per equivalent unit
Added materials
TK
Conversion costs
TK
4,700
18,100
22,800
600
9,600
10,200
1,000
11,800
12,800
3,800 units
3,400 units
3,200 units
TK 6
TK 3
TK 4
143
EVALUATION STATEMENT
Output to finished goods (2,800 units)
Closing inventory
Process 1
material
TK
16,800
6,000
Added
materials
TK
8,400
1,800
Conversion
costs
TK
11,200
1,600
Total
cost
TK
36,400
9,400
45,800
Units
2,800
TK
36,400
1,000
3,800
9,400
45,800
PROCESS 2 ACCOUNT
Opening inventory b/f
Process 1 a/c
Added materials
Conversion costs
Units
800
3,000
3,800
TK
6,300
Finished goods a/c
18,100
9,600
11,800 Closing inventory c/f
45,800
TREATMENT OF NORMAL LOSS, ABNORMAL LOSS
Normal loss is an unavoidable loss which occurs due to the inherent nature of the materials and production
process under normal conditions. It is normally estimated on the basis of past experience of the industry.
In case of Normal Loss, the cost per unit is calculated by the under given formulae.
Cost of Good Unit = Total Cost - Sale value of Scrap
Input - Normal Loss Units
Abnormal losses arrive when actual losses are more than expected losses. Abnormal losses in calculated as
per under given formulae:
Value of Abnormal Loss
=
Total Cost – Scrap value of normal loss x units in abnormal loss
Input - Normal Loss Units
Example
Prepare a Process Account and Abnormal Loss Account from the following information.
Input of Raw material
1000 units TK 20 per Unit
Direct Material
TK 4,200
Direct Wages
TK 6,000
Production Overheads
TK 6,000
Actual output transferred to process II
900 units
Normal Loss
5%
Value of Scrap per unit
TK 8
144
Solution
Dr.
Particulars
To Basic material
To Direct Material
To direct labour
To Production overhead
Process Account
Units
1,000
Amount in
TK
20,000
4,200
6,000
6,000
Particulars
By Normal Loss
By Abnormal Loss
By Process II (Output
transferred to next processes)
Units
Cr.
Amount in TK
50
50
900
400
1,884
39,916
36,200
36,200
Value of Abnormal Loss
=
Total Cost – Scrap value of normal loss x units in abnormal loss
Input - Normal Loss Units
=
36200 - 400 x 50
1000 - 50
Abnormal Loss Account
Particulars
Units
To Process A/c
50
Amount in TK
Particulars
Units
Amount in TK
1884 By Bank Account
50
400
By Costing P & L A/c.
50
1884
1484
50
1884
NORMAL AND ABNORMAL LOSSES WITH SCRAP VALUE AND WASTE
WITH DISPOSAL COST
The scrap value of normal loss is usually deducted from the cost of materials.
The scrap value of abnormal loss (or abnormal gain) is usually set off against its cost, in an abnormal loss
(abnormal gain) account.
The following steps to be followed:
 Separate the scrap value of normal loss from the scrap value of abnormal loss or gain.
 Subtract the scrap value of normal loss from the cost of the process, by crediting it to the process
account (as a ‘value’ for normal loss).
 Subtract the value of abnormal loss scrap from the cost of abnormal loss, by crediting the abnormal
loss account.
Example
KK has a factory which operates two production processes, cutting and Sewing. Normal loss in each process
is 10%. Scrapped units out of the cutting process sell for TK 3 per unit whereas scrapped units out of the
Sewing process sell for TK 5. Output from the cutting process is transferred to the Sewing process: output
from the Sewing process is finished output ready for sale.
145
Relevant information about costs for control period 44 are as follows.
Input materials
Transferred to pasting process
Materials from cutting process
Added materials
Labour and overheads
Output to finished goods
Cutting
Units
18,000
16,000
TK
54,000
Sewing
Units
16,000
14,000
32,400
TK
70,000
135,000
28,000
Prepare accounts for the cutting process, the Sewing process, abnormal loss, abnormal gain and scrap.
Solution
a) Cutting process
Determine output and losses
The normal loss is 10% of 18,000 units = 1,800 units, and the actual loss is (18,000
– 16,000) = 2,000 units. This means that there is abnormal loss of 200 units.
Actual output 16,000 units
Abnormal loss 200 units
Expected output (90% of 18,000)
16,200 units
Calculate cost per unit of output and losses
i) The total value of scrap is 2,000 units at TK 3 per unit = TK 6,000. We must split this between the scrap
value of normal loss and the scrap value of abnormal loss.
TK
5,400
600
6,000
Normal loss (1,800 TK 3)
Abnormal loss (200 TK 3)
Total scrap (2,000 units TK 3)
ii) The scrap value of normal loss is first deducted from the materials cost in the process, in order to
calculate the output cost per unit and then credited to the process account as a ‘value’ for normal loss. The
cost per unit in the cutting process is calculated as follows.
Materials
Less normal loss scrap value*
Labour and overhead
Total
Total cost
TK
54,000
5,400
48,600
32,400
81,000
Unit of output
TK
(16,200)
(16,200)
( 16,200)
* It is usual to set this scrap value of normal loss against the cost of materials.
146
3.00
2.00
5.00
Calculate total cost of output and losses
Output
Normal loss
Abnormal loss
(16,000 units TK5)
(1,800 units TK 3)
(200 units TK 5)
80,000
5,400
1,000
86,400
Complete accounts
PROCESS 1 ACCOUNT
Units
Materials
Labour and
overhead
18,000
18,000
* At TK 5 per unit
TK 54,000
32,400
86,400
Output to Sewing process *
Normal loss (scrap a/c) **
Abnormal loss a/c *
Units
16,000
TK
80,000
1,800
200
18,000
5,400
1,000
86,400
** At TK 3 per unit
b) Sewing process
Determine output and losses
The normal loss is 10% of the units processed = 10% of (16,000 + 14,000) = 3,000 units. The actual loss
is (30,000 – 28,000) = 2,000 units, so that there is abnormal gain of 1,000 units. These are deducted from
actual output to determine expected output.
Actual output
Abnormal gain
Expected output (90% of 30,000)
Calculate cost per unit of output and losses
28,000
(1,000)
27,000
(i)
The total value of scrap is 2,000 units at TK 5 per unit = TK 10,000. We must split this between
the scrap value of normal loss and the scrap value of abnormal gain. Abnormal gain’s scrap value
is ‘negative’.
TK
Normal loss scrap value
3,000 units TK 5
15,000
(5,000)
Abnormal gain scrap value
1,000 units TK 5
10,000
Scrap value of actual loss
2,000 units TK 5
(ii)
The scrap value of normal loss is first deducted from the cost of materials in the process, in order to
calculate a cost per unit of output, and then credited to the process account as a ‘value’ for normal
loss. The cost per unit in the Sewing process is calculated as follows.
147
Total cost Cost per expected unit of output
Materials:
Transfer from cutting process
80,000
70,000
Added in Sewing process
150,000
15,000
Less scrap value of normal loss
135,000
135,000
Labour and overhead
270,000
( 27,000)
( 27,000)
(27,000)
Calculate total cost of output and losses
TK
280,000
15,000
295,000
(10,000)
285,000
Output
(28,000 units TK 10)
Normal loss (3,000 units TK 5)
Abnormal gain (1,000 units TK 10)
Complete accounts
From cutting process
Added materials
Labour and overhead
Abnormal gain a/c
* At TK 10 per unit
c) and d)
Cutting process
SEWING PROCESS ACCOUNT
Units
TK
16,000 80,000 Finished output *
14,000 70,000
135,000 Normal loss
30,000 285,000 (scrap a/c)
1,000* 10,000
31,000 295,000
Units
200
Units
28,000
TK
280,000
3,000
15,000
31,000
295,000
ABNORMAL LOSS ACCOUNT
TK
1,000 Scrap a/c (scrap value of ab. loss)
Income statement (balance)
1,000
ABNORMAL GAIN ACCOUNT
TK
Scrap a/c (scrap value of abnormal gain units)
5,000 Sewing process
Income statement (balance)
5
5
10
Units
1,000
TK
600
400
1,000
TK
10,000
5000
10,000
10,000
Scrap account
This is credited with the cash value of actual units scrapped. The other entries in the account should all be
identifiable as corresponding entries to those in the process accounts, and abnormal loss and abnormal gain
accounts.
148
e)
Normal loss:
Cutting process (1,800 TK 3)
Sewing process (3,000 TK 5)
Abnormal loss a/c
SCRAP ACCOUNT
TK
Cash:
5,400 Sale of cutting process scrap (2,000 TK 3)
15,000 Sale of Sewing process scrap (2,000 TK 5)
600 Abnormal gain a/c
21,000
TK
6,000
10,000
5,000
21,000
LOSSES WITH A DISPOSAL COST
The basic calculations required in such circumstances are as follows.
 Increase the process costs by the cost of disposing of the units of normal loss and use the resulting
cost per unit to value good output and abnormal loss/gain.
 The normal loss is given no value in the process account.
 Include the disposal costs of normal loss on the debit side of the process account.
 Include the disposal costs of abnormal loss in the abnormal loss account and hence in the transfer of
the cost of abnormal loss to the income statement.
For example, input to a process was 1,000 units at a cost of TK 4,500. Normal loss is 10% and there are no
opening and closing inventories. Actual output was 860 units and loss units had to be disposed of at a cost
of TK 0.90 per unit.
Normal loss = 10% 1,000 = 100 units. Abnormal loss = 900 – 860 = 40 units
Cost per unit = TK 4,500 100 TK 0.90
900
= TK 5.10
The relevant accounts would be as follows.
PROCESS ACCOUNT
TK
Units
TK
Units Cost of input 1,000
4,500 Output
860
4,386
Disposal cost of
normal loss
Normal loss
90 Abnormal loss
4,590
100
40
1,000
204
4,590
1,000
ABNORMAL LOSS ACCOUNT
TK
Process a/c
204
Disposal cost (40 $0.90)
36
240
Income statement
TK
240
240
149
Process costing: It is a method of costing under which all costs are accumulated for each stage of production
or process, and the cost per unit of product is ascertained at each stage of production by dividing the cost
of each process by the normal output of that process.
Equivalent Production Units: The term equivalent unit means a notional quantity of completed units
substituted for an actual quantity of incomplete physical units in progress, when the aggregate work
content of the incomplete units is deemed to be equivalent to that of the substituted quantity. The principle
applies when operation costs are apportioned between work in progress and completed units.
FIFO Method: The FIFO method of costing is based on the assumption of that the opening work-inprogress units are the first to be completed.
LIFO Method: In LIFO method the assumption is that the units entering into the process is the last one
first to be completed. The cost of opening work-in-progress is charged to the closing work-in- progress
and thus the closing work-in progress appears cost of opening work-in-progress. The completed units are
at their current cost.
Weighted Average Cost Method: In this method no distinction is made between completed units
from opening inventory and completed units from new production. All units finished during the current
accounting period are treated as if they were started and finished during that period.
Losses: It may occur in process. If a certain level of loss is expected, this is known as normal loss.
Abnormal loss: If losses are greater than expected, the extra loss is abnormal loss.
Abnormal gain: If losses are less than expected, the difference is known as abnormal gain.
Scrap value: The scrap value of abnormal loss (or abnormal gain) is usually set off against its cost, in an
abnormal loss (abnormal gain) account.
150
SELF-REVIEW QUESTIONS
1.
2.
3.
4.
5.
6.
7.
What is process costing?
Define an equivalent unit.
What is the weighted average cost method of inventory valuation?
How is revenue from scrap treated?
What is normal and abnormal loss?
How do you treat normal and abnormal loss in process costing?
Following details are related to the work done in Process ‘Y’ Company during the month of January,
2021:
Opening work-in progress (2,000 units)
Value in TK
Materials
80,000
Labour
15,000
Overheads
45,000
Materials introduced in Process ‘A’ (38,000 units)
14,80,000
Direct Labour
3,590500
Overheads
10,77,000
Units scrapped -3000 Units, Degree of Completion:
Material
100%
Labour and Overhead
80%
Closing work-in progress:
2,000 units
Degree of Completion
Material
100%
Labour and Overhead
80%
Units finished and transferred to Process B 35000 Units, Normal Loss is 5% of total Output including
opening work-in-progress. Scrapped units fetch TK 20 per unit
You are required to prepare:
(i) Statement of equivalent production
(ii) Statement of cost
(iii) Statement of distribution cost, and
(iv) Process ‘A’ Account, Normal and Abnormal Loss Accounts
8. During the month of July 2021 in an Industry, 2,000 units were introduced into Process I. The cost of
the 2,000 units was TK 11,600. At the end of the month 1,500 units had been produced and transferred
to Process II; 360 units were still in process; and 140 units had been scrapped. A normal loss of 5% on
input is allowed. It was estimated that the incomplete units (i.e. the work-in-progress) had reached a
stage in production as follows:
Material
75% completed
Labour
50% completed
Production overhead
50% completed
The total cost incurred were (in addition to the 2,000 units):
Direct materials introduced during the process
TK 3,080 Direct wage TK 6,880
Production overheads
TK 3,440
Units scrapped realized
TK 2 each
151
The units scrapped had passed through the process, so were 100% completed as regards material,
labour and overhead.
You are required to prepare the Process Account and Abnormal Loss Account.
9. The product of a company passes through 3 distinct process. The following information is obtained
from the accounts for the month ending January 31, 2021.
Particulars
Process A
Process B
Process C
Direct Material
7800
5940
8886
Direct Wages
6000
9000
12000
Production Overheads
6000
9000
12000
3000 units @ TK 3 each were introduced to process I. There was no stock of materials or work in progress.
The output of each process passes directly to the next process and finally to finished stock A/c.
The following additional data is obtained:
Process
Output
Normal Loss in %
Realizable Value of Scrap
2
Process 1
2,850
5%
Process 2
2,520
10%
4
Process 3
2,250
15%
5
Prepare Process Cost Account, Normal Loss Account and Abnormal Gain or Loss Account.
10. A product passes through three processes— A, B and C. 10,000 units at a cost of TK 1.10 were issued
to Process A. The other direct expenses were as follows:
Direct Materials
Direct labour
Direct expenses
PROCESS A
1,500
4,500
1,000
PROCESS B
1,500
8,000
1,000
PROCESS C
1,500
6,500
1,503
The wastage of process ‘A’ was 5% and in process ‘B’ 4%. The wastage of process ‘A’ was sold at TK 0.25
per unit and that of ‘B’ at TK 0.50 per unit and that of C at TK 1.00. The overhead charges were 160% of
direct labour. The final product was sold at TK 10 per unit targeting a profit of 20% on sales. Find out the
percentage of wastage in Process ‘C’ and also
prepare process cost account.
152
CHAPTER-C3
SERVICE COSTING
CHAPTER OVERVIEW
Cost Accounting has been traditionally associated with manufacturing
companies. However, in the modern competitive market, cost accounting
has been increasingly applied in service industries like banks, insurance
companies, transportation organizations, electricity generating companies
and hospitals. The costing method applied in these industries is known as
‘Service Costing’. It is the cost of producing and monitoring a service. It is
a method of costing applied to undertakings which provide service rather
than production of commodities. Service may be performed internally and
externally. Services are termed as internal when they have to be performed
on interdepartmental basis in factory itself e.g. Power house services,
canteen service etc. Services are termed as external when they are to be
rendered to outside parties.
153
Chapter Learning Outcomes (CpLOs)
Determine cost of services
This Study Note Covers (Subtopics)
Distinguishing features of service costing
Features of service organization
Cost units and analysis
Application of service costing in different organization
Level of Study Required
U, AP
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1
CLO1
CLO1
CLO 1
CLO1
CLO1
DISTINGUISHING FEATURES OF SERVICE COSTING
The main features of operating costing are as following:
(1) The undertaking which adopts service costing does not produce any tangible goods. These undertakings
render unique services to their customers.
(2) The expenses are divided into fixed and variable cost. Such a classification is necessary to ascertain the
cost of service and the unit cost of service.
(3) The cost unit may be simple or composite. The examples of simple cost units are cost per unit in
electricity supply, cost per litre in water supply, cost per meal in canteen etc. Similarly cost per passenger
kilometres in transport cost per patient-day in hospital, costs per room-day in hotel etc. are the examples
of composite cost unit.
(4) Total cost is averaged over the total amount of service rendered.
(5) Costs are usually computed period-wise. However, in the case of utilization of vehicles, use of road
rollers etc., the costs are computed order wise.
(6) Service costing can be used for service performed internally or externally.
(7) Documents like the daily log sheet, cost sheet etc. are used for the collection of cost data.
FEATURES OF SERVICE ORGANIZATION
Most of the service organizations have the following features:
 Highly effective service organizations are guided by a coherent strategy that aligns service initiatives
to overall corporate goals and objectives.
 Effective service organizations have the means to monitor the current level of performance for
established success metrics with data and analytical insights.
 Success metrics provide not only visibility into progress against goals, but also insights into areas to
strengthen within the service organization.
 Service organizations employ active customer feedback mechanisms to continually assess the effect
of service initiatives.
 Service organizations have the tools and resources required to execute service strategies.
154
COST UNITS AND ANALYSIS
The major problem with service costing is the determination of the cost unit to use in measuring the output
of the service. For example, for a transport business, service could be measured in terms of kilometers
travelled or the weight of goods carried, or combination of both. Other cost-units in the service industry
are as follows:
Service
Cost units
Hotel
Occupied room-day
Restaurant
Electricity
Hospital
Transport
Meal served
Kilowatt-hour
Patient-day
Miles travelled
College
Fulltime equivalent student
Service cost analysis should be performed in a manner which ensures that the following objectives are
attained.
 Planned costs should be compared with actual costs. Differences should be investigated and corrective
action taken as necessary.
 A cost per unit of service should be calculated. If each service has a number of variations (such as
maintenance services provided by plumbers, electricians and carpenters) then the calculation of a cost
per unit of each service may be necessary.
 The cost per unit of service should be used as part of the control function. For example, costs per unit
of service can be compared, month by month, period by period, year by year and so on and any unusual
trends can be investigated.
 Prices should be calculated for services being sold to third parties. The procedure is similar to job
costing. A mark-up is added to the cost per unit of service to arrive at a selling price.
 Costs should be analyzed into fixed, variable and semi-variable costs to help assist management with
planning,
Transport Costing
In transport undertakings, the cost unit is normally the tonne-km or passenger-km; but according to the
nature of the undertakings, the organisation may vary the cost unit control and decision making.
Canteen costs
Another example of service costing is the cost of a company’s canteen services. A feature of canteen costing
is that some revenue is earned when employees pay for their meals, but the prices paid will be insufficient
to cover the costs of the canteen service.
Hospital Costing
The main purpose of hospital costing is to ascertain the cost of providing medical services. Hospital may
have different departments catering to varied services to the patients – such as Out Patient, In Patient,
X-Ray, Scanning, Catering, Laundry, Power house, Transport, Dispensary, etc. Common unit of costs of
various departments are as follows:
155
Scanning
Per Case
Laundry –
Out Patient
In Patient –
Per 100 items laundered
Per Out-patient
Per Room Day
Example
Rick Shaw operates a small fleet of delivery vehicles. Standard costs have been established as follows.
Loading
1 hour per tonne loaded
Loading costs:
Labour (casual)
TK 2 per hour
Equipment depreciation
TK 80 per week
Supervision
Petrol
Drivers’ wages (fixed)
Repairs
TK 80 per week
10c per kilometre
TK 100 per man per week
5c per kilometre
Depreciation
Supervision
Other general expenses (fixed)
TK80 per week per vehicle
TK 120 per week
TK 200 per week
There are two drivers and two vehicles in the fleet.
During a slack week, only six journeys were made.
Journey
Tonnes carried
(one way)
5
8
2
4
6
5
1
2
3
4
5
6
One-way distance
of journey Kilometres
100
20
60
50
200
300
Required
Calculate the expected average full cost per tonne/kilometre for the week.
Solution
Variable costs
Loading labour
Petrol (both ways)
Repairs (both ways)
156
Journey
1
TK
10
20
10
40
2
TK
16
4
2
22
3
TK
4
12
6
22
4
TK
8
10
5
23
5
TK
12
40
20
72
6
TK
10
60
30
100
Total costs
Variable costs (total for journeys 1 to 6)
TK
279
Loading equipment depreciation
80
Loading supervision
80
Drivers’ wages
200
Vehicles depreciation
160
Drivers’ supervision
120
Other costs
200
1,119
Journey
Tonnes
5
8
2
4
6
5
1
2
3
4
5
6
Cost per tonne/kilometre =
=
One way distance
Kilometres
Tonne/kilometres
100
500
20
160
60
120
50
200
200
1,200
300
1,500
3,680
$1,119
3,680
$0.304
Note that the large element of fixed costs may distort this measure but that a variable cost per tonne/
kilometre of TK 279/3,680 = $0.076 may be useful for budgetary control.
APPLICATION OF SERVICE COSTING IN DIFFERENT ORGANIZATION
Service costing is very useful in determining the cost of providing services which became a base for
ascertaining the price of services. Service costing is extensively used in transport industries, hotel industries,
electricity company etc. Service costing helps an organisation in ascertaining
1. Inter-departmental service prices
2. Service cost to be charged from outside clients
3. Benchmarking the processes/operations
4. Tracking and controlling the excess cost
Example
Alco Transport Company supplies the following details in respect of a truck of 5 tonne capacity:
Cost of truck
TK 4,50,000
Estimated life
10 years
Diesel, oil, greese
TK 150 per trip each way
157
Repairs and maintenance
Drivers’ wages
Cleaners’ wages
Insurance
Tax
General supervision charges
5,000 per month
5,000 per month
2,500 per month
4,800 per year
2,400 per year
4,800 per year
The truck carries goods to and from the city covering a distance of 50 km. each way. In outward trip, freight
is available to the extent of full capacity and on return 20% of capacity. Assuming that the truck runs on an
average of 25 days a month, work out:
 Operating cost per tonne-km.
 Rate per tonne per trip that the company should charges if a profit of 50% on freight is to be earned.
Solution
Alco Transport Company Statement showing operation costs
Cost per month
TK
Per ton Km.
TK
Fixed Costs:
Driver’s wages
Cleaner’s wages
Insurance
Taxes
General supervision
Variable Costs:
Diesel, oil, grease
5,000
2,500
400
200
400
Depreciation
Repairs and maintenance
(a) Operating Costs
(b) Freight rate:
Cost per tonne-km
Profit per tonne-km
3,750
5,000
8,500
1.133
16,250
24,750
2.167
3.300
7,500
3.30
3.30
6.60
Freight per trip (both ways) TK 1,980.
Working Notes:
 It is assumed that the truck makes only one trip per day.
 Tonne-km per month = 6 tonnes x 50 km x 25 days = 7,500 tonne - km. (5 tonnes on outward trip and
one tonne on return trip)
 The scrap value of the truck is assessed to be nil. Depreciation = TK 4,50,000/10= TK 45,000.
158
Service costing can be used by companies operating in a service industry or by companies wishing to
establish the cost of services carried out by some of their departments. Service organizations do not make
or sell tangible goods.
Specific characteristics of services
 Simultaneity
 Heterogeneity
 Intangibility
 Perishability
Service cost analysis should be performed in a manner which ensures that planned costs should be
compared with actual costs. Differences should be investigated and corrective action taken as necessary.
Transport Costing is normally the tonne-km or passenger-km; but according to the nature of the
undertakings.
Canteen costs is the cost of a company’s canteen services. A feature of canteen costing is that some
revenue is earned when employees pay for their meals, but the prices paid will be insufficient to cover the
costs of the canteen service.
Hospital Costing is to ascertain the cost of providing medical services.
Service organizations are guided by a coherent strategy that aligns service initiatives to overall corporate
goals and objectives.
The operating costing adopts service costing which does not produce any tangible goods.
SELF-REVIEW QUESTIONS
1.
2.
3.
4.
What is service costing?
State the industries where service costing is it to be used.
State the salient features of service costing.
Match up the following services with their typical cost units:
Service
Cost unit
a. Hotels
i.
Patient-day
b. Hospitals
ii. Full-time student
c. Catering organizations
iii. Occupied bed-night
d. Education
iv. Meal served
159
5.
6.
7.
8.
9.
What is the advantage of organisations within an industry using a common cost unit?
Cost per service unit ...................................................
In hospital the cost unit is ...................................................
In electricity companies, the cost unit is
. ..................................................
The method of costing used in undertaking like gas companies, cinema houses,
hospitals etc is known as…………………
10. In motor transport costing two example of fixed cost are…….
And…….
.
11. Service department costing is used to establish a specific cost for an ‘internal service’ which is a
service provided by one department for another. Identify true or false.
12. Operating costing is applied to ascertain the cost of products. Identify true or false.
13. Cost of operating the service is ascertained by preparing job account. Identify true
or false.
14. J T Co. has been given a route 20 km. long for running buses. The company has a
fleet of 10 buses each costing TK 50,000 and having a life of 5 years without any scrap value. From
the following estimated expenditure and other details calculate the bus fare to be charged from each
passenger.
Particulars
TK
Annual tax for each bus
1,000
Insurance charges
3 % p.a.
Total garage charges
1,000
Drivers’ salary for each bus
150 p.m
Annual repairs to each bus
1,000
Commission to be shared by the driver and conductor equally:
10% of the takings
Cost of stationary
500 p.m
conductor’s salary for each bus
100 p. m
Accountant’s salary
1,500 p.m
Petrol and oil
25 per 100 km
Manager’s salary
2,000 p.m.
Each bus will make 3 round trips carrying on an average 40 passengers on each trip. The bus will run on an
average for 25 days in a month. Assuming 15% profit on takings, calculate, the bus fare to be charged from
each passenger.
15. A transport service company is running 4 buses between two towns which are 50 miles apart. Seating
capacity of each bus is 40 passengers. The following particulars were obtained from their books for April,
2021.
Particulars
Wages of Drivers, Conductors and Cleaners
Salaries of Office and Supervisory Staff
Diesel and oil and other oil
Depreciation
160
TK
2,400
1,000
4,000
2,600
Taxation, Insurance, etc.
Repairs and Maintenance
Interest and Other Charges
1,600
800
2,000
14,400
Actual passengers carried were 75% of the seating capacity. All the four buses ran on all days of the month.
Each bus made one round trip per day. Find out the cost per passenger mile.
16. A university with annual running costs of $3 million has the following students.
Classification
3 year
4 year
Sandwich
Attendance Number
weeks per annum
Hours per week
2,700
1,500
1,900
30
30
35
28
25
20
Required: Calculate a cost per suitable cost unit for the university to the nearest cent.
17. Mr. Su owns a fleet of taxies and the following information is available from the
by him.
(i) Salary of manager
(ii) Cost of each Taxi
(iii) Number of Taxis
(iv) Salary of Accountant
(v) Salary of cleaner
(vi) Salary of Mechanic
(vii) Garage Rent
(viii) Insurance premium
(ix) Annual Tax
(x) Drivers Salary
(xi) Annual Repairs
records maintained
TK 6000 p.m.
TK 2,00,000
10
TK 5000 p.m.
TK 3000 p.m.
TK 4000 p.m.
TK 7000 p.m.
5%
TK 6000 per taxi
TK 4000 p.m.
TK 15,000 per taxi
Total life of a taxi is about 2,00,000 kms. A taxi runs in all 3000 kms. in a month of which 25% its runs
empty. Petrol consumption is one liter for 10 kms @ TK 40 per liter. Oil and other sundries are TK 10 per
100 kms. Calculate the cost of running a taxi per km.
Answers:
4. (a) iii, (b) i, (c) iv, (d) ii
6. Cost per service unit
=
Total costs for period
Number of service units in the period
7. per bed, 8. Kilowatt, 9. Operating costing, 10. Insurance and Depreciation 11. True
12. False 13. False
161
CHAPTER-C4
STANDARD COSTING
CHAPTER OVERVIEW
Standard Costing is a method of costing which is used as a control tool
by the management. Controlling is a principal function of management
along with planning, directing and staffing. Every organization sets a goal
and to achieve it management of the organization make plans, get these
plans executed and monitor the work for any deviation from the plan.
Deviation means the amount by which a single measurement differs
from a fixed value such as the mean or standard (here it is used in the
context of cost accounting). Deviation is measured by comparing actual
figure with the standard figure.
162
Chapter Learning Outcomes (CpLOs)
1. determine standards for different cost elements
2. compare actual and standard costs in identifying variances evaluate variances for corrective actions
3. evaluate variances for corrective actions
This Study Note Covers (Subtopics)
Purpose of Using Standard Costing
Variance Analysis
Materials, Labor and overhead standards
Variance Analysis for Costs, volume and price variances, sales mix, and yield variances
Responsibility analysis for cost variances
Reconcile standard profit and actual profit using absorption and marginal costing systems
Accounting disposition of variances
Interpretation of variances and Inter-relationships between variances.
Level of Study Required
R, U, AP, AN & E
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2,3
CLO2
CLO1, 2,3
CLO 1, 2
CLO1,2,3
CLO2,3
INTRODUCTION
A standard is a benchmark for measuring performance. Standards are also widely used in managerial
accounting where they relate to the quantity and acquisition price of inputs used in manufacturing goods
or providing services.
Quantity standards specify how much of an input should be used to make a product or provide a service.
Price standards specify how much should be paid for each unit of the input. If either the quantity or
acquisition price of an input departs significantly from the standard, managers investigate the discrepancy
to find the cause of the problem and eliminate it. There are two types of standards: quantity standard and
price standard.
These price and quantity standards can be set in terms of
a) Direct material
b) Direct labor
c) Manufacturing overhead
Direct material standard:
Direct material standard specifies how much price or quantity to be used to produce one unit of product
or to provide service. Managers need to set both standard quantity and standard price for direct materials.
The standard quantity per unit defines the amount of direct materials that should be used for each unit
of finished product. If there is any allowance for scrap or spoilage, it should be considered while setting
163
quantity standard. The standard quantities of materials to be used per unit of production can be laid down
by one of the following means:
(a) By reference to the weight of materials in the final production.
(b) Based on the past performance with due allowance for change in conditions.
(c) By means of test runs conducted under different conditions and taking an average of quantities used.
(d) Due allowance must be made for normal wastage. This is generally based on an estimate wastage which
is unavoidable, e.g., normal loss through evaporation, off-cuts, broken parts, etc.
The standard price per unit defines the price that should be paid for each unit of direct materials and it
should reflect the final, delivered cost of those materials. If there is any volume or cash discount for material
purchase, it should be deducted to set the final price per unit.
Direct labor standard
Direct labor standard specifies how much labor hour or rate to be paid to produce one unit of product or
provide service. Managers need to set both standard rate per hour and standard hour for direct labor.
Standard rate per hour tells how much per hour to be paid to direct labor to produce one unit of product
or to provide service. Managers often use a single rate. The object is to plan for the actual wages to be
paid. A variety of factors should be considered while setting standard wage rates: (1) future trend of wages
should be anticipated; (2) collective agreement between Labor and management should be considered; (3)
guaranteed minimum wages and overtime wages, if the level of activity makes overtime inevitable should
be thought of. Both these standards must be set after a detailed study of Labor work involved. Besides, the
workers employed must be graded on a standard basis.
Standard hour per unit tells how much hour to be required to produce one unit of product or to provide
service. Managers use time and motion study for each labor operation. The main object of setting standard
hour per unit is to derive maximum efficiency in the use of Labor time.
Manufacturing overhead standard:
Manufacturing overhead standard rate per unit tells us how much manufacturing overhead cost to be paid
for one unit of product or service. The principal object of setting standard overhead rates is to minimize the
overhead costs chargeable to production. Following steps are necessary for setting standard rates:
(i) The level of activity of production departments and the work to be done by the service departments
should be determined.
(ii) Overheads costs should be classified into fixed, variable, and semi-variable overheads. The costs
expected to be incurred under each head for each of the production and service departments should be
calculated for a given period. The expected costs may be laid down in details in the form of cost-budgets
based on experience, present conditions and future trends.
(iii) The standard overhead rates for each of the service departments should be calculated and applied to the
producing departments.
(iv) The standard overhead rates for the producing departments may be determined as a direct Labor hour
rate, or a machine hour rate, or as a percentage of direct wages.
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PURPOSE OF USING STANDARD COSTING
•
•
•
•
•
•
The main purpose of standard cost is to provide management with information on the day-to-day control
of operations.
Standard costs are predetermined costs that provide a basis for more effectively controlling costs.
Standard cost offers a criterion against which actual costs incurred by the business can be measured
and analyzed.
The difference between actual costs and standard costs is known as variance. Variance is identified and
carefully analyzed, and it is reported to managers to inform suitable corrective actions.
Standard costs are used to set budgets and based on these budgets managerial performance is evaluated.
Standard cost is used for calculating profitability from a project/ order/ activity proposed to be
undertaken. Hence, standard cost is very useful for decision making purpose.
Standard costs are the target cost which should not be crossed. It keeps challenging target before the
responsibility centers. Management of responsibility centers monitor the performance continuously
against the set standards and deviations are immediately corrected.
VARIANCE ANALYSIS
The primary object of standard costing is to reveal the difference between actual cost and standard cost. A
‘variance’ in standard costing refers to the deviation of actual cost from standard cost. Variances of different
cost items provide the key to cost control. They indicate whether and to what extent standards set have
been achieved. This enables management to correct adverse tendencies. After standard costs have been
established, the next step is to ascertain the actual cost under each element and compare them with the
standard cost. The difference between these two is termed as cost variance.
Cost variance is the difference between a standard cost and the comparable actual cost incurred during a given period.
The Chartered Institute of Management Accountants London defines variance as “the
difference between planned, budgeted, or standard cost and actual cost; and
similarly for revenue”.
Variance analysis can be defined as “the analysis of performance by means of variances”. It is the process
of computing the amount of and isolating the cause of variances between actual costs and standard costs
Variance analysis involves:
(a) Computation of individual variances, and
(b) Determination of the cause(s) of each variance.
Actual cost which is higher than the standard costs would be a sign of inefficiency and the difference would
be termed as unfavorable or adverse. A variance that reduces profit is adverse or unfavorable. A variance that
increases profit is favorable. Variance are computed under each element of cost for which standards have
been established. Each variance is analyzed to ascertain the causes so that the management can exercise
proper control. The cause is affixed to the variance, for example, materials price variance will show that the
variance arose due to change in the price of materials. Some of the variance are controllable while others are
not. The purpose of such classification is that proper emphasis can be placed on the controllable variance.
This follows the principle of management by exception.
Variances occurring in a period may be compared with variances on the same account expressed as a
percentage of the standard costs and compared with the percentage for the previous month. Comparison
may be made between the standard and actual or between basic standard and current standard.
165
As already stated, the origin and causes of the variances need to be traced by analyzing the total variances
into their components parts to determine and isolate the causes giving rise to each variance. Equal emphasis
should be laid on favorable and unfavorable variances. An unfavorable variance points out the inefficiency
in use or waste of materials, Labor, and resources. A favorable variance may be due to improvement in
efficiency or production of substandard products or an incorrect standard. An unfavorable variance may be
offset by a favorable variance; hence the need for analysis and appropriate action.
MATERIALS, LABOR AND OVERHEAD STANDARDS
Material Cost Variance:
Material cost variance is the difference between standard cost and actual cost. Mathematically it is
written as.
Material Cost variance = (Standard quantity x Standard Price) – (Actual quantity x Actual price)
Or MCV = (SQ × SP) – (AQ × AP)
Reasons: Material cost variance arises mainly because of either difference in material price from the
standard price or difference in material consumption from standard consumption or because of both
reasons. Analysis of material cost variance is done dividing it into two parts namely Material Price
variance and Material Usage variance.
Material Price variance:
It measures variance arises in the material cost due to difference in actual material purchase price from
standard material price. Mathematically it is written as
Material price variance = (standard price - Actual price) x actual quantity
Or MPV = (SP - AP) x AQ
Here actual quantity means actual quantity of material purchased. If in the question material purchase is not
given, it is taken as equal to material.
Material price variance may arise from variety of reasons out of which some may be controllable, and
some may be beyond the control of the purchase department. If price variance arises due to inefficiency
of purchase department or any other reason within the control of the company, then it is very important
to report variance as early as possible.
Responsibility: Generally, purchase department purchases materials from the market. Purchase
department is expected to perform its function very prudently so that company never suffers loss due
to its inefficiency. Purchase department is held responsible for adverse price variance arises due to the
factors controllable by the department.
Material Usage Variance:
It measures variance in material cost due to usage/ consumption of materials. It is computed as below:
Material usage/ quantity variance = (standard quantity - Actual quantity) x standard price
Or MUV / MQV = (SQ - AQ) x SP
Material usage is the responsibility of production department and it is held responsible for adverse usage
variance.
166
Reasons of material usage variance: Actual material consumption may differ from the standard quantity
due to either difference in proportion used from standard proportion or due to difference in actual yield from
standard yield. Material usage variance is divided into two parts (a) Material usage mix variance and (b)
Material yield variance.
Material Mix Variance:
Variance in material consumption may arise due to difference in proportion used from the standard mix/
proportion. It arises only when two more inputs are used to produce a product.
Material Yield variance:
Yield variance is the difference between the standard yield specified and the actual yield obtained. In other
words, the difference between actual yield of materials in manufacture and the standard yield (i.e. expected.
yield from a given standard input) valued at standard output price is known as materials yield variance. This
variance is of great significance in processing industries, in which the output of one process becomes the
input of the next process till the finished product is obtained at the final stage. The analysis of this variance
helps effective control over usage. A low actual yield is unfavorable yield variance which indicates that
consumption of materials was more than the standard. A high actual yield indicates efficiency, but a constant
high yield is a pointer for the revision of the standard.
Material Yield Variance = Standard cost per unit (Actual yield – Standard yield)
The yield variance may be caused by such factors as: defective methods of operation, sub-standard quality
of materials purchased, lack of due care in handling, lack of proper supervision etc.
Illustration 1 (Calculation of material cost variance)
The standard and actual figures of product ‘Z’ are as under:
Material quantity
Standard
50 units
Actual
45 units
Material price per unit
Taka 1.00
Taka 0.80
Calculate material cost variance.
Solution:
The variances may be calculated as under:
(a) Standard cost
= Std. qty × Std. price = 50 units × Taka 1.00
= Taka 50
(b) Actual cost
= Actual qty. × Actual price = 45 units × Taka 0.80
=Taka 36
Material cost variance
= standard cost - Actual cost
= Taka 50 - Taka 36 = 14 Favorable
Price variance
= (standard price - Actual price) x actual quantity
= (1 -0.80) x 45 = Taka 9 Favorable
= (standard quantity - Actual quantity) x
standard price
= (50 units -45 units) x Taka 1.00 per
= Taka 5 Favorable
Quantity variance
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Illustration 2 (Calculation of Material cost, price and usage variance)
For making 10 kg. of CEMCO, the standard material requirements is:
Material
A
Quantity
8
B
4
Rate per kg. Taka)
6.00
4.00
During April, 1,000 kg of CEMCO were produced. The actual consumption of materials is as under:
Material
Quantity (Kg.)
Rate per kg.(Taka)
A
750
7.00
B
500
5.00
Req: Calculate (A) Material Cost Variance; (b) Material Price Variance; (c) Material usage Variance.
Solution:
Basic Calculations
A
B
Total
Standard for 1,000 kg.
Qty.
Rate
Kg.
(Taka)
800x
6
400x
4
1,200
Amount
(Taka)
4,800
1,600
6,400
Actual for 1,000 kg.
Qty.
Rate
Kg.
(Taka)
750
7
500
5
1,250
(A : 8÷10 ×1000 = 800 B : 4÷10 × 1000 = 400)
Calculation of Variances:
(a) Material Cost Variance
= Standard cost - Actual cost
= Taka 6400 – Taka 7,750
= Taka 1, 350 (Unfavorable)
(b) Material Price Variance
(Unfavorable)
B
Material price variance
(c) Material Usages Variance
A
B
MUV
Check
MCV
1,350 (Unfavorable)
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= (SP - AP) x AQ
A
= (6 -7) × 750
= (4 -5) × 500
= Taka 750
= Taka 500 (Unfavorable)
= Taka 1,250 (Unfavorable)
= (SQ - AQ) × SP
= (800 -750) × 6 = Taka 300 (Favorable)
= (400 -500) × 4 = Taka 400 (Unfavorable)
= Taka 100 (Unfavorable)
= MPV + MUV
= 1,250 (Unfavorable) + 100 (unfavorable)
Amount
(Taka)
5,250
2,500
7,750
Example: 1
For producing one unit of a product, the materials standard is:
Material X : 6 kg. @ Taka 8 per kg., and
Material Y : 4 kg. @ Taka 10 per kg.
In a week, 1,000 units were produced the actual consumption of materials was:
Material X : 5,900 kg. @ Taka 9 kg., and
Material Y : 4,800 kg. @ Taka 9.50 per kg.
Compute the various variances.
Solution to example: 1
Standard cost of materials of 1,000 units:
Taka
Material X: 1000 units @6 kg per unit =6,000 kg. @ Taka 8 48,000
Material Y: 1000 units @4 kg per unit =4,000 kg. @ Taka 10 40,000
Total 88,000
Actual cost:
Material X 5,900 kg. @ Taka 9 per kg
53,100
Material Y 4,800 kg. @ Taka 9.50 per kg
45,600
Total 98,700
Total materials cost variance = standard cost – actual cost
= 88000 – 98700 =
10,700 (Unfavorable)
Material Price Variance=Actual Quantity (Standard Price - Actual Price)
X = 5900 kg (Taka 8 - Taka 9) = Taka 5,900 (Unfavorable)
Y = 4800 kg (Taka 10 - Taka 9.50)
= Taka 2,400 (Favorable)
Total price variance = 3,500 (Unfavorable)
Material Usage Variance=Standard Price (Standard Quantity - Actual Quantity)
X = Taka 8 (6,000 - 5,900) = Taka 800 (Favorable)
Y = Taka 10 (4,000 - 4,800) = Taka 8,000 (Unfavorable)
Total material usage variance = 7,200 (Unfavorable)
Verification
Material Cost Variance = Materials price variance [Taka 3,500 (Unfavorable)] + Material Usage Variance
[Taka 7200 Unfavorable] = Taka 10,700 unfavorable
Material Mix Variance = SP (RSQ – AQ)
For Material X = Taka 8 (6420 – 5900) = Taka 4160 (Favorable)
For Material Y = 10 (4280 – 4800) = Taka 5200 (Unfavorable)
Total mix variance = Taka 4160 Favorable + Taka 5200 Unfavorable = 1040 Unfavorable
Labor cost variances
Labor cost variance (also termed as direct wage variance) is the difference between the standard direct
wages specified for the activity achieved and the actual direct wages paid. The formula for Labor cost
variance is:
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LCV = (Standard Hours x Standard Rate) - (Actual Hours x Actual Rate)
As the cost of Labor is determined by Labor time and wages, the Labor cost variance is composed of either
or both of variances relating to Labor time and Labor rate. As such, Labor cost variance is analyzed into two
separate variances, viz., wages (Labor) rate variance and Labor efficiency variance.
Labor rate variance:
This is that portion of the wages variance which is due to the difference between the actual rate and standard
rate of any specified. It is calculated like the materials price variance.
Labor Rate Variance = Actual Hours (Standard Rate - Actual Rate)
Labor efficiency variance:
Also termed as Labor efficiency variance, is that portion of the direct wages variance which is due to the
difference between the standard Labor hours specified and the actual Labor hours expended. Obviously,
this variance provides a key to the control of workers’ efficiency and Labor cost. In effect, it is a usage
variance. The computation of variance is as follows:
Labor Efficiency Variance = Standard Wage Rate (Standard Hours of Production – Actual Hours Worked)
The causes giving rise to Labor efficiency variance are as follows:
(i) Lack of proper supervision or stricter supervision than specified;
(ii) Poor working conditions;
(iii) Defective machinery and equipment;
(iv) Discontentment in workers due to unsatisfactory personnel relations;
(v) Increase in Labor turnover;
(vi) Use of non-standard material requiring more or less operation time;
Illustration: 3
Assuming
Actual hours worked 5,600
Actual wage paid Taka 78,400
Standard rate per hour Taka 20
Standard hours produced 4,000
Wages variance = Standard cost – Actual cost
=(4,000 × Taka 20) – Taka 78400
= Taka 80,000 – Taka 7,8400
= Taka 1600 (Favorable)
Wages rate variance = Actual hours (Standard rate - Actual rate)
= 5600 (20-14)
= Taka 33,600 (Favorable)
Actual Rate = 78400/ 5600= Taka 14
Labor efficiency rate variance = (Standard hour – actual hour) x standard rate
= 20 (4,000 – 5,600)
= Taka 32,000 (Unfavorable)
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Labor Cost Variance= Labor Rate Variance + Labor Efficiency Variance
= 33,600 (Favorable) + 32,000 (Unfavorable)
= Taka 1600 (Favorable)
Labor efficiency variance is sub-divided into the following variances:
(i) Idle time variance
(ii) Labor mix variance
(iii) Labor yield variance (or Labor revised-efficiency variance)
Idle time variance:
This variance which forms a portion of wages efficiency variance, is represented by the standard cost of the
actual hours for which the workers remain idle due to abnormal circumstances.
Labor Idle Time Variance (LITV) = (Actual hours paid for x Standard rate) – (Actual hours
worked x Standard rate)
It is also known as Gang Composition Variance. This is a sub-variance which arises due to change in the
composition of a standard gang or combination of Labor force.
Labor mix variance = (Actual hours at standard rate of actual gang – Actual hours at standard
rate of standard gang)
Labor yield variance:
This is due to the difference in the standard output specified and the actual output obtained. This is computed
as follows:
Labor yield variance = Standard Labor cost unit (Actual output – Standard output)
Illustration: 4
A factory, working for 50 hours a week, employs 100 workers on a job work. The standard rate is Taka 10
an hour and standard output is 200 units per gang hour. During a week in June, ten employees were paid at
Taka 8 an hour and five at Taka 12 an hour. Rest of the
employees were paid at the standard rate. Actual number of units produced was 10,200
Calculate Labor cost variances.
Solution:
Cost variance = standard cost – actual cost = Taka 49500 – Taka 50,000 = Taka 500
Calculation of actual cost
85 workers for 50 hours @10 Taka per hour = Taka 42500
10 workers for 50 hours @8 Taka per hour
= Taka 4000
5 workers for 50 hours @ 12 Taka per hour
= Taka 3000
Total actual cost = Taka 49500
Calculation of standard rate
Standard cost (per gang hour) = 100 workers x 50 hours x Taka 10 per = Taka 50,000
Standard production (per gang hour)
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= 100 workers @ 200 units x 50 hours
= 10,000 units
Standard rate per unit = Taka 50,000 / 10,000 units = Taka 5 per unit
Calculation of standard cost
Actual production x standard rate
= 10200 units x Taka 5 per unit
= Taka 51000
Rate variance
As the actual rate deviated from standard rate in respect of only 15 workers from out of a total 100 workers,
wages rate variance should be calculated in respect of only 15 workers.
Rate variance = (standard rate – actual rate) * actual hour
Rate variance for 10 workers = (10 -8) x 500 hours = Taka 1000 favorable
Actual hour for 10 workers= 10 workers x 50 hours per = 500 hours
Rate variance for 5 workers = (10 -12) x 250 hours = Taka 500 unfavorable
Actual hour for 5 workers = 5 workers x 50 hours per = 250 hours
Thus, total rate variance = Taka 1000 Favorable + Taka 500 unfavorable
= Taka 500 Favorable
Efficiency variance
Efficiency variance is indicated by the fact that, as compared with standard production of 10,000 units (200
units x 50 hours), actual production is 10,200 units
Efficiency variance
= (Standard hours – Actual hours) x Standard rate
= (5100 - 5000) x Taka 10 per hour
= Taka 1000 favorable
Calculation of standard hours = 5000 hours / 10,000 units x 10200 units = 5100 hours
Yield variance = (standard yield – actual yield) x standard labor cost per unit of output
= (10,000 -10200) x 5 Taka per unit
= Taka 1000 favorable
Verification:
Cost variance = rate variance + efficiency variance
= Taka 500 Favorable + Taka 1000 favorable
= Taka 1500 favorable
Example-3
Standard cost of a product in a factory is predetermined as follows:
Taka
Material (5 units @ Taka 4 each) 20
Labor (20 hours @ Taka 1.50 per hour) 30
Overhead expenses 10
Total 60
During a period, 8,000 units were produced whose actual cost was as follows:
Material (40,500 units @ Taka 5 each)
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Taka
2,02,500
Labor (1,50,000 hours @ Taka 1.60 each)
Overhead expenses
Total
Prepare a statement showing standard cost, actual cost and variances.
2,40,000
90,000
5,32,500
Solution:
Statement of Standard Cost, Actual Cost, and Variances
Particulars
Standard cost (Taka)
Actual cost (Taka)
Material
1,60,000
2,02,500
Labor
2,40,000
2,40,000
Overhead expenses
80,000
90,000
Total
4,80,000
5,32,500
Variance (Taka)
42,500 (Unfav)
—
10,000 (Unfav)
52,500 (Unfav)
Overhead cost variances
Overhead cost variances can be classified as:
• Variable overhead variance
• Fixed overhead variance
It is the difference between the standard variable overhead cost allowed for the actual output achieved and
the actual variable overheads. Normally this variance is represented by expenditure (cost) variance only
because variable overhead cost will vary in proportion to production so that only a change in expenditure
can cause such variance.
Variable Overhead Variance = (Standard Variable Overhead Rate × Actual Output) - Actual Variable
Overheads
Overhead cost variance:
The variable overhead cost variance is usually calculated in total only since variable overheads vary
according to output and not according to time, hence, there is only one variance. However, some accountants
argue that certain variable overhead may vary according to time also, hence variable overhead efficiency
variance arise just like Labor efficiency variance and it can be calculated if information relating to actual
time taken and allowed is given. In such case variable overhead variance can be segregated into two parts.
• Variable Overhead Expenditure Variance
• Variable Overhead Efficiency Variance
Variable Overhead Expenditure Variance = (Actual Hours × Standard Variable Overhead Rate per Hour)
– Actual Variable Overhead
Variable Overhead Efficiency Variance (VOEfV):
Variable overhead efficiency variance is as follows:
(Standard Time for Actual Production × Standard Variable Overhead Rate per Hour) – Actual Hours Worked
× Standard Variable Overhead Rate per Hour).
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VARIANCE ANALYSIS FOR COSTS, VOLUME AND PRICE VARIANCES,
SALES MIX AND YIELD VARIANCE
Cost variance analysis
The cost variance analysis is the most common performance evaluation tool when evaluating a cost center.
A cost center is a subunit of an organization that has control over costs but not revenues and investments.
Examples of cost centers are production department, maintenance department, finance and accounting, etc.
Variance analysis of costs is performed by comparing actual costs and budgeted costs. With sufficient data,
the variance may be split into price variance and volume variance. In production departments, variance
analysis may be done for different cost components, i.e. direct materials, direct labor, and factory overhead.
Total Cost Variance
Total cost variance is equal to the difference between actual costs and budgeted costs. If actual costs are
higher than budgeted costs, the there is an unfavorable variance. If actual costs are less than budgeted
costs, such variance is favorable.
Total cost variance = Actual costs - Budgeted costs
The total cost variance may be split into price variance and volume variance.
Total cost variance = Price variance + Volume variance
Price variance
Price variance refers to the variance resulting from the difference in the purchase price per unit of the input.
It results from changes in the price per unit of direct materials and labor (and factory overhead) rates. Price
variance can be computed as:
Price variance = Actual quantity x (Actual price - Standard price)
If actual price is higher than standard price, there is an unfavorable variance. Otherwise, the variance is
favorable.
Volume Variance
Volume variance refers to the variance resulting from the difference in the actual quantity used and budgeted
quantity as per standards. Volume variance is computed as:
Volume variance = Standard price x (Actual quantity - Standard quantity )
If the actual quantity used is higher than standard quantity, the variance is unfavorable.
Example
ABC Company uses plastic pellets in producing its product. Based on its monthly budget, one unit of its
final product requires 5 plastic pellets. A plastic pellet normally costs Taka 2.00.
The company produced 5,000 units of its product last month. The company used 26,000 plastic pellets and
paid Taka 1.80 for each pellet.
Cost Variance Analysis:
If the cost of producing a unit of the final product is Taka 10 (5 pellets @ Taka 2 each), the budgeted cost
in producing 5,000 units is Taka 50,000. The company used 26,000 pellets at a cost of Taka1.80 each. The
actual cost is equal to Taka46,800. Hence, there is a favorable material cost variance of Taka 3,200.
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This Taka 3,200 favorable variance can be split into: (a) the portion brought about by difference in the price
of the pellets (price variance), and (b) the portion brought about by the difference in quantity used (volume
variance).
a. Price variance
Price Variance
Price Variance
Volume variance
Volume variance
Volume variance
=
=
=
AQ x (AP - SP)
26,000 x (Taka 1.80 – Taka 2.00)
Taka 5,200 favorable
=
=
=
SP x (AQ - SQ)
Taka 2.00 x (26,000 - 25,000)
Taka 2,000 unfavorable
When using cost variance analysis in evaluating a cost center, the manager should be evaluated based
only on costs he or she was able to control (controllable costs). Non-controllable costs such as depreciation,
allocated repairs and maintenance costs, allocated administrative costs, and others not under his or her
influence should be separated.
Sales mix variances
Sales mix variance is the difference between a company’s budgeted sales mix and the actual sales mix. Sales
mix is the proportion of each product sold relative to total sales. Sales mix variance includes each product
line sold by the firm.
Suppose ABC travel agency sells two types of tickets: standard ticket and luxury ticket. Budgeted data for
2020 is as follows:
Selling
Variable
Contribution
Sales
Sales mix Contribution
price
cost per
margin per
volume in
based on
margin
unit
unit
units
units
Standard ticket 980
755
225
93,000
60 %
20,925,000
Luxury ticket
1050
775
275
62,000
40 %
17,050,000
Total
155,000
100 %
37,975,000
Actual data for 2020 is as follows:
Selling
Variable
price
cost per
unit
Standard ticket 975
749
Luxury ticket
1049
784
Total
Contribution
Sales
margin per
volume in
unit
units
226
100,000
265
50,000
150,000
Sales mix
based on
units
66.67 %
33.33 %
100 %
Contribution
margin
22600,000
13250,000
35850,000
The sales-mix variance is the difference between (1) budgeted contribution margin for the actual sales mix and
(2) budgeted contribution margin for the budgeted sales mix. The formula and computations (using data from page
570) are as follows:
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Actual units of
all tickets sold
Standard ticket
150,000 units
Luxury ticket
150,000 units
Total sales mix
variance
Actual sales mix
percentage
x
– budgeted sales
mix percentage
x 66.67 %-60%
x 33.33% - 40%
Budgeted
Sales mix
contribution
variance
x margin per
unit
225
2250,000 fav
275
2750,000 Unfav
500,000 Unfav
A favorable sales-mix variance arises for the standard ticket because the 66.67% actual sales-mix percentage
exceeds the 60% budgeted sales-mix percentage. In contrast, the luxury ticket has an unfavorable variance
because the 33.33% actual sales-mix percentage is less than the 40% budgeted sales-mix percentage. The
total sales-mix variance is unfavorable because actual sales mix shifted toward the less profitable standard
ticket relative to budgeted sales mix.
Yield Variance
Yield variance is the difference between actual output and standard output of a production
or manufacturing process, based on standard inputs of materials and labor. The yield variance is valued at
standard cost. Yield variance is generally unfavorable, where the actual output is less than the standard or
expected output, but it can be that output expects expectations as well.
Yield variance is calculated as the actual yield minus the standard yield multiplied by standard unit cost.
Yield Variance =SC x (Actual Yield − Standard Yield)
where: SC = Standard unit cost
For example, 1,000 units of a product are the standard output based on 1,000 kilograms of materials in an
8-hour production unit, and the actual output is 990 units, there is an unfavorable yield variance of 10 units
(1,000 - 990). If the standard cost is Taka 25 per unit, the unfavorable yield variance would be Taka 250
(10 x Taka 25).
Or consider company ABC, which will produce 1,000,000 units of a toy for every 1,500,000 units of
specialized plastic parts. In its most recent production run, Company ABC used 1,500,000 plastic units, but
only produced 1,250,000 toys. The cost of plastic units is Taka0.50 per unit.
The yield variance is:
(1,250,000 actual toy output - 1,500,000 expected toy output) * Taka0.50 per unit cost = Taka125,000
unfavorable yield variance
RESPONSIBILITY ANALYSIS FOR COST VARIANCES
The determination of standard cost and the variance as defined by the deviation of actual cost from standard
cost is of great use to the managers. Each type of variance is the responsibility of a particular department
of the organization. For example, purchasing department is responsible for material purchase. So, the price
variance as defined by the deviation of actual price from standard price lies on the purchasing department. If
there is unfavorable price variance meaning actual price of materials exceeds the standard price of materials
per unit, the purchasing department will be held accountable for this. Their promotion or increment will be
176
decided upon their performance. On the other hand, the material quantity variance is the responsibility of
the manufacturing department. If there is unfavorable quantity variance meaning actual quantity exceeds
the standard quantity, the production manager will be held accountable for this. For this reason, to compute
quantity variance. the standard price is used to so that the production manager is not held responsible for
the purchasing manager’s performance.
Production managers are usually held accountable for labor variances also because they can influence the:
•
•
•
•
Mix of skill levels assigned to work tasks
Level of employee motivation
Quality of production supervision
Quality of training provided to employees etc.
Unfavorable variances force them to identify potential problem areas or consider if the variance was a
one-time occurrence. Requiring managers to explain favorable variances allows them to assess whether the
favorable variance is sustainable. Knowing what caused the favorable variance allows management to plan
for it in the future, depending on whether it was a one-time variance or it will be ongoing.
The proper use of variance analysis is a significant tool for an organization to reach its long-term goals. When
its accounting system recognizes a variance, an organization needs to understand the significant influence
of accounting not only in recording its financial results, but also in how reacting to that variance can shape
management’s behavior toward reaching its goals. Many managers use variance analysis only to determine
a short-term reaction, and do not analyze why the variance occurred from a long-term perspective. A more
long-term analysis of variances allows an approach that is responsibility accounting in which authority
and accountability for tasks is delegated downward to those managers with the most influence and control
over them. It is important for managers to analyze the reported variances with more than just a short-term
perspective.
Managers sometimes focus only on making numbers for the current period. For example, a manager
might decide to make a manufacturing division’s results look profitable in the short term at the expense
of reaching the organization’s long-term goals. A recognizable cost variance could be an increase in
repair costs as a percentage of sales on an increasing basis. This variance could indicate that equipment
is not operating efficiently and is increasing overall cost. However, the expense of implementing new,
more efficient equipment might be higher than repairing the current equipment. In the short term, it might
be more economical to repair the outdated equipment, but in the long term, purchasing more efficient
equipment would help the organization reach its goal of eco-friendly manufacturing. If the system use for
controlling costs is not aligned to reinforce management of the organization with a long-term perspective,
the manager has no organizational incentive to be concerned with important issues unrelated to anything
but the immediate costs related to the variance. A manager needs to be cognizant of his or her organization’s
goals when making decisions based on variance analysis.
RECONCILING STANDARD PROFIT AND ACTUAL PROFIT USING
ABSORPTION AND MARGINAL COSTING SYSTEMS:
Top management will be interested in the reason for the actual profit being different from the budgeted
profit. By adding the favorable production and sales variances to the budgeted profit and deducting the
adverse variances, the reconciliation of budgeted and actual profit shown in Exhibit 1 can be presented in
respect of Example 5.
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Example-5 assumes that Alpha Ltd produces a single product consisting of a single operation and that the
activities are performed by one responsibility center. In practice, most companies make many products,
which require operations to be carried out in different responsibility centers. A reconciliation statement such
as that presented in Exhibit 17.4 will therefore normally represent a summary of the variances for many
responsibility centers. The reconciliation statement thus represents a broad picture to top management that
explains the major reasons for any difference between the budgeted and actual profits.
Example -5
Alpha manufacturing company produces a single product, which is known as sigma. The product requires a
single operation and the standard cost for this operation is presented in the following standard
cost card: Standard cost card for product sigma
(Taka)
Direct materials:
2kg of A at Taka 10 per kg
20.00
1kg of B at Taka 15 per kg
15.00
Direct labor (three hours at Taka 9 per hour)
27.00
6.00
Variable overhead (three hours at Taka 2 per direct labor hour)
Total standard variable cost
68.00
20.00
Standard contribution margin
88.00
Standard selling price
Alpha Ltd plan to produce 10 000 units of sigma in the month of April and the budgeted costs based on the
information contained in the standard cost card are as follows:
Budget based on the above standard costs and an output of 10,000 units
(Taka)
(Taka)
(Taka)
Sales (10000 units of sigma at Taka 88 per unit)
880 000
Direct materials:
A: 20,000kg at Taka 10 per kg
200 000
150 000
350 000
B: 10,000kg at Taka 15 per kg
Direct labor (30,000 hours at Taka 9 per hour)
270 000
Variable overheads (30,000 hours at
60 000
680 000
Taka 2 per direct labor hour)
Budgeted contribution
200 000
120,000
Fixed overheads
80,000
Budgeted profit
Annual budgeted fixed overheads are Taka 1440000 and are assumed to be incurred evenly throughout the
year. The company uses a variable costing system for internal profit measurement purposes.
The actual results for April are:
(Taka)
Sales (9000 units at Taka 90)
Direct materials:
A: 19 000kg at Taka 11 per kg
178
209 000
(Taka)
810 000
B: 10 100kg at Taka 14 per kg
Direct labor (28 500 hours at Taka 9.60 per hour)
Variable overheads
Contribution
Fixed overheads
Profit
141 400
273 600
52 000
676 000
134 000
116 000
18 000
Manufacturing overheads are charged to production on the basis of direct labor hours. Actual production
and sales for the period were 9000 units.
EXHIBIT -1
Reconciliation of budgeted and actual profits for a standard variable costing system
(Taka )
Budgeted net profit Sales variances:
Sales margin price Sales margin volume
Direct cost variances: Material: Price
Usage Labor: Rate
Efficiency
Manufacturing overhead variances: Fixed overhead expenditure Variable overhead expenditure
Variable overhead efficiency
Actual profit
(Taka )
80 000
18,000Fav
20,000Unfav
8 900 Unfav
26 500 Unfav
17 100 Unfav
13 500 Unfav
4 000Fav
5 000Fav
3 000Unfav
2 000Uf
35 400Unfav
30 600Unfav
6 000Fav
62 000Unfav
18 000
ACCOUNTING DISPOSITION OF VARIANCES
There is no unanimity of opinion in respect to disposition of variances. The following are the various
methods:
(a) Write off all variances to profit and loss account or cost of sales every month.
(b) Distribute the variance pro-rata to cost of sales, work-in-progress and finished good stocks.
(c) Write off quantity variance to profit and loss account but the price variances may be spread over cost
of sales, work-in-progress and finished goods stocks. The reason behind apportioning price variances
to inventories and cost of sales is that they represent cost although they are described as variance.
INTERPRETATION AND INTER-RELATION BETWEEN VARIANCE
Variance analysis is a mend of assessing performance, but it is only a method of signaling to management
areas of possible weakness where control action might be necessary. It does not provide a ready-made
diagnosis of faults, nor does it provide management with a reedy made indication of what action needs to
be taken.
Interrelationships between variances
With regard to variance analysis for all production costs (direct material, direct labor, and overhead), it is
important to note that each variance does not represent a separate and distinct problem to be handled in
isolation. All variances in one way or another are interdependent. For example, the labor rate variance may
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be favorable because lower-paid workers are being used. This could lead to an (1) unfavorable material
usage variance because of a higher incidence of waste, (2) unfavorable labor efficiency variance because it
takes longer hours to make the equivalent number of products, (3) unfavorable overhead efficiency variance
because the substandard work causes more hours to be spent for a specified output, and (4) unfavorable
overhead volume variance arising from abnormally high machine breakdowns because of less skilled
operators.
For example,
Material price and usage—if cheaper materials are purchased in order to obtain a favorable price variance,
materials wastage might be higher, and an adverse usage variance will occur. If the cheaper material is more
difficult to handle, there might be an adverse labor efficiency variance too. If more expensive material is
purchased, however the price variance will be adverse, but the usage variance might favorable.
labor efficiency and variable overhead efficiency variance - If the direct labor is not efficient when
producing the good output, there will be an unfavorable labor efficiency variance. That inefficiency will
likely cause additional variable manufacturing overhead which will result in an unfavorable variable
manufacturing overhead efficiency variance. If the inefficiencies are significant, the company might not be
able to produce enough good output to absorb the planned fixed manufacturing overhead costs. This in turn
can also cause an unfavorable fixed manufacturing overhead volume variance.
The standard quantity per unit defines the amount of direct materials that should be used for each unit
of finished product.
The standard price per unit defines the price that should be paid for each unit of direct materials and it
should reflect the final, delivered cost of those materials.
Standard rate per hour tells how much per hour to be paid to direct labor to produce one unit of product
or to provide service. Managers often use a single rate
Direct labor Standard hour per unit tells how much hour to be required to produce one unit of product or
to provide service. Managers use time and motion study for each labor operation.
Manufacturing overhead standard rate per unit tells us how much manufacturing overhead cost to be
paid for one unit of product or service.
A variance in standard costing refers to the deviation of actual cost from standard cost.
Material cost variance is the difference between standard cost and actual cost
MCV = (SQ × SP) – (AQ × AP)
MPV = (SP - AP) x AQ
MUV / MQV = (SQ - AQ) x SP
Material Yield Variance = Standard cost per unit (Actual yield – Standard yield)
Labor Cost Variance = (Standard Hours x Standard Rate) - (Actual Hours x Actual Rate)
Labor Rate Variance = Actual Hours (Standard Rate - Actual Rate)
Labor Efficiency Variance = Standard Wage Rate (Standard Hours of Production – Actual Hours Worked)
Labor Idle Time Variance (LITV) = (Actual hours paid for x Standard rate) – (Actual hours worked x Standard rate)
Labor mix variance = (Actual hours at standard rate of actual gang – Actual hours at standard rate of
standard gang)
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Labor yield variance = Standard Labor cost unit (Actual output – Standard output)
Overhead cost variances can be classified as: Variable overhead variance and Fixed overhead variance
Variable Overhead Variance (VOV) is the difference between the standard variable overhead cost allowed
for the actual output achieved and the actual variable overheads.
Variable Overhead Variance = (Standard Variable Overhead Rate × Actual Output) - Actual Variable
Overheads
Or VOV= (Standard Rate × Actual output) – (Actual Rate × Actual output)
Variable overhead efficiency variance = (Actual Hours × Standard Variable Overhead Rate per Hour) –
Actual Variable Overhead
SELF-REVIEW QUESTIONS
1) What is a quantity standard? What is a price standard?
2) Why are separate price and quantity variances computed?
3) Who is generally responsible for the materials price variance? The materials quantity variance? The
labor efficiency variance?
4) If the materials price variance is favorable but the materials quantity variance is unfavorable, what
might this indicate?
5) What effect, if any, would you expect poor-quality materials to have on direct labor variances?
6) If variable manufacturing overhead is applied to production on the basis of direct labor hours and
the direct labor efficiency variance is unfavorable, will the variable overhead efficiency variance be
favorable or unfavorable, or could it be either? Explain.
Problem-1
Product B requires 4.5 kg of material per unit. The standard price of the material is Tk.6 per kg. The
budgeted production for last month was 750 units. Actual results were as follows.
Material used 2,250 kg
Production 780 units
Material cost Tk.14,175
Due to worldwide increases in the price of the material used it was realized, after the month had ended, that
a more realistic material standard price would have been Tk.6.50 per kg.
Required:
(i) Calculate planning and operational variances for material costs for the month.
(ii) State three possible causes of the operational usage variance you have calculated.
Problem -2
NGF Corporation produces a single product RMG. The company operates a standard absorption costing
system and a just-in-time purchasing system. Standard production cost details per unit of product RMG are:
Materials (5 kg at Tk.20 per kg) Tk.
100
Labour (4 hours at Tk.10 per hr) 40
Variable overheads (4 hours at Tk.5 per hr)
20
Fixed overheads (4 hours at Tk.12.50 per hr) 50 210
Fixed and variable overheads are absorbed on the basis of labor hours. Budget data for product RMG for
November are detailed below:
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Production and sales 1,400 units
Selling price Tk. 250 per unit
Fixed overheads Tk. 70,000
Actual data for product RMG for November are as follows:
Production and sales 1,600 units
Selling price Tk. 240 per unit
Direct materials 7,300 kg costing Tk.153,300
Direct labor 5,080 hours at Tk.9 per hour
Variable overheads Tk. 25,400
Fixed overheads Tk. 74,000
Required:
(a) Produce a statement that reconciles the budgeted and actual gross profit for product RG for November
showing the variances in as much detail as possible.
(b) The following details have been extracted from the company’s accounting records for December.
Output of RMG
Materials
Cost per kg
Budget
800 units
4,000kg
Tk.20.00
Actual
890 units
4,375kg
Tk.21.60
It has now been realized that the standard cost per kg of the material should have been Tk.20.90.
Calculate the following materials variances for December:
(i) The total materials cost variance.
(ii) The planning variance for materials price.
(iii) The operational variances for materials price and materials usage.
(a) Discuss three advantages of using a standard costing system that identifies both planning and operational variances.
Problem- 3
The following data are available in respect of a manufacturing company
Particulars
Budget
Actual
Production - units
400
360
Man-hours to produce above
8000
7000
Variable overheads
Tk.10,000
Tk.9,150
The standard time to produce one unit of the product is 20 hours. Calculate variable overhead variances.
Problem- 4
Huron Company produces a commercial cleaning compound known as Zoom. The direct materials and
direct labor standards for one unit of Zoom are given below:
Standard Quantity or Hours
Direct materials . . . . 4.6 pounds
Direct labor . . . . . . . . 0.2 hours
Standard Price or Rate
$2.50 per pound
$12.00 per hour
Standard Cost
$11.50
$2.40
During the most recent month, the following activity was recorded:
a. Twenty thousand pounds of material were purchased at a cost of $2.35 per pound.
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b. All of the material purchased was used to produce 4,000 units of Zoom.
c. 750 hours of direct labor time were recorded at a total labor cost of $10,425
Required:
1. Compute the materials price and quantity variances for the month.
2. Compute the labor rate and efficiency variances for the month.
Problem- 5
Refer to the data in Exercise 10–6. Assume that instead of producing 4,000 units during the month, the
company produced only 3,000 units, using 14,750 pounds of material. (The rest of the material purchased
remained in raw materials inventory.)
Required:
Compute the materials price and quantity variances for the month.
Problem- 6
Marvel Parts, Inc., manufactures auto accessories. One of the company’s products is a set of seat covers
that can be adjusted to fit nearly any small car. The company has a standard cost system in use for all of
its products. According to the standards that have been set for the seat covers, the factory should work
2,850 hours each month to produce 1,900 sets of covers. The standard costs associated with this level of
production are:
Total
Per Set of Covers
Direct materials
$42,560
$22.40
Direct labor
$17,100
9.00
3.60
Variable manufacturing overhead (based on direct labor-hours)
$6,840
$35.00
During August, the factory worked only 2,800 direct labor-hours and produced 2,000 sets of covers. The
following actual costs were recorded during the month:
Total
Per Set of Covers
Direct materials (12,000 yards)
$45,600
$22.80
Direct labor
$18,200
9.10
3.50
Variable manufacturing overhead
$7,000
$35.40
At standard, each set of covers should require 5.6 yards of material. All of the materials purchased during
the month were used in production.
Required:
Compute the following variances for August:
1. The materials price and quantity variances.
2. The labor rate and efficiency variances.
3. The variable overhead rate and efficiency variances.
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CHAPTER-C5
JOINT PRODUCT AND BY-PRODUCT COSTING
CHAPTER OVERVIEW
This chapter contemplate costing for the more multifaceted cases where
two or more products are simultaneously produced with each other,
rather than emphasise costing either for single-product companies or for
companies in which individual products are separately produced. Costs
experienced in this more complex cases are labelled as joint costs. The
cost of processing a production input (raw material) that would amount to
joint products is known as Joint Cost. Although joint costs sometimes pose
problems of allocation, it may be possible to trace resources consumption
to ultimate cost objects such as individual products or organisational
units. This can be valuable in making certain types of managerial decision
e.g. decide whether to sell or process further. This chapter observes
accounting treatment and methods for allocating joint costs to by-products
and services.
184
Chapter Learning Outcomes (CpLOs)
Account for joint and by-product applying different methods
Decide whether to sell or process further
This Study Note Covers (Subtopics)
Joint Products in Process Accounts
Accounting treatment of By- Products
Methods of Allocation of joint cost
Decision to sell by-product at the time of separation or by further process
Level of Study Required
AP, AN, E, D
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
JOINT PRODUCTS IN PROCESS ACCOUNTS
Joint products are two or more products separated in the course of processing, each having a sufficiently
high saleable value to merit recognition as a main product. Joint products include products produced as a
result of the oil-refining process, for example, petrol and paraffin.
This example illustrates how joint products are incorporated into process accounts.
Three joint products are manufactured in a common process, which consists of two consecutive stages.
Output from process 1 is transferred to process 2, and output from process 2 consists of the three joint
products, Pans, Mils and Bats. All joint products are sold as soon as they are produced. Data for period 2
of 2021 are as follows:
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Opening and closing inventory
Direct material
Conversion costs
Normal loss
Scrap value of normal loss
Output
Process 1
None
(30,000 units at TK 2 per unit)
TK 76,500
10% of input
TK 0.50 per unit
26,000 units
Process 2
None
TK 60,000
TK 226,200
10% of input
TK 2 per unit
10,000 units of Pan
7,000 units of Mils
6,000 units of Bats
Selling prices are TK18 per unit of Pan, TK 20 per unit of Mil and TK 30 per unit of Bats.
Requirements:
(a)
(b)
(c)
Prepare the Process 1 account.
Prepare the Process 2 account using the sales value method of apportionment.
Prepare a profit statement for the joint products.
Solution
(a) Process 1 equivalent units
Total units
26,000
3,000
1,000
30,000
Output to process 2
Normal loss
Abnormal loss (balance)
Equivalent units
26,000
0
1,000
27,000
Costs of process 1
Direct materials
Conversion costs
Less : Scrap Value of Normal Loss (3,000 TK 0.50)
TK
60,000
76,500
136,500
1,500
135,000
Cost per equivalent unit = TK 135,000 ÷ 27,000 = TK 5
Direct materials
Conversion costs
186
Process 1 account
60,000 Output to process 2 (26,000 TK 5)
76,500 Normal loss (scrap value)
Abnormal loss a/c (1,000 TK 5)
136,500
130,000
1,500
5,000
136,500
(b) Process 2 equivalent units
Total units
Units of Pans produced
Units of Mils produced
Units of Bats produced
Normal loss (10% of 26,000)
Abnormal loss (balance)
10,000
7,000
6,000
2,600
400
26,000
Equivalent units
10,000
7,000
6,000
0
400
23,400
Costs of process 2
TK
Material costs – from process 1
Conversion costs
130,000
226,200
356,200
5,200
351,000
Less scrap value of normal loss (2,600 $2)
Cost per equivalent unit 351,000 ÷ 23,400 = TK 15
Cost of good output (10,000 + 7,000 + 6,000) = 23,000 units TK 15 = TK 345,000
The sales value of joint products, and the apportionment of the output costs of TK 345,000, is as follows:
Pans (10,000 TK 18)
Mils (7,000 TK20)
Bats (6,000 TK 30)
Process 1 materials
Conversion costs
Sales
Costs
Profit
Profit/ sales ratio
Sales value TK
180,000
140,000
180,000
500,000
%
36
28
36
100
Costs (process 2) TK
124,200
96,600
124,200
345,000
Process 2 Account
TK
130,000 Finished goods accounts
226,200 – Pans
– Mils
– Bats
Normal loss (scrap value)
Abnormal loss a/c
356,200
(c) Profit statement
Pans
Mils
TK’000
TK’000
180.0
140.0
124.2
96.6
55.8
43.4
31%
31%
TK
124,200
96,600
124,200
5,200
6,000
356,200
Bats
TK ‘000
180.0
124.2
55.8
31%
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ACCOUNTING TREATMENT OF BY- PRODUCTS
Products that only have a minor sales value when compared with the joint products are called by-products.
The most common method of accounting for by-products is to deduct the net realizable value of the byproduct from the cost of the main products.
A by-product has some commercial value and any income generated from it may be treated as follows:
 Income (minus any post-separation further processing or selling costs) from the sale of the by- product
may be added to sales of the main product, thereby increasing sales turnover for the period.
 The sales of the by-product may be treated as a separate, incidental source of income against which are
set only post-separation costs (if any) of the by-product. The revenue would be recorded in the income
statement as ‘other income’.
 The sales income of the by-product may be deducted from the cost of production or cost of sales of the
main product.
 The net realizable value of the by-product may be deducted from the cost of production of the main
product.
Example
During November 2020, SA Co recorded the following results.
Opening inventory of main product S, full by-product P, full. Cost of production TK 120,000. Sales of the
main product amounted to 90% of output during the period, and 10% of production was held as closing
inventory at 30 November. Sales revenue from the main product during November 2019 was TK 150,000.
A by-product P is produced, and output had a net sales value of TK 1,000. Of this output, TK 700 was sold
during the month, and TK 300 was still in inventory at 30 November.
Requirements:
Calculate the profit for November using the four methods of accounting for by-products.
Solution
The four methods of accounting for by-products are shown below:
(a) Income from by-product added to sales of the main product
Sales of main product (TK 150,000 + TK 700)
Opening inventory
Cost of production
Less closing inventory (10%)
Cost of sales
Profit, main product
TK 150,700
0
120,000
12,000
108,000
42,700
The closing inventory of the by-product has no recorded value in the cost accounts.
(b) By-product income treated as a separate source of income
Sales of main product
Opening inventory
Cost of production
Less closing inventory (10%)
188
TK
0
120,000
12,000
TK 150,000
Cost of sales
Profit, main product
Other income
Total profit
108,000
42,000
700
42,700
The closing inventory of the by-product again has no value in the cost accounts.
c) Sales income of the by-product deducted from the cost of production in the period
Sales, main product
Opening inventory
Cost of production (120,000
TK
TK 150,000
0
700)
Less closing inventory (10%)
Cost of sales
119,300
119,300
11,930
107,370
42,630
d) Net realisable value of the by-product deducted from the cost of production in the period.
Sales, main product
TK
TK 150,000
Opening inventory
0
Cost of production (120,000
1,000)
Less closing inventory (10%)
Cost of sales
Profit, main product
119,000
119,000
11,900
107,100
42,900
METHODS OF ALLOCATION OF JOINT COST
The most frequently used methods that are used to allocate joint costs up to split-off point can be divided
into the following two categories:
 Methods based on physical measures.
 Methods based on allocating joint costs relative to the market values of the products.
Physical measures method
Using the physical measures method, it simply allocates the joint cost in proportion to volume. Each product
is assumed to receive similar benefits from the joint cost, and is therefore charged with its proportionate
share of the total cost. To understand this method, consider the following example:
In the month of July, the VPN Company processes a basic raw material through a manufacturing process
that yields three products – products X, Y and Z. There were no opening inventories and the products are
sold at the split-off point without further processing. We shall initially assume that all of the output is sold
during the period. Details of the production pro- cess and the sales revenues are given in the following table:
189
Joint costs
Split-off point
Product X – 40000 units
Product Y – 20000 units
Product Z – 60000 units
TK 600000
Sales value of TK 7.50 per unit
Sales value of TK 25 per unit
Sales value of TK 3.33 per unit
The cost allocations using this method are as follows:
Product
Units produced
X
Y
Z
40 000
20 000
60 000
Proportion to
total
1/3
1/6
1/2
Joint costs allocated (TK)
120 000
200 000
100 000
300 000
Cost per unit
(TK)
5
5
5
600 000
Sales value at split-off point method
When the sales value at split-off point method is used, joint costs are allocated to joint products in proportion
to the estimated sales value of production. A product with higher sales value will be allocated a higher
proportion of the joint costs.
Using the information in above example, the allocations under the sales value method would be as follows:
Product
Units produced
Sales value (TK)
Proportion of sales
value to total (%)
Joint costs
allocated (TK)
X
40 000
300 000
30
180 000
Y
Z
20 000
60 000
500 000
200 000
1 000 000
50
20
300 000
120 000
600 000
The revised product profit calculations would be as follows:
Product
X
Sales revenue
300 000
Total cost (TK)
180 000
Profit (loss) (TK)
120 000
Profit/sales(%)
40
Y
Z
500 000
200 000
1 000 000
300 000
120 000
600 000
200 000
80 000
400 000
40
40
Net realizable value method
To estimate the sales value at the split-off point, it is therefore necessary to use the estimated sales value
at the point of sale and work backwards. This method is called the net realizable value method. The net
realizable value at split-off point can be estimated by deducting the further processing costs from the sales
revenues.
190
Assume the similar circumstances that was applied in physical measures method except that further
processing cost now apply. The production process details and revenues are given in the following table:
Joint costs
Split-off point
Product X – Further processing cost TK 80,000
Product Y – Further processing cost TK 1,00,000
Product Z – Further processing cost TK 20,000
TK 600000
Sales value of TK 3,00,000
Sales value of TK 5,00,000
Sales value of TK 2,00,000
The calculation of the net realizable value and the allocation of joint costs using this method is as follows:
Product
Sales value
Costs
Net realizable Proportion Joint costs
Profit
Gross
beyond
value at
to total
allocated
profit
split-off
split-off point
point
(TK)
(TK)
(TK)
(%)
(TK)
(TK)
(%)
X
300 000
80 000
220 000
27.5
165 000
55 000
18.33
Y
500 000
100 000
400 000
50.0
300 000
100 000
20.00
200 000
20 000
180 000
22.5
135 000
45 000
22.50
Z
1 000 000
200 000
800 000
600 000
200000
20.00
Note* Joint costs are now allocated in proportion to each product’s net realizable value at split-off point.
Constant gross profit percentage method
When joint products are subject to further processing after split-off point and the net realizable method is
used, the gross profit percentages are different for each product.
From the information contained in example of net realizable value method, the joint costs would be allocated
in such a way that the resulting gross profit percentage for each of the three products is equal to the overall
gross profit percentage of 20 per cent. Note that the gross profit percentage is calculated by deducting the
total costs of the three products (TK 800 000) from the total sales (TK 1 000 000) and expressing the profit
(TK 200 000) as a percentage of sales (i.e. 20 per cent). The calculations are as follows:
Product X
(TK)
300 000
Product Y
(TK)
500 000
Product Z
(TK)
200 000
Total
(TK)
1 000 000
Gross profit (20 per cent)
Cost of goods sold
Less separable further
60 000
240 000
100 000
400 000
40 000
160 000
200 000
800 000
processing costs
Allocated joint costs
80 000
160 000
100 000
300 000
20 000
140 000
200 000
600 000
Sales value
191
DECISION TO SELL BY-PRODUCT AT THE TIME OF SEPARATION OR
BY FURTHER PROCESS
Many manufacturing companies constantly face the decision of whether to process further a joint product.
Meat products may be sold as cut or may be smoked, cured, frozen, canned and so forth. Petroleum refiners
are perpetually trying to adjust to the most profitable product mix. The refining process necessitates
separating all products from crude oil, even though only two or three may have high revenue potential.
In designing reports for managers’ decisions of this nature, the accountant must concentrate on incremental
costs rather than on how historical joint costs are to be allocated among various products. The only relevant
items are incremental revenue and incremental costs. This next example illustrates the importance of the
incremental cost viewpoint.
Example
AJ oils jointly processes a speciality chemical that yields two oils: 50 ml of C and 150 ml of N. The sales
values per millilitre at split-off are TK 6 for C and TK 4 for N. The joint costs incurred up to the split-off
point are TK 880. The manager has the option of further processing 150 ml of N to yield 100 ml of P. The
total additional costs of converting N into P would be TK 160 and the selling price per millilitre of P would
be TK 8.
The correct approach in deciding whether to further process N into P is to compare the incremental revenue
with the incremental costs, if all other factors such as invested capital and the time period are held constant:
Incremental revenue of P (100 × TK 8) – (150 × TK 4)
TK 200
Incremental costs of P, further processing
TK 160
Incremental operating profit from converting N into P
TK 40
The following is a total income computation of each alternative. The revenues reported for each product are C (50 ml
at TK 6 per ml = TK 300), N (150 ml at TK 4 per ml = TK 600) and P (100 ml at TK 8 per ml = TK 800).
Alternative 1: Sell C and N Alternative 2: Sell C and P Difference
Total revenues
Total processing costs
Operating profit
(300 + 600) TK 900
TK 880
TK 20
(300 + 800) TK 1100
(880 + 160) TK 1040
TK 60
TK 200
160
TK 40
It is profitable to extend processing and to incur additional costs on a joint product as long as the incremental
revenue exceeds incremental costs. Conventional methods of joint-cost allocation may mislead managers
who rely on unit-cost data to guide their sell-or-further-process decisions. For example, the physical measure
method (millilitres in our example) would allocate the TK 880 joint costs as follows:
Product
C
N
Total
Millilitres
50
150
200
Weight
50 ÷ 200 = 0.25
150 ÷ 200 = 0.75
Allocation of joint costs
0.25 × TK 880 = TK 220
0.75 × TK 880 = 660
TK 880
The resulting product-line income statement for the alternative of selling C and P would erroneously imply
that the company would suffer a loss by selling P:
192
Revenues
Joint costs allocated
Separable costs
Cost of goods sold
Operating profit
C
TK 300
220
–
220
TK 80
P
TK 800
660
160
820
TK (20)
Joint products Products that have a high relative sales value and are crucial to the commercial viability
of the organization.
The purposes for allocating joint costs to products include stock costing for external financial reporting,
internal financial reporting, cost reimbursement under contracts, customer profitability analysis, insurance
settlements and rate regulation.
By-products Products that are incidental to the production of joint products and have a low relative sales
value.
The incremental-cost analysis It emphasised elsewhere in this book applies equally to joint-cost situations.
No techniques for allocating joint-product costs should guide decisions about whether a product should be
sold at the split-off point or processed beyond split-off because joint costs are irrelevant.
Net realizable value method A method of allocating joint costs on the basis of net realizable value at the
split-off point, which is calculated by deducting further processing costs from sales revenues.
Physical measures method A method of allocating joint costs in proportion to volume.
Sales value at split-off point method A method of allocating joint costs in proportion to the estimated
sales value of production.
Split-off point The point in a production process at which a joint product or by-product separates from
the other products.
SELF-REVIEW QUESTIONS
1.
2.
3.
4.
5.
6.
7.
What is the difference between a joint product and a by-product?
Explain why it is necessary to allocate joint costs to products.
What is meant by the term ‘split-off’ point?
Explain the factors that should influence the choice of method when allocating joint costs to products.
Name two methods of apportioning common costs to joint products.
Describe the methods of accounting for by-products.
Lucy Ltd operates several manufacturing processes in which stocks of work in progress are never held.
In process K, joint products (P1 and P2) are created in the ratio 2:1 by volume from the raw materials
input. In this process, a normal loss of 4 per cent of the raw materials input is expected. Losses have
a realizable value of TK 5 per litre. The joint costs of the process are apportioned to the joint products
using the sales value basis. At the end of process K, P1 and P2 can be sold for TK 25 and TK 40 per
litre respectively.
The following information relates to process K for last month:
Raw material input
90 000 litres at a total cost of
Actual loss incurred
4800 litres Conversion costs incurred
TK 450, 000.
TK 2,16, 000
193
Requirement:
Prepare the process K account for last month in which both the output volumes and values for each joint
product are shown separately.
The company could further process product P1 in process L to create product XP1 at an incremental cost
of TK 3 per litre input. Process L is an existing process with spare capacity. In process L, a normal loss of
8 per cent of input is incurred which has no value. Product XP1 could be sold for TK 30 per litre. Based
on financial considerations only, determine, with supporting calculations, whether product P1 should be
further processed in process L to create product XP1.
8. XYZ, a paint manufacturer, operates a process costing system. The following details related to process
2 for the month of October:
TK
Opening work in progress
5,000 litres fully complete as to transfers from process 1 and 40% complete
as to labour and overhead,
60, 000
Transfer from process 1
65, 000 litres valued at cost
5,78, 500
Direct labour
1,01, 400
Variable overhead
80, 000
Fixed overhead
40, 000
Normal loss 5% of volume transferred from process 1 Scrap value
2.00 per litre
Actual output 30, 000 litres of paint X (a joint product) 25, 000 litres of paint Y (a joint product) 7, 000
litres of by-product Z
The final selling price of products X, Y and Z are:
There are no further processing costs associated with either paint X or the by-product, but paint Y requires
further processing at a cost of TK 1.50 per litre.
All three products incur packaging costs of TK 0.50 per litre before they can be sold.
Requirements:
(a) Prepare the process 2 account for the month of October, apportioning the common costs between the
joint products, based on their values at the point of separation.
(b) Prepare the abnormal loss/gain account, showing clearly the amount to be transferred to the profit and
loss account.
9. A company simultaneously produces three products (X, Y and Z) from a single process. X and Y are
processed further before they can be sold; Z is a by-product that is sold immediately for TK 6 per unit
without incurring any further costs. The sales prices of X and Y after further processing are TK 50 per
unit and TK 60 per unit respectively. Data for October are as follows:
TK
Joint production costs that produced 2,500 units of X, 3,500 units of Y and 3,000 units of Z 1,40, 000
Further processing costs for 2,500 units of X
24, 000
Further processing costs for 3,500 units of Y
46, 000
Joint costs are apportioned using the final sales value method.
Requirement:
Calculate the total cost of the production of X for October.
194
CHAPTER-C6
ACTIVITY-BASED-COSTING
CHAPTER OVERVIEW
In this chapter, the measurement of indirect relevant costs for decisionmaking using activity-based costing (ABC) techniques will be examined.
The aim of this chapter is to provide with a conceptual understanding
of ABC. ABC is that costing in which costs are first traced to activities
and then to products. This costing system assumes that activities are
responsible for the incurrence of costs and create the demands for
activities. Today, companies produce a wide range of products; direct labor
often represents only a small fraction of total costs, and overhead costs
are of considerable importance. Simplistic overhead allocations cannot
be justified, particularly when information processing costs are no longer
a barrier to introducing more sophisticated cost systems. Furthermore,
today’s intense global competition has made decision errors due to poor
cost information more probable and more costly.
195
Chapter Learning Outcomes (CpLOs)
Understands basic elements of ABC
Outline the steps in designing an ABC system
This Study Note Covers (Subtopics)
Outline of an ABC system
Cost Pools and Cost Drivers
Designing an ABC system
Absorption costing versus ABC
Marginal costing versus ABC
Benefits of ABC System
Application of ABC/ABM
Use of ABC/ABM in improving activities
ABC in service organizations
Level of Study Required
R, U
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
OUTLINE OF AN ABC SYSTEM
Activity based costing (ABC) involves the identification of the factors which cause the costs of an
organization’s major activities. Support overheads are charged to products on the basis of their usage of the
factor causing the overheads. The major ideas behind activity based costing are as follows:
 Activities cause costs, Activities include ordering, Material handling, Machining, Assembly,
Production scheduling and Dispatching.
 Producing products creates demand for the activities.
 Costs are assigned to a product on the basis of the product’s consumption of activity.
An ABC system operates as follows:
Stage 1 Identify an organization’s major activities.
Stage 2 Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers.
Stage 3 Collect the costs associated with each cost driver into what are known
as cost pools.
Stage 4 Determine “ABC rate = Cost pool / Cost Driver”.
Stage 5 Charge costs to products on the basis of their usage of the activity.
196
COST POOLS AND COST DRIVERS
CIMA defined cost pool as, ‘the point of focus for the costs relating to a particular activity in an activity
based costing system.’ For example, in case of a manufacturing organisation, as regards to stores, cost of
classification, cost of issue of stores requisitions, inspection costs etc. can be pooled under the heading
‘stores’. Thus cost pool concept is similar to the concept of cost centre. The cost pool is the point of focus
or in other words, it is the total cost assigned to an activity. It is the sum of all the cost elements assigned
to an activity.
Cost pool
Hierarchy
Human Resources
Facility-level
Parts management
Product-level
Purchasing
Batch-level
Quality Control
Unit-level
Equipment set-up
Unit-level
Training employees
Facility-level
Assembly department
Unit-level
Receiving department
Batch-level
CIMA stated, ‘cost driver is any factor which causes a change in the cost of an activity, e.g. the quality
of parts received by an activity is a determining factor in the work required by that activity and therefore
affects the resources required. An activity may have multiple cost drivers associated with it.’ In other words,
cost driver means the factors which determine the cost of an activity. For example, in stores, no. of stores
197
requisitions will be cost drivers, in customer order processing the no. of customers as well as no. of orders
will be cost drivers. Thus a cost driver is an activity which generates cost. Activity Based Costing is based
on the belief that activities cause costs and therefore a link should be established between activities and
product. The cost drivers thus are the link between the activities and the cost.
Function
Research and Development
Customer Service






Cost Drivers
Number of research projects
Personnel hours on a project
Technical complexities of projects
Number of service calls
Numbr of products serviced
Hours spent on servicing products
DESIGNING AN ABC SYSTEM
ABC (activity-based costing) has been developed to provide more accurate ways of assigning the costs
of indirect and support resources to activities, business processes, products, services and customers.
ABC is used for improving value-added activities and for decreasing non-value-added activities in a selfperpetuating system of improvement. ABC is useful for the organizations where the indirect cost proportion
is more than the direct costs. The various steps involved in designing ABC system are as follows:
Phase 1: Classify resources
Resources represent the expenditure of an organization. These are the same costs that are represented in a
traditional accounting. ABC links these cost to products, customers or services.
Phase 2: Recognize activities
Activities are the aggregation of many different tasks, events or units of work that cause the consumption of
resources. For example, purchasing materials might be identified as a separate activity. This activity consists
of the aggregation of many different tasks, such as receiving a purchase request, identifying suppliers,
preparing purchase orders, mailing purchase orders and performing follow-ups.
Phase 3: Ascertain cost objects
ABC provides profitability by one or more cost object. Cost object profitability is utilized to identify
money- losing customers to validate separate divisions or business units. Defining outputs to be reviewed
is an important step in a successful ABC implement action.
Phase 4: Define resource drivers
Resource drivers provide the link between the expenditure of an Organization and activities performed
within the Organization.
Phase 5: Determine cost drivers
In order to assign the costs attached to each activity cost centre to products, a cost driver must be selected
for each activity centre. Cost drivers used at this stage are called activity cost drivers. Several factors must
be borne in mind when selecting a suitable cost driver. First, it should provide a good explanation of costs
in each activity cost pool. Second, a cost driver should be easily measurable, the data should be relatively
easy to obtain and be identifiable with products. The costs of measurement should therefore be taken into
account.
Activity Cost Driver Rate = Total Cost of Activity (Cost pool) ÷ Activity Cost Driver
198
Phase 6: Allocate cost to the cost objects
In order to assign the costs attached to each activity cost center to products, a cost driver must be selected
for each activity center. Cost drivers used at this stage are called activity cost drivers. Several factors must
be borne in mind when selecting a suitable cost driver. First, it should provide a good explanation of costs
in each activity cost pool. Second, a cost driver should be easily measurable, the data should be relatively
easy to obtain and be identifiable with products. The costs of measurement should therefore be taken into
account. We can use following formula for assigning costs to the cost objects.
Costs = Resources Consumed × Activity Cost Driver Rate.
ABSORPTION COSTING VERSUS ABC
Cost accounting can use a number of methods to allocate costs to products where each consist of their
own merits and demerits. Costing is a vital contributor in deciding the selling prices; thus costs should be
determined accurately. Absorption costing and activity based costing are two widely used costing systems.
The key difference between absorption costing and activity based costing is that while absorption costing is
a way of allocating all costs to individual production units, activity based costing is a way of using multiple
cost drivers to allocate costs.
The main difference between absorption costing and activity based costing lies with the manner indirect
costs (overheads) are allocated. The allocation of direct cost remains the same across the two methods.
Activity based costing is preferred by many managers due the nature and relevance of information provided;
however, it is time-consuming and costly to use this method.
Particulars
Cost Base
Absorption Costing
Absorption costing uses a single
base to allocate all the costs.
Time Period
Absorption costing is less time consuming
and less accurate method of cost allocation
Usage
and Absorption costing is a traditional costing
Popularity
system and most managers agree that it is a
less successful cost allocation method.
Activity Based Costing
Activity based costing uses multiple cost
bases for cost allocation.
Activity based costing is time-consuming but has an increased accuracy.
Activity based costing is a modern method of cost accounting and is gaining fast
popularity.
MARGINAL COSTING VERSUS ABC
Conventional costing distinguishes between variable and fixed costs. Variable costs per unit can at least
be measured, and the sum of the variable costs per unit is the marginal cost per unit. The marginal cost is
the additional costs caused when one more unit is produced.
Particulars
Basic Idea
Marginal Costing
Activity Based Costing
Marginal costing only includes variable Activity based costing uses multiple cost
production overheads in cost of products.
bases for cost allocation.
Adjustment of Marginal costing considers only variable Assigns the cost of each activity to all
overheads
costs and then add them to reach the cost of a products and services according to the
product. Due to this under marginal costing no actual consumption by each.
under or over absorption of overheads occurs
because only marginal or additional cost of
making a product is added to the volume of
production and other costs (fixed costs) are
subtracted in full.
199
Inventory
valuation
Reported
Profits
Application
Marginal costing does not take fixed costs into Under ABC the inventory reporting can
account while calculating the cost of products be divided in two parts, first reporting
of direct expenses/cost, and second
reporting of indirect expenses/overheads.
The value of closing stock is lower in The ABC method record profit by
marginal costing and as this closing stock identifying accurate overhead costs and
is lessened from the cost of goods sold the cost drivers leading to more streamlined
reported profits under marginal costing are business processes.
lower.
Marginal costing is easy to apply because it ABC is generally used as a tool for
only adds marginal costs to the cost of product understanding product and customer
which is easy to trace.
cost.
BENEFITS OF ABC SYSTEM
The following are the main advantages of Activity Based Costing.
 Activity Based Costing helps to reduce costs by providing meaningful information on the opportunities
available for reducing costs.
 Activity Based Costing is working only on the activities. Hence, the management can take the quality
decision by knowing the nature of each activity.
 The activities can be classified into two i.e. value adding activities and non-value adding activities. The
Activity Based Costing helps the management on focusing the forces on value adding activities and
eliminate non-value adding activities.
 Some costs are termed as non-manufacturing costs, for example, advertisement. Even though,
advertisement is a non-manufacturing cost which constitutes a major portion of the total cost of any
product. These non-manufacturing costs can be easily allocated since the relationship between costs
and its causes can be properly understood by using Activity Based Costing.
 The accurate allocation of costs to various products leads to proper pricing policy.
 The statement of expenditure is prepared on activity-wise and compare the costs of each activity with
one another to find the activities which are to be eliminated or improved for better performance.
 The accurate cost information helps the management to adopt productivity improvement approaches
like Total Quality Management, Business Process Re-engineering etc.
 The management can take make or buy decisions by considering the cost of manufacture of a product
or sub contract the same with an outside agency through Activity Based Costing analysis.
 If the available resources cannot be used properly even after sub-contracting the manufacture of any
product, the management can do the activity of manufacture of such a product within the firm.
APPLICATION OF ABC/ABM
ABM (activity-based management) is used to help management find out which areas of the business are
losing money so that they can be improved or cut altogether. ABM often makes use of information gathered
with activity-based costing (ABC), a means of identifying and reducing cost drivers by better use of
resources.
Example 1
The Bangladeshi Company produces only two products: a major Computer Accessories and Mobile Phone.
The company uses a normal cost system and overhead costs are currently allocated using a plant-wide
overhead rate based on direct labor hours. Outside cost consultants have recommended that the company
use activity-based costing to charge overhead to products.
200
The company expects to produce 4,000 computer parts and 2,000 cell phones in 2021. Each computer
accessories requires two direct labor hours to produce and each mobile phone requires one-half hour to
produce. The direct material and direct labor costs included in the two products are as follows:
Item
Direct Material (per unit) in TK
Direct labor cost per unit in TK
Computer Accessories
30
16
Budgeted (Estimated) Total Factory Overhead Data for 2021:
Activity
Budgeted Overhead in TK
Production Setups
80,000
Material Handling
70,000
Packaging and Shipping
120,000
Total Factory Overhead
Mobile Phone
17
4
Estimated Volume Level
20 setups
5,000 lbs.
6,000 boxes
270,000
Based on an analysis of the three overhead activities, it was estimated that the two products would require
these activities as follows in 2021.
Activity
Computer Accessories
Mobile Phone
Total
Production Setups
Material handling (lbs)
Packaging and Shipping (boxes)
5
1000
4000
15
4000
2000
20
5000
6000
Requirements:
1. Calculate the cost of each product using a plant-wide rate based on direct labor hours.
2. Calculate the activity cost rates for (a) setups, (b) material handling and (c) packaging and shipping.
3. Cost out the two products using an activity-based costing system.
Solution
Calculation of Labour Cost Per Direct labour Hours (D.L.H)
Item
Computer Accessories
Direct labour cost per unit in TK
16
Number of Direct Labour Hour per unit
2
Direct Labour Cost per hour
8
Mobile Phone
4
0.5
8
Req: 1. The Cost of Each Product Using a Plant-Wide Rate Based on Direct Labour Hours:
Calculation of plant-wide overhead rate:
Total budgeted DLH = 4,000 computer accessories x 2 DLH per part + 2,000 mobile phones x 0.5 DLH per
phone = 9,000 DLH
Overhead Rate=Total Budgeted Overhead TK/Total Budgeted Direct Labor Hours
=
TK 270,000/ 9,000 DLH
=
TK 30 per DLH
201
Calculation of each product’s cost using a plant-wide rate:
Item
Computer Accessories
Mobile Phone
Direct Material (per unit) in TK
30
17
Direct labour cost per unit in TK
16
4
Manufacturing overhead @TK 30 per labour hour
60
15
Total
106
36
Req: 2. The Activity Cost Rates for (1) Setups, (2) Material Handling and (3) Packaging and Shipping:
Activity
Budgeted
Estimated Volume Activity cost rates
Overhead in TK
Levels
Production Setups
80,000
20
4000 per setup
Material handling (lbs)
70,000
5000
14 per lbs
Packaging and Shipping (boxes)
1,20,000
6000
20 per box
Req: 3. Cost of the Two Products Using an Activity-Based Costing System:
Item
Computer Accessories
No of item
Mobile Phone
4,000
2,000
Direct Material cost in TK
1,20,000
34,000
Direct labour cost in TK
64,000
8,000
Production set up cost in TK
20,000
60,000
Material handling cost in TK
14,000
56,000
Packaging and Shipping TK
80,000
40,000
Total manufacturing cost for all units in TK
298,000
198,000
4,000 parts
2,000 phones
74.50
99
Total Units Produced
Total Cost Per Unit in TK
Example 2
Trial Limited makes three main products, using broadly the same production methods and equipment for
each. A conventional product costing system is used at present, although an Activity Based Costing (ABC)
system is being considered. Details of the three products, for typical period are:
Product X
Product Y
Product Z
Labour Hours per
unit
½
1½
1
Machine Hours
per unit
1½
1
3
Material Per unit
Volumes Units
TK 20
TK 12
TK 25
750
1,250
7,000
Direct labour costs TK 6 per hour and production overheads are absorbed on a machine hour basis. The rate
for the period is TK 28 per machine hour.
You are required to:
(a) calculate the cost per unit for each product using conventional methods.
202
Further analysis shows that the total of production overheads can be divided as follows:
Costs relating to set-ups
%
35
Costs relating to machinery
20
Costs relating to materials handling
15
Costs relating to inspection
30
Total production overhead
100%
The following activity volumes are associated with the product line for the period as a whole.
Total activities for the period
Number of Set-ups
Number of movements
of materials
75
12
115
21
480
87
670
120
Product X
Product Y
Product Z
Number of Inspections
150
180
670
1,000
b) Calculate the cost per unit for each product using ABC principles.
Solution:
(a) Computation of cost per unit using Conventional Methods:
Total overheads
= 750 x 1.5 x 28
= 1250 x 1 x 28
= 7000 x 3 x 28
X
Y
Z
TK
31,500
35,000
5,88,000
6,54,500
=
=
=
Computation of Cost
Particulars
Materials
Labour
Overheads
Factory Cost
X
TK
Y
TK
Z
TK
20
3
42
65
12
9
28
49
25
6
84
115
b) Under ABC Costing
Setup
Cost
Machine
Cost
Machine
Handling Cost
Inspection Expenses
Total
Costs (TK)
2,29,075
1,30,900
98,175
1,96,350
6,54,500
Cost Driver
No. of setups
Machine hours
No. of movement
of materials
No. of Inspections
Cost driver
rates (TK)
341.90
5.6
(229075/670) 130900/23375)
818.125
(98,175/120)
196.35 (196350/1000)
203
Particulars
Materials
Labour
Overheads
Setup Cost
Machine cost
Machine Handling Cost
Inspection Cost
Total Cost
Cost per unit under ABC costing
X
TK
TK
TK
20.00
3.00
34.19
8.40
13.09
39.27
94.95
117.95
31.45
5.60
13.74
28.27
Y
Z
TK
12.00
9.00
79.06
100.06
TK
23.44
16.80
10.17
18.79
TK
25.00
6.00
69.20
100.20
USE OF ABC/ABM IN IMPROVING ACTIVITIES
The areas in which activity based information is used for decision making are as follows:
Customer profitability: ABC system can categories additional overhead costs e.g unusually high
customer service levels, product return handling, and cooperative marketing agreements that determine
which customers are actually providing a reasonable profit. This analysis may result in some unprofitable
customers being turned away, or more emphasis being placed on those customers who are contributing
more in profits.
Activity costs: ABC is designed to track the cost of activities, so we can use it to see if activity costs are
in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of
specific services as management focuses on cost reduction.
Make or buy: ABC enables the manager to decide whether he should get the activity done within the firm
or outsource the same. Outsourcing may be done if the firm is incurring higher overhead costs as compared
to the outsourcer or vice-versa.
Distribution cost: Organization uses a variety of distribution channels to sell its products, such as retail,
Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution
channel is overhead, so if we can make a reasonable determination of which distribution channels are using
overhead, we can make decisions to alter how distribution channels are used, or even to drop unprofitable
channels.
Minimum price: Product pricing is really based on the price that the market will bear, but the marketing
manager should know what the cost of the product is, in order to avoid selling a product that will lose a
company money on every sale. ABC is very good for determining which overhead costs should be included
in this minimum cost, depending upon the circumstances under which products are being sold.
Margins: With proper overhead allocation from an ABC system, we can determine the margins of various
products, product lines, and entire subsidiaries. This can be quite useful for determining where to position
company resources to earn the largest margins.
Production facility cost: It is usually quite easy to segregate overhead costs at the plant-wide level, so we
can compare the costs of production between different facilities.
204
VARIANCE ANALYSIS IN ABC SYSTEM
Regardless of whether a company uses the traditional costing approach or an activity-based costing approach,
the process of performing variance analysis is the same. Similar to the traditional costing approach, the
variable overhead spending variance for activity-based costing is calculated for each activity as follows:
Variable overhead spending variance = Actual cost − (AQ × SR).
The variable overhead efficiency variance is calculated for each activity using activity-based costing as
follows: Variable overhead efficiency variance = (AQ × SR) − (SQ × SR).
Instead of using AH and SH to represent actual hours and standard hours it uses AQ and SQ to represent
actual quantity and standard quantity for various activities used in activity-based costing. The following
steps are to be followed:
The first step in activity-based variance analysis is to assign all overhead costs to a level of activity. Next,
activity standards (standard rates) must be calculated. To reach this standard rate, the annual overhead cost
is divided by the cost centre’s practical capacity. Practical capacity is used so that idle capacity may be
found and put to better use. The standard rates calculated for batch and product level activities do not vary
with production volume. This is a fundamental difference between ABC and traditional variance analysis.
Variance analysis can be examined for the unit-level, batch-level, and product-level activities. Since facility
level costs can only be assigned arbitrarily, variances cannot be calculated for this level of activity.
Exhibits 3, 4, and 5 show that under activity-based variance analysis, variances can be calculated for Model
A and B boards separately. This makes it possible to discover if one product is subsidizing another. For
example, in Exhibit 4 Panel B, production schedulers may be providing too much set up activity to the
Model A line and not enough to the Model B line.
Unit-Level Overhead Cost Variances
By looking at the unfavourable unit-level cost variances in Exhibit 3, we can tell that there is no idle
capacity. Unit-level costs are driven by production volume. Therefore, the more boards produced, the more
machine hours needed. The 59,000 actual hours exceeds the standard 57,600 hours. This may tell managers
to expect a greater number of machine hours in the future.
Unit Level Costs - (Exhibit 3)
Machinery Overhead
Standard Quantity
Actual Quantity
Standard
Model
(Machine Hours)
(Machine Hours)
Rate*
A
38,400
39,000
TK 3.20
B
19,200
20,000
TK 3.20
Total
57,600
59,000
*Annual cost/Practical Capacity = TK 184,320 ÷ 57,600 = TK 3.20 per hour
Variance
TK 1,920U
TK 2,560U
TK 4,480U
Batch-Level Overhead Cost Variances
In Exhibit 4, all Model A variances are unfavourable while all Model B variances are favourable. With
this pattern, management may be able to explain the reasons for the variances. In addition to the realized
costs (as shown by the variances), the company may be incurring an opportunity cost with the insufficient
capacity for Model B boards.
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Batch-Level Costs - (Exhibit 4 Panel A)
Receiving and Inspection
Standard Quantity
Actual Quantity
Standard
Model
Variance
(Shipments)
(Shipments)
Rate*
A
2,100
2,350
TK 50
TK 12,500U
B
2,900
2,600
TK 50
TK 15,000F
Total
5,000
4,950
TK 2,500F
*Annual cost/Practical Capacity = TK 250,000 ÷ 5,000 shipments = TK 50 per shipment
Batch-Level Costs - (Exhibit 4 Panel B)
Setup
Standard Quantity
Actual Quantity
Standard
Model
Variance
(Setup Hours)
(Setup Hours)
Rate*
A
292
350
195
TK 11,310U
B
540
480
195
TK 11,700F
Total
832
830
TK 390F
*Annual cost/Practical Capacity = TK 162,240 ÷ 832 setup hours = TK 195 per setup hour
Model
A
Batch-Level Costs - (Exhibit 4 Panel C)
Material Handling
Standard Quantity
Actual Quantity
Standard Rate*
(Material Moves)
(Material Moves)
672
750
TK 65
Variance
TK 5,070
B
1,200
980
TK 65
TK 14,300
Total
1,872
1,730
TK 9,230
*Annual cost/Practical Capacity = TK 121,680 ÷ 1,872 material moves = TK 65 per move
Product-Level Overhead Cost Variances
Product-Level issues can be revealed by the variances in Exhibit 5. In Panel A, Model B requires more
change orders (165) than the standard quantity (150). These extra change orders could be necessary to keep
customers. The product’s life cycle may be getting shorter. Model A used only 60 percent of the standard
change orders, but there is still an overall favourable variance of TK 80,000. This overall favourable
variance tells us that although Model B is receiving more change orders, Model A is not suffering fewer
change orders.
The variances related to quality assurance (Panel B) may be caused by changing customer characteristics.
For example, customers of Model B may not inspect the boards before purchase, because they expect the
quality level to be high, while customers of Model A inspect the product before purchase. If this is the case,
Omega would not need to guarantee a high level of quality.
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Product-Level Costs - (Exhibit 5 Panel A) Engineering
A
B
Standard Quantity
(Change Orders)
100
150
60
165
Total
250
225
Model
Actual Quantity
(Change Orders)
Standard
Rate*
TK 3,200
TK 3,200
Variance
TK 128,000F
TK 48,000U
TK 80,000F
*Annual cost/Practical Capacity = TK 800,000 ÷ 250 change orders = TK 3,200 per change order.
Product-Level Costs – (Exhibit 5 Panel B) Quality Assurance
Model
Standard Quantity
(Test Hours)
Actual Quantity
(Test Hours)
A
B
55,200
120,000
40,000
132,000
Total
175,200
172,000
Standard
Rate*
TK 3
TK 3
Variance
TK 45,600F
TK 36,000U
TK 9,600F
*Annual cost/Practical Capacity = TK 525,600 ÷ 175,200 test hours = TK 3 per test hour.
Although managers are not provided with answers, activity-based variances do suggest questions that
managers will need to look into. Manager’s attention can be directed toward specific areas or product lines
that need attention to improve profitability. For instance, activities with idle capacity can be identified and
corrected. Troublesome products or customers can be identified. The variance analysis in Exhibit 5 suggests
that customers who demand excessive engineering or product changes, may be too costly to maintain. Ways
of addressing variances are suggested by the analysis. In other words, if there is a variance in a productlevel activity, then a product-level activity should be investigated, not a unit or batch-level activity.
ABC IN SERVICE ORGANIZATIONS
While ABC (activity-based costing) originated in manufacturing companies, many service organizations
today are obtaining great benefits from this approach as well. Applying ABC to service organizations
requires a keen appreciation of costing for committed resources. This means that costing in the service
sector needs to be forward-looking, and ABC is a tool for such analysis. There are several service industries
where ABC has started to emerge, and will continue to prove useful.
Financial Services
As the regulation ended in the banking industry, costing became more important as banks competed with
one another. Banking costs are not driven by the volume of customers, but rather the number of transactions
processed. Traditional volume based costing is obviously inappropriate in this case. Banks are moving to
the concept where the user pays for the cost of the services they use, so that all users do not share the bill
evenly. To do so they must have an accurate reflection of the activity based costing.
Healthcare
Healthcare providers used to be able to increase their prices or service to increase revenues and profitability.
Today Medicare or managed care firms essentially set revenues with their prospective payment system. All
healthcare providers can do to improve profitability is make good decisions with accurate cost information.
Prospective payment system improved the sophistication of cost accounting systems in healthcare. In a
survey of hospital administrators about what information they needed to manage effectively, it is to be
found:
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Accurate allocation of administrative costs to products.
The cost of an episode of care.
A comparison of costs and their causes over time.
Information regarding the cost of various activities.
All of this information is available from an ABC system. ABC can be applied in service industries other
than those described here. It has become increasingly important for companies whose markets are becoming
more competitive. Since ABC is really about cost management, using it allows service companies to reduce
and control their costs in order to make correct pricing and other decisions, and to increase their profitability.
It is likely to continue to become more prevalent in the service industry in the future.
The Activity-Based Costing (ABC) is a costing system, which focuses on activities performed to produce
products. ABC is that costing in which costs are first traced to activities and then to products.
ABC systems classify activities along a cost hierarchy consisting of unit-level, batch-level, productsustaining and facility-sustaining activities.
ABC is developed due to many deficiencies of Traditional Cost systems.
The design of ABC systems involves the following four stages: (a) identify the major activities that take
place in the organization; (b) create a cost centre/cost pool for each activity; (c) deter- mine the cost driver
for each major activity; and (d) trace the cost of activities to the product according to a product’s demand
(using cost drivers as a measure of demand) for activities.
In traditional product costing system, costs are first traced not to activities but to an organizational unit,
such as department or plant and then to products.
Cost driver is an activity which generate cost. Costs are grouped according to what drives them or causes
them to be incurred.
ABC systems are models of resource consumption. They measure the cost of using resources and not the
cost of supplying resources.
A Cost Object: It is an item for which cost measurement is required e.g. Product, job or a customer.
The ABC profitability analysis hierarchy categorizes costs according to their variability at different
hierarchical levels to report different hierarchical contribution levels.
Non-volume-based cost drivers: A method of allocating indirect costs to cost objects that uses alternative
measures instead of assuming that a product’s consumption of overhead resources is directly related to
the number of units produced.
SELF-REVIEW QUESTIONS
1.
2.
3.
4.
5.
6.
7.
What is Activity Based Costing? Why is it needed?
Describe the circumstances when traditional costing systems are likely to report distorted costs.
What is a ‘Cost Driver’? What is the role of cost driver in tracing cost to products?
Explain the circumstances in which ABC is likely to be preferred to traditional costing systems.
Discuss the steps in applying Activity Based Costing?
Distinguish between resource cost drivers and activity cost drivers.
The traditional methods of cost allocation, cost apportionment and absorption into products are being
challenged by some writers who claim that much information given to management is misleading when
these methods of dealing with fixed overheads are used to determine product costs.
You are required to explain what is meant by cost allocation, cost apportionment and absorption and to
describe briefly the alternative approach of activity-based costing in order to ascertain total product costs.
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8.
XYZ electronics makes audio player model ‘AB 100’. It has 80 components. XYZ sells 10,000 units
each month at TK 3,000 per unit. The cost of manufacturing is TK 2,000 per unit or TK 200 lakhs per
month for the production of 10,000 units. Monthly manufacturing costs incurred are as follows:
Direct material costs
Direct manufacturing labour costs
Machining costs
Testing costs
Rework costs
Ordering costs
Engineering costs
100.00
20.00
20.00
25.00
15.00
0.20
19.80
200.00
Labour is paid on piece rate basis. Therefore, XYZ considers direct manufacturing labour cost as variable cost.
The following additional information is available for ‘XY 100’
(i) Testing and inspection time per unit is 2 hours.
(ii) 10 per cent of ‘XY 100’ manufactured are reworked.
(iii) It currently takes 1 hour to manufacture each unit of ‘XY 100’
(iv) XYZ places two orders per month for each component. A different supplier supplies each component.
XYZ has identified activity cost pools and cost drivers for each activity. The cost per unit of the cost driver
for each activity cost pool is follows:
Manufacturing
Description of activity
Cost driver
Cost per unit of cost
Activity
driver (TK)
Machine hours of capacity
200
Machine costs
Machining components
Testing costs
Testing components and finished
Testing hours
125
products. (Each unit of ‘XY 100’ is
tested individually)
Rework costs
Correcting and fixing
Units of ‘XY 100’
1,500 per unit
errors and defects
reworked
Ordering costs
Ordering of components
Number of orders
125 per order
Engineering
Designing and managing of products
Engineering hours
1,980 per engineering
costs
and processes
hour
Over a long-run horizon, each of the overhead costs described above vary with chosen cost drivers.
In response to competitive pressure XYZ must reduce the price of its product to TK 600 and to reduce the
cost by at least TK 400 per unit. ABC does not anticipate increase in sales due to price reduction. However,
if it does not reduce price it will not be able to maintain the current sales level.
Cost reduction on the existing model is almost impossible. Therefore, XYZ has decided to replace ‘XY
100’ by a new model ‘XY 200’, which is a modified version of ‘XY 100’. The expected effect of design
modifications are as follows:
(i) The member of components will be reduced to 50.
(ii) Direct material costs to be lower by TK 200 per unit.
(iii) Direct manufacturing labour costs to be lower by TK 20 per unit.
(iv) Machining time required to be lower by 20 per unit.
(v) Testing time required to be lower by 20 per cent.
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(vi) Rework to decline to 5 per cent.
(vii) Machining capacity and engineering hours’ capacity to remain the same. XYZ currently out sources
the rework on defective units.
Required:
(i) Compare the manufacturing cost per unit of ‘XY 100’ and ‘XY 200’.
(ii) Determine the immediate effect of design change and pricing decision on the operating to apply to
‘XY 200’. Ignore income tax, Assume that the cost per unit of each cost driver for ‘XY 100’ continues
to apply to ‘XY 200’.
9. Large service organizations, such as banks and hospitals, used to be noted for their lack of standard
costing systems, and their relatively unsophisticated budgeting and control systems compared with large
manufacturing organizations. But this is changing and many large service organizations are now revising
their use of management accounting techniques.
Requirements:
 Explain which features of large-scale service organizations encourage the application of activity-based
approaches to the analysis of cost information.
 Explain which features of service organizations may create problems for the application of activity-based costing.
 Explain the uses for activity-based cost information in service industries.
Many large service organizations were at one-time state owned, but have now been privatized. Examples in some countries
include electricity supply and telecommunications. They are often regulated. Similar systems of regulation of prices by an independent authority exist in many countries and are designed to act as a surrogate
for market competition in industries where it is difficult to ensure a genuinely competitive market.
 Explain which aspects of cost information and systems in service organizations would particularly interest a regulator, and why these features would be of interest.
10.The basic ideas justifying the use of activity- based costing (ABC) and activity-based budgeting (ABB)
are well publicized, and the number of applications has increased. However, there are apparently still
significant problems in changing from existing systems.
Requirements:
 Explain which characteristics of an organization, such as its structure, product range, or environment,
may make the use of activity-based techniques particularly useful.
 Explain the problems that may cause an organization to decide not to use, or to abandon use of, activity-based techniques.
 Some categorizations of cost drivers provide hierarchical models:
 unit-level activities;
 batch activities;
 product-sustaining activities;
 facility-sustaining activities.
Other analyses focus on ‘value adding’ and ‘non-value adding’ activities.
Requirement:
Explain what is meant by ‘non-value adding activities’, and discuss the usefulness of this form of analysis.
210
COST ACCOUNTING (COA)
PART-D
Contemporary Cost Accounting Tools
[WEIGHT 25%]
Level of
Study Required
Probable
Weight
D1. Target Costing (TC)
U, AP, AN
40%
D2. Quality Costing (QC)
R, AP, AN
30%
D3. Life-Cycle Costing (LCC)
U, AP, AN
30%
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CHAPTER-D1
TARGET COSTING
CHAPTER OVERVIEW
The origin of target costing (TC) is allied with Japanese firms1. More
specifically, the Japanese approach to target costing appears to have
been developed at Toyota in the early 1960s7, 9. It became popular among
European and American firms only in the 1990s1, 2. Research on the
adoption of TC to date revealed that TC has been highly adopted in the
Japanese firms1, 3, 4 as compared to non-Japanese firms5. A number of
companies have used target costing, including Compaq, Cummins Engine,
Chrysler, Ford, Isuzu Motors, ITT Automotive, Komatsu, Matsushita
Electric, Mitsubishi Kasei, Nissan, Olympus, Sharp, Texas Instruments,
and Toyota16.
Several synonyms are used to represent ‘target costing’ in the literature1
including ‘cost planning’, ‘cost projection system’2, ‘design to cost’,
‘manufacturing cost reduction’, ‘direct cost feasibility study’6, and ‘cost
management’7. In the context of Bangladesh, the application of TC is
critical specifically for Ready-made Garments sector as majority of the
companies in this sector run their production activities against customers
orders where price is fixed by negotiation between the parties beforehand.
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Chapter Learning Outcomes (CpLOs)
Identify the factors influence target costing
Illustrate the application of TC
This Study Note Covers (Subtopics)
Underlying philosophy of Target Costing (TC)
Western vs. Japanese cost management
Factors influencing the TC process
Process of target costing
Application of TC indifferent sectors with special focus on market driving, product level and component
level TC
TC vs. Kaizen costing
Corresponding BCAS
Level of Study Required
U,AP,AN
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
UNDERLYING PHILOSOPHY OF TARGET COSTING
Target costing (TC) is basically a technique for profit management7. TC is adopted by a firm to make sure
that future products will generate sufficient profits to enable the firm to achieve its long-term profit plans7.
To do so, a firm must have the capability to design its products that can satisfy the customer demands and
at the same time manufactured them at a sufficiently low cost7.
Simply, Target Costing (TC) is defined as a systematic process of managing costs of products by establishing
target market prices and profit margins during the design phase of a new product1, 2, 7. Pitcher (2105, p. 17)
define target costing in CIMA’s academic research report as “an activity which is aimed at reducing the lifecycle costs of new products, by examining all possibilities for cost reduction at the research, development
and production stage. It is not a costing system, but a profit-planning system-the selling price and profit
requirement are set during the research stage, thus creating a target cost”8.
Target cost (or maximum allowable cost) = attainable selling price - required profit margin6. The responsibility
to achieve the target costs is generally rest with the product development team. The team runs several trials
through its product and process design until the target cost and quality is reached.
The two most important objectives of target costing are: (1) reduction of new product cost to ensure the
attainment of target profit along with satisfying customers in respect of quality, and (2) inspiring the work
forces to attain the target profits during the development of new product1, 9.
Proper application of target costing results in a number of advantages to the firms including:
1. long-term approach to cost management;
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2. directs focus on customers;
3. removes barriers between departments;
4. enhances employee awareness and augments their participation and empowerment; fosters co-operation
and better relation with suppliers;
5. reduces non value added activities;
6. promote selection of activities with the lowest cost; and
7. reduces delivery time to market1, 10, 11.
However, the implementation of TC has some dark sides including development of detailed data, cooperation
from all managerial levels, difficulties in quantification of non-financial data, inferior quality and finally
significant costs required for the implementation and maintenance of TC1.
WESTERN VS. JAPANESE COST MANAGEMENT
The difference between Western and Japanese cost management is well depicted in the following figure.
Figure: Western vs. Japanese cost management [Source: Worthy, F. (1991), Japan’s smart secret weapon,
Fortune 124, 1991, 4, pp. 72-75.]
While the first two steps are identical, the next steps are quite different. For instance, in the third phase, the
design of the product is finalized in the western cost management system, whereas the product development
team has to do a lot to finalize the design of the product to facilitate the achievement of target cost and
profit in the Japanese cost management system. Another difference is that in the Western approach if cost is
found high, it returns to design phase to search for any opportunity to trim down them to the desired level.
However, in the Japanese approach the product development team pays substantial efforts and works with
other wings/department at the design stage to keep the costs within the predetermined level i.e., the target
214
cost. Consequently, it does not require returning back further to the design phase to trim down the product
cost. Finally, while the western cost management approach focuses on the periodic cost reduction effort,
Japanese cost management concentrates on continuous cost reduction with prime focus to control them at
the design phase. Therefore, it can be held that Japanese cost management approach is radically different
from that of the Western cost management approach.
Factors influencing the Target Costing Process
To illustrate what forces influence the target costing (TC) process, the TC process can be broken into three
major steps: market-driven TC, product-level TC, and component-level TC7. A comparative analysis of TC
process at six Japanese firms by Cooper and Slagmulder (1997) revealed the following five major forces
that shape the TC process.
1. Intensity of competition (market-driven TC)
To what extent a firm should pay attention to competitive offerings in the TC process is largely affected
by the intensity of competition the firm faces in the industry. Based on the state of technology adopted, a
firm can have four to six direct competitors which cannot develop sustainable competitive advantage over
each other and these compel them to adopt confrontational strategy7, 14. A straightforward adoption of
cost leadership or differentiation strategy does not work in a market where customers are more informed,
rivals are more aggressive, and survival zones are squeezed7, 14. To survive in such situation, a firm needs to
compete head on in terms of cost, quality and functionality of the product7. TC can be highly beneficial in
such situations as firms cannot afford too many mistakes when launching new products.
2. Nature of the customer (market-driven TC)
The degree of customer satisfaction, the rate at which future customer requirements are changing, and the
degree to which customers understand their future product requirements have substantial bearings on the
success of TC7. TC is particularly useful for firms that compete in environments having narrow survival
zones; locations are changing rapidly, but are relatively predictable.
3. The firm’s product strategy (product-level TC)
The benefits derived from TC are largely dependent on the three characteristics of firm’s product strategy:
the number of products in the line, the frequency of redesign, and the degree of innovation7. Typically, firms
whose products strategy creates substantial uncertainty about how customers will react to new products
need to pay considerable efforts on TC as compared to their counterparts. Put differently, the higher the
number of products in the line, the frequency of redesign, and the degree of innovation, the higher the
emphasis placed on the TC system.
4. Characteristics of the product (product-level TC)
The benefits derived from TC and its way of practice is affected by the three characteristics of products:
complexity (how difficult it is to manage the design process), magnitude of up-front investment (amount
spent in the R&D, getting ready for production, and launching the product), and the duration of the product
development process (the time it takes to go from product conception to release to Production)7. The higher
the complexity, magnitude of up-front investment, and the duration of the product development process, the
higher the benefits of using TC system in reducing the costs of products7.
5. The firm’s supplier base strategy (component-level TC)
The three aspects of supplier-base strategy (the degree of horizontal integration, the power over supplier,
and the nature of supplier relations) have significant influence on the degree of benefits derived from TC
system7. The first one captures the percentage of the firm’s product costs that are sourced externally. A
greater reliance on supplier for larger percentage of inputs would create greater chance of deriving benefits
215
using component-level TC (e.g., creating pressures on suppliers to reduce their prices). Moreover, they can
be held responsible for the design of the larger portion of the products. When buyer power is high, greater
effort is paid on reducing component-level TC (purchase price). Finally, a cooperative relationship with
suppliers creates further opportunity to reduce costs and improve creativity in design. For example, the firm
can visit supplier’s site to help them with design problems.
PROCESS OF TARGET COSTING
The two simple stages of target costing are: first, determination of target costs, and second, attainment of the
target cost1. Implementation of target costing requires a number of stages to be followed, and prior studies
demonstrate diversity in the identification of these stages. For instance, Ax et al., (2008, p. 93-94) specified
seven (7) stages in the implementation of TC based on the outcome of several prior studies as follows:
1. Identifying the desired product and service attributes,
2. Establishing the target price,
3. Determining the target profit,
4. Determining the target cost,
5. Decomposing the target cost,
6. Closing the cost gap, and
7. Continuous improvements.
In contrast, Cokins (2002) specified four stages of TC:
1. determination of target selling price;
2. focus on target market and consumer behavior;
3. determination of target profit; and
4. ascertain the target cost by deducting target profit from target selling price.
New product
marketing input
Competitive
market condition
Competitive
market condition
Supply management/
supplier input
Supply management
Suppliers/marketing
Step 1
Product/service
characteristics desired
Step 2
Target selling price
Step 3
Target cost= Target price – Desired profit
margin
Step 4
Cost breakdown to
materials/component
level
Step 5
Cost management activities
Supplier development
Design change
Material change
Specifications change
Cost trade-offs
Step 6
Continuous
improvement
[Source: Ellram (1999)]
216
Customer input
Customer input
Management
Input/strategic plan
Engineering/
R&D input
R&D/Design
Manufacturing
Apart from those, Ewert and Ernst (1999, p. 23-24) identified only three elements of TC. These three elements are: (1)
a market orientation, as the selling price is the starting point to determine TC; (2) a coordination function, since the TC
coordinates the activities of product designers; and (3) strategic learning, as it influences the long-term cost structure
by interacting with other factors1.
The stages cited by Ax et al., (2008) are somewhat identical to Ellram (1999) who demonstrated the following steps
of TC system.
APPLICATION OF TC IN DIFFERENT SECTORS WITH SPECIAL FOCUS
ON MARKET DRIVING, PRODUCT LEVEL AND COMPONENT LEVEL TC
In a non-target costing environment, a product is first developed and marketed as soon as a price is set
by adding up a required/desired markup with the cost of the product. However, in TC environment, the
sequence of events is just the reverse. More specifically, the company already knows what price should be
charged; the most challenging task is to develop a product that can be marketed profitably at the desired
price16.
Illustration 1: [Adopted from Garrison et al., 2015]
ABC Limited wishes to invest BDT 2,000 million to design, develop, and produce a new product X. The
company’s Marketing Department surveyed the features and prices of competing products and determined
that a price of BDT 600 would enable Handy to sell an estimated 1,000,000 units per year. The company
desires a 12% return on investment (ROI).
Required: Determine the target cost to manufacture, sell, distribute, and service per unit of product X.
Solution:
Projected sales (1,000,000 mixers @ BDT 300 per unit)
Less: Desired profit (12% of 2,000 million)
Target cost for 1,000,000 units
Target cost per unit (360 million ÷ 1 million)
600 million
240 million
360 million
BDT 360
So, the company must develop a prototype of the product that would allow it a maximum of BDT 360
per unit to manufacture, sell, distribute and service if the company wants to earn a return of 12% on its
investment. To achieve this target cost, the company must break down the target costs for the various
functions such as manufacturing, marketing, distribution, post-sale services and so on. More importantly,
each functional division must be held responsible for keeping their actual costs within the target.
TC VS. KAIZEN COSTING
Kaizen costing is somewhat similar to TC except the fact that whereas TC focuses on reducing costs at
design and development stage, in Kaizen costing continuing efforts are made in the manufacturing phase
to secure further cost savings5. In Kaizen costing, improvements to a process are made through small
incremental amounts, rather than through large innovations15. Accordingly, this costing is applied during
the manufacturing stage of the products life cycle. Its prime focus is on achieving cost reductions through
the increased efficiency of the production process15.
Significant cost reductions can be achieved through continual efforts of the work force over time around
the monthly or yearly cost goal. At the end of the period (month or year for which the cost goal was set up),
actual cost figures are compared against the Kaizen goal. Eventually, the actual cost figures then become
217
the base line for setting the new Kaizen goal for the following month or year15. As Kaizen costing focuses
on cost saving while the products are already at the production stage, the magnitude of cost savings are
essentially smaller than the TC15.
CORRESPONDING BCAS
BCAS10 presents the concept and application of target costing system. The standard spells out the
objectives, scope, key features, and guidelines for recording and reporting target costs. In the objective
phase, the purpose of TC was cited as the use of estimated cost information during the product and process
design phases to reduce a product’s life cycle costs.
The standard defines target cost as the maximum cost that the producer is willing to spend to have the
product manufactured. In its appendix, the standard states eight different stages to be followed in setting up
the target cost:
1. Establish a selling price
2. Determine the target cost
3. Perform functional cost analysis for individual components and processes
4. Determine the estimated cost of the product
5. Compare estimate with the target
6. Repeat value engineering if the estimated cost exceeds target cost
7. Finalize the launch of the product
8. Manage cost during production of the product
It has also outlined four phases of target costing system:
Phase 1: Get know price points-market research
Phase 2: Determine margin and cost feasibility
Phase 3: Meet margin goal and target cost through design improvements
Phase 4: Implement continuous improvements
The standard can be downloaded from the website of the ICMAB or by clicking on the link below: http://
www.icmab.org.bd/professional-standards/
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KEY POINTS OF THE CHAPTER:
KP1:
The origin of target costing (TC) is allied with Japanese firms, and was developed at Toyota in the early
1960s.
KP2:
Target Costing (TC) is a systematic process of managing costs of products by establishing target market
prices and profit margins during the design phase of a new product.
KP3:
Target cost (or maximum allowable cost) = attainable selling price - required profit margin. The responsibility
to achieve the target costs is generally rest with the product development team which runs several trials
through its product and process design until the target cost and quality is reached.
KP4:
TC system should allow a firm to reduce its product cost along with satisfying customers in respect of
quality and inspire the work forces to attain the target profits during the development of new product.
KP5:
In the Western approach if cost is found high, it returns to design phase to search for any opportunity to
trim down them to the desired level; whereas in the Japanese approach the product development team pays
substantial efforts at the design stage to keep the costs within the predetermined level i.e., the target cost.
KP6:
In Kaizen costing, continuing efforts are made in the manufacturing phase to secure further cost savings
with prime focus on achieving cost reductions through the increased efficiency of the production process.
KP7:
BCAS10 addresses the concept and application of target costing system in Bangladesh.
KP8:
The two simple stages of target costing are: first, determination of target costs, and second, attainment of
the target cost.
KP9:
TC system is affected by many factors including the intensity of competition, nature of customers, nature
of products, and suppliers’ characteristics.
KP10:
The dark side of implementation of TC may be: development of detailed data, cooperation from all
managerial levels, difficulties in quantification of non-financial data, quality and significant costs required
for the implementation and maintenance of TC.
219
EXERCISE
1. Shimada Products Corporation of Japan is anxious to enter the electronic calculator market. Management
believes that in order to be competitive in world markets, the price of the electronic calculator that the
company is developing cannot exceed BDT 400. Shimada’s required rate of return is 12% on all investments.
An investment of BDT 300,000,000 would be required to purchase the equipment needed to produce the
500,000 calculators that management believes can be sold each year at the BDT 400 price.
Required: Compute the target cost of one calculator. [Adopted from Garrison et al., 2015]
Solution:
Projected sales (500,000 calculators @ BDT 300 per unit)
Less: Desired profit (12% of 300 million)
Target cost for 500,000 calculators
Target cost per unit (114 million ÷ 500,000 calculators)
150 million
36 million
114 million
BDT 228
So, the company must develop a prototype of the product that would allow it a maximum of BDT 228
per unit to manufacture, sell, distribute and service if the company wants to earn a return of 12% on its
investment. To achieve this target cost, the company must break down the target costs for the various
functions such as manufacturing, marketing, distribution, post-sale services and so on. More importantly,
each functional division must be held responsible for keeping their actual costs within the target.
SELF-ASSESSMENT QUESTIONS
State whether the following statements are true/false:
1. Target costing system assumes that company has significant control over the market price of the product.
2. In a TC system, substantial cost reduction decisions are taken at the production stage of a product.
3. TC emphasizes significant cost reduction during the design phase whereas Kaizen costing focuses on
continuous cost reduction.
4. BCAS 12 guides the application of target costing system in Bangladesh.
5. In TC environment, the sequence of events is just the reverse to non-target costing environment in the
sense that product margin is set by the external force like market price.
Answer to Self-Assessment Questions:
1. False; 2. False; 3. True; 4. False; 5. True
SELF-REVIEW QUESTIONS/DISCUSSION QUESTIONS
1.
2.
3.
4.
How target costing is different from kaizen costing?
Explicate the underlying philosophy of TC.
Sketch the TC process applicable for a manufacturing company.
In what respects Western cost management approach is different from Japanese cost management
approach.
5. What factors can influence the successful implementation of TC system in your organization?
6. Criticise the guidelines suggested by BCAS 10 in regard to the application of TC system.
220
EXERCISE
1. BDAUTO Ltd. is anxious to enter the automobile markets in Bangladesh. Management believes that
in order to be competitive in the markets, the price of its only product-easy bike- that the company is
developing cannot exceed BDT 350,000. BDAUTO’s required rate of return is 16% on all investments.
An investment of BDT 800,000,000 would be required to purchase the equipment needed to produce the
120,000 easy bikes that management believes can be sold each year at the target price.
Required: Compute the target cost of one easy bike.
2. National Restaurant Supply, Inc., sells restaurant equipment and supplies throughout most of the United
States. Management is considering adding a machine that makes sorbet to its line of ice cream making
machines. Management will negotiate the price of the sorbet machine with its Swedish manufacturer.
Management of National Restaurant Supply believes the sorbet machine can be sold to its customers in the
United States for $4,950. At that price, annual sales of the sorbet machine should be 100 units. If the sorbet
machine is added to National Restaurant Supply’s product lines, the company will have to invest $600,000
in inventories and special warehouse fixtures. The variable cost of selling the sorbet machines would be
$650 per machine.
Required:
I. If National Restaurant Supply requires a 15% return on investment (ROI), what is the maximum amount
the company would be willing to pay the Swedish manufacturer for the sorbet machines?
II. The manager who is flying to Sweden to negotiate the purchase price of the machines would like to
know how the purchase price of the machines would affect National Restaurant Supply’s ROI. Construct
a chart that shows National Restaurant Supply’s ROI as a function of the purchase price of the sorbet
machine. Put the purchase price on the X-axis and the resulting ROI on the Y-axis. Plot the ROI for
purchase prices between $3,000 and $4,000 per machine.
III. After many hours of negotiations, management has concluded that the Swedish manufacturer is
unwilling to sell the sorbet machine at a low enough price so that National Restaurant Supply is able
to earn its 15% required ROI. Apart from simply giving up on the idea of adding the sorbet machine to
National Restaurant Supply’s product lines, what could management do?
221
CHAPTER-D2
QUALITY COSTING (QC)
CHAPTER OVERVIEW
This chapter focuses on the cost of quality which can be a source
competitive advantage in the modern business environment where
competition is more aligned with providing reliable and quality products at
mass produced costs. On this ground, Quality costing (QC) is considered
as a strategically-oriented costing tool1. Measuring and reporting these
costs should be considered a critical issue for any manager who aims to
achieve competitiveness in today’s markets2. However, despite the fact
that quality costs can be a source of competitive advantage, many firms do
not systematically monitor these costs which may seriously damage their
organizational competitiveness6.
Existing accounting systems are considered poorly fitted to generate reports
on quality measurements2, 14. They do not provide appropriate quality
related data, and benefits resulting from improved quality. Although most
CoQ measurement methods are activity/process oriented, traditional cost
accounting establishes cost accounts by the categories of expenses instead
of activities. Thus, many CoQ elements need to be estimated or collected
from sources external to the traditional accounting/cost accounting system.
Moreover, these costs are frequently underestimated by organizations as
the assessment of external failure costs involves considerable subjectivity.
The following sections explicate different models applied in the analysis
and evaluation of the effects of maintaining quality costing system across
different industries of the globe.
222
Chapter Learning Outcomes (CpLOs)
•
•
describe the underlying philosophy of QC
illustrate the application of different QC models
This Study Note Covers (Subtopics)
Cost of quality models
P.A.F models of QC
Trade-off between the levels of conformance and non-conformance costs
Opportunity/Intangible cost models
ABC models of QC
Application of QC indifferent sectors
Corresponding BCAS
Level of Study Required
R, AP, AN
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO1, 2
CLO2
CLO1, 2
CLO 1, 2
CLO2
CLO2
COST OF QUALITY MODELS
Quality costs represent costs incurred in the design, implementation, operation and maintenance of a quality
management system, the cost of resources committed to continuous improvement, the costs of system,
product and service failures, and all other necessary costs required to achieve a quality product or service2,
3
. Academics and practitioners categorized these quality costs into three to four classes: prevention costs,
appraisal costs and failure costs4; failure costs being broken down to internal failure and external failure
costs 5, 6. Several models of quality costing have been developed and used to collect, categorize and measure
quality costs2. The very traditional method offered by Juran (1951) and Feigenbaum (1956) is P-A-F
(Prevention-Appraisal-Failure) which classifies quality costs into prevention, appraisal, and failure costs2.
Crosby (1979) also offered a model to measure quality costs similar to Juran (1951) except that Crosby sees
quality as “conformance to requirements” and quality costs are the sum of price of conformance and nonconformance2. Ross (1977) developed process cost model which was further used by Marsh (1989) with
the distinctiveness of focusing process instead of product or service2. Robison (1997) offered a different
method that focus on team approach to trace costs that have gone wrong in a process2. Among the several
methods mentioned above, the traditional model has been widely used by firms and experienced favourable
impact on performance2.
Cost of quality models are widely integrated within Total Quality Management (TQM)9, 10, which is built
on two concepts: (1) get it right first time (to achieve zero rejects and 100% quality) and (2) continuous
improvements (dissatisfaction with the status quo; the philosophy that it is always possible to improve and
to be able to get it more right next time).
223
P-A-F MODELS OF QC
P-A-F (Prevention-Appraisal-Failure) Model of QC appears to be the most widely recognized scheme for
categorizing quality costs3. Most cost of quality models are based on the P-A-F models of Feigenbaum’s and
Juran’s P-A-F model. This P-A-F scheme has been adopted by the American Society for Quality Control,
and the British Standard Institute, and it is employed by most of the companies which use quality costing6.
Prevention costs are incurred to reduce or eliminate defective products to occur5, 7. In other words, these
costs represent the cost of any action taken to investigate, prevent, or reduce the risk of nonconformity
or defects6. Appraisal costs are incurred in detecting defectives before they are shifted to customers5, 7.
Alternatively, these costs are incurred for evaluating the achievement of quality requirements6. Failure costs
arise due to the nonconformity both internal (discovered before delivery to the customer, including scrap,
rework, re-inspection and redesign) and external (discovered after delivery to the customer, including
warranty costs and service calls)6.
Quality level
Figure 1: The relationship between appraisal and prevention cost and failure cost [The old model]
Spending significant amount for prevention activities are expected to reduce internal (reworks, scrape) and
external failure costs (returns, lost sales), which in turn can facilitate substantial savings and achievement
of competitive advantage1, 7. Moreover, this can be used to reduce overall production costs and to increase
productivity and customer satisfaction8.
As can be seen in the figure, as appraisal costs rise, failure costs tend to fall. Quality costs should be
expressed as a ratio against sales turnover, production costs or the value of material used6. This classical
model also views that an optimum cost of quality exists at the level at which the cost of securing higher
quality would exceed the benefits of the improved quality. However, it is hardly possible to determine such
economic level of quality that will cause zero defects, or more specifically spending on prevention can
always be justified; rather it is well evident that failure costs can continue to decline with no corresponding
increase in prevention and appraisal cost.
224
Figure 2: The relationship between appraisal and prevention cost and failure cost [The old CoQ model9]
In the old cost of quality (CoQ) model (prevailed earlier in the 20th century), the curve representing costs
of prevention and appraisal rises to infinity as perfection is approached when technology and human ability
were unable to achieve 100 percent of product perfection9. Accordingly, the optimum level of quality was
somewhere below perfection.
However, the advancement in technology, robotics and automated production in the later part of the
twentieth century allows firms to reduce defects rate to almost zero (and to zero by few firms). Consequently,
perfections can be achieved at finite costs which results in a weak increase in appraisal and prevention costs
and the cost optimum shifts to perfect quality level9 as displayed in the new CoQ model in figure 3.
Figure 3: The relationship between appraisal and prevention cost and failure cost [The new CoQ model9]
225
TRADE-OFF BETWEEN THE LEVELS OF CONFORMANCE AND NONCONFORMANCE COSTS
An alternative to P-A-F model is proposed by Philip Crosby in 1979 that views quality as “conformance
to requirements” and therefore, defines the CoQ as the sum of price of conformance and price of nonconformance2. More specifically, Crosby classifies PAF costs into ‘conformance costs’ (includes prevention
and appraisal costs) and non-conformance costs (involves internal and external failure costs).
Conformance costs are incurred to ensure customer satisfaction, while non-conformance costs arise when
low quality products are produced or shipped to customers9. Put differently, the price of conformance is the
cost involved in making certain that things are done right the first time, which includes actual prevention
and appraisal costs, and the price of non-conformance is the money wasted when work fails to conform to
customer requirements, usually calculated by quantifying the cost of correcting, reworking or scrapping,
which corresponds to actual failure costs2.
Crosby basically focused on prevention activities, and his approach to quality is best described by the
following six principles/concepts12:
1. Do it right the first time (and every time): Manage quality by prevention, not detection and testing.
2. Zero defects and zero defects day: Zero defect does not mean that the product has to be perfect.
Rather, every individual in the organization is committed to meet the requirement and not meeting the
requirement is not acceptable.
3. The four absolutes of quality:
I. Quality is conformance to the requirements
II. The system of quality is prevention
III. The performance standard is “Zero Defects”
IV. The measurement of quality is the price of non-conformance.
4. The prevention processes: Prevention involves thinking, planning, and analyzing processes to anticipate
where errors could occur, and then taking action to keep them from occurring.
5. The quality vaccine: Problem is seen as “bacteria of non-conformance” and must be ‘vaccinated’
with ‘antibodies’ to prevent problems. Quality vaccine consists of three distinct management actionsdetermination, education and implementation12.
6. The six C’s: Education is a multi-stage process that every organization must go through. Comprehension,
commitment, competence, communication, correction and continuance12.
So, a company must trade-off between cost of conformance and non-conformance. Put differently, it must
decide whether it will make adequate investment in prevention and appraisal costs to keep defects from
occurring or it will allow defects to occur and then rectify it before or after shipping.
OPPORTUNITY/INTANGIBLE COST MODEL
Opportunity costs and intangible costs are also included in the CoQ models by several academics (e.g.,
Modarres and Ansari, 1987; Sandoval-Chavez and Beruvides, 1998) and practiced by several firms. These
costs can only be estimated but not actually incurred by the firm. Examples include profits not earned
because of lost customers, reduction in revenue due to non-conformance of quality.
Opportunity losses can further be broken down into three categories: underutilization of installed capacity,
inadequate material handling, and poor delivery of service, and can be included in the traditional P-A-F
226
model of CoQ2, 15. Carr (1992) includes opportunity cost and reports evidence of its successful use in a
quality program. Quality costs are defined in three categories: the cost of conformance, the cost of nonconformance and the cost of lost opportunity2. Some other costs that have been incorporated in the CoQ
models are: the costs of inefficient resource allocation and quality design costs16.
Accordingly, it can be held that there are diversified models of CoQ that includes opportunity/intangible
costs. What is to be included and what is ignored depends on the relative magnitude of the particular cost
items in the cost structure of the firm examining the impact of CoQ. However, despite the difficulty associated
with measuring these types of quality costs, their successful applications in industrial undertakings are well
evident across the globe2.
ABC MODELS OF QC
Activity-based costing model is actually not a CoQ model; rather it is an alternative approach to identify,
quantify and allocate quality costs among products and, therefore helps managers to manage CoQ more
effectively2. Tsai (1998) proposes an integrated CoQ-ABC framework, in which ABC and CoQ systems
are merged and share a common database in order to supply various cost and non-financial information
for related management techniques2. The long-term goal of this model is to eliminate non-value added
activities and to continuously improve processes, activities and quality so that no defects are produced2.
Tsai (1998) illustrate the following comparison among the three approaches of CoQ.
Aspects of comparison
P-A-F approach
Orientation
Activity-oriented
Activity/cost categories
Prevention,
Conformance
appraisal, internal
Nonand external failure conformance
No consensus method to allocate
COQ elements under current COQ
measurement systems and traditional
cost accounting
No adequate method to trace quality
costs to their sources
Treatment of OH
Tracing costs to their sources
Improvement objects
Process cost
approach
Processoriented
CoQ related
Processes
activities
activities
Tools for improvement
Quality circle
Brainstorming
Nominal group technique
Cause and effect analysis
Fishbone diagram
Forcefield analysis
Related management techniques Total Quality Management
ABC approach
Activity oriented-cost
assignment view
Process oriented-process view
Value-added
Non-value-added
Assigning overhead to activities
by using resource drivers in
the first stage of ABC cost
assignment view
Tracing activity costs to cost
objects by using activity drivers
in the second stage
of ABC cost assignment view
Processes/activities
Process/activity value analysis
Performance measurement
Benchmarking
Cost driver analysis
Activity-Based-Management
227
APPLICATION OF QC IN DIFFERENT SECTORS
For the successful application of CoQ models in the firms, a rigorous understanding and awareness of the
CoQ items seems to be inevitable. Considering this importance, this section first presents a comprehensive
list of quality costs proposed by the British Standards Institute.
Cost categories
Cost elements as per British Standards 6143: Part 2
Prevention
Quality planning
Design and development of equipment
Quality review and design verification
Maintenance and calibration of production equipment
Maintenance and calibration of inspection equipment
Supplier assurance
Quality training
Quality auditing
Reporting of quality data
Quality improvement programs
Appraisal
Pre-production verification
Receiving inspection
Laboratory acceptance testing
Inspection and testing
Inspection and test equipment
Inspection and test materials
Analysis and reporting of test results
Field performance testing
Approvals and endorsements
Evaluation of field check
Record storage
Internal failure
Scrap
Replacement, rework and repair
Troubleshooting
Reinsertion and retesting
Scarp and rework: supplier fault
Modification permits, concessions
Downgrading
Downtime
228
External failure
Complaints
Warranty claims
Product liability
Products rejected and returned
Concessions
Recall costs
Lost sales
[Source: Dale and Wan, 2002]
Quality Cost Reports
As an initial step in quality improvement programs, companies often construct a quality cost report that
provides an estimate of the financial consequences of the company’s current level of defects. A quality cost
report details the prevention costs, appraisal costs, and costs of internal and external failures that arise from
the company’s current quality control efforts. Managers are often shocked by the magnitude of these costs.
CORRESPONDING BCAS
BCAS 29 spells out the following key aspects of quality costing:
• the applicability of quality costing.
• the basic principles of quality costing.
• pricing decision & cost-volume profit analysis decision.
• the steps & principals of applying quality costing.
• list the potential benefit of using quality costing.
29.7 Recording and Reporting
29.7.1 Organization should have a quality cost control team consisting of members from every division who
will be involved in finding the cost of quality.
29.7.2 Organization should have a mechanism of setting quality cost with reference to particular department.
29.7.3 Organization should have a formal communication process of preparing and reporting of quality
costing information.
29.7.4 Organization should identify critical factors related to quality costs control.
29.7.5 Organization should report cost of quality information across all the four categories as per the format
prescribed in appendix or in a different format which may disclose more information with a quality of better
understandability of the users.
In the appendix of the standard, the CoQ diagrams and illustration of a quality cost report have been cited.
This standard can be downloaded from the website of the ICMAB or by clicking on the link below: http://
www.icmab.org.bd/professional-standards/
229
KEY POINTS OF THE CHAPTER
KP1:
Quality costing (QC) is considered as a strategically-oriented costing tool. Measuring and reporting these
costs should be considered a critical issue for managers who aim to achieve competitiveness in today’s
markets.
KP2:
Existing accounting systems are considered poorly fitted to generate reports on quality measurements and
provide inappropriate quality related data and benefits resulting from improved quality.
KP3:
Quality costs are frequently underestimated by organizations as the assessment of external failure costs
involves considerable subjectivity, and this can be suicidal to compete in the prevailing market where
diversified and reliable products are key weapons to compete.
KP4:
Quality costs represent costs incurred in the design, implementation, operation and maintenance of a quality
management system, the cost of resources committed to continuous improvement, the costs of system,
product and service failures, and all other necessary costs required to achieve a quality product or service.
KP5:
Conformance costs are incurred to ensure customer satisfaction, while non-conformance costs arise when
low quality products are produced or shipped to customers.
KP6:
Prevention costs are incurred to reduce or eliminate defective products to occur; these costs basically
represent the cost of any action taken to investigate, prevent, or reduce the risk of nonconformity or defects.
KP7:
Appraisal costs are incurred in detecting defectives before they are shifted to customers; these costs are
incurred for evaluating the achievement of quality requirements.
KP8:
Failure costs arise due to the nonconformity both internal (discovered before delivery to the customer,
including scrap, rework, re-inspection and redesign) and external (discovered after delivery to the customer,
including warranty costs and service calls).
KP9:
An increase in prevention and appraisal costs should trim down failure costs. Quality costs should be
expressed as a ratio against sales turnover, production costs or the value of material used
KP10:
BCAS 29 addresses the concept and application of quality costing system in Bangladesh.
230
SELF-ASSESSMENT QUESTIONS
State whether the following statements are true or false:
1. An increase in prevention cost will lead to a decrease in failure costs.
2. Cost of quality analysis is an integral part of TQM.
3. For the successful implementation of TQM, investment in cost of conformance should be given priority
over cost of non-conformance.
4. Reporting of quality data is an appraisal cost.
5. The measurement of quality is the price of non-conformance.
Answer to the Self-Assessment Questions:
1. True; 2. True; 3. True; 4. False; 5. True
SELF-REVIEW/DISCUSSION QUESTIONS
1. How quality costs can be a source of competitive advantage? Explain.
2. What is the core philosophy of traditional P-A-F model? How this can be used to improve efficiency of
an organization?
3. Explain the six principles of quality cost model proposed by Philip Crosby.
4. Compare and contrast P-A-F models with process cost approach and ABC approach of cost of quality.
5. Illustrate how BCAS 29 can be applied to design a cost of quality model for a manufacturing undertaking.
EXERCISE
1.
A number of terms relating to the cost of quality and quality management are listed below:
Appraisal costs, Quality circles, Quality cost report, Prevention costs, Quality of conformance, External
failure costs, internal failure costs, Quality costs
Required:
Choose the term or terms that most appropriately complete the following statements. The terms can be used
more than once and a blank can hold more than one word.
1. A product that has a high rate of defects is said to have a low ______________.
2. All of the costs associated with preventing and dealing with defects once they occur are known as
______________________.
3. In many companies, small groups of employees, known as _______________, meet on a regular basis
to discuss ways to improve quality.
4. A company incurs _______and _________in an effort to keep defects from occurring.
5. A company incurs ___________and _________ because defects have occurred.
6. Of the four groups of costs associated with quality of conformance, _________-are generally the most
damaging to a company.
7. Inspection, testing, and other costs incurred to keep defective products from being shipped to customers
are known as __________ .
8. ________are incurred in an effort to eliminate poor product design, defective manufacturing
practices, and the providing of substandard service.
9. The costs relating to defects, rejected products, and downtime caused by quality problems are known
as _________.
10. When a product that is defective in some way is delivered to a customer, ________are incurred.
11. Over time a company’s total quality costs should decrease if it redistributes its quality costs by placing
its greatest emphasis on ______and _________.
12. One way to ensure that management is aware of the costs associated with quality is to summarize such
costs on a ____________. [Adapted from Garrison et al., 2015]
231
2.
Mercury, Inc., produces cell phones at its plant in Texas. In recent years, the company’s market share has
been eroded by stiff competition from overseas. Price and product quality are the two key areas in which
companies compete in this market.
A year ago, the company’s cell phones had been ranked low in product quality in a consumer survey.
Shocked by this result, Jorge Gomez, Mercury’s president, initiated a crash effort to improve product quality.
Gomez set up a task force to implement a formal quality improvement program. Included on this task force
were representatives from the Engineering, Marketing, Customer Service, Production, and Accounting
departments. The broad representation was needed because Gomez believed that this was a companywide
program and that all employees should share the responsibility for its success.
After the first meeting of the task force, Holly Elsoe, manager of the Marketing Department, asked John
Tran, production manager, what he thought of the proposed program. Tran replied, “I have reservations.
Quality is too abstract to be attaching costs to it and then to be holding you and me responsible for cost
improvements. I like to work with goals that I can see and count! I’m nervous about having my annual
bonus based on a decrease in quality costs; there are too many variables that we have no control over.”
Mercury’s quality improvement program has now been in operation for one year. The company’s most
recent quality cost report is shown below.
Mercury Inc.
Quality Cost Report
Last year
This year
Prevention costs:
70
120
Machine maintenance
0
10
Training suppliers
0
20
Quality circles
70
150
Total prevention costs
Appraisal costs:
20
40
Incoming inspection
80
90
Final testing
100
130
Total appraisal costs
Internal failure costs:
50
130
Rework
40
70
Scrap
90
200
Total internal failure costs
External failure costs:
90
30
Warranty repairs
320
80
Customer returns
410
110
Total external failure costs
670
590
Total quality costs
4200
4800
Total production costs
As they were reviewing the report, Elsoe asked Tran what he now thought of the quality improvement
program. Tran replied. “I’m relieved that the new quality improvement program hasn’t hurt our bonuses,
but the program has increased the workload in the Production Department.
It is true that customer returns are way down, but the cell phones that were returned by customers to retail
outlets were rarely sent back to us for rework.”
232
Required:
1. Expand the company’s quality cost report by showing the costs in both years as percentages of both
total production cost and total quality cost. Carry all computations to one decimal place. By analyzing
the report, determine if Mercury, Inc.’s quality improvement program has been successful. List specific
evidence to support your answer.
2. Do you expect the improvement program as it progresses to continue to increase the workload in the
Production Department?
3. Jorge Gomez believed that the quality improvement program was essential and that Mercury, Inc., could
no longer afford to ignore the importance of product quality. Discuss how Mercury, Inc., could measure
the cost of not implementing the quality improvement program. [Adapted from Garrison et al., 2015]
Illustration 3:
In response to intensive foreign competition, the management of Florex Company has attempted over the
past year to improve the quality of its products. A statistical process control system has been installed and
other steps have been taken to decrease the amount of warranty and other field costs, which have been
trending upward over the past several years. Costs relating to quality and quality control over the last two
years are given below:
Inspection
Quality engineering
Depreciation of test equipment
Rework labor
Statistical process control
Cost of field servicing
Supplies used in testing
Systems development
Warranty repairs
Net cost of scrap
Product testing
Product recalls
Disposal of defective products
Last year
750
420
210
1050
0
1200
30
480
3600
630
810
2100
720
This year
900
570
240
1500
180
900
60
750
1050
1125
1200
750
975
Sales have been flat over the past few years, at $75,000,000 per year. A great deal of money has been spent in
the effort to upgrade quality, and management is anxious to see whether or not the effort has been effective.
Required:
1. Prepare a quality cost report that contains data for both this year and last year. Carry percentage
computations to two decimal places.
2. Prepare a bar graph showing the distribution of the various quality costs by category.
3. Prepare a written evaluation to accompany the reports you have prepared in (1) and (2) above. This
evaluation should discuss the distribution of quality costs in the company, changes in this distribution
that you see taking place, the reasons for changes in costs in the various categories, and any other
information that would be of value to management. [Adapted from Garrison et al., 2015]
233
CHAPTER-D3
LIFE-CYCLE COSTING (LCC)
CHAPTER OVERVIEW
While majority of the costing tools focus on appraising costs annually,
Life-cycle-costing (LCC) considers the total costs of a product throughout
its life cycle-from the design to decline, through introduction, growth and
maturity. Rapid technological change and shortened life cycles have made
product life cycle cost analysis critical to organizations3. Accordingly,
it becomes critical to analyze the costs and benefits a firm incurs and
enjoys during the lifetime of a product. Specifically, a firm can lock-in or
commit most of the cost in the design stage of a product. Once a product is
commercialized, it is rarely practical to cut substantial costs as doing so is
expected to severely affect the quality and thereby customers perceptions
with regard to the quality of the product. This chapter focuses on several
aspects of LCC including their application.
234
Chapter Learning Outcomes (CpLOs)
• Identify the elements associated in LCC
• Illustrate the framework for considering the entire incremental costs over the total life extent of a
product /project
This Study Note Covers (Subtopics)
Concept of LCC
Underlying features of LCC
Significance and benefits of LCC
Application of LCC
LCC for project
Limitations of LCC
Life-cycle budgeting
Level of Study Required
U, AP, AN
Linking CpLOs to CLOs
CpLO1
CpLO2
CpLO3
CpLO4
CpLO5
CpLO6
CpLO7
CLO1
CLO2
CLO1,2
CLO1, 2
CLO 1, 2
CLO2
CLO1,2
CONCEPT OF LIFE-CYCLE COSTING (LCC)
The origin of Life-cycle costing (LCC) can be traced back to 1964 in a report by the Logistics Management
Institute with the aim of reporting the use of equipment of the US government1. The magnetism of LCC lies
in the fact that rapid technological changes have made product life cycle shorter which makes LCC vital in
the attainment of goals. LCC considers the total costs of a product throughout its life cycle-from the design
to decline, through introduction, growth and maturity2.
Put differently, Life cycle costs comprise all costs attributable to a product from conception to those
customers incur throughout the life of the product, including the costs of installation, operation, support,
maintenance and disposal3. For example, life cycle costs for a manufacturer include planning, design,
testing, production, marketing, distribution, administration, and service and warranty costs3.
More precisely, LCC captures costs that occur not only during the manufacturing stage but also in earlier
and/or later stages of a product’s life cycle5. Because these costs are relevant to decisions, firms are well
advised to consider them at an early stage. The consideration of research and design cost is justified
by the fact that such costs affect the product’s lifetime performance2. Guarantee and warranty costs are
appropriate examples of later stage costs because although such costs are incurred in later stages, they must
be incorporated into the sales price5.
So, based on the foregoing discussion, life cycle costs may be classified as follows:
• Planning and development costs
• Design costs
• Manufacturing costs
235
•
•
•
Marketing costs,
Distribution costs, and
Post-sale warranty and guarantee costs
UNDERLYING FEATURES OF LCC
•
•
•
•
•
•
Life cycle costing can be applied to products, services, customers, assets, and projects to analyze cost
over their projected life.
Life cycle costs of a product can be many times the initial investment costs and research findings
revealed that 70-90 percent of these total life cycle costs can be defined in the design phase7.
Life cycle costs includes the costs incurred during the earlier stage of a product’s life cycle (such as
research and development costs), during the manufacturing stage, and costs to be incurred during the
later stage of the life cycle (such as warranty and guarantee costs).
While found new uses for an existing product, the original life cycle can be further extended and
therefore may require revision to the original LCC output.
Successful implementation of LCC and the maximization of benefits from the use of LCC depend
on several facts including maximization of life cycle itself, management of initial design costs,
minimization of the time to market and management of product’s cash flows.
LCC systems for assets, projects and customers are substantially different in terms of costs ingredients,
extent of life cycle, revenues generation, and cash flow streams from that adopted for product LCC.
SIGNIFICANCE AND BENEFITS OF LCC
A number of benefits of LCC can be cited. First, LCC gives due attention to costs incurred during the
design and engineering stages which assist firms to affect manufacturing and service costs in the later stages
along with product quality3. Second, environmental agencies and regulators from both European Union
(European Union’s Industry Directorate) and USA (Environmental Protection Agency) recommend the use
of LCC to increase firm’s environmental awareness and to initiate pollution prevention strategies, and that
the application of LCC can protect the interest of both parties (environmental regulators and firms)3. The
inclusion of environmental costs in the LCC can have favourable impact on product design, operations and
maintenance decisions, recycling and disposal methods, strategic consequences in terms of product choices,
and finally improved organizational performance through products that are environmentally preferable in
the market place4.
Reviewing the outcome of exiting research, Dunk (2004) recognized that paying attentions to product life
cycle is expected to enable an organization:
1. to assess better the effectiveness of planning by comparing actual with budgeted life cycle costs as
well as the distribution of those costs
2. to enhance their capacity to make better pricing decisions
3. to improve the assessment of product profitability
4. to aid in the design of more environmentally desirable products
5. to facilitate an understanding of the environmental impact of products from development through
manufacture, distribution, customer use, disposal and potential recycling
6. to focus on post-sale factors that have become a larger percentage of life cycle costs, including
warranty, cost of parts, service and maintenance, as well as being increasingly important to customers
in their purchasing decisions3,6.
However, to maximize a product’s return over its life cycle, a number of factors are to be managed well by
the organizations8.
236
•
•
•
•
Maximize the length of the product’s life cycle
Control over the design costs of the product
Manage the product’s cash flows
Minimize the time to market the product
APPLICATION OF LCC
For the successful application of LCC, a company must have a detailed plan for product, process, and
logistic support. The following figure demonstrate life cycle engineering approach that goes beyond the
life of the product itself and simultaneously focuses on the issues of manufacturing process and the product
service systems9.
Acquisition phase
Utilization
Recycling
phase
phase
Conceptual
Preliminary
Detail
Production
Product use
Retirement/
Product
design
design
design
Disposal
Manufacturing system
Manufacturing
Recycling
Process
design
operations
processes
Logistic support
Support system design
Support and
maintenance
Recycling
support
Figure: Parallel life cycles in product development [Source: Asiedu and Gu, 1998]
In essence, these six phases can be grouped into four phases: design and development, production, use,
and disposal9. The process life cycle begins with the definition of the production task by the preliminary
product design10 which entails production planning, plant layout, equipment selection, process planning and
other similar tasks9. The third life cycle which concentrates on logistics support9 should also be initiated at
the preliminary design phase and involves the development of support for the design and production stages,
customer support and maintenance during the product usage, and support for product recycling.
Fabrycky and Blanchard (1991) demonstrated details cost items associated with each of the four phases of
LCC system for a product. The first phase is the R & D which includes cost items like product management,
product planning, product research, design documentation, and evaluation and testing. The second phase
involves manufacturing of the product that includes cost items like manufacturing management, industrial
engineering, quality control etc. The third phase focuses on operations and maintenance costs including
product operation, distribution, maintenance, inventory, and operator training. The final phase includes
disposal and retirement costs including their documentation. This is well exhibited in the figure below.
237
Total Product Cost
Research and
Development Cost
Product
managment
Product
planning
Production Cost
Manufacturing
management
Industrial engineering
and operational
analysis
Product
research
Manufacturing
Design
documentation
Product software
Product test and
evaluation
Quality control
Initial logistic
support
Operations and
Maintenance Cost
Retirement and
Disposal Cost
Disposal of nonrepairable
Operation/maintenance
management
Product
operation
Product retirement
Product
distribution
Documentation
Product
maintenance
Inventory
Operator and
maintenance
training
Technical
data
Product
modification
Figure: Cost breakdown structure [Source: Adapted from Fabrycky and Blanchard 1991)
LCC FOR PROJECT
LCC for project is different from LCC for products in several respects. It requires much different information
for the project life cycle phase cost calculation12. These costs usually include purchase price (if the project
is taken for equipment)/investment, energy cost, maintenance cost and other relevant cost12. The following
table illustrates the main categories of life cycle costs of a project.
Category of cost
Investment (acquisition costs)
Cost items
Cost of design and survey works
Project cost (property, plant and equipment)
Cost of operating files
Operating costs for the preparation and acquisition
of assets
Operation costs
Cost of energy supply
Waste disposal cost
Service fees, insurance
Costs for security and safety
Cost of cleaning
Administrative charges
Cost Accounting I Page 239 of 254
238
Maintenance costs
Services, general inspection; warranty inspections
Plan of maintenance
Downtime; Break time
Renewal costs
Repair service
Depreciation
Disposal or retirement costs
Cost of disposal of the assets
Cost of recycling materials
Figure: Life cycle costs [Source: Adapted from Spickova and Myskova, 2015]
Spickova and Myskova (2015) cited an example of how LCC project can be evaluated using traditional
NPV method.
Equipment A
Equipment B
Acquisition cost
590,000
295,000
Operation cost [per 1 hour]:
Electricity
10
6
Variable overhead
14
12
Labor costs
3*5
5*5
Repair and maintenance:
Service interval p.a.
6
12
Service cost
2000
2500
Unplanned failure
1 p.a.
3 p.a.
Failure cost
7000
5000
Maximal capacity
Operational hours p.a.
Gross operating contribution per hour
Expected economic life
Net salvage value
2000
100
20
10000
1500
100
20
10000
Gross operating contribution per hour
Operation costs/h
Operational contribution
Machine capacity hours p.a.
Overall contribution p.a.
Service costs
Unplanned failures
Net contribution p.a.
Equipment A
100
39
61
2000
122000
12000
7000
103000
Equipment B
100
43
57
1500
85500
30000
15000
40500
NPV_Machine A = - 590 000 + (8.5126 x 103 000) + (0.149 x 10 000) = 288 287
NPV_Machine B = - 295 000 + (8.5126 x 40 500) + (0.149 x 10 000) = 51 250
Based on the combination of LCC analysis and NPV calculation, we recommend the purchase of Machine
239
A. This machine has both the higher acquisition price and maximal capacity p.a.. Moreover, the Service
Costs are significantly lower than for Machine B. Finally, the Net Present Value of Machine A is higher by
237 037 CU. The machine A is more cost-efficient throughout the whole economic life cycle.
LIMITATIONS OF LCC
The principal limitation of LCC is that this method heavily relies on the estimation of revenue based on
market research. Accordingly, the ultimate profitability of a product depends on the extent of accuracy of
those estimates. If the actual revenues and costs figures differ from estimates unfavorably and significantly,
the firm may even incur a loss over the life cycle of the product.
The second limitation is that competitors may come up with products having improved quality and reliability
during the life cycle of a firm’s product. This will certainly threaten and shorten the life cycle of a firm’s
product.
LIFE-CYCLE BUDGETING
Illustration 1: [Adapted from CIMA]
GENTECH Ltd specializes in the manufacture of gaming devices. It is planning to introduce a new game
playing device specially designed for young children. Development of the new device is to begin shortly,
and GENTECH Ltd is in the process of preparing a product life cycle budget. It expects the new product to
have a life cycle of 3 years and estimates the following costs:
Units manufactured and sold
Gaming devices per batch
Price per device
R&D and design costs
Production costs:
Variable costs per device
Variable cost per batch
Fixed costs
Marketing costs:
Variable costs per device
Fixed costs
Distribution costs:
Devices per batch
Variable costs per device
Variable cost per batch
Fixed costs
Customer service costs per device
Year 1
50,000
400
BDT 45
900,000
Year 2
200,000
500
BDT 40
100,000
Year 3
150,000
500
BDT 35
16
700
600,000
15
600
600,000
15
600
600,000
3.60
400,000
3.20
300,000
2.80
300,000
200
1
120
240,000
2
160
1
120
240,000
1.50
120
1
100
240,000
1.50
Requirements:
(a) Calculate the budgeted life cycle operating profit for the new gaming device.
(b) Market research has indicated that reducing the selling price by BDT 3 each year would result in
increased sales volume of 10 per cent each year. If sales increase by 10 per cent, GENTECH Ltd plans
240
to increase its production and distribution batch sizes by 10 per cent as well. Assuming all other costs
remain the same should the price be reduced by BDT 3?
(c) Explain how an organization would benefit from a product life cycle costing exercise.
Sample Answer:
[Note before start answering: Part (a) of the question requires you to calculate the life cycle profit– the sum
of the three years data given. Part (b) tests your knowledge of sensitivity analysis – a drop in selling price
increases demand. What effect would this have on profit given the increased batch sizes?]
Statement showing life cycle operating profit for the new device:
Year 1
Year 2
Year 3
Sales revenue
2,250,000
8,000,000
5,250,000
R&D and design costs
900,000
100,000
Production costs:
Variable costs of device
800,000
3,000,000
2,250,000
Variable cost (batch)
87,500
240,000
180,000
Fixed costs
600,000
600,000
600,000
Marketing costs:
Variable costs/device
180,000
640,000
420,000
Fixed costs
400,000
300,000
300,000
Distribution costs:
Variable costs/device
50,000
200,000
150,000
Variable cost/batch
30,000
150,000
125,000
Fixed costs
240,000
240,000
240,000
100,000
300,000
225,000
Customer service costs per device
Operating profit
(1,137,500)
2,230,000
760,000
Life cycle
15,500,000
1,000,000
6,050,000
507,500
1,800,000
1,240,000
1,000,000
400,000
305,000
720,000
625,000
1,852,500
b) Effect on operating profit when selling price reduced by BDT 3 and volume increased by 10 per cent:
New selling price
Sales volume
Production batch size
Distribution batch size
Operating statement
Sales revenue
R&D and design costs
Production costs:
Variable costs of device
Variable cost (batch)
Fixed costs
Marketing costs:
Variable costs/device
Year 1
BDT 42
55,000 units
440
220
Year 2
37
220,000
550
176
Year 3
32
165,000
550
132
Life cycle
2,310,000
900,000
8,140,000
100,000
5,280,000
15,730,000
1,000,000
880,000
87,500
600,000
3,300,000
240,000
600,000
2,475,000
180,000
600,000
6,655,000
507,500
1,800,000
198,000
704,000
462,000
1,364,000
241
Fixed costs
Distribution costs:
Variable costs/device
Variable cost/batch
Fixed costs
Customer service costs per device
Operating profit
400,000
300,000
300,000
1,000,000
55,000
30,000
240,000
110,000
(1,190,500)
220,000
150,000
240,000
330,000
1,956,000
165,000
125,000
240,000
247,500
(485,500)
440,000
305,000
720,000
687,500
1,251,000
The proposed changes will decrease the life cycle profit by BDT 601,500. Therefore, GENTECH should
not reduce selling price as the reduction in costs through economies of scale due to the 10 per cent increase
in volume will not lead to improve current profit.
(c) A life cycle costing exercise enables an organization to appraise the profitability over the whole life of
the product rather than a period at a time. Thus, products that are loss making initially but profitable in the
longer term will be accepted. A large proportion of the costs are locked in at the design stage – a life cycle
costing exercise will enable organizations to reconsider some of these costs at the R & D stage. It also enables
management to focus marketing and promotion when required – at certain critical points of the life cycle.
CORRESPONDING BCAS
BCAS-11 deals with different aspects of Life-Cycle-Costing (LCC) and guides the recording and reporting
process. This standard focuses on the following key points:
• Presenting the concept of life cycle costing as a part of cost management;
• Identifying different costs incurred during different phases of development;
• Bringing total cost of ownership as an important part of decision making process;
• Bringing the concept of invisible costs as a part of total costs for analytical issues; and
• Presenting different methods of applying life cycle costing.
The standard also guides what should be included in the life-cycle cost of a product as:
The life-cycle cost should include all costs that a product imposes on the organization. The life-cycle
cost calculation should be presented so that it identifies the amount, type, and timing of each life-cycle
cost element. Moreover, the cost estimate should include reasonable allowances for cost savings due to
reengineering, continuous improvement (kaizen activities), and activity-based management activities
during the product’s lifetime. [11.6.1]
It further emphasizes that:
Each element of the product lifecycle cost should be estimated using the principle of cause and effect.
Product life-cycle cost components should not be estimated during the planning stage using allocations of
existing costs. [11.6.3]
The standard specifies five distinct phases of a product’s life-cycle:
a) Planning and development;
b) Introduction and growth;
c) Maturity;
d) Decline; and
e) Abandonment or renewal. [11.6.5]
242
According to this standard, the following life-cycle cost can be included in the model:
a) design cost
b) development costs;
c) introduction costs;
d) manufacturing costs;
e) selling and logistical costs;
f)
service and warranty costs; and
g) abandonment costs. [11.6.6]
Recording and Reporting
11.7.1 Life cycle costs associated with activities such as research, design, production, operation,
maintenance, and disposal must be viewed on an integrated and long term basis.
11.7.2 Life Cycle Costing to be used as Life Cycle Cost Management is life cycle thinking from producer,
user, consumer and societal or environmental perspective.
11.7.3 Procurement and production costing technique considers all life cycle costs. In procurement, it
aims to determine the lowest cost of ownership of a fixed asset considering the quality (purchase
price, installation, operation, maintenance and upgrading, disposal, and other costs) during the
asset’s economic life.
11.7.4 In manufacturing it aims to estimate not only the production costs but also how much revenue a
product will generate and what expenses will be incurred at each stage of the value chain during
the product’s estimated life cycle duration”.
Steps in Applying Life Cycle Cost Analysis
A systematic use of Life Cycle Cost Analysis requires the following steps:
1) Define System Requirements,
2) Describe the System Life Cycle and Identify the Major Activities in Each Phase,
3) Develop a Cost Breakdown Structure,
4) Estimate the Costs for Each Phase of the Life Cycle,
5) Select a Computer-Based Model to Facilitate the Analysis Process,
6) Develop a “Baseline” Cost Profile,
7) Develop a Cost Summary and Identify the High-Cost Contributors,
8) Determine the Cause-and-Effect Relationships Pertaining to High-Cost Areas,
9) Conduct a Sensitivity Analysis,
10) Conduct a Pareto Analysis to Identify Major Problem Areas,
11) Identify and Evaluate Feasible Alternatives,
12) Select a Preferred Design Approach.
This standard can be downloaded from the website of the ICMAB or by clicking on the link below: http://
www.icmab.org.bd/professional-standards/
243
Life-cycle-costing considers the total costs of a product throughout its life cycle-from the design to decline,
through introduction, growth and maturity.
A company can lock-in or commit most of the cost (around 70-90 per cent) in the design stage of a product.
The appeal of LCC lies in the rapid technological changes that have made product life cycle shorter, and
this makes LCC crucial in the attainment of goals.
Life cycle costing can be applied to products, services, customers, assets, and projects to analyse their costs
over their projected life.
Successful implementation of LCC and the maximization of benefits from the use of LCC depend on
several facts including maximization of life cycle itself, management of initial design costs, minimization
of the time to market and management of product’s cash flows.
While found new uses for an existing product, the original life cycle can be further extended and therefore
may require revision to the original LCC output.
The inclusion of environmental costs in the LCC can have favourable impact on product design, operations
and maintenance decisions, recycling and disposal methods, strategic consequences in terms of product
choices, and finally improved organizational performance through products that are environmentally
preferable in the market place.
For the successful application of LCC, a company must have a detailed plan for product, process, and
logistic support.
A life cycle costing exercise enables an organization to appraise the profitability over the whole life of the
product rather than a period at a time. Thus, products that are loss making initially can be profitable in the
longer term.
BCAS-11 deals with different aspects of Life-Cycle-Costing (LCC) and guides the recording and reporting
process.
KEY POINTS OF THE CHAPTER
KP1:
Life-cycle-costing considers the total costs of a product throughout its life cycle-from the design to decline,
through introduction, growth and maturity.
KP2:
A company can lock-in or commit most of the cost (around 70-90 per cent) in the design stage of a product.
KP3:
The appeal of LCC lies in the rapid technological changes that have made product life cycle shorter, and
this makes LCC crucial in the attainment of goals.
244
KP4:
Life cycle costing can be applied to products, services, customers, assets, and projects to analyze cost over
their projected life.
KP5:
Successful implementation of LCC and the maximization of benefits from the use of LCC depend on
several facts including maximization of life cycle itself, management of initial design costs, minimization
of the time to market and management of product’s cash flows.
KP6:
While found new uses for an existing product, the original life cycle can be further extended and therefore
may require revision to the original LCC output.
KP7:
The inclusion of environmental costs in the LCC can have favourable impact on product design, operations
and maintenance decisions, recycling and disposal methods, strategic consequences in terms of product
choices, and finally improved organizational performance through products that are environmentally
preferable in the market place.
KP8:
For the successful application of LCC, a company must have a detailed plan for product, process, and
logistic support.
KP9:
A life cycle costing exercise enables an organization to appraise the profitability over the whole life of the
product rather than a period at a time. Thus, products that are loss making initially can be profitable in the
longer term”.
KP10:
BCAS-11 deals with different aspects of Life-Cycle-Costing (LCC) and guides the recording and reporting
process.
SELF-ASSESSMENT QUESTIONS
State whether the following statements are true or false:
1. A life cycle costing exercise enables an organization to appraise the profitability of a product over its
life span.
2. A firm can lock-in or commit insignificant portion of the cost of a product in the design stage of the
product.
3. LCC heavily relies on the estimation of revenue and costs based on market research.
4. The inclusion of environmental costs in the LCC can have an adverse effect on company profitability
as the inclusion involves the incurrence of substantial costs with least effect on performance.
5. In today’s business environment, LCC is becoming less relevant to firms.
Answer to the Self-Assessment Questions:
1. True; 2. False; 3. True; 4. False; 5. False.
245
SELF-REVIEW QUESTIONS
1. Explicate the underlying philosophy of life-cycle costing.
2. Suppose you are the COO of a Mobile phone manufacturing company. The company is contemplating
to launch a new model. Sketch the life-cycle costing system for this specific model for your company.
3. List the benefits of implementing LCC in a manufacturing company.
4. Despite there is evidence that LCC provides several benefits in terms of cost management, why this
costing system did not get desirable attention across the industrial undertakings?
5. In what respects LCC for a product is different from that of project.
6. TRX Ltd specializes in the manufacture of water bottles. It is planning to introduce a new quality bottle
specially designed for teenagers and school-going children. Development of the new bottle is to begin
shortly, and TRX Ltd is in the process of preparing a product life cycle budget. It expects the new
product to have a life cycle of 3 years and estimates the following costs:
Units manufactured and sold
Batch size
Price per bottle
R&D and design costs
Production costs:
Variable costs per bottle
Variable cost per batch
Fixed costs
Marketing costs:
Variable costs per bottle
Fixed costs
Distribution costs:
Devices per batch
Variable costs per bottle
Variable cost per batch
Fixed costs
Customer service costs per bottle
Year 1
150,000
500
BDT 60
600,000
Year 2
220,000
500
BDT 50
200,000
Year 3
130,000
500
BDT 45
20
700
600,000
18
600
600,000
16
600
600,000
3.60
400,000
3.20
300,000
2.80
300,000
200
1
120
240,000
2
160
1
120
240,000
1.50
120
1
100
240,000
1.50
Requirements:
(a) Calculate the budgeted life cycle operating profit for the new bottle.
(b) Market research has indicated that reducing the selling price by BDT 5 each year would result in
increased sales volume of 15 per cent each year. If sales increase by 15 per cent, TRX Ltd plans to
increase its production and distribution batch sizes by 20 per cent as well. Assuming all other costs
remain the same should the price be reduced by BDT 5?
246
7. ABC Ltd is going to assess the acceptability of a project using LCC and NPV methods.
Acquisition cost
Operation cost [per 1 hour]:
Electricity
Variable overhead
Labor costs
Repair and maintenance:
Service interval p.a.
Service cost
Unplanned failure
Failure costs
Maximal capacity
Operational hours p.a.
Gross operating contribution per hour
Expected economic life
Net salvage value
Equipment A
790,000
Equipment B
395,000
12
14
4 Hours @ Tk 4
7
12
5 hours @ Tk 5
7
2000
2 p.a.
9000
10
2500
3 p.a.
8000
3000
4000
120
20
5000
120
20
5000
Requirement:
Advice which equipment the company should purchase based on the cost-efficiency throughout the whole
economic life cycle.
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