COST ACCOUNTING
By the same author and publisher:

A Textbook of Cost and Management Accounting
For MBA, MCom, CA, ICMA, CS etc.

Cost Accounting: Principles and Practice

Cost Accounting
For BCom (Hons), University of Delhi
COST ACCOUNTING
As per Choice Based Credit System (CBCS)
For BCom (Hons), Semester IV,
University of Delhi, School of Open Learning and
Other Central Universities
FOURTH EDITION
CMA M N Arora
MCom, FCMA
Associate Professor (Retd)
Hans Raj College, University of Delhi
Visiting Faculty in Business Schools
Priyanka Katyal
MCom, MPhil.
Associate Professor
Maharaja Agrasen College, University of Delhi
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Cost Accounting (Delhi University)
ISBN: 978-93-5453-854-4
Product Code: V8COA48ACCN10ENAD21O
Special DU Edition 2013
Fourth Edition 2022
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Copyright © M N Arora, 2013, 2016, 2019, 2022
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PREFACE TO THE FOURTH EDITION
The first three editions of this book, prepared especially for BCom (Hons.) course of
Delhi University, have been received very well by professors and students alike and
became immediate success resulting in their various reprint editions. We received
numerous communications from the readers lauding the book and suggesting how it
could be improved further. We also have our own ideas of revision based on our
experiences. With the help of all this information, we have thoroughly revised the book
and present its fourth edition keeping in view the latest CBCS syllabus. The most
obvious changes in this edition are revision of certain portions of the text to bring it
in line with the latest syllabus and adding some new questions and problems and also
deleting some. The book is also updated with the latest question papers along with
their solutions Professors who have taught from this book earlier should find the
revised edition even more useful. Our main audience remains the students of the
regular course and those of open learning.
We have greatly profited from the comments and thoughtful suggestions of many
of our colleagues, students and friends and feel extraordinarily grateful to everyone
who has provided ideas for improving the book.
We also feel grateful to our publishers Vikas Publishing House for all cooperation
in bringing out this new edition in a most professional manner.
M N Arora
aroramn59@yahoo.co.in
Priyanka Katyal
priyanka.katyal@hotmail.com
PREFACE TO THE FIRST EDITION
I am pleased to bring out this special edition of Cost Accounting as per the new
syllabus of BCom (Hons) Semester IV of the University of Delhi. This has been done
on the suggestions received from many professors and students to meet the specific
needs of the course. The detailed feedback has helped tremendously in the preparation
of this book. The book is divided into twelve chapters as per the syllabus. Some
recent question papers of BCom (Hons) of the University have also been appended
with their answers. I hope the book will help students to study in a focused manner.
I remain grateful to professors, students, my family and other well-wishers for
their feedback, support and encouragement. Many people at Vikas Publishing House
have earned my deepest thanks, particularly Mr Sudhanshu Gupta, for looking after
the book in its editorial work.
I welcome comments on how to improve continuously and add value for students.
I shall feel amply rewarded for my efforts if readers are benefited by it.
M N Arora
aroramn59@yahoo.co.in
ACKNOWLEDGEMENTS
The author thankfully acknowledges the invaluable suggestions and encouragement
received from the following friends, colleagues and well wishers in various colleges
of the University of Delhi:
Aastha Dewan, SRCC.
Abha Ajay Kumar, SGTB Khalsa College.
Amrita Singh, SRCC.
Anjula Bansal, Kalindi College.
Archana Gupta, IP College.
D K Pandey, BR Ambedkar College.
G P Agarwal, Shyam Lal College (Eve).
Garima Gupta, DAV College (Eve).
Hema Gupa, Aditi Mahavidyalya.
Hemender Porwal, College of Business
Studies.
Himanshu Garg, Bharati College.
Jagmohan Gupta, MLN College.
Jasvinder Kaur, Sri Guru Gobind Singh
College.
Jyoti Dhawan, Kamla Nehru College.
Kawal Gill, Sri Guru Gobind Singh College.
K B Gupta, School of Open Learning
Keshav Gupta, Satyawati College (Eve).
Kinneri Jain, SRCC.
Lata Sharma, Laxmi Bai College.
M M Goyal, PGDAV College.
Madhu Aggarwal, Daulat Ram College.
Mamta Bhushan, Kamla Nehru College.
Mamta Yadav, BR Ambedkar College.
Manisha Verma, Hans Raj College.
Manju Sahai, Gargi College.
Manjula Grover, SPM College.
Meenakshi, Sri Aurobindo College.
Meenakshi Aggarwal, Vivekananda College.
Mukesh Jain, Zakir Husain College.
N K Agarwal, School of Open Learning.
N L Sharma, Swami Shraddhanand College.
Pinky, SRCC
Pankaj, SRCC
P S Rathore, Rathore College of Commerce,
(Private College).
Prabhsharan Kaur, Mata Sundari College.
Preetinder Kaur, Hans Raj College.
Poonam Sachdeva, Kalindi College.
R D Arora, Bhagat Singh College.
R K Arora, Sri Venketeswara College.
Raj Nangia, Laxmi Bai College.
Rajiv Goel, Delhi College of Arts and
Commerce.
Ravinder Gupta, Deshbandhu College (Eve).
Ravinder Thukral, Maharaja Agrasen College.
Renu Chaudhry, IP College.
Renu Sobti, Swami Shraddhanand College.
Richa, SRCC
Romila Aggarwal, Bharti College.
Rupali A. Khanna, Kamla Nehru College.
S C Garg, School of Open Learning.
S C Jain, Bhagat Singh College (Eve).
S N Gupta, Sri Aurobindo College.
S S Lamba, Sri Guru Gobind Singh College.
Sangeeta Jairath, Gargi College.
Santosh Sabharwal, SRCC.
Sarita Jain, Daulat Ram College.
Savita Gopal, Lady Shriram College.
Sneh Lata, SRCC.
Sneha Suri, Hans Raj College.
Sudesh Kumari, Hans Raj College.
Subhash Chand, Deshbandhu College.
Sukhvir Singh, SGTB, Khalsa College.
Tajinder Kaur, Mata Sundari College.
Usha Jain, Janki Devi Mahavidyalaya.
Venugopal, SGTB Khalsa College.
V K Aggarwal, Shyam Lal College.
V K Yadav, Maharaja Agrasen College.
V P Bansal, Satyawati College (Eve).
Vibha Jain, Janaki Devi Mahavidyalaya.
Vibha Mathur, Jesus and Mary College.
Vipin Kr. Aggarwal, Sri Aurobindo College.
SYLLABUS-BOOK MAPPING
BCom (Hons) Semester IV
COST ACCOUNTING
Course Objective: To provide an in-depth study of the cost accounting principles for identification,
classification and analysis of cost components and cost ascertainment in different industries using various
costing methods
Unit
Unit 1
Unit II
Unit III
Topics
Introduction: Meaning, scope, objectives and advantages of
cost accounting; Difference between financial and cost
accounting. Cost concepts and classifications, Overview of
elements of cost and Cost sheet. Role of a cost accountant in an
organisation. Introduction to Cost Accounting Standards & Cost
Accounting Records and Audit Rules
Elements of Cost: Material and Labour:
(a)Materials: Material/inventory control techniques. Accounting
and control of purchases, storage and issue of materials. Inventory
systems, Methods of pricing of materials issues — FIFO, LIFO,
Simple Average, Weighted Average, Replacement, Standard Cost;
Physical Verification, Accounting treatment and control of
losses— Wastage, scrap, spoilage and defectives
(b) Labour: Accounting and Control of labour cost. Time-keeping
and time-booking. Concept and treatment of idle time, over time,
labour turnover and fringe benefits. Methods of wage payment
and Incentive schemes- Halsey, Rowan, Taylor’s differential piece
wage.
Elements of Cost: Overheads: Classification, allocation,
apportionment and absorption of overheads, Under- and overabsorption; Capacity Levels and Costs; Treatments of certain
items in costing like interest on capital, packing expenses, bad
debts, research and development expenses. Activity based
costing.
Unit IV
Methods of Costing: Unit costing, Job costing, Contract
costing, Process costing (including process losses, valuation of
work-in-progress, joint and by-products). Service costing
(only transport).
Unit V
Cost Accounting Book-Keeping Systems: Integral and nonintegral systems; Reconciliation of cost accounting records with
financial accounts.
Chapter(s) in
the book
Chapter 1
Chapters 2, 3
Chapter 4
Chapters 5, 6, 7, 8,
Chapters 10, 11
CONTENTS
Preface to the Fourth Edition v
Preface to the First Edition vi
Acknowledgements vii
Syllabus Mapping viii
1. INTRODUCTION
1.1–1.54
Learning Objectives 1; Limitations of Financial Accounting 3; Meaning of
Costing and Cost Accounting 4; Objectives and Functions of Cost Accounting 6;
Cost Accounting and Financial Accounting —Comparison 6; Meaning of Cost 11;
Cost Centre 12; Cost Unit 13; Methods of Costing 14; Techniques of Costing 16;
Cost Ascertainment and Cost Estimation 17; Classifications of Cost 18; Special
Costs for Management Decision-Making 25; Installation of a Costing System 34;
Advantages of Cost Accounting 36; Limitations or Objections Against Cost
Accounting 37; Essentials of a Good Cost Accounting System 38; Introduction
to Cost Accounting Standards (CAS) 39; Problems and Solutions 41; Summary
and Key Terms 48; Examination Questions 49; Answers 54
2. MATERIAL COST
2.1–2.78
Learning Objectives 1; Meaning of Material 1; Direct and Indirect Materials 1;
Material Control (Inventory Control) 2; Techniques of Inventory Control 3;
ABC Technique (Selective Control) 4; Stock Levels 5; Inventory Turnover 12;
Slow, Non-Moving and Obsolete Materials 13; Purchase of Materials 14; Purchase
Procedure 15; Purchase Price 20; Storekeeping 21; Materials Codes 23; Stores
Records 23; Documents Authorizing Movements of Materials 26; Inventory
Systems 31; Methods of Pricing Material Issues 32; Average Price Methods 38;
Material Losses 43; Waste, Scrap, Spoilage and Defectives 44; Problems and
Solutions 47; Summary and Key Terms 67; Examination Questions 68;
Answers 77
3. LABOUR COST (Employee Cost)
3.1–3.48
Learning Objectives 1; Introduction 1; Personnel Department 2; Labour
Turnover 3; Time-Keeping Department 7; Payroll Department 13; Idle Time
17; Overtime 19; Methods of Wage Payment (Labour Remuneration) 21;
Treatment of Special Items 28; Problems and Solutions 29; Summary and Key
Terms 44; Examination Questions 44; Answers 48
x
Contents
4. OVERHEAD COST
4.1–4.111
Learning Objectives 1; Meaning Of Overhead Cost 1; Classifications of Overhead
Costs 2; Segregation of Semi-Variable Costs 4; Standing Order Numbers
(Codification of Overheads) 7; Overheads Distribution 8; Collection of
Overheads 8; Allocation and Apportionment of Overheads (Primary Distribution) 8;
Re-Apportionment of Service Department Costs (Secondary Distribution) 13;
Absorption of Overheads 22; Types of Overhead Rates 33; Capacity Utilization
and Overheads 37; Administration Overheads (Office or General Overheads)
40; Selling and Distribution Overheads 41; Under-Absorption and OverAbsorption of Overheads 44; Treatment of Special Items Of Overheads 48;
Activity Based Cost Allocation 53; Activity Based Costing Approach 55; Problems
and Solutions 62; Summary and Key Terms 95; Examination Questions 96;
Answers 110
5. OUTPUT OR UNIT COSTING (Cost Sheet)
5.1–5.44
Learning Objectives 1; Costing Procedure 1; Cost Sheet 1; Treatment of
Stocks 2; Treatment of Administrative Overheads 3; Items Excluded From
Cost 4; Treatment of Scrap 4; Production Account 8; Price Quotations and
Estimated Cost Sheet 9; Problems and Solutions 10; Summary and Key
Terms 35; Examination Questions 36; Answers 43
6. JOB COSTING
6.1–6.18
Learning Objectives 1; Introduction 1; Objectives of Job Costing 1; Job Costing
Procedure 2; Completion of Jobs 4; Problems and Solutions 6; Summary and
Key Terms 13; Examination Questions 14; Answers 17
7. CONTRACT COSTING
7.1–7.43
Learning Objectives 1; Contract Costing and Job Costing-Distinction 1; Features
of Contract Costing 2; Contract Costing Procedure 2; Special Points in Contract
Costing 3; Cost of Materials 3; Cost of Labour 3; Plant 3; Sub-Contracts 4;
Payment Based on Architect's Certificate 4; Work Certified and Work Uncertified
4; Retention Money and Cash Ratio 4; Extra Work 5; Profit on Uncompleted
Contracts 5; Notional Profit 5; Estimated Profit 5; Portion of Notional Profit
or Estimated Profit to be Transferred to Profit and Loss Account 6; Escalation
Clause 9; Cost-Plus Contracts 9; Problems and Solutions 10; Summary and
Key Terms 32; Examination Questions 33; Answers 42
8. PROCESS COSTING
8.1–8.94
Learning Objectives 1; Essential Characteristics of Process Costing 1; Process
Costing and Job Costing—A Comparison 2; Process Costing Procedure 2;
Process Losses and Wastages 4; Normal Process Loss 5; Abnormal Process
Loss 5; Abnormal Gain or Effectiveness 7; When the Output of a Process is
Partly Sold and Partly Transferred to the Next Process 10; Work-in-Progress
(Equivalent Production) 13; When there is Opening as well as Closing stock of
Work-in-progress 17; FIFO (First-in, First out) Method 18; Average Cost
Method 21; FIFO Method vs Average Cost Method 23; Joint Products and Byproducts 26; Joint Costs and Subsequent Costs 27; Accounting for Joint Products
27; Distinction between Joint Products and By-products 31; By-products,
xi
Contents
Scrap and Waste 32; Accounting for By-products 32; Decision Regarding
Further Processing of Joint and By-products 34; Limitations of Joint Cost Analysis
34; Problems and Solutions 35; Summary and Key Terms 77; Examination
Questions 78; Answers 92
9. OPERATING COSTING (Service Costing)
9.1–9.31
Learning Objectives 1; Characteristics 1; Cost Unit 2; Transport Costing 2;
Determination of Number of Cost Units 3; Absolute tonne-km and Commercial
tonne-km 3; Log Sheet 3; Transport Costing Procedure 4; Price Quotations
6; Problems and Solutions 7; Summary and Key Terms 22; Examination
Questions 23; Answers 30
10. INTEGRAL AND NON-INTEGRAL SYSTEMS
10.1–10.24
Learning Objectives 1; Non-integrated Accounts 1; Ledgers to be Maintained
2; Meaning of Control Accounts 2; Principal Accounts to be Maintained 3;
Integrated Accounts 7; Meaning 7; Distinctive Features 7; Advantages 8;
Disadvantages 8; Accounting Entries 8; Problems and Solutions 11; Summary
and Key Terms 22; Examination Questions 23; Answers 24
11. RECONCILIATION OF COST AND
FINANCIAL ACCOUNTS
11.1–11.26
Learning Objectives 1; Need for Reconciliation 1; Reasons for Disagreement in
Profit/Loss 1; Method of Reconciliation 3; Memorandum Reconciliation Account 4;
Problems and Solutions 4; Summary and Key Terms 17; Examination
Questions 17; Answers 26
APPENDIX: Past Question Papers
A.1–A.36
CHAPTER
1
INTRODUCTION
Learning Objectives
After studying this chapter, you should be able to:
• Understand and define the terms ‘costing’, ‘cost accounting’ and ‘management
accounting’ and list the differences inter se
• Describe the various objectives and functions of cost accounting
• Understand the meaning of cost, cost object, cost centre and cost unit
• Know the various method and techniques of costing
• Discuss the various classifications of cost
• Understand the elements of cost and components of total cost
• Know the steps in the installation of a cost accounting system and the difficulties
faced therein
• Describe the advantages of cost accounting to management and others
• Understand the role of a cost accountant and essentials of a good cost accounting
system
• Know the meaning of cost audit and cost accounting standards
The importance of accounting information to the successful operation of a business
has long been recognised. Accounting provides timely and accurate financial information
concerning the activities of an enterprise to a diverse group of people such as
shareholders, managers, creditors, tax authorities, etc. On the basis of the purpose for
which this information is used, accounting is divided into three parts—financial
accounting, cost accounting and management accounting.
Accounting
Financial
Accounting
Cost
Accounting
Management
Accounting
This introductory chapter provides a framework of cost accounting, explaining
its basic concepts, cost classifications, costing methods and techniques, elements
of cost etc.
1.2
Introduction
Financial Accounting–the Forerunner of Cost Accounting
For centuries financial accounting was considered adequate for meeting the informational
needs of the management for control of business operations. In financial accounting,
the focusis on the preparation of annual financial statements which comprise of:
(a) Profit and Loss Account showing the net profit or loss during the period;
(b) Balance Sheet showing the financial position of the firm at a point of time;
(c) Cash Flow Statement showing the inflows and outflows of cash arising from
the business activities during the period covered by the statement.
Thus, the objective of financial accounting is to present a true and fair view of a
company’s income, financial position and funds at regular intervals of one year.
Cost Accounting
Compared with financial accounting, cost accounting is a relatively recent development.
Modern cost accounting developed only during the nineteenth century. In fact, cost
accounting started as a branch of financial accounting, but it is now regarded as an
accounting system in its own right. The vital importance that cost accounting has
acquired in the modern age is because of the increasing complexity of modern industry.
Financial information supplied by financial accounting in the form of financial
statements stated above relate to past activity. Cost accounting, on the other hand, is
not restricted to just the past. It is concerned with the ascertainment of past, present
and expected future costs of products manufactured or services supplied. Detailed
meaning and definition of cost accounting is given later in this chapter. In brief, cost
accounting is a system of not only determining the costs of products and services but
also plays a critical role in supporting tactical business decisions and enhancing
profitability.
Cost accounting has primarily developed to meet the needs of management. Profit
and Loss Account and Balance Sheet are presented to the management by the financial
accountant. But modern management needs much more detailed information than
those supplied by these financial statements. Cost accounting provides detailed cost
information to various levels of management for efficient performance of their functions.
The information supplied by cost accounting acts as a management tool for decisionmaking, to optimise the utilisation of scarce resources and ultimately add to the
profitability of business by controlling expenditure under various heads.
Management Accounting
The term ‘management accounting’ is the modern concept of accounts as a tool of
management. It is a broad term and is concerned with all such accounting information
that is useful to management. In simple words, the term management accounting is
applied to the provision of accounting information for management activities such as
planning, controlling and decision-making, etc. Thus, “any form of accounting which
enables a business to be conducted more efficiently” may be regarded as
management accounting. Management accounting information can help managers identify
problems, solve problems and evaluate performance. In USA, the management
accountant is called the ‘Controller’ or ‘Financial Controller’.
Introduction
1.3
Meaning and Definition
In the words of R. Anthony, “Management accounting is concerned with
accounting information that is useful to management.”
According to National Association of Accountants (USA), management accounting
is “the process of identification, measurement, accumulation, analysis, preparation
and communication of financial information used by management to plan. evaluate
and control within the organisation and to assure appropriate use and
accountability for its resources.
The Chartered Institute of Management Accountants (CIMA) of UK has
given a very authoritative and comprehensive definition as follows:
“Management accounting is an Integral part of management concerned with
identifying, presenting and interpreting information used for —
(i) formulating strategy;
(ii) planning and controlling activities;
(iii) decision-making:
(iv) optimising the use of resources;
(v) disclosure to shareholders and others external to the entity:
(vi) disclosure to employees; and
(vii) safeguarding assets.”
The Institute of Cost Accountants of India (ICAI) has defined management
account-ing as “a system of collection and presentation of relevant economic
information relating to an enterprise for planning, controlling and decision
making.”
These definitions make it clear that management accounting plays a vital role in
providing the necessary information to managers in performing their functions of planning,
controlling, organising and decision-making.
LIMITATIONS OF FINANCIAL ACCOUNTING
Cost accounting has emerged mainly because of certain limitations of financial
accounting. Financial accounting is so limited and inadequate in regard to the information
which it can supply to management that businessmen have been eager to adopt
supplementary accounting systems like cost accounting. The limitations of financial
accounting are summarised as follows:
1. Shows only overall performance. Financial accounting provides information about
profit, loss, cost, etc., of the collective activities of the business as a whole. It does
not furnish costing data classified in terms of departments, products, processes, sales
territories, etc.
2. Historical in nature. Financial accounting is historical, since the data are summarised
only at the end of the accounting period. There is no system of computing day-to-day
cost and also computing pre-determined costs.
3. No performance appraisal. In financial accounting, there is no system of developing
norms and standards to appraise the efficiency in the use of materials, labour and
other costs by comparing the actual performance with what should have been
accomplished during a given period of time.
1.4
Introduction
4. No material control system. Generally, there is no proper system of control over
materials which may result in losses in the form of obsolescence, deterioration, excessive
scrap, misappropriation, etc.
5. No labour cost control. In financial accounting, there is no system of recording
loss of labour time, i.e., idle time. Labour cost is not recorded by jobs, processes or
departments, and as such it offers no system of incentives that may be easily used to
compensate workers for their above-standard performance.
6. No proper classification of costs. In financial accounting, costs are not classified
into direct and indirect, fixed and variable and controllable and uncontrollable costs.
These classifications have utility of their own.
7. No analysis of losses. Financial accounting does not fully analyse the losses due
to idle time, idle plant capacity, inefficient labour, sub-standard materials, etc. Thus,
exact causes of the losses are not known.
8. Inadequate information for price fixation. Costs are not available as an aid in
determining prices of products, services or production orders.
9. No cost comparison. Comparison is the foundation of modern management control.
But financial accounting does not provide data for comparison of costs of different
periods, different jobs or departments, sales territories, etc.
10. Fails to supply useful data to management. Financial accounting fails to supply
useful data to management for taking various decisions like replacement of labour by
machines, introduction of new products, make or buy, selection of the most profitable
product mix, etc.
MEANING OF COSTING AND COST ACCOUNTING
Costing is concerned with determining the costs of products/services and also planning
and controlling such costs. The Chartered Institute of Management Accountants (CIMA),
London has defined costing as, “the techniques and processes of ascertaining
costs.” Wheldon has defined costing as, “the proper allocation of expenditure and
involves the collection of costs for every order, job, process, service or unit.”
Thus, costing simply means cost finding by any process or technique. It consists of
principles and rules which are used for determining:
(a) the cost of manufacturing a product, e.g., motor car, furniture, chemical, steel,
paper, etc., and
(b) the cost of providing a service, e.g., electricity, transport, education, etc.
The terms ‘costing’ and ‘cost accounting’ are often used interchangeably. Cost
accounting is a formal system of accounting for costs in the books of account by
means of which costs of products and services are ascertained and controlled. According
to L.C. Cropper, “cost accounting means a specialised application of the general
principles of accounting in order to ascertain the cost of producing and marketing
any unit of manufacture or of carrying out any particular job or contract.” An
authoritative definition of cost accounting has been given by CIMA, London as follows:
“Cost accounting is the process of accounting for costs from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units. In its widest usage, it embraces the preparation
of statistical data, the application of cost control methods and ascertainment of
profitability of activities carried out or planned.”
Costing and Cost Accounting—Difference Though the terms ‘costing’ and ‘cost
Introduction
1.5
accounting’ are often interchangeably used, there is a difference between the two.
Costing is simply determining costs by using any method like arithmetic process,
memorandum statements, etc. Cost accounting, on the other hand, denotes the formal
accounting mechanism by means of which costs are ascertained by recording them in
the books of account. In simple words, costing means finding out the cost of products
or services by any technique or method, while cost accounting means costing using the
double entry system.
Cost Accountancy Cost accountancy is a very wide term. It means and includes the
principles, conventions, techniques and systems which are employed in a business to
plan and control the utilisation of its resources. It is defined by CIMA, London as, “the
application of costing and cost accounting principles, methods and techniques to
the science, art and practice of cost control and the ascertainment of profitability.
It includes the presentation of information derived therefrom for the purposes of
managerial decision making.”
Cost accountancy is thus the science, art and practice of a cost accountant. It is
a science in the sense that it is a body of systematic knowledge which a cost accountant
should possess for the proper discharge of his duties and responsibilities. It is an art
as it requires the ability and skill on the part of a cost accountant in applying the
principles of cost accountancy to various managerial problems like price fixation, cost
control, etc. Practice refers to constant efforts on the part of cost accountant in the
field of cost accountancy. Theoretical knowledge alone would not enable a cost
accountant to deal with the various intricacies involved. He should, thus, have sufficient
practical training, and exposure to real life costing dilemmas.
Scope of Cost Accountancy
The following functional activities are included in the scope of cost accounting:
1. Costing—It is concerned with ascertainment of cost of products, processes, jobs
services, etc. In fact, ascertainment of cost is the most important function of cost
accounting.
2. Cost accounting—It involves maintaining complete record of all costs incurred
from their incurrence up to the charging to final products/services. Such records are
kept on the basis of double entry system.
3. Cost analysis—Costs recorded in the books are analysed according to categories
such as direct and indirect costs, fixed and variable costs, controllable and uncontrollable
costs, etc.
4. Cost control—Cost accounting includes the comparison of actual cost incurred
with the predetermined standard cost so that the difference between the two can be
analysed and used for cost control purpose.
5. Cost reports—Cost accounting includes the presentation of periodical cost reports
such as weekly, monthly reports for use by management at different levels. These
reports form the basis of planning and control, performance appraisal and managerial
decision making.
6. Cost audit—Cost audit is the verification of cost accounts and a check on the
adherence to the cost accounting plan. It lays stress on the propriety of expenditure
and efficiency of performance.
Introduction
1.6
Applications of Cost Accounting
Cost accounting is generally considered as being applicable only to manufacturing
concerns. This is not so. Its applications are in fact much wider. All types of activities,
manufacturing and non-manufacturing, in which monetary value is involved, should
consider the use of cost accounting. Wholesale and retail businesses, banking and
insurance companies, railways, airways, shipping and road transport companies, hotels,
hospitals, schools, colleges, universities, farming and cinema houses, all may employ
cost accounting techniques to operate efficiently. It is only a matter of recognition by
the management of the applicability of these costing concepts and techniques in their
own fields of endeavour.
OBJECTIVES AND FUNCTIONS OF COST ACCOUNTING
The main objectives of cost accounting are as follows:
1. Ascertainment of cost and profit. This is the primary objective of cost accounting.
In cost accounting, cost and profit of each unit of production, job, or process etc. is
ascertained. Not only actual costs incurred are ascertained but costs are also predetermined for various purposes. For cost ascertainment, various methods and
techniques are employed under different situations.
2. Cost control and cost reduction. Cost accounting aims at improving profitability by
controlling and reducing costs. For this purpose, various specialised techniques like
standard costing, budgetary control, inventory control, value analysis, etc., are used. This
objective of cost control and cost reduction is becoming increasingly important in the
present scenario because of growing competition in the business world.
3. Guide to business policy. Cost accounting aims at serving the needs of the
management in conducting the business with utmost efficiency. Cost data provide
guidelines for various managerial decisions like make or buy, selling below cost, utilisation
of idle plant capacity, introduction of a new product, etc.
4. Determination of selling price. Cost accounting provides cost information on the
basis of which selling prices of products or services may be fixed. In periods of
depression, cost accounting guides in deciding the extent to which the selling prices
may be reduced to meet the situation.
In order to realise these objectives, the data provided by cost accounting may have
to be re-classified, re-organised and supplemented by other relevant business data
from outside the formal cost accounting system.
COST ACCOUNTING AND FINANCIAL ACCOUNTING —COMPARISON
Both cost accounting and financial accounting are concerned with systematic recording
and presentation of financial data. The two systems rest on the same principles concerning
debit and credit and have the same sources of recording the transactions. But cost
accounting is much more detailed than financial accounting. This is because in financial
accounting, profit or loss is ascertained for the business as a whole whereas in cost
accounting, detailed cost and profit data for various parts of business like departments,
products, etc. are shown. This is explained in the following illustration.
Suppose a company is manufacturing three products—X, Y and Z. Under financial
accounting and cost accounting, the following types of statements are prepared:
Introduction
1.7
Under Financial Accounting A Profit and Loss Account is prepared to compute
profit as shown below (data is assumed):
Profit and Loss Account
for the period..........
To Materials
To Wages
To Other expenses
To Profit (Balance figure)
`
75,000
20,000
25,000
30,000
1,50,000
`
1,50,000
By Sales
1,50,000
This statement shows that total profit is `30,000 but it does not disclose the details
of profit/loss of each of the products X, Y and Z in the total profit. This is revealed
by cost accounting.
Under Cost Accounting A detailed statement is prepared as follows: (Data of
above Profit and Loss Account with further assumptions).
Statement of Cost and Profit
for the period..........
Total
`
Product X
`
Product Y
`
Product Z
`
Materials
Wages
Other expenses
75,000
20,000
25,000
40,000
10,000
20,000
12,000
5,000
3,000
23,000
5,000
2,000
Total cost
Sales
1,20,000
1,50,000
70,000
96,000
20,000
28,000
30,000
26,000
30,000
26,000
8,000
(–) 4,000
Profit/Loss (–)
The above detailed statement prepared under cost accounting shows that in the
total profit of `30,000, Product X contributed `26,000 and Product Y `8,000, whereas
Product Z gave a loss of `4,000. When management gets this information, it will
investigate to find out the reasons for loss in product Z. If product Z cannot be made
profitable, its production should be stopped to improve the overall profit picture of the
company. However, this type of information is not revealed by financing accounting.
Differences between cost accounting and financial accounting are explained below:
Basis
Financial accounting
1. Purpose
The main purpose of financial
accounting is to prepare Profit and
Loss Account and Balance Sheet for
reporting to owners or shareholders
and other outside agencies, i.e.,
external users.
Cost accounting
The main purpose of cost
accounting is to provide detailed
cost information to management,
i.e., internal users.
(Contd.)
Introduction
1.8
Basis
Financial accounting
Cost accounting
2. Statutory
These accounts have to be prepared
requirements according to the legal requirements
of Companies Act and Income Tax
Act.
Maintenance of these accounts is
voluntary except in certain
specified industries where it has
been made obligatory to keep cost
records under the Companies Act.
Financial accounts reveal the profit
or loss of the business as a whole
for a particular period. It does not
show the figures of cost and profit
for individual products, departments
and processes.
Cost accounts show the detailed
cost and profit data for each
product
line,
department,
process, etc.
3. Analysis of
cost and
profit
Financial reports (Profit and Loss Cost reporting is a continuous
4. Periodicity
of reporting Account and Balance Sheet) are process and may be daily, weekly
prepared periodically, usually on an monthly, etc.
annual basis.
It lays emphasis on the recording
of financial transactions and does
not attach any importance to the
control aspect.
It provides for a detailed system
of controls with the help of
certain special techniques like
standard costing and Inventory
control etc.
It is concerned almost exclusively
6. Historical
with historical records. The
and
predetermined historical nature of financial
accounting can be easily understood
costs
in the context of the purposes for
which it was designed.
It is concerned not only with
historical costs but also with
predetermined costs. This is
because cost accounting does not
end with what has happened in
the past. It extends to plans and
policies to improve performance
in the future.
7. Format of
presenting
information
Financial accounting has a single
uniform format of presenting
information, i.e., Profit and Loss
Account, Balance Sheet and Cash
Flow Statement.
Cost accounting has varied
forms of presenting cost
information which are tailored to
meet the needs of management
and thus lacks a uniform format.
8. Types of
transactions
recorded
Financial accounting records only
external transactions like sales,
purchases, receipts, etc., with
outside parties.
Cost accounting records not
only external transactions but
also internal or inter-departmental
transactions like issue of
materials by store keeper to
production departments.
5. Control
aspect
(Contd.)
Introduction
1.9
Basis
Financial accounting
9. Types of
statements
prepared
Financial accounting prepares general
purpose statements like Profit and
Loss Account and Balance Sheet.
That is to say, financial accounting
must produce information that is
used by many classes of people,
none of whom have explicitly
defined informational needs.
Cost accounting
Cost accounting generates special
purpose statements and reports
like Report on Loss of Materials,
Idle Time Report, Variance
Report, etc. Cost accounting
identifies the user, discusses his
problems and needs and provides
tailored information.
COMPARISON BETWEEN FINANCIAL ACCOUNTING AND
MANAGEMENT ACCOUNTING
Basis
Financial Accounting
Management Accounting
1. External and
internal users
Financial accounting information is
mainly intended for external users
like investors, shareholders,
creditors, Govt. authorities, etc.
Management accounting information is
mainly meant for internal user, i.e.,
management.
2. Accounting
method
It is based on double entry system
for recording business transactions.
It is not based on double entry
system.
3. Statutory
requirements
Under company law and tax laws,
financial accounting is obligatory to
satisfy various statutory provisions.
Management accounting is optional
though its utility makes it highly
desireable to adopt it.
4. Analysis of cost
and profit
It shows the profit/loss of the
business as a whole. It does not
show the cost and profit for
individual products, processes or
departments, etc.
Management accounting provides
detailed information about individual
products, plants, departments or any
other responsibility centre.
5. Past and future
data
It is concerned with recording
transactions which have already
taken place, i.e., it represents past
or historical records.
It is future oriented. It concen-trates
on what is likely to happen in future
though it may use past data for
future projections.
6. Periodic and
continuous
reporting
Financial reports, i.e.. Profit & Loss
Account and Balance Sheet are
prepared usually on a year to year
basis.
Management accounting reports are
prepared frequently, i.e., these may be
monthly, weekly or even daily,
depending on managerial requirements.
7. Accounting
standards
Companies are required to prepare
financial accounts according to the
standards issued by the Institute of
Chartered Accountants of India.
Management accounting is not bound
by accounting standards.It may use
any practice which generates useful
information to management.
(Contd.)
Introduction
1.10
Basis
Financial Accounting
Management Accounting
8. Types of
statements
prepared
It prepares general purpose
statements, P&L A/c and Balance
Sheet, which are used by external
users.
Here, specific purpose reports are
prepared, e.g.. performance report of
sales or other department managers,
which are used by top management.
9. Publication and
audit
Financial statements (P&L A/c
and Balance Sheet) are made
public for their use and also sent
to shareholders. These have to be
audited by the CAs.
Management accounting statements are
for internal use and thus neither
published for general public use nor
these are required to be audited by
Chartered Accountants.
10. Monetary and
non-monetary
measurements
Financial accounting provides
information in terms of money
only.
It may apply monetary or nonmonetary units of measurement, e.g.,
information may be expressed in terms
of rupees or units of quantity,
machine / labour hours, etc.
COMPARISON BETWEEN COST ACCOUNTING AND
MANAGEMENT ACCOUNTING
Basis
Cost Accounting
Management Accounting
1.
Scope
Scope of cost accounting is limited to
providing cost information for
managerial uses.
Its scope is broader than that of cost
accounting as it provides all types of
information (cost accounting as well as
financial accounting) for managerial use.
2.
Emphasis
Main emphasis is on cost ascertain-ment
and cost control to ensure maximum
profit.
Main emphasis is on planning, controlling and
decision making to maximize profit.
3. Techniques
employed
Various techniques used by cost
accounting include standard costing and
variance analysis, marginal cost-ing and
cost volume profit analysis, budgetary
control, uniform costing and inter-firm
comparison, etc.
It uses all techniques used in cost accounting but in addition it also uses techniques like
ratio analysis, funds flow statement,
statistical analysis, operations research and
some from other disciplines, like mathematics, and economics, whatsoever can help
management in its tasks.
4. Evolution
Evolution of cost accounting is mainly
due to the limitations of financial
accounting.
It evolved due to the limitations of cost
accounting. In fact, it is an extension of the
managerial aspects of cost accounting.
5. Statutory
requirements
Maintenance of cost records is compulsory in selected industries as notified
by Govt. from time to time.
Management accounting is purely voluntary
and its use depends upon its utility to
management.
6. Database
It is based on data derived from financial
accounts.
It is based on data derived from cost
accounting, financial accounting and other
sources.
7. Status in the
Organization
In the organizational set-up, cost
accountant is placed at a lower level in
hierarchy than the management
accountant.
Management accountant is generally placed
at a higher level of hierarchy than the cost
accountant.
8. Installation
Cost accounting system can be installed
without management accounting.
Management accounting cannot be installed
without a proper system of cost accounting.
Introduction
1.11
MEANING OF COST
The term ‘cost’ does not have a definite meaning and its scope is extremely broad and
general. It is, therefore, not easy to define or explain this term without leaving any
doubt concerning its meaning. Cost accountants, economists and others develop the
concept of cost according to their needs because one complete description of ‘cost’
to suit all situations is not possible.
According to the Oxford Dictionary, cost means “the price paid for something.”
Some other definitions of cost are given below:
1. Cost is “the amount of expenditure (actual or notional) incurred or attributable
to a given thing.” (CIMA, London)
2. “A cost is the value of economic resources used as a result of producing or
doing the things costed.” (WM Harper)
3. “Cost is a measurement, in monetary terms, of the amount of resources used for
the purpose of production of goods or rendering of services”. ICWA of India.
In fact, in order to assign a definite meaning to the term ‘cost’, it should be used
with a modifier or an adjective according to the specific purpose for its use. For
example, direct cost, fixed cost, variable cost, controllable cost, material cost, selling
cost, prime cost, marginal cost, differential cost, standard cost, estimated cost, actual
cost, joint cost, conversion cost, etc. have specific meanings. All these terms have
been explained in this book.
Cost vs. Expense and Loss
Often the terms ‘cost’ and ‘expense’ are used interchangeably. But cost should be
distinguished from expense and loss.
Cost
Unexpired Cost
Expired Cost
Expense
Loss
Shown in
Profit and Loss
Account
on debit side
Fig. 1.1
Shown in
Balance Sheet
as an asset
Relation of cost, expense and loss.
Introduction
1.12
Expense is defined as “an expired cost resulting from a productive usage of
an asset.” It is that cost which has been applied against revenue of a particular
accounting period in accordance with the principle of matching costs to revenue. In
other words, an expense is that portion of the revenue earning potential of an asset
which has been consumed in the generation of revenue. Unexpired or unconsumed
part of the cost is recorded as an asset in the balance sheet. Such an unexpired cost
is converted into an expense when it expires while helping to earn revenue. For
example, when a plant is purchased, depreciation on plant (expired cost) is charged
to profit and loss account as an expense and cost of plant remaining after providing
depreciation (unexpired cost) is shown as an asset in the balance sheet. Every year,
depreciation on plant representing expense is debited to profit and loss account and
depreciated value representing unexpired cost is shown in the balance sheet. Prepaid insurance is also an example of unexpired cost which is shown in the balance
sheet as an asset.
Loss Loss is defined as “reduction in a firm’s equity, other than from withdrawals
of capital for which no compensating value has been received.” A loss is an
expired cost resulting from the decline in the service potential of an asset that generated
no benefit to the firm. Obsolescence or destruction of stock by fire are examples of
loss.
COST CENTRE
For the purpose of ascertaining cost, the whole organisation is divided into small parts
or sections. Each small section is treated as a cost centre of which cost is ascertained.
A cost centre is defined by CIMA, London as “a location, person, or item of
equipment (or group of these) for which costs may be ascertained and used for
the purpose of control.” Thus, a cost centre refers to a section of the business to
which costs can be charged. It may be a location (a department, a sales area), an item
of equipment (a machine, a delivery van), a person (a salesman, a machine operator)
or a group of these (two automatic machines operated by one workman). The main
purpose of ascertaining the cost of a cost centre is control of cost.
Cost centres are primarily of two types:
(a) Personal cost centre—Which consists of a person or a group of persons.
(b) Impersonal cost centre—Which consists of a location or an item of equipment
or group of these.
From a functional point of view, cost centres may be of the following two types:
(a) Production cost centre. These are those cost centres where actual production
work takes place. Examples are weaving department in a textile mill, melting shop in
a steel mill, cane crushing shop in a sugar mill, etc.
(b) Service cost centre. These are those cost centres which are ancillary to and
render services to production cost centres. Examples of service cost centres are
power house, tool room, stores department, repair shop, canteen, etc.
A cost accountant sets up cost centres to enable him to ascertain the costs he
needs to know. A cost centre is charged with all the costs that relate to it, e.g., if a
cost centre is a machine, it will be charged with the costs of power, light, depreciation
and its share of rent etc. The purpose of ascertaining the cost of a cost centre is cost
Introduction
1.13
control. The person in charge of a cost centre is held responsible for the control of
cost of that centre.
COST UNIT
It has been seen above that cost centres help in ascertaining costs by location,
equipment or person. A cost unit goes a step further by breaking up the cost into
smaller sub-divisions, thereby helping in ascertaining the cost of saleable products or
services.
A cost unit is defined by CIMA, London as a “unit of product or service in
relation to which costs are ascertained.” According to Institute of Cost Accountants
of India (ICAI), ‘Cost unit is a form of measurement of volume of production or
service. This unit is generally adopted on the basis of convenience and practice
in the industry concerned’. For example, in a sugar mill, the cost per tonne of sugar
may be ascertained, in a textile mill the cost per metre of cloth may be ascertained.
Thus ‘a tonne’ of sugar and ‘a metre’ of cloth are cost units.
All sorts of cost units are adopted, the criterion for adoption being the applicability
of a particular cost unit to the circumstances under consideration. Broadly, cost units
may be of two types as explained below:
(i) Units of production, e.g., a ream of paper, a tonne of steel, a metre of cable, etc.
or
(ii) Units of service, e.g., passenger miles, cinema seats, consulting hours, etc.
A few more examples of cost units in various industries are given below:
Industry/Business
Cement/Sugar/Steel
Chemicals
Bricks
Soft drink
Nursing home/Hospital
Interior decoration
Flour
Shoes
Pencils
Electricity
Transport
Car
Paper
Printing press
Cotton or jute
Building construction
Timber
Brewing
Mines
Carpets
Cost Unit
Tonne (MT)
Tonne, kilogram, litre, gallon, etc.
1,000 bricks or 500 bricks
Crate of 24 bottles or 12 bottles
Bed per day/Out patient
Each job
Tonne
Pair or dozen pairs
Dozen or gross
Kilowatt hour (KWH)
Passenger kilometre/tonne kilometre
Each car
Ream
Thousand copies
Bale
Each building or flat
Cubic foot
Barrel
Tonne of mineral
Square foot
Introduction
1.14
Hotel
Gas
Education
Petroleum
Room per day
Cubic foot/cubic metre
Student year
Barrel/tonne/litre
The cost units and cost centres should be those which are natural to the business
and which are readily understood and accepted by all concerned.
Cost Object
Cost object is defined as “anything for which a separate measurement of cost may
be desired”. A cost accountant may want to know the cost of a particular ‘thing’ and
such a ‘thing’ is called a cost object. A cost object ‘includes a product, service, cost
centre, activity, sub-activity, project, contract, customer or distribution channel
or any other unit in relation to which costs are ascertained’. CIMA, London.
Examples of cost objects are given below:
Cost Object
Examples
Product
Car, shaving razor
Service
Telephone hotline, taxi service
Process
Melting process in a steel mill, weaving process
in a textile mill
Activity
Developing a webside on the Internet, setting
a machine, placing a purchase order
METHODS OF COSTING
The methods or types of costing refer to the techniques and processes employed in
the ascertainment of costs. Several methods have been designed to suit the needs of
different industries. The method of costing to be applied in a particular concern depends
upon the type and nature of manufacturing activity. Basically, there are two methods
of costing:
1. Job costing or job order costing, and
2. Process costing.
All other methods are variations of either job costing or process costing. The
various methods given here are in outline only and detailed discussion of each of these
is given in later chapters.
1. Job order costing. This method “applies where work is undertaken to customers’
special requirements.”* Cost unit in job order costing is taken to be a job or work
order for which costs are separately collected and computed. A job, big or small,
comprises a specific quantity of a product or service to be provided as per customer’s
specifications. Industries where this method is used include printing repair shops,
interior decoration, painting, etc.
2. Contract costing or terminal costing. This is a variation of job costing and,
therefore, principles of job costing apply to this method. The difference between job
and contract is that job is small and contract is big. It is well said that a contract is
* CIMA, London Terminology.
Introduction
1.15
a big job and a job is a small contract. The cost unit here is a ‘contract’ which
is of a long duration and may continue over more than one financial year. Contract
costing is most suited to construction of buildings, dams, bridges and roads, shipbuilding, etc.
3. Batch costing. Like contract costing, this is also a variation of job costing. In this
method, the cost of a batch or group of identical products is ascertained and therefore
each batch of products is a cost unit for which costs are ascertained. This method is
used in companies engaged in the production of readymade garments, toys, shoes,
tyres and tubes, component parts, etc.
4. Process costing. As distinct from job costing, this method is used in mass production
industries manufacturing standardised products in continuous processes of manufacturing.
Costs are accumulated for each process or department. Here raw material has to pass
through a number of processes in a particular sequence to completion stage. In order
to arrive at cost per unit, the total cost of a process is divided by the number of units
produced. The finished product of one process is passed on to the next process as raw
material. Textile mills, chemical works, sugar mills, refineries, soap manufacturing,
etc., may be cited as examples of industries which employ this method.
Costing Techniques
Marginal
costing
A
bs
co orp
st ti
in on
g
rm
ifo n g
Un o s t i
c
St
a
co nda
sti rd
ng
ry
eta l
g
d
Bu o n t r o
c
Cost
Data
Job
costing
Factory
job
costing
Batch
costing
Process
Unit
costing
Contract
costing
Operation
costing
Multiple
costing
Costing Methods
Fig. 1.2
Costing methods and techniques.
Operating
costing
Introduction
1.16
5. Operation costing. This is nothing but a refinement and a more detailed application
of process costing. A process may consist of a number of operations and operation
costing involves cost ascertainment for each operation instead of a process. This
method provides minute analysis of costs and ensures greater accuracy and better
control.
6. Single, output or unit costing. This method of cost ascertainment is used when
production is uniform and consists of a single or two or three varieties of the same
product. Where the product is produced in different grades, costs are ascertained
grade-wise. As the units of output are identical, the cost per unit is found by dividing
the total cost by the number of units produced. This method is applied in mines,
quarries, brick kilns, steel production, flour mills, etc.
7. Operating or service costing. This method should not be confused with operation
costing. It is used in undertakings which provide services instead of manufacturing
products. For example, transport undertakings (road transport, railways, airlines, shipping
companies), electricity companies, hotels, hospitals, cinemas, etc., use this method.
The cost units are passenger-kilometer or tonne-kilometre, kilowatts hour, a room per
day in a hotel, a seat per show in a cinema hall, etc. This method is a variation of
process costing.
8. Multiple or composite costing. It is an application of more than one method of cost
ascertainment with respect to the same product. This method is used in industries where
a number of components are separately manufactured and then assembled into a final
product. For example, in a car manufacturing company, manufacture of different component
parts may require different production methods and thus different methods of costing
may have to be used. Assembly of these components into final product requires yet
another method of costing. Other examples of industries which make use of this method
are air-conditioners, refrigerators, scooters, laptops, locomotives, etc.
Note: It is important to understand that there are no hard and fast rules regarding the
method of costing to be applied in a particular industry. There may sometimes be a
choice of method to be used. For example, in a sugar mill, unit costing may be used
because it is a single product company and cost of a tonne/bag of sugar may be
ascertained. But for sugar production, the raw material has to pass through a number
of processes of manufacture, the process costing may also be used to provide cost
information relating to each process. Thus it depends on the type of cost information
required and the size of the company that the method of costing to be used is decided.
TECHNIQUES OF COSTING
It is the type of industry that determines which of the eight methods of costing discussed
above will be used in a particular enterprise. However, in addition to these methods,
there are certain techniques of costing which are not alternatives to the methods discussed
above. These techniques are those which help a company to present the cost data in a
particular manner to facilitate achievement of a special purpose like cost control, decision
making, etc. These techniques are briefly explained below.
1. Standard costing. This is a very valuable technique of controlling cost. In this
technique, standard cost is pre-determined as target of performance, and actual
performance is measured against the standard. The difference between standard and
Introduction
1.17
actual costs are analysed to know the reasons for the difference so that corrective
actions may be taken.
2. Budgetary control. Closely allied to standard costing is the technique of budgetary
control. A budget is an expression of a firm’s business plan in financial form and
budgetary control is a technique applied to the control of total expenditure on materials,
wages and overheads by comparing actual performance with planned performance.
Thus, in addition to its use in planning, the budget is also used for control and coordination of business operations.
3. Marginal costing. In this technique, separation of costs into fixed and variable
(marginal) is of special interest and importance. This is so because marginal costing
regards only variable costs as the cost of the products. Fixed cost is treated as period
cost and no attempt is made to allocate or apportion this cost to individual cost centres
or cost units. It is transferred to costing profit and loss account of the period. This
technique is used to study the effect on profit of changes in volume or type of output.
4. Total absorption costing. It is a traditional method of costing whereby total costs
(fixed and variable) are charged to products. This is in complete contrast to marginal
costing where only variable costs are charged to products. Although until recently, this
was the only technique employed by cost accountants, but now a days it is considered
to have only a limited application.
5. Uniform costing. This is not a separate technique or method of costing like
standard costing or process costing. It simply denotes a situation in which a number
of firms adopt a uniform set of costing principles. It has been defined by CIMA,
London as “the use by several undertakings of the same costing principles and/
or practices.” This helps to compare the performance of one firm with that of other
firms and thus, to derive the benefit of anyone’s better experience and performance.
Costing Methods and Techniques are Tools
Methods and techniques of costing described above should be regarded as tools of a
cost accountant and it should not be construed that a particular method or technique
is superior to any other. Just as a skilled workman uses different tools for different
tasks, similarly, a cost accountant should use these methods and techniques appropriately
either individually or in combination. For example, standard costing may be combined
with process costing to give ‘standard process costing’, or standard costing may be
combined with marginal costing as well as process costing to give ‘standard marginal
process costing’. Although this may appear confusing, yet if principles involved in each
method or technique are clearly understood, there should not be any difficulty in
making the best use of these methods and techniques.
COST ASCERTAINMENT AND COST ESTIMATION
Cost Ascertainment Cost ascertainment is concerned with computation of actual
costs incurred. It refers to the methods and processes employed in ascertaining costs.
It has been seen earlier that in different types of industries, different methods are
employed for ascertaining cost. These methods are job costing, contract costing, batch
costing, process costing, operating costing, single costing and multiple costing. The
basic principles underlying these methods are the same but these methods have been
Introduction
1.18
designed to suit the needs of individual business conditions. The ascertainment of
actual cost has very little utility because of the following reasons:
1. Actual costs cannot be used for the purpose of price quotations and filling
tenders.
2. Actual cost has practically no utility for cost control purposes.
3. Actual costs are ineffective as means of measuring performance efficiency.
In spite of these limitations, ascertainment of actual costs proves very useful in
many cases. For instance, ascertainment of actual costs reveals unprofitable activities,
losses and inefficiencies occurring in the form of idle time, excessive scrap, etc.
Cost Estimation As against ascertainment of actual costs, costs may also be predetermined. Cost estimation is the process of pre-determining costs of goods or services.
The costs are determined in advance of production and precede the operations. Estimated
costs are definitely the future costs and are based on the average of past actual costs
adjusted for anticipated changes in future. Cost estimates may have the following uses:
1. Cost estimates are used in making price quotations and bidding for contracts.
2. Cost estimates are used in the preparations of budgets.
3. They help in evaluating performance.
4. They are used in preparing projected financial statements.
5. Cost estimates may serve as targets in controlling the costs.
Extreme care should be taken in cost estimation because a high price quotation may
result in loss of business.
CLASSIFICATIONS OF COST
Classification is the process of grouping costs according to their common characteristics.
It is a systematic placement of like items together according to their common features.
There are various ways of classifying costs as given below. Each classification
serves a different purpose.
1. Classification into Direct and Indirect Costs
Costs are classified into direct costs and indirect costs on the basis of their identifiability
with cost units or jobs or processes or cost centres.
Direct costs These are those costs which can be easily and conveniently identified
with a unit of product or other cost object. Cost of raw materials used and wages of
a machine operator are common examples of direct costs. To be specific, cost of steel
used in manufacturing a machine can be easily known. It is, therefore, a direct cost.
Similarly, wages paid to a tailor in a readymade garments company for stitching a pair
of trousers is a direct cost because it can be easily identified in the cost of that
garment.
Indirect costs These are general costs and are incurred for the benefit of a number
of cost units, processes or departments. These costs cannot be easily and conveniently
identified with a unit of product or other cost object. Depreciation of machinery,
insurance, lighting, power, rent, managerial salaries, materials used in repairs, etc., are
Introduction
1.19
common examples of indirect costs. For example, depreciation of machine for stitching
a pair of trousers cannot be known and thus it is an indirect cost.
Costs are not traced or identified directly with a cost unit for one of the following
three reasons:
1. It is impossible to do so; e.g., rent of building, etc.
2. It is not convenient or feasible to do so; e.g., nails used in furniture, sewing
thread, etc.
3. Management chooses not to do so; i.e., many companies classify certain items
of cost as indirect because it is customary in the industry to do so; e.g.,
carriage inward may be treated as an indirect expense (Alternatively, it may
be treated as a part of the cost of materials purchased).
The terms ‘direct’ and ‘indirect’ should be used in relation to the object of costing.
An item of cost may be a direct cost in one case and the same may be indirect in
another case. It is the nature of business and the cost unit chosen that will determine
whether a particular cost is direct or indirect. For example, depreciation of asphalt
mixing plant used by a road building contractor at site is a direct cost, whereas
depreciation of plant used in a factory is an indirect cost. It is because in the factory,
plant would probably benefit more than one cost unit and it may not be convenient to
allocate depreciation to various cost units with any degree of accuracy.
This classification is important from the point of view of accurate ascertainment of
cost. Direct costs of a product can be conveniently determined while the indirect costs
have to be arbitrarily apportioned to various cost units. For example, in readymade
garments, the cost of cloth and wages of tailor are accurately ascertained without any
difficulty and are thus direct costs. But the rent of factory building, managerial salaries,
etc., which are indirect costs, have to be apportioned to various cost units on some
arbitrary basis and cannot be accurately ascertained.
2. Classification into Fixed and Variable Costs
Costs behave differently when level of production rises or falls. Certain costs change
in sympathy with production level while other costs remain unchanged. As such on the
basis of behaviour or variability, costs are classified into fixed, variable and semivariable.
(i) Fixed costs. These costs remain constant in ‘total’ amount over a specific range
of activity for a specified period of time, i.e., these do not increase or decrease
when the volume of production changes. For example, building rent and managerial
salaries remain constant and do not change with change in output level and thus are
fixed costs. But fixed cost ‘per unit’ decreases when volume of production increases
and vice versa, fixed cost per unit increases when volume of production decreases.
For example, if total fixed cost is `20,000 per month, per unit fixed cost will be as
follows:
No. of units produced
1
2
20
200
2,000
Total fixed cost `
20,000
20,000
20,000
20,000
20,000
Fixed cost per unit `
20,000
10,000
1,000
100
10
Introduction
1.20
Y
`Cost
`Cost
Y
Total fixed cost line
X
O
Volume of Production
Fig. 1.3
Fi
xe
d
co
st
pe
r
un
it
X
O
Volume of Production
Behaviour of fixed cost.
The line representing fixed cost per unit will not touch X-axis because the fixed
cost per unit cannot be zero.
Relevent range – Fixed cost remains fixed only in
Fixed Costs
relation to a given range of output and for a given time • Rent and lease
span. If the output is to be increased beyond the range, • Managerial salaries
the fixed cost will also increase. Relevent range refers • Building insurance
to the band of activity or volume in which specific • Salaries and wages of
relationship between the level of activity and the fixed
permanent staff
cost in question is valid.
• Municipal taxes
The characteristics of fixed cost are:
(a) fixed total amount within a relevant range of
Variable Costs
output;
• Direct materials
(b) increase or decrease in per unit fixed cost when
• Direct wages
quantity of production changes;
• Power
(c) apportioned to departments on some arbitrary
• Royalties
basis;
• Normal spoilage
(d) such cost can be controlled mostly by top level
• Commission of salesmanagement.
men
• Small tools
(ii) Variable costs. These costs tend to vary in direct proportion to the volume of
output. In other words, when volume of output increases, total variable cost
also increases, and vice versa, when volume of output decreases, total variable cost
also decreases, but the variable cost per unit remains fixed. It is shown in Fig. 1.4.
Thus, in general, variable costs show the following characteristics:
(a) variability of the total amount in direct proportion to the volume of output;
(b) fixed amount per unit in the face of changing volume;
(c) easy and reasonably accurate allocation and apportionment to departments;
(d) such costs can be controlled by functional managers.
Introduction
1.21
Y
t
To
al
v
ia
ar
bl
e
co
st
Cost (`)
Cost (`)
Y
X
O
Variable cost per unit
X
O
Volume of Production
Volume of Production
Fig. 1.4
Behaviour of variable costs.
When variable cost per unit is `25, total variable cost will be as calculated below:
No. of units produced
(a)
Variable cost per unit
` (b)
Total variable cost
` (a × b)
1
25
25
2
25
50
20
25
500
200
25
5,000
2000
25
50,000
Variable cost (V.C.) behaviour in cost accounting and economic
theory
In cost accounting the relationship between volume of output and total variable cost
is continuous linear i.e., a straight line is formed when plotted on a graph. In economic
theory, this relationship is curvi-linear. This is illustrated in the graph.
0
Volume
Fig. 1.5
Total V.C. in
economic theory
cost (`)
cost (`)
Total V.C. in
cost accounting
0
Volume
Comparative behaviour of total variable cost.
Introduction
1.22
One can understand that the assumption of a curvi-linear relationship is probably
more realistic. But there are special reasons for assuming a linear relationship in cost
accounting.
O
al
i-
ia
b
co
Volume of Production
O
Fig. 1.6
To
s
tal
em
a
i-v
ria
ble
co
st
Cost (`)
t
To
m
se
r
va
le
st
Cost (`)
Cost (`)
(iii) Semi-variable or semi-fixed costs (mixed costs). These costs include both a
fixed and a variable component, i.e. these are partly fixed and partly variable.
A semi-variable cost often has a fixed element below which it will not fall
at any level of output. The variable element in
semi-variable costs changes either at a constant
Semi-variable Costs
rate or in lumps. For example, introduction of an
• Supervision
additional shift in the factory will
• Maintenance and repairs
require additional supervisors and certain costs
• Compensation for accidents
will increase by steps. In the case of a telephone
• Telephone expenses
connection, there is a minimum rent and beyond
• Light and power
a specified number of calls, the charges very
• Depreciation
according to the number of calls made. In fact,
there is no definite pattern of behaviour of semivariable costs. This is shown in Fig. 1.6.
O
Volume of Production
t
To
al
se
m
i-
r
va
ia
bl
e
co
st
Volume of Production
Behaviour of semi-variable cost.
3. Classification into Committed and Discretionary Costs
It is explained above that costs may be classified into fixed and variable. Fixed costs
are further classified into committed costs and discretionary (or programmed) costs.
This classification is based on the degree to which a firm is locked into an asset or
service that is generating the fixed cost.
Committed costs These are those costs that are incurred in maintaining physical
facilities and managerial set up. Such costs are committed in the sense that once the
decision to incur them has been made, they are unavoidable and invariant in the short
run. For example, salary of the managing director may represent a committed cost if,
by policy, the managing director is not to be relieved unless the firm is liquidated.
Similarly, depreciation of plant and equipment is committed because these facilities
cannot be easily changed in the short run.
Introduction
1.23
Y
Cost (`)
A
B
C
A = Fixed cost line
B = Semi-variable cost line
C = Variable cost line
O
Volume of Production
Fig. 1.7
X
Comparative behaviour of total fixed, variable and semi-variable costs.
Discretionary costs These are those costs which can be avoided by management
decisions. Such costs are not permanent. Advertising, research and development cost
and salaries of low level managers are examples of discretionary costs because these
costs may be avoided or reduced in the short run, if so desired by the management.
This classification into committed and discretionary costs is important from the
point of view of cost control and decision making.
4. Classification into Product Costs and Period Costs
Product costs These are those costs which are necessary for production and which
will not be incurred if there is no production. These consist of direct materials, direct
labour and some of the factory overheads. Product costs are ‘absorbed by’ or ‘attached
to’ the units produced. These are called inventoriable costs because these are included
in the cost of product as work-in-progress, finished goods or cost of sales.
Period costs These are those costs which are not necessary for production and are
incurred even if there is no production. These are written off as expenses in the period
in which these are incurred. Such costs are incurred for a time period and are charged
to Profit and Loss Account of the period. Showroom rent, salary of company executives,
travel expenses, etc., are examples of period costs. These costs are not inventoried,
i.e., these are not included in the value of stocks. Administration and selling expenses
are generally treated as period costs.
Classification into product and period cost is important from the point of view of
profit determination. This is so because product cost is carried forward to the next
accounting period as part of the unsold finished stock, whereas period cost is written
off in the accounting period in which it is incurred.
5. Classification into Controllable and Non-controllable Costs
From the point of view of controllability, costs are classified into controllable costs and
non-controllable costs.
Controllable costs These are the costs which may be directly regulated at a given
level of management authority. Variable costs are generally controllable by department
heads. For example, cost of raw material may be controlled by purchasing in larger
quantities.
Introduction
1.24
Product Cost
For unsold goods
For
Period Cost
Fig. 1.8
sol
d g
ood
Recorded as an asset in the
form of inventory in the
Balance Sheet
s
Recorded as an expense in the
Profit and Loss Account of the
current period
Accounting treatment of product and period costs.
Non-controllable costs These are those costs which cannot be influenced by the
action of a specified member of an enterprise. For example, it is very difficult to
control costs like factory rent, managerial salaries, etc.
Two important points should be noted regarding this classification. First, controllable
costs cannot be distinguished from non-controllable costs without specifying the level
and scope of management authority. In other words, a cost which is uncontrollable at
one level of management may be controllable at another level of management. For
example, a departmental manager may have no control over the number of supervisors
employed in his department, but this decision may have to be taken by the production
manager. Thus, supervision cost will be non-controllable at the departmental manager’s
level, but it will be controllable at the level of production manager. Secondly, all costs
are controllable in the long run at some appropriate management level.
It is a misconception that variable costs are controllable and fixed costs are noncontrollable. However, variable costs are more prone to control than fixed costs.
6. Classification into Historical Costs and Pre-determined Costs
On the basis of time of computation, costs are classified into historical costs and predetermined costs.
Historical costs These are the costs which are ascertained after these have been
incurred. Historical costs are thus, nothing but actual costs. These costs are not
available until after the completion of the manufacturing operations.
Pre-determined costs These are future costs which are ascertained in advance of
production on the basis of a specification of all the factors affecting cost. These costs
are extensively used for the purpose of planning and control.
7. Classification into Normal and Abnormal Costs
Normal cost may be defined as a cost which is normally incurred on expected lines
at a given level of output. This cost is a part of cost of production. Abnormal cost is
that which is not normally incurred at a given level of output. Such cost is over and
above the normal cost and is not treated as a part of the cost of production. It is
charged to costing Profit and Loss Account.
Introduction
1.25
SPECIAL COSTS FOR MANAGEMENT DECISION-MAKING
There are certain costs which are specially computed for use by the management for
the purpose of decision-making. These costs may not be recorded in the books of
account.
Relevant Costs and Irrelevant Costs
Relevant cost. Not all costs are relevant for specific decisions. A relevant cost is a
cost whose magnitude will be affected by a decision being made. In decision-making,
management should consider only future costs and revenues that will differ under each
alternative. Management is concerned only with those things it can affect. Management
cannot change the cost of plant and machinery purchased in 1995. It can change
future costs by its current decisions. Hence, relevant costs are future costs that will
differ depending on the actions of the management. For each decision, the management
must decide which costs are relevant. For example, in pricing a competitive bid, only
differential costs are relevant. In measuring firm’s ability to survive short run adversity,
only liabilities and future out of pocket costs are relevant.
Whether a cost is relevant or not depends upon the circumstances. In one case, a
cost may be relevant but in another case the same cost may not be relevant. It is thus
not possible to prepare a list of relevant costs to be used in all types of decisions.
Irrelevant costs. These are those costs that will not be affected by a decision. To
take an example from day-to-day life, one may have to decide about making a journey
by own car or by a public transport bus. In this decision, insurance cost of car is
irrelevant because it will not change, whatever alternative is chosen. However, cost
of petrol and other operating costs of car will differ under the two alternatives and
thus, are relevant for this decision.
Sunk Costs
A sunk cost is an expenditure made in the past that cannot be changed and over which
management no longer has control. These costs are not relevant for decision-making
about the future. Thus, the book value of an asset currently being used is not relevant
in making the decision to replace it. Similarly, the cost of land purchased in 2006 is
not relevant in deciding whether to sell the land or hold it. What is relevant is how
much cash could be realised in future by selling it. Despite the fact that sunk costs,
which are historical costs, are irrelevant for making decisions, they are frequently
analysed in detail before decisions about future courses of action are made. For
example, historical costs may affect future tax payments which will differ depending
on the course of action selected by management. Moreover, an analysis of historical
costs may provide information about how future costs will differ under alternative
courses of action.
One should understand the difference between sunk costs and irrelevant costs. Not
all irrelevant costs are sunk costs but all sunk costs are irrelevant. To take an example,
in choosing from the two alternative methods of production, if direct material cost is
the same under the two alternatives, it is an irrelevant cost. But direct material cost
is not a sunk cost because it will be incurred in future and is a future cost. In the
1.26
Introduction
opinion of Horngren, a well known authority on the subject, sunk cost has the same
meaning as the past cost and all past costs are irrelevant.
Differential (or Incremental) Costs
This cost may be regarded as the difference in total cost resulting from a contemplated
change. In other words, differential cost is the increase or decrease in total cost that
results from an alternative course of action. It is ascertained by subtracting the cost of
one alternative from the cost of another alternative. The alternative choice may arise
because of change in method of production, in sales volume, change in product mix,
make or buy decisions, take or refuse decision, etc.
For differential cost analysis, we need to know the incremental revenues (the change
in revenue) and incremental cost (the change in cost) arising from the decision.
Marginal Cost
Marginal cost is the additional cost of producing one additional unit. Marginal cost is
the same thing as variable cost. Marginal costing (or variable costing) is a technique
of charging only variable costs to products. Inventory is also valued at variable cost
only. Fixed cost is treated as period cost and written off in Profit and Loss Account
of the period. Marginal costing is also a very important analytical and decision making
tool in the hands of management. It helps in decisions like make or buy, pricing of
products, selection of sales mix, etc.
Imputed Costs
These are hypothetical costs which are specially computed outside the accounting
system for the purpose of decision-making. Interest on capital invested is a common
type of imputed cost. As interest on capital is usually not included in cost, it is
considered necessary to take it into account when deciding about the alternative
capital investment projects. The failure to consider imputed interest cost may result in
an erroneous decisions. For example, project A requires a capital investment of `50,000
and project B `40,000. Both the projects are expected to yield `10,000 as additional
profit. Obviously, these two projects are not equally profitable since project B requires
less investment and thus, it should be preferred. Similarly, rental value of building
owned by a firm is also an imputed cost.
Opportunity Cost
Opportunity cost is the sacrifice involved in accepting an alternative under consideration.
In other words, it is a cost that measures the benefit that is lost or sacrificed when
the choice of one course of action requires that other alternative course of action be
given up. For example, a company has deposited `1 lakhs in bank at 10% p.a. interest.
Now, it is considering a proposal to invest this amount in debentures where the yield
is 17% p.a. If the company decides to invest in debentures, it will have to forego bank
interest of `10,000 p.a., which is the opportunity cost.
Opportunity cost is a pure decision making cost. It is an imputed cost that does not
require cash outlay and it is not entered in the accounting books.
Introduction
1.27
Replacement Cost
This is the cost at which there could be purchased an asset identical to that which is
being replaced. In simple words, replacement cost is the current market cost of
replacing an asset. When the management considers the replacement of an asset, it
has to keep in mind its replacement cost and not the cost at which it was purchased
earlier. For example, a machinery purchased in 1990 at `10,000 is discarded in 1998
and a new machinery of the same type is purchased for `15,000. So the replacement
cost of the machinery is `15,000.
Out-of-pocket Cost (Explicit and Implicit Costs)
There are certain costs which require cash payment to be made (such a wages,
rent) whereas many costs do not require cash outlay (such as depreciation). Out-ofpocket costs, also known as explicit costs, are those costs that involve cash outlays
or require the utilisation of current resources. Examples of these costs are wages,
material cost, insurance, power cost, etc. Out-of-pocket cost may be either fixed
(manager’s salary) or variable (raw materials and direct wages). Depreciation on
plant and machinery is an implicit cost because it does not invlove any immediate
cash outlay and therefore is not an out-of-procket cost. Out-of-pocket cost is frequently
used as an aid in make or buy decisions, price fixation during depression and many
other decisions.
Future Cost
No decision can change what has already happened. The past is history and decisions
made now can affect only what will happen in the future. Thus, the only relevant costs
for decision making are pre-determined or future costs. But it is the historical costs
which generally provide a basis for computing future costs. However, changing
relationships in the future are also given due consideration while estimating future
costs.
Conversion Cost
Conversion cost is the total of direct labour and factory overhead costs in the production
of a product. In other words, conversion cost is the factory cost minus direct material
cost. It is the total cost of ‘converting’ a raw material into finished product. Appropriate
use of this cost can be made in certain managerial decisions.
Direct Material
Direct Labour
Prime cost
Factory Overhead
Conversion cost
It should be noted that direct labour cost is a part of prime cost as well as
conversion cost.
ELEMENTS OF COST
A cost is composed of three elements, i.e., material, labour and expense. Each of
these elements may be direct or indirect. This is shown below:
Introduction
1.28
Total Cost
Direct Cost
Direct
Material
Direct
Labour
Indirect Cost
Direct
Expenses
Indirect
Material
Indirect
Labour
Indirect
Expenses
Material Cost
The substance from which the finished product is made is known as material. According
to CIMA, London, material cost is “the cost of commodities supplied to an
undertaking.” Material cost includes cost of
procurement, freight inwards, taxes, insurance, etc.,
Direct Materials
directly attributable to the acquisition. Trade
•
Clay in bricks
discounts, rebates, duty drawbacks, refund on
•
Leather in shoes
account of modvat, sales tax, etc., are deducted in
•
Steel
in machines
determining the cost of material. Materials may be
•
Cloth
in garments
direct or indirect.
• Timber in furniture
Direct materials Direct material cost is that which
can be easily identified with and allocated to cost
units. Direct materials generally become a part of
Indirect Materials
the finished product. For example, cotton used in a
• Lubricating oil
textile mill is a direct material. However, in many
• Consumables
cases, though a material forms a part of the finished
• Nuts and bolts
product, yet, it is not treated as direct material; e.g.,
• Coal
nails used in furniture, thread used in stitching
• Small tools
garments, etc. This is because value of such
• Office stationery
materials is so small that it is quite difficult and
futile to measure it. Such materials are treated as
Direct Labour
indirect materials.
• Machine operator
Indirect materials These are those materials which
• Shoe-maker
cannot be easily identified with individual cost units.
• Carpenter
These are minor in importance, such as (i) small and
• Weaver
relatively inexpensive items which may become a part
• Tailor
of the finished product, e.g., pins, screws, nuts and
bolts, thread, etc., (ii) those items which do not
Indirect Labour
physically become a part of the finished products,
• Supervisor
e.g., coal, lubricating oil and grease, sand paper used
• Inspector
in polishing, soap, etc.
• Works manager
• Clerk
Labour Cost
• Peon
The human effort required to convert the materials
• Watchman
into finished product is called labour. The labour cost
Introduction
1.29
is “the cost of remuneration (wages, salaries, commissions, bonuses, etc.) of the
employees of an undertaking.” (CIMA). It includes all fringe benefits like P.F.
contribution, gratuity, ESI, overtime, incentive bonus, wages for holidays, idle time etc.
Direct labour Direct labour cost consists of wages paid to workers directly
engaged in converting raw materials into finished products. These wages can be
conveniently identified with a particular product, job or process. Wages paid to a
machine operator or a carpenter are examples of direct wages.
Indirect labour It is of general character and cannot be conveniently identified
with a particular cost unit. In other words, indirect labour is not directly engaged in
the production operations but only to assist or help in production operations. For
example, foreman’s salary, gatekeeper’s salary, etc.
Expenses
All costs other than material and labour are termed as expenses. It is defined as “the
cost of services provided to an undertaking and the notional cost of the use of
owned assets.” (CIMA).
Direct expenses According to CIMA, London, “direct expenses are those
expenses which can be identified with and allocated to cost centres or units.”
These are those
expenses which are
Direct or Chargeable Expenses
specifically incurred in
• Hire of special plant for a particular job
connection with a
• Travelling expenses in securing a particular contract
particular job or cost
• Cost of patent rights
unit. Direct expenses
• Experimental costs
are also known as
• Cost of special drawings, designs and layouts
chargeable expenses.
• Job processing charges
• Royalty paid in mining
Indirect expenses
• Depreciation or hire of a plant used on a contract at site
All indirect costs, other
than indirect materials
and indirect labour costs, are
termed as indirect expenses.
Indirect Expenses
These cannot be directly identified
• Rent and rates
with a particular job, process or
• Depreciation
work order and are common to
• Lighting and power
cost units or cost centres.
• Advertising
• Insurance
Prime Cost
• Repairs
This is the aggregate of direct
material cost, direct labour cost
and direct expenses. Thus,
Prime Cost = Direct material + Direct labour + Direct expenses
Overhead
This is the aggregate of indirect material cost, indirect labour cost and indirect expenses.
Thus,
1.30
Introduction
Overhead = Indirect material + Indirect labour + Indirect expenses
Overheads are divided into three groups as follows:
1. Production overhead. Also known as factory overhead, works overhead or
manufacturing overhead, these are those overheads which are concerned with the
production function. They include indirect materials, indirect wages and indirect expenses
in producing goods or services.
(a) Indirect material—Examples: Coal, oil, grease, etc.; stationery in factory office,
cotton waste, brush, sweeping broom, etc.
(b) Indirect labour—Examples: Works manager’s salary, salary of factory office
staff, salary of inspector and supervisor, wages of factory sweeper, wages of
factory watchman.
(c) Indirect expenses—Examples: Factory rent, depreciation of plant, repair and
maintenance of plant, insurance of factory building, factory lighting and power,
internal transport expenses.
2. Office and administration overhead. This is the indirect expenditure incurred in
general administrative function, i.e., in formulating policies, planning and controlling
the functions, directing and motivating the personnel of an organisation in the attainment
of its objectives.
These overheads are analysed into those related to production activities and those
not related to production activities. This category of overhead is also classified into
indirect material, indirect labour and indirect expenses.
(a) Indirect material—Examples: Stationery used in general administrative office,
postage, sweeping broom and brush, etc.
(b) Indirect labour—Examples: Salary of office staff, salary of managing director,
remuneration of directors of the company.
(c) Indirect expenses—Examples: Rent of office building, legal expenses, office
lighting and power, telephone expenses, depreciation of office furniture and
equipments, office air-conditioning, sundry office expenses.
3. Selling and distribution overhead. Selling overhead is the cost of promoting sales
and retaining customers. It is defined as “the cost of seeking to create and stimulate
demand and of securing orders.” Examples are advertisements, samples and free
gifts, salaries of salesmen, etc.
Distribution cost includes all expenditure incurred from the time the product is
completed in the works until it reaches its ultimate customer. It is defined as “the cost
of sequence of operations which begins with making the packed product available
for despatch and ends with making the reconditioned returned empty packages
if any, available for reuse.” Examples are carriage outwards, insurance of goods in
transit, upkeep of delivery vans, warehousing, etc.
Selling and distribution overhead are also grouped into indirect material, indirect
labour and indirect expenses.
(a) Indirect material—Examples: Packing material; stationery used in sales office,
cost of samples, price list; catalogues, oil, grease etc., for delivery vans, etc.
(b) Indirect labour—Examples: Salary of sales manager, salary of sales office
staff, salary of warehouse staff, salary of drivers of delivery vans, etc.
Introduction
1.31
(c) Indirect expenses—Examples: Advertising, travelling expenses, showroom
expenses, carriage outwards, rent of warehouse, bad debts, insurance of goods
in transit, etc.
Illustration 1.1 A manufacturer has shown an amount of `19,310 in his books as
“Establishment” which really include the following expenses:
`
Interest on debentures
1,200
Agents’ commission
6,750
Warehouse wages
1,800
Warehouse repairs
1,500
Lighting of office
70
Office salaries
1,130
Director’s remuneration
1,400
Travelling expenses of salesmen
1,760
Rent, rates and insurance of warehouse
310
Rent, rates and insurance of office
230
Lighting of warehouse
270
Printing and stationery
1,500
Trade magazine
70
Donations
150
Bank charges
100
Cash discount allowed
770
Bad debts
300
From the information prepare a statement showing total:
(a) Selling expenses.
(c) Administration expenses.
(b) Distribution expenses.
(d) Expenses which you would exclude from costs.
(B.Com., Kerala; Adapted )
Solution
`
6,750
1,760
300
(a) Selling Expenses:
Agents’ commission
Travelling expenses of salesmen
Bad debts
Total
`
1,800
1,500
310
270
(b) Distribution Expenses:
Warehousing wages
Warehouse repairs
Rent, rates and insurance of warehouse
Lighting of warehouse
Total
(c) Administration Expenses:
Office salaries
Office lighting
Director’s remuneration
Rent, rates and insurance of office
Printing and stationery
8,810
3,880
`
1,130
70
1,400
230
1,500
(Contd.)
Introduction
1.32
Trade magazine
70
Total
4,400
`
150
770
100
1,200
(d) Items not included in costs:
Donations
Cash discount allowed
Bank charges
Interest on debentures
Total
Note:
2,220
For details of items excluded from cost, refer to chapter—6 on page 6.3 to 6.4.
Components of Total Cost—Elements of cost may be grouped as follows.
(i) Prime Cost = Direct material + Direct labour + Direct expenses.
(ii) Works Cost or Factory Cost = Prime cost + Factory overhead.
(iii) Cost of Production = Works cost + Administration overhead.
(iv) Total Cost or Cost of Sales = Cost of production + Selling and
distribution overhead.
Total Cost
Material
Cost
Direct
Material
Indirect
Material
Labour
Cost
Direct
Labour
Indirect
Labour
Expenses
Direct
Expenses
Prime
Cost
Indirect
Expenses
Overhead
Production
Overhead
Fig. 1.9
Administration
Overhead
Elements of cost.
Selling and
Distribution
Overhead
Introduction
1.33
Cost Sheet (Cost Statement)
It is a statement which is prepared periodically to provide detailed cost of a cost centre
or cost unit. 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.
Specimen of a simple cost sheet is given below:
A Sample Cost Sheet (or Statement of Cost)
for the period.......
No. of units produced......
Particulars
Total cost Cost per unit
`
`
Direct materials
Direct labour (employee) cost
Direct (or chargeable) expenses
Prime Cost
Works overheads
Works Cost
Administrative overheads (Related to production)
Cost of Production
Selling and distribution overheads
[Adm. overhead (general)]
Total Cost or Cost of Sales
Profit or loss
Sales
Illustration 1.2 From the following information for the month of January, prepare a
cost sheet to show the following components: (a) Prime Cost, (b) Factory Cost, (c) Cost
of Production, (d) Total Cost.
`
Direct material
Direct wages
Factory rent and rates
Office rent and rates
Plant repairs and maintenance
Plant depreciation
Factory heating and lighting
Factory manager’s salary
Office salaries
Director’s remuneration
Telephone and postage
Printing and stationery
Legal charges
Advertisement
Salesmen’s salaries
Showroom rent
Sales
57,000
28,500
2,500
500
1,000
1,250
400
2,000
1,600
1,500
200
100
150
1,500
2,500
500
1,16,000
Introduction
1.34
Solution
Cost Sheet
for the month of Jan. ......
`
57,000
28,500
Direct materials
Direct wages
Prime Cost
Factory Overhead:
Factory rent and rates
Plant repair and maintenance
Plant depreciation
Factory heating and lighting
Factory manager’s salary
Factory Cost
Adm. Overhead (Assumed to be related to production):
Office salaries
Director’s remuneration
Telephone and postage
Office rent and rates
Printing and stationery
Legal charges
Cost of Production
Selling and Distribution Overhead:
Advertisement
Salesmen’s salaries
Showroom rent
85,500
2,500
1,000
1,250
400
2,000
7,150
92,650
1,600
1,500
200
500
100
150
4,050
96,700
1,500
2,500
500
Total Cost (or Cost of Sales)
PROFIT
Sales
4,500
1,01,200
14,800
1,16,000
INSTALLATION OF A COSTING SYSTEM
There cannot be a readymade costing system for every undertaking. In order to meet the
special needs of a business, a costing system has to be specially devised to give it a blend
of efficiency and economy. The installation of a costing system requires a thorough study
and understanding of all the aspects involved as otherwise the system may be a misfit
and enterprise will not be able to derive full advantage from it.
To start with, it is important to make cost benefit analysis, i.e., weigh the cost of
the system against the likely benefits to be derived from it. The benefits from the
system must exceed the amount spent on it. The management must feel the need for
it and should be able to make full use of the information available from the system in
the conduct of business. In other words, the system should be justified on the basis
of its value to management.
Steps in Installation
The installation of a costing system requires the following steps:
1. Preliminary investigations should be made relating to the technical aspects of the
business. For instance, the nature of the product and methods of production will
determine the type of costing system to be applied.
Introduction
1.35
2. The organisation structure of the business should be studied to ascertain the
scope of authority of each executive. The existing organisation should be disturbed to
the minimum as may be advisable after full consideration.
3. The methods of purchase, storage and issue of materials should be examined and
modified as per requirements.
4. The existing methods of remunerating labour should be examined for the purpose
of introducing any incentive plans.
5. Forms and accounting records should be so designed so as to involve minimum
clerical labour and expenditure.
6. The size and layout of the factory should be studied.
7. The system should be effective in cost control and cost reduction.
8. Costing system should be simple and easy to operate. Unnecessary details should
be avoided.
9. The installation and operation of the system should be economical.
10. The system should be introduced gradually.
Practical Difficulties
Apart from technical costing problems, a cost accountant is confronted with certain
practical difficulties in installing a costing system. These are:
1. Lack of support of top management. In order to make the costing system a
success, it must have the whole-hearted support of every member of the management.
Many a time, the costing system is introduced at the behest of the Managing Director
or the Financial Director without the support of functional managers. They view the
system as an interference in their work and do not make use of the system.
Before the system is installed, the cost accountant should ensure that the management
is fully committed to the costing system. A sense of cost consciousness should be
created in their minds by explaining to them that the system is for their benefit. A cost
manual should be prepared and distributed to them giving the details and functions of
the system.
2. Resistance from the accounting staff. The existing accounting staff may not
welcome the new system. This may be because they look with suspicion at a system
which is not known to them. The cooperation of the employees should be sought by
convincing them that the system is needed to supplement the financial accounting
system and that it is for the betterment of all.
3. Non-cooperation of working and supervisory staff. Correct activity data which
is supplied by supervisory staff and workers is necessary for a costing system. They
may not cooperate and resist the additional paper work arising as a result of the
introduction of the system. Such resistance generally arises out of ignorance. Proper
education should be given to the staff regarding benefits of the system and the important
roles they have to play to make it successful.
4. Shortage of trained staff. In the initial stages, there may be shortage of trained
costing staff. The staff should be properly trained so that the costing department can
run efficiently.
Introduction
1.36
ADVANTAGES OF COST ACCOUNTING
The deficiencies of financial accounting may be re-stated as the advantages of cost
accounting because the latter has emerged to overcome the limitations of the former.
However, the extent of the advantages obtained will depend upon the efficiency with
which the cost system is installed and also the extent to which the management is
prepared to accept the system.
The principal advantages of cost accounting are as follows:
Advantages to Management
1. Reveals profitable and unprofitable activities. A system of cost accounting
reveals profitable and unprofitable activities. On this information, management may
take steps to reduce or eliminate wastages and inefficiencies occurring in any form
such as idle time, under-utilisation of plant capacity, spoilage of materials, etc.
2. Helps in cost control. Cost accounting helps in controlling costs with special
techniques like standard costing and budgetary control.
3. Helps in decision making. It supplies suitable cost data and other related
information for managerial decision making such as introduction of a new product line,
replacement of old machinery with an automatic plant, make or buy, etc.
4. Guides in fixing selling prices. Cost is one of the most important factors to be
considered while fixing prices. A system of cost accounting guides the management in
the fixation of selling prices, particularly during depression period when prices may
have to be fixed below cost.
5. Helps in inventory control. Perpetual inventory system, which is an integral part
of cost accounting, helps in the preparation of interim profit and loss account. Other
inventory control techniques like ABC analysis, level setting, etc., are also used in cost
accounting.
6. Aids in formulating policies. Costing provides information that enables the
management to formulate production and pricing policies and preparing estimates of
contracts and tenders.
7. Helps in cost reduction. It helps in the introduction of a cost reduction programme
and finding out new and improved ways to reduce costs.
8. Reveals idle capacity. A concern may not be working to full capacity due to
reasons such as shortage of demand, machine breakdown or other bottlenecks in
production. A cost accounting system can easily work out the cost of idle capacity so
that the management may take immediate steps to remedy the position.
9. Checks the accuracy of financial accounts. Cost accounting provides a reliable
check on the accuracy of financial accounts with the help of reconciliation between
the two at the end of the accounting period.
10. Prevents frauds and manipulation. Cost audit system, which is a part of cost
accountancy, helps in preventing manipulation and frauds and thus reliable cost data
can be furnished to the management and others.
Introduction
1.37
Advantages to Workers
Workers are benefited by introduction of incentive plans which is an integral part of
a cost system. This results not only in higher productivity but also higher earnings for
them.
Advantages to Society
An efficient cost system is bound to lower the cost of production, the benefit of which
is passed on to the public at large in the form of lower prices of products
or services.
Advantages to Government Agencies and Others
A cost system produces ready figures for use by government, wage tribunals, chambers
of commerce and industry trade unions, etc., for use in problems like price fixing,
wage level fixation, settlement of industrial disputes, policy matters, etc.
LIMITATIONS OR OBJECTIONS AGAINST COST ACCOUNTING
Despite the fact that the development of cost accounting is one of the most significant
steps to improve performance, certain objections are raised against its introduction.
These are as follows:
1. It is unnecessary. It is argued that maintenance of cost records is not necessary
and involves duplication of work. It is based on the premise that a good number of
concerns are functioning prosperously without any system of costing. This may be
true, but in the present world of competition, to conduct a business with utmost
efficiency, the management needs detailed cost information for correct decision- making.
Only a cost accounting system can serve this need of the management and thus help
in the efficient conduct of a business.
2. It is expensive. It is pointed out that installation of a costing system is quite
expensive which only large concerns can afford. It is also argued that installation of
the system will involve additional expenditure which will lead to a diminution of profits.
In this respect, it may be said that a costing system should be treated as an investment
and the benefits derived from the system must exceed the amount spent on it. It should
not prove a burden on the finances of the company. For an economical operation of
the system, the maintenance of the records should be kept to the minimum taking into
account the need and use of each record.
3. It is inapplicable. Another argument sometimes put forward is that modern methods
of costing are not applicable to many types of industry. This plea is hardly tenable,
given the complexities of operating any enterprise today. The fault lies in an attempt
to introduce a readymade costing system in an industry. A costing system must be
specially designed to meet the needs of a business. Only then will the system work
successfully and achieve the objectives for which it was introduced. In fact, applications
of costing are very wide. All types of activities, manufacturing and non-manufacturing,
should consider the use of cost accounting.
4. It is a failure. The failure of a costing system in some concerns is quoted as an
argument against its introduction in other undertakings. This is a very fallacious argument.
If a system does not produce the desired results, it is wrong to jump to the conclusion
that the system is at fault. The reasons for its failure should be probed. Often it is
Introduction
1.38
discovered that employees were opposed to the introduction of a costing system
because they might have looked with suspicion at the introduction of any method
which was not known to them or to which they were not accustomed. Thus, to make
the system a success, the utility of the system should be explained to the management
and the cooperation of the employees should be sought by convincing them that the
system is for the betterment of all.
Role of a Cost Accountant in an Organisation
A cost accountant plays a very important role in an organiastion, particularly in
manufacturing concerns. Important roles of a cost accountant are as follows:
1. Establishment of Cost Accounting Department. A cost accountant establishes
a cost accounting department and instals a costing system. Installation of costing
system in an organization should be as per the nature and special needs of the business.
2. Type of Cost Information. Cost accountant decides the types of cost information
that will be produced by the costing system and its utility for different levels of
management. He should ensure timely availability of information and that no manager
feels deficiency of cost information for decision making.
3. Developing a Cost Manual. The manual contains a detailed description of what
work is to be done and how to apply it. Cost accountant develops a cost manual
which lays down the objectives and functions of cost accounting department, the
informational needs of various managers, makes cost analysis, develops various formats
in which information will be compiled and submitted to managers, the frequency of
supplying information, etc. It may be stated that various functions to be performed by
cost accounting department include cost ascertainment, cost control and cost reduction,
guidance in managerial decisions, determining selling price, etc.
ESSENTIALS OF A GOOD COST ACCOUNTING SYSTEM
The essential principles of a good system of cost accounting are as follows:
1. Suitability. The method of costing adopted, i.e., job or process costing, should be
suitable to the industry and serve the objectives of installing the system.
2. Specially designed system. A readymade costing system cannot be suitable for
every business. The cost accounting system should be tailormade according to the
requirements of a business.
3. Support of executives. If a costing system is to be successful, it must be fully
supported by executives of various departments and everyone should participate
in it.
4. Cost of the system. The cost of installing and operating the system should be
justified by the results produced.
5. Clearly defined cost centres. In order to derive maximum benefits from a costing
system, well defined cost centres and responsibility centres should be identified within
the organisation.
6. Controllable costs. Controllable and non-controllable costs of each responsibility
centre should be separately shown.
Introduction
1.39
7. Integration with financial accounts. There should be cooperation and coordination
between cost accounting and financial accounting departments. In order to avoid
duplication of accounts, cost and financial accounts may be integrated.
8. Continuous education. Well trained and educated staff should be employed to
operate the system. In order to educate the costing staff, written manuals and meetings
etc. should be arranged on a continuous basis.
9. Prompt and accurate reports. The cost accounting department should prepare
accurate reports and promptly submit the same to appropriate level of management so
that action may be taken without delay.
10. Avoid unnecessary details. Resources should not be wasted on collecting and
compiling cost data that is not required. Only useful cost information should be compiled
and used whenever required.
INTRODUCTION TO COST ACCOUNTING STANDARDS (CAS)
Cost Accounting Standards are a set of standards that are designed to achieve uniformity
and consistency in cost accounting practices. The main functions of CAS are:
1. To bring CONSISTENCY in cost accounting records.
2. To make cost accounting data more uniform for inter-firm COMPARISON.
3. To make cost allocations more ACCURATE and objective.
4. To make cost accounting data more RELIABLE.
The Institute of Cost Accountants of India, recognising the need for structured
approach to the measurement of cost in manufacture or service sector and to provide
guidance to the user organisations, government bodies, regulators, research agencies
and academic institutions to achieve uniformity and consistency in classification,
measurement and assignment of cost to product and services, has constituted Cost
Accounting Standards Board (CASB) with the objective of formulating the Cost
Accounting Standards.
CASB has so far issued 24 cost accounting standards as listed below:
CAS
1.
2.
3.
4.
s.
6.
7.
8.
9.
10.
11.
12.
13.
Title
Classification of Cost
Capacity Determination
Production and Operation Overheads
Cost of Production for Captive Consumption
Determination of Average (Equalized) Cost of Transportation
Material Cost
Employee Cost
Cost of Utilities
Packing Material Cost
Direct Expenses
Administrative Overheads
Repairs and Maintenance Cost
Cost of Service Cost Centre
(Contd.)
Introduction
1.40
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
Pollution Control Cost
Selling and Distribution Overheads
Depreciation and Amortisation
Interest and Financing Charges
Research and Development Costs
Joint Costs
Royalty and Technical Know-How Fee
Quality Control
Manufacturing Cost
Overburden Removal Cost
Treatment of Revenue in Cost Statements
Cost Accounting Records and Audit Rules in India
The Companies Act (Section 148) empowers the Central Government to direct the
companies specified in the production of goods or provisions of service to include
particulars relating to utilization of material or labour or other items of cost in the
books of accounts of the company and getting such cost records audited
Based on the above provisions of the Companies Act, the central government
prescribes, in respect of a class of companies, Cost Accounting Records Rules to keep
details in respect of utilization of material, labour or other items of cost. These Rules
are aimed to have control over their operations and cost with a view to achieve
optimum utilization of resources in the economy.
These are called COMPANIES (COST RECORDS AND AUDIT) RULES 2014.
These are being amended from time to time. These Rules are applicable only to
selected companies incorporated under the Companies Act (whether private company
or public company) and not to the other forms of business such as partnership, sole
proprietary, etc.
The Cost Accounting Records Rules refers to only maintenance of cost records. It
does not mean that there has to be a cost audit also. Cost Audit Order is separately
issued after the initial notification of cost accounting records rules. These cost audit
orders are issued on the selected companies only.
What is cost audit?
There is no definition of cost audit given in The Companies Act, 2013 or in any other
Law. However, CIMA London has defined cost audit as “the verification of cost
accounts and a check on the adherence to the cost accounting plan”. An analysis of
this definition shows that cost audit performs two basic functions:
First function is to verify that cost accounts have been properly prepared, and
Second function is to check their adherence to the cost accounting plan.
Apart from these, there is a third function of cost audit which is to detect errors
and to prevent frauds and possibly misappropriations. This third function is in fact the
function of all types of audit and not of cost audit alone.
Introduction
1.41
What governs cost audit in India?
In India, cost audit is governed by Section 148 of The Companies Act, 2013 read with
The Companies (Cost Records and Audit) Rules, 2014 and The Cost and Works
Accountants Act, 1959. Accordingly, only a qualified Cost Accountant, holding a
certificate of practice is authorised to conduct cost audit.
PROBLEMS AND SOLUTIONS
Problem 1.1 Prepare a Cost Sheet from the following information of Relic India Ltd
for the year ending 31–3–2022.
`
Sales
3,50,000
Purchase of raw materials
1,55,000
Freight paid on raw material purchase
4,000
Productive wages paid
75,000
Unproductive wages
22,000
Productive wages outstanding
7,000
Royalty on production (direct expense)
18,000
Fuel and power
4,500
Factory rent
6,300
Insurance of machinery
1,700
Loading and unloading charges on
purchase of raw materials
3,500
Loss on sale of old machinery
5,400
Depreciation of machinery
8,300
Lighting – factory
700
Factory cleaning
400
Advertising
3,700
Carriage outwards
1,300
Income tax
6,040
Factory telephone
890
Plant repairs and maintenance
2,500
Office computer depreciation
12,000
Office stationery
2,100
Travelling expenses
– Salesmen
– Office staff
Donations
Salaries of sales staff
Marketing research expenses
Bank charges and interest
Expenses on office cars
Office managers salary
Bad debts
3,500
1,800
1,350
7000
1,400
340
3,500
5,400
700
Note: Assume administration overhead are relating to production activities.
Introduction
1.42
Solution
Cost Sheet
for the year ending 31–3–2022
`
Purchase of raw materials
Add: Freight paid
Loading and unloading charges
Cost of materials consumed
Production wages paid
Add: Outstanding
Direct expenses (royalty)
1,55,000
4,000
3,500
1,62,500
7,5000
7,000
Prime Cost
Factory Overhead:
Unproductive wages
Fuel and power
Factory rent
Insurance of machinery
Depreciation on machinery
Lighting
Factory cleaning
Telephone
Plant repairs and maintenance
Note:
82,000
18,000
2,62,500
22,000
4,500
6,300
1,700
8,300
700
400
890
2,500
Factory Cost
Administrative Overhead:
Depreciation of office computers
Office stationery
Travelling expenses of office staff
Expenses on office cars
Office managers salary
Cost of Production
Selling and Distribution Overhead
Advertising
Carriage outwards
Treavelling expenses
Salaries of sales staff
Marketing research expenses
Bad debts
Cost of Sales
Sales
Loss
`
47,290
3,09,790
12,000
2,100
1,800
3,500
5,400
3,700
1,300
3,500
7,000
1,400
700
The following items are not included in cost, being of purely financial nature:
1. Loss on sales of machinery
24,800
3,34,590
17,600
3,52,190
3,50,000
(–) 2,190
Introduction
1.43
2. Income tax
3. Bank charges and interest
4. Donations.
Problem 1.2 The following data have been extracted from the books of MICO Ltd. for
the year ending 31st March 2022:
Wages – direct
indirect (factory)
Rent and rates – factory
office
Salary – office
salesmen
75,000
10,000
5,000
500
1,500
2,000
Indirect materials
1,500
Office expenses
900
Managing Director’s remuneration 12,000
Advertisement
2,000
Commission on issue of shares 6,000
Profit on sales of capital asset
2,000
Transfer of general reserve
10,000
Factory expenses
3,700
Selling expenses
1,000
Travelling expenses of salesmen
1,100
Carriage and Freight outwards
1,000
Sales
2,30,000
Purchase of raw materials
75,000
Other direct charges
15,000
Depreciation – plant
2,500
office furniture
1,100
Advance income tax paid
15,000
Goodwill written off
8,000
Managing Director’s remuneration is to be allocated – `4,000 to factory, `2,000 to the
office and `6,000 to selling department, From the above information prepare:
(a) Prime Cost, (b) Works Cost, (c) Cost of Production, (d) Cost of Sales and (e) Net Profit.
Solution
Statement of Cost and Profit of MICO Ltd.
for the year ending 31–3–2022
`
Direct materials
Direct wages
Other direct charges
Prime Cost
Factory Overheads:
Indirect wages
Rent and rates
Indirect materials
Depreciation of plant
Factory expenses
Managing Director’s remuneration
Works Cost
Administration Overheads:
Rent and rates
Depreciation on office furniture
Salary – Office
Office expenses
Managing director’s remuneration
Cost of Production
Selling and Distribution Overheads:
Salary – salesmen
Managing director’s remuneration
`
75,000
75,000
15,000
1,65,000
10,000
5,000
1,500
2,500
3,700
4,000
26,700
1,91,700
500
1,100
1,500
900
2,000
6,000
1,97,700
2,000
6,000
(Contd.)
Introduction
1.44
Selling expenses
Advertisement
Trevelling expenses
Carriage and freight outward
1,000
2,000
1,100
1,000
Cost of Sales
2,10,800
Profit (Bal. Figure)
19,200
Sales
Note:
13,100
2,30,000
The following items are not included in cost sheet, being of financial nature:
1. Advance income tax
2. Commission on issue of shares
3. Profit on sale of capital asset
4. Transfer to general reserve
5. Goodwill written off.
6. It is assumed adm. overheads are related to production.
Problem 1.3 From the following information relating to Pune Industries Ltd. for the year
ending 31st March, 2022, you are required to prepare a statement of cost showing (a) Prime
Cost, (b) Factory Overhead, (c) Factory Cost, (d) Total Cost, and (e) Profit or Loss for the
period.
`
Direct wages
2,40,000
Direct materials purchased
3,22,000
Purchase returns
13,000
Drawing office salaries (Technical)
3,100
Carriage on direct materials
4,200
Chargeable expenses
2,800
Provision for bad debts
2,400
Office expenses relating to production activity
6,400
Factory rent and rates
14,600
Depreciation on plant
8,600
Showroom rent
3,000
Misc. selling expenses
3,200
Lighting
900
Gas and water
3,400
Power
2,800
Haulage hire
2,000
Travelling expenses
6,000
Showroom telephone expenses
1,500
Labour welfare expenses
4,600
Sales of scrap
450
Factory supervision
3,500
Sales
6,40,000
(Adapted)
Solution
Statement of Cost
for the year ending 31st March, 2022
`
Direct materials purchased
Add: Carriage on materials
Less: Purchase returns
3,22,000
4,200
3,26,200
13,000
Cost of Materials Consumed
Direct wages
Chargeable expenses
`
3,13,200
2,40,000
2,800
(Contd.)
Introduction
1.45
Prime Cost
Factory Overheads:
Drawing office salaries
Factory rent and rates
Depreciation on plant
Lighting
Gas and water
Power
Haulage hire
Labour welfare expenses
Factory supervision
5,56,000
3,100
14,600
8,600
900
3,400
2,800
2,000
4,600
3,500
Less: Sales of scrap
43,500
450
Factory Cost
Administrative Overhead:
Office expenses
Cost of Production
Selling and Distribution Overheads:
Travelling expenses
Showroom rent
Showroom telephone expenses
Miscellaneous selling expenses
43,050
5,99,050
6,400
6,05,450
6,000
3,000
1,500
3,200
13,700
6,19,150
Profit
20,850
Sales
6,40,000
Note: Provision for bad debts is not included in cost.
Problem 1.4 The following information were received
Co. for the quarter ending on 31st March, 2022.
Stock of material on 31.3.2022
70,000
Stock of material on 1.1.2022 1,00,000
Purchase of materials
8,03,290
Travelling expenses
5,100
Carriage inwards
4,500
Carriage outwards
9,150
Drawing office salaries
7,000
Depreciation on plant
20,000
Factory rent, rates and insurance 11,200
Office rent, rates and insurance 29,100
Showroom expenses
9,000
Productive wages paid
2,27,000
Repairs of machine, plant & tool 10,000
from the books of Poonam &
Expenses of stationery
11,350
Travellers’ salaries and commission9,000
Depreciation on office furniture
700
Director’s fees
8,000
Fuel, gas and water
17,900
Manager’s salary
6,000
Income tax paid
12,000
Donations
4,600
Office expenses
5,000
Air-conditioning charges
4,000
Labour welfare expenses
7,200
Outstanding productive wages
33,000
Sales
13,70,000
Prepare Cost Sheet giving following information, assuming that administrative overhead
related to production activity.
(i) Material used, (ii) Prime cost, (iii) Works overhead and its percentage on wages,
(iv) Factory cost, (v) Office overhead and its percentage on works cost, (vi) Total cost
and (vii) Net profit and its percentage on total cost.
(CA Inter; Adapted)
Introduction
1.46
Solution
Cost Sheet
for the quarter ending 31st March, 2022
`
Opening stock
Add: Purchase of raw materials
Carriage inward
1,00,000
8,03,290
4,500
8,07,790
Less: Closing stock of raw materials
9,07,790
70,000
Cost of Raw Material Consumed
Productive Wages: Paid
Outstanding
2,27,000
33,000
8,37,790
Prime Cost
Factory (or works) Overheads:
Repairs of machines, plants & tools
Depreciation on plant
Factory rent, rates, & insurance
Fuel, gas and water
Drawing office salaries
10,000
20,000
11,200
17,900
7,000
7,200
Works Cost
Adm. Overheads:
Office rent, rates, & insurance
Expenses of stationery
Depreciation on office furniture
Director’s fees
Manager’s Salary
Office expenses
Air-conditioning charges
2,60,000
10,97,790
Labour welfare expenses
73,300
11,71,090
29,100
11,350
700
8,000
6,000
5,000
4,000
Cost of Production
Selling & Distribution Overheads:
Travelling expenses
Carriage outwards
Showroom expenses
Travellers commission & salary
Note:
`
64,150
12,35,240
5,100
9,150
9,000
9,000
32,250
Cost of Sales (i.e., Total Cost)
12,67,490
Profit
1,02,510
Sales Value
13,70,000
Income tax and donations are not included in cost.
(i) Percentage of works overheads on productive wages:
73,300
× 100 = 28.19%
2, 60,000
(ii) Percentage of office overheads on works cost:
(Contd.)
Introduction
1.47
(iii) Percentage of profit on total cost:
1, 02,510
× 100 = 8.09%
12, 67, 490
Problem 1.5 Classify the following items into factory overheads, administration
overheads, and selling and disribution overheads and items excluded from cost.
Cost of gas and water
Grease and oil for machines
Unproductive wages
Advertisement cost
Director’s remuneration
Chargeable expenses
Dividend paid
Bad debts
Provision for bad debts
Appropriation to sinking fund
Factory repairs and renewals
Wages of foreman
Carriage inwards
Carriage outwards
Upkeep of delivery vans
Sales branches office expenses
Transfer to general reserve
Collection charges
Mobile phone charges of salesman
Travelling charges of salesmen
Stationery – Office
– Showroom
Income tax paid
Legal charges
Preliminary expenses written off
Labour welfare expenses
Warehouse rent
Electricity – Office
Factory
Shworoom
`
2,200
800
4,850
3,000
12,000
1,200
7,800
700
1,600
3,300
2,400
1,350
670
1,700
2,700
3,800
2,600
1,300
2,100
1,900
450
340
1,250
400
850
2,600
750
700
1600
800
Solution
Factory Overhead:
Cost of gas and water
Grease and oil for machine
Unproductive wages
Factory repairs and renewals
Wages of foreman
Labour welfare
Electricity – Factory
Total
`
2,200
800
4,850
2,400
1,350
2,600
1,600
15,800
Introduction
1.48
Administration Overhead:
Director’s remuneration
Office stationery
Legal charges
Electricity – Office
12,000
450
400
700
Total
Selling and Distribution Overhead:
Advertisement cost
Carriage outward
Upkeep of delivery vans
Sales branch office expenses
Collection charges
Mobile phone charges of salesman
Travelling charges of salesman
Stationery showroom
Warehouse rent
Electricity showroom
Bad debt
13,550
3,000
1,700
2,700
3,800
1,300
2,100
1,900
340
750
800
700
Total
19,090
Items Excluded from Cost:
Divided paid
Provision for bad debts
Appropriation to sinking fund
Transfer to general reserve
Income tax paid
Preliminary expenses written off
7,800
1,600
3,300
2,600
1,250
850
Total
17,400
Note: Chargeable expenses and carriage inwards are parts of the prime cost and are not overhead.
SUMMARY AND KEY TERMS
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Cost Accounting is a specialized branch of accounting, which is concerned
with ‘the techniques and processes of ascertaining costs’ of products and
services.
Management Accounting in all that accounting information which is useful
to management.
The emergence of cost accounting is due to limitations of financial accounting
to meet the informational needs of the management.
Cost accounting is applicable to manufacturing and non-manufacturing
activities in which monetary value is involved.
Several methods of ascertainment of costs have been devised according to
the nature of operations of different industries.
The main objectives of cost accounting include: (i) Ascertainment of cost,
(ii) Cost control and cost reduction, (iii) Determination of selling price, and
(iv) Guide to management in decision making.
Introduction
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1.49
It is essential to understand basic concepts of cost accounting in order to
clearly understand this subject.
Cost is defined as a measurement, in monetary terms, of the amount of resources
used for the purpose of production of goods or rendering of services.
Cost object may be defined as anything for which a separate measurement of
cost may be desired, like a car, melting process in a steel mill, taxi service, etc.
Cost centre is a section of the organization, like a person, an equipment, a
department, etc., for which costs may be ascertained and used for the purpose of
control.
Cost unit is a unit of product like ‘a tonne’ of sugar or service like hotel
room per day in relation to which costs are ascertained.
Direct costs are incurred for and conveniently identified with a particular
cost unit, process or department, like cost of raw materials.
Indirect costs are common costs for the benefit of a number of cost units,
processes or departments, like depreciation of machines and building rent.
Fixed costs remain constant in ‘total’ amount over a specific range of activity
for a specified period of time, i.e., those, which do not increase or decrease
when the volume of production changes, like building rent.
Variable costs are the costs which vary in direct proportion to the volume
of output. In other words, when volume of output increases, total variable
cost also increases, and vice versa.
Semi-variable or semi-fixed costs are partly fixed and partly variable.
Controllable costs are the costs which may be directly regulated at a given
level of management authority, whereas non-controllable costs are the
costs which cannot be influenced by the action of management.
In management decision making, only those costs are relevant costs which
are future costs and which differ under each alternative. Irrelevant costs
are those that will not be affected by a managerial decision.
Element-wise, costs are divided into material cost, labour cost and expenses.
The aggregate of direct material cost, direct labour cost and direct expenses
is called prime cost and the aggregate of indirect material cost, indirect
labour is termed as overheads.
Cost Sheet is a statement which is prepared periodically to provide detailed
element-wise cost of a cost centre or cost unit. A cost sheet not only shows
the total cost but also the various components of the total cost. Period
covered by it may be a year, a month or a week, etc.
EXAMINATION QUESTIONS
Objective Type Questions
I. Indicate whether each of the following statements is True or False. Give reasons
in brief.
1. Variable cost per unit remains unchanged when output is increased or decreased.
2. Cost accounting is a branch of financial accounting.
3. Cost accounting is used in manufacturing and non-manufacturing undertakings.
4. Cost means expired cost while expense means expired as well as unexpired
cost.
5. Abnormal cost is uncontrollable.
6. Main purpose of cost accounting is to maximise profit.
7. Conversion cost is the aggregate of direct labour and manufacturing overhead.
Introduction
1.50
8. Supervisor’s salary is a part of administration overhead.
9. Contract costing is used in the supply of tyres and tubes for a long term
contract with a car manufacturing company.
10. Nails used in furniture manufacture is an indirect material cost.
11. All costs are controllable.
12. Contract costing is used in ship building.
13. Variable cost per unit varies with increase or decrease in the volume of output.
14. Depreciation is an out-of-pocket cost.
15. Fixed cost per unit remains fixed.
16. An item of cost that is direct for one business may be indirect for another.
17. Fixed cost does not change in the same proportion in which output change.
I I . Fill in the blanks
1. Aggregate of all direct costs is known as ........ .
2. Fixed cost per unit ........ with increase in the size of output.
3. Factory cost + administration overhead = ........
4. ..........is the technique/process of ascertaining costs.
5. Cost is a ........ and price is a ........
6. Method of costing used in toy making is ........
7. An example of chargeable expense is ........
8. ........ is a unit of product, service or time in relation to which cost may be
ascertained.
9. Indirect material + Indirect Labour + ........ = Overhead.
10. ........ and ........ are examples of fixed cost.
III.
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
(x)
Match the following:
Total fixed cost
Total variable cost
Unit variable cost
Unit fixed cost
Standard cost
Period cost
Actual cost
Labour and overhead
Incremental cost
Budgeted cost
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
What cost should be
Incurred cost
Increases with output
Cost of conversion
What costs are expected to be
Decreases with rise in output
Remains constant in total
Remains constant per unit
Cost not assigned to product
Added value of a new product
(B.Com. Hons., Delhi)
IV. Match the following column A to column B giving reasons:
A
B
(a) Interior designing
1. Process
(b) Automobile
2. Output
(c) Sugar
3. Batch
(d) Bricks
4. Multiple
(e) Toys
5. Job
(B.Com)
V. Given below is a list of industries. Give the method of costing and the cost unit
against each industry:
(a) Nursing home; (b) Road transport; (c) Steel; (d) Coal; (e) Bicycles
(f) Bridge construction; (g) Interior decoration; (h) Advertising
(i) Furniture; (j) Sugar company having its own sugarcane fields.
(C.A., Inter)
Introduction
1.51
Theoretical Questions
1.
“Limitations of financial accounting have made the management realise the importance
of cost accounting.” Comment.
(B.Com. Hons., Delhi)
2. “Cost accounting is becoming more and more relevant in today’s emerging economic
and business scenario.” Discuss.
(B.Com. Hons., Delhi)
3. What is cost accounting? Discuss briefly its objectives and advantages.
(B.Com., Madras, Bangalore, Andhra)
4. State and explain the main differences between cost accounting and financial
accounting.
(B.Com., Delhi, Meerut)
5. What are the essential principles of a good costing system? What are the objections
to the introduction of a costing system?
(B.Com., Mysore)
6. “A good system of costing serves as a means of control over expenditure and helps
to secure economy in manufacture.” Discuss.
(B.B.M., Mysore)
7. What are the main benefits that may be expected from the installation of a costing
system in a manufacturing business?
(B.Com., Delhi)
8. “Costing system has become an essential tool in the hands of management.”
Comment.
(B.Com. Hons., Delhi, M.Com., Kerala)
9. Money spent on installing a costing system not an expense but an investment. Give
your views.
(B.Com., Kerala)
10. What does management expect of a costing system?
(M.Com., Bangalore)
11. It is said, “Cost accounting is a system of foresight and not postmortem examination;
it turns losses into profits, speeds up activities and eliminates wastes.” Discuss in
detail this statement.
(B.Com. Hons., Delhi)
12. “A costing system that simply records costs for the purpose of fixing sale prices
has accomplished only a small part of its mission.” Discuss. What other functions
does costing perform?
(B.Com. Hons., Delhi, B.Com., Bangalore)
13. “Major policy decisions in business are based on cost factors.” Comment on the
possible uses of cost information to management.
(B.Com., Andhra)
14. Write notes on (i) Cost unit; and (ii) Cost centre. (B.Com., Delhi; C.A., Inter)
15. The following are some of the ways in which costs may be classified:
(a) Direct and indirect; (b) Variable and fixed; and (c) Controllable and uncontrollable.
Bring out clearly the significance of each of these classifications and explain the
meaning of the terms used therein.
(B.Com., Hons., Delhi)
16. List out the different methods of costing and explain their practical application.
(B.Com., Nagarjuna)
17. “Costing systems are classified according to the nature of operations.” Set out the
classification with a brief description of the operations covered by each heading.
(B.Com., Delhi)
18. Distinguish beetween:
(i) Expired cost and unexpired cost
(ii) Direct and indirect cost.
(B.Com. Hons., Delhi)
19. Distinguish between variable cost and direct cost.(B.Com. Hons., Delhi; C.A., Inter)
20. Explain the meaning and features of relevent costs. Give suitable examples to
support your explanation.
(B.Com. Hons., Delhi)
21. Describes briefly the role of cost accounting in a manufacturin organisation.
(C.A., Inter)
22. What do you understand by the term ‘unit of cost’? State the unit of cost and
method of costing generally used for cost accounting purpose in the following
cases:
(i) Brick works
(ii) Electricity company
(iii) Colliery
(iv) Readymade garments
(B.Com., Delhi)
1.52
Introduction
23.
Which method of costing would you adopt for the following and why?
(a) Hosiery Mill
(b) Paper Mill
(c) Oil Refining
(d) Furniture Manufacturer
(e) Road Transport Company.
(B.Com., Andhra)
What are the methods of costing? Explain their adaptability in different industries.
(B.Com., Andhra)
Which method of costing would you recommend for the following industries? Give
reasons:
(i) Shipbuilding; (ii) Toy making; (iii)Oil refinery; (iv) Sugar; (v) Radio receivers
(I.C.W.A., Inter)
Name at least three industries in which each of the following methods would be
suitable:
(a) Process costing
(b) Unit costing
(c) Operation costing
(d) Job costing
(B.Com., Kerala)
Define ‘direct’ and ‘indirect’ wages. Enumerate the considerations that need to be
given to any type of labour to distinguish between direct and indirect wages.
(I.C.W.A., Inter)
State the important ways of classification of cost and discuss each of them in
detail.
(B.Com., Madras)
“The classification of costs as controllable and non-controllable depends upon a
point of reference.” Explain.
(M.Com., Madras)
Distinguish between ‘cost’, ‘expense’ and ‘loss’.
(B.Com. Hons., Delhi)
Enumerate the characteristics of fixed and variable costs. (B.Com. Hons., Delhi)
You have been asked to install a costing system in a manufacturing business. What
practical difficulties would you expect and how do you propose to overcome them?
(C.A., Inter; I.C.W.A., Inter; B.Com. Hons., Delhi)
Why is cost accounting necessary? Mention steps which should be taken to install
a cost accounting system.
(C.A., Inter)
Briefly explain the preliminary steps you would like to take if you are asked to
introduce a costing system in a factory.
(B.Com., Nagarjuna)
“Costs may be classified in a variety of ways according to their nature and the
information needs of management.” Explain and discuss this statement giving examples
of classification required for different purposes.
Distinguish between cost centre and cost unit.
(B.Com. Hons., Delhi)
Explain in brief the following:
(i) Product cost
(ii) Relevent range
(iii) Batch costing
(B.Com. Hons., Delhi)
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
Practical Questions
1.
From the following information, calculate the prime cost.
Productive wage paid
33,500
Unproductive expenses
10,500
Chargeable expenses
5,600
Materials used in manufacturing
72,000
Materials used in final packing
4,600
Productive wage accrued
3,000
Freight on materials purchased
870
Import duty on materials
2,130
Introduction
1.53
2.
Calculate the cost of materials consumed from the following information for 2021–22.
`
Stock of raw materials on 1–4–2021
35,000
Stock of raw materials on 31–3–2022
42,000
Purchase of raw materials
2,45,000
Purchase returns
18,000
Freight on purchases
5,400
Expenses on purchase
600
3.
Calculate cost of production from the following information:
Woks overhead
52,000
Works cost
2,70,000
Office overhead
35,000
Selling overhead
13,500
Classify the following items into various types of overhead, separately showing the items
which are not included in cost.
Factory rent and taxes
10,000
Direct expenses
4000
Managers salary (to be allocated 70%
14,000
to factory and rest to office)
Collection charges
3,600
Market research expenses
7,500
Heating and airconditioning – Office
5,500
– Showroom
12,000
Loss on sale of old machinery
2,800
Cost of printing price list and catalogues
3,500
Showroom rent
3,000
Power
6,700
Interest paid
4,500
Damages payable at law
6,000
Bonus to office staff
8,000
Carriage outwards
2,000
Telephone charges – Factory
3,000
– Office
1,800
– Showroom
4,500
Directors fees
6,000
Audit fees
3,500
Indirect wages
7,800
Internal transport charges
2,700
Plant repairs
1,200
4.
5.
In a factory the production was 1,00,000 units and prime cost per unit was: Direct
materials per unit `1.80, Direct wages `1.20. The net selling price was `4.70 per
unit. All the units were sold. Assume administration overhead related to production.
The following overheads were incurred:
Rent and taxes of factory premises
Factory lighting and power
Depreciation (plant)
Staff salaries
Management salaries
Coal
2,800
5,200
7,000
24,000
12,000
9,000
Introduction
1.54
Indirect wages
Repairs and maintenance of plant
Cost of rectification of defective work
Consumable stores
Selling expenses
General expenses
Receipts from the sale of scrap
24,500
20,000
5,600
15,000
14,700
9,200
2,400
Prepare a cost sheet showing Prime and Factory costs and per unit cost and profit.
ANSWERS
Objective Type Questions
I. True — 1, 3, 7, 10, 12, 16, 17; False — 2, 4, 5, 6, 8, 9, 11, 13, 14, 15
II. 1. Prime cost; 2. decreases; 3. Cost of production; 4. Costing; 5. fact, policy;
6. Batch costing; 7. Hire of special crane for a contract; 8. Cost unit;
9. Indirect expenses; 10. Rent, manager’s salary
III. (i) 7, (ii) 3, (iii) 8, (iv) 6, (v) 1, (vi) 9, (vii) 2, (viii) 4, (ix) 10, (x) 5
IV. (a) 5, (b) 4, (c) 1, (d) 2, (e) 3
V. (a) Operating costing/per room or bed per day (b) Operating/per passenger
kilometre (c) Process/per tonne (d) Output/per tonne(e) Multiple/per bicycle
(f) Contract/Bridge (g) Job/per job (h) Job/per job (i) Job/per item of furniture
(j) Process/per tonne
Practical Questions
1. Prime cost `1,17,100 [Hint. Materials used in final packing is selling and distribution
overhead and unproductive wages is factory overhead]
2. `2,26,000
3. `3,05,000
4. Factory overhead `41,200, Adm. overhead `29,000, Selling and distribution
overhead `36,100, Items not included in cost `13,300 [Hint. Direct expenses
are not considered in this classification because it is a part of prime cost]
5. Prime cost `3,00,000, per unit `3, Factory cost `3,86,700, per unit `3.867, Cost
of production `4,31,900, per unit `4.319. Profit `23,440, per unit `0.234
[Hint. Sale of scrap is deducted from factory overhead]
CHAPTER
2
MATERIAL COST
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning and importance of material control and the various
techniques used
• Know how stock levels are set to keep them at optimum level
• Understand the procedure of purchasing, storage and issue of materials
• Know the importance of good storekeeping and how it is achieved
• Explain perpetual inventory records and various documents used to authorize
the movement of materials into and out of stores
• Understand the various methods of pricing the material issues and their effect
on cost and profit
• Describe the types of material losses and their accounting treatment
MEANING OF MATERIAL
Material is any substance which is used for the purpose of production of goods or
services. It is defined as ‘anything that can be stored, stacked or stockpiled.’
Materials are classified into ‘direct’ materials and ‘indirect’ materials.
DIRECT AND INDIRECT MATERIALS
“Direct material cost is the cost of material which can be direcly allocated to a cost
centre or a cost object in an economically feasible way.” CAS – I of ICAI. In other
words, direct materials are those which can be conveniently identified with a cost
object. Direct materials include not only the raw materials entering at the start of the
production but all of the following:
(a) Component parts used in a product, e.g., tyres and tubes in a car or picture
tube in a television set.
(b) Any material used in production but wholly consumed in the production process,
e.g., fertilizer used in growing plants.
(c) Any primary packing material, i.e., any container sold with the final product,
e.g., cans for tinned food and drink, bottles for beer, etc.
Indirect materials are those which cannot be easily identified with a particular cost
centre or cost object. Examples are coal, grease and oil, soap and sandpaper.
2.2
Material Cost
The term ‘inventory’ is used to cover the stocks of raw materials, components,
work-in-progress and finished goods. It has been defined by the Accounting Principles
Board as ‘the aggregate of those items of tangible personal property which (i) are
held for sale in the ordinary course of business; (ii) are in the process of production
for such sales; or (iii) are to be currently consumed in the production of goods or
services to be available for sale.’
MATERIAL CONTROL (Inventory Control)
Significance No cost accounting system can become effective without proper and
efficient control of materials. This is so because quite often material is the single largest
element of cost and as such, an efficient system of material control leads to a significant
economy in the total cost. Material is as much cash as cash itself and any theft, waste
and excessive use of materials leads to immediate and direct financial losses. Where
slack methods exist, it is easy for such losses to pass unnoticed.
Meaning and Definition Material or inventory control may be defined as
‘systematic control and regulation of purchase, storage and usage of materials in
such a way so as to maintain an even flow of production, at the same time avoiding
excessive investment in inventories. Efficient material control cuts out losses and
wastes of materials that otherwise pass unnoticed.’
Thus an efficient system of material control should be comprehensive enough to
cover purchase system, storage system, issue to production and determination of stock
levels for each item of material.
Objectives of Material or Inventory Control
The broad objectives of material control are listed below:
1. No under-stocking Under-stocking inevitably leads to materials running out of
stock at some time or the other. Shortage of material may arise at a time when they
are urgently needed and production may then be held up. The delay or stoppage in
production due to non-availability of materials is very costly and results in loss of profits.
2. No over-stocking Investment in materials must be kept as low as possible
considering the production requirements and the financial resources of the business.
Over-stocking of materials locks up capital and causes high storage costs, thereby
resulting in adverse effect on profits. This may also result in loss due to obsolescence.
3. Economy in purchasing The purchasing of materials is a highly specialized
function. By purchasing materials at the most favourable prices, the purchaser is able
to make a valuable contribution to the reduction in cost.
4. Proper quality While purchasing materials, due consideration should be given to
the quality. It is no use purchasing materials of inferior quality or very superior quality.
For each type of product, there is a particular type of quality of material which is needed
and that quality alone should be purchased.
5. Minimum wastage In order to minimize the loss of materials, proper storage
conditions must be provided to different types of materials. Losses of materials occur
due to deterioration, obsolescence, pilferage and theft and evaporation. All round efforts
should be made to keep these losses to the minimum.
Material Cost
2.3
6. Information about materials Not only should materials be available when required,
there should also be a system to give complete and up-to-date accounting information
about the availability of materials. Sometimes inadequate information about availability
of materials may cause new purchases to be made of materials already in stock.
Essential Requirements or Principles of Inventory Control
Ideally, material control must ensure that the following requirements are fully met:
1. There should be proper coordination and cooperation between various
departments dealing in materials, viz., Purchasing Department, Stores
Department, Receiving and Inspecting Department, Accounting Department, etc.
2. There should be a central purchasing department under the control of a
competent and expert purchase manager.
3. There should be proper classification and codification of materials.
4. Material requirements should be properly planned.
5. The perpetual inventory system should be operated so that up-to-date information
is available about the quantity of material in stock.
6. Adequate records should be introduced to control materials during production
and the quantities manufactured for stock.
7. The storage of all materials should be well planned, subject to adequate
safeguards and supervision.
8. The various stock levels like minimum, maximum, etc., should be fixed for each
item of material.
9. Purchases of materials should be controlled through budgets.
10. An efficient system of internal audit and internal check should be operated so
that all transactions involving materials are checked by reliable and independent
persons.
11. There should be regular reporting to management regarding purchases, issues
and stock of materials. Special reports should be prepared for obsolete items,
spoilage, returns to suppliers, etc.
TECHNIQUES OF INVENTORY CONTROL
Various techniques commonly used for inventory control are listed below:
1. ABC technique
2. Stock levels—Minimum, maximum and reorder levels
3. Economic order quantity (EOQ)
4. Just in time (JIT) purchasing
5. Proper purchase procedure
6. Proper storage of materials
7. Inventory turnover ratio to review slow and non-moving materials
8. Perpetual inventory system
9. Fixation of material cost standards (Used in Standard Costing)
10. Preparation of material budgets (Used in Budgetary Control)
2.4
Material Cost
ABC TECHNIQUE (Selective Control)
ABC technique is a value based system of material control. In this technique, materials
are analysed according to their value so that costly and more valuable materials are
given greater attention and care. All items of materials are classified according to their
value—high, medium and low values, which are known as A, B and C items, respectively.
ABC technique is sometimes called Always Better Control method.
‘A’ Items—These are high value items which may consist of only a small percentage
of the total items handled. On account of their high cost, these materials should be under
the tightest control and the responsibility of the most experienced personnel.
‘B’ Items—These are medium value materials which should be under the normal
control procedures.
‘C’ Items—These are low value materials which may represent a very large number
of items. These materials should be under simple and economical methods of control.
The point of classifying stock into A, B and C categories is to ensure that material
management focuses on A items where sophisticated controls should be installed. B items
may be given less attention and C items least attention.
Thus ABC technique is a selective control which aims at concentrating efforts on
those materials where attention is needed most. This is so because it is unwise to give
equal attention to all items in stock. The items are listed and ranked in the order of
their descending importance showing quantity and value of each item. This is illustrated
below with arbitrary percentage figures.
Category
% of total value
% of total quantity
A
B
C
70
25
5
10
30
60
Total
100
100
Type of control
Strict control
Moderate control
Loose control
In the above table it is shown that 10 per cent of the total items account for as
much as 70 per cent of the total value. These are A category items which need very
strict control because of their high cost significance. The second type of items represent
30 per cent of the total quantity but account for 25 per cent of the total value. These
are B items which need routine type of control. Finally, the items representing 60 per
cent of the total quantity account only for 5 per cent of total value. These C items are
kept under simple physical control. The rules regarding purchasing, storing and issuing
of various categories of items should be formed according to the value and importance
of materials.
The information in the above table has been presented in the following diagram.
Advantages The advantages of ABC technique are as follows:
1. Closer and stricter control can be exercised on those items which represent large
amounts of capital invested.
2. Investment in inventory is regulated and funds can be utilized in the best possible
way.
3. Economy in stock carrying costs.
4. It helps in maintaining enough safety stock for ‘C’ category items.
5. Selective control helps in maintaining high stock turnover rate.
2.5
Material Cost
However, a limitation of ABC analysis is that it does not stress on items which are
less costly but may be vital.
100
95
‘B’
‘C’
% of total value
70
‘A’
50
O
10
40 50
100
% of total quantity
Fig. 2.1
ABC categories of stock (cumulative percentages).
STOCK LEVELS
In order to guard against under-stocking and over-stocking, most of the large companies
adopt a scientific approach of fixing stock levels. These levels are:
(i) maximum level; (ii) minimum level; (iii) reorder level; and (iv) reorder quantity. By
adhering to these levels, each item of material will automatically be held within
appropriate limits of control. These levels are not permanent and must be changed to
suit changing circumstances. Thus, changes will take place if consumption of material
is increased or decreased or if—in the light of a review of capital available—it is decided
that the overall inventory must be increased or decreased.
Modern inventory management makes use of operations research and statistical
techniques in fixing stock levels. However, given below is the description of various
levels along with formulae that are commonly used in their computations.
Factors Some of the factors which influence stock levels are:
1. Anticipated rate of consumption
2. Amount of capital available
3. Availability of storage space
4. Storage/warehousing costs
5. Procurement costs
6. Reliability of suppliers
7. Minimum order quantities imposed by suppliers
8. Risk of loss due to: (a) obsolescence; (b) deterioration; (c) evaporation; and
(d) fall in market prices
2.6
Material Cost
Maximum Level
This is that level above which stocks should not normally be allowed to rise. The
maximum level may, however, be exceeded in certain cases, e.g., when unusually
favourable purchasing condition arise. It is computed by the following formula:
 Minimum
Minimum 
Maximum
Reorder  Reorder
–  consumption  reorder period

level
level
quantity


The following factors are taken into account in setting this level:
1. Rate of consumption of material
2. Risk of obsolescence and deterioration
3. Storage space available
4. Costs of storage and insurance
5. Availability of funds needed
6. Seasonal considerations, e.g., bulk purchases during off-season at low prices
7. Reorder quantity
8. Restrictions imposed by government or local authority in respect of certain
materials in which there are inherent risks of fire, explosion, etc.
The idea of setting maximum stock level is to ensure that capital is not unnecessarily
blocked in stores and also to avoid loss due to obsolescence and deterioration.
Minimum Level
It is that level below which stock should not normally be allowed to fall. This is
essentially a safety stock and is not normally touched. In case of stock falling below
this level, there is a risk of stoppage in production and thus top priority should be given
to the acquisition of fresh supplies. It is computed by the following formula:
 Normal
Normal 
Reorder
Minimum
 level   consumption  reorder period
level


In fixing this level, the following factors are considered:
1. Rate of consumption.
2. The time required to acquire fresh supplies under top priority conditions so that
stoppage in production can be avoided.
Reorder Level or Ordering Level
This is that level of material at which purchase requisition is initiated for fresh supplies.
This level is fixed somewhere above minimum level. This is fixed in such a way that by
reordering when materials fall to this level, then in the normal course of events, new
supplies will be received just before the minimum level is reached. Its formula is:
Reorder  Maximum
level
consumption

Maximum
reorder period
The following factors are considered in fixing this level:
1. Rate of consumption of the material
2. Minimum level
2.7
Material Cost
3. Delivery time—i.e., the time normally taken from the time of initiating a purchase
requisition to the receipt of materials. This is also known as lead time
4. Variations in delivery time
Danger Level
Sometimes purchased materials are not received in time and stock level goes below
the minimum level. In order to meet such a situation a danger level is fixed. Danger
level is a level at which normal issues are stopped and materials are issued for important
jobs only. This level is generally fixed somewhat below the minimum level. When stock
reaches danger level, urgent action is needed for the replenishment of stock so that
stoppage in production can be avoided. Purchasing materials on an urgent basis results
in higher purchasing cost. Its formula is:
Danger
Max. reorder period
Normal


consumption
under emergency conditions
level
Average Stock Level
This is computed as follows:
Average stock level = ½ (Minimum level + Maximum level)
Alternatively, Average stock level = Minimum level + ½ (Reorder quantity)
Maximum level
900—
Ra
te
800—
of
nsu
600—
mp
tion
Quantity (units)
Co
700—
Reorder level
500—
400—
Minimum level
300—
Lead time
200—
100—
0
1
2
3
4
5
6
7
8
Time (weeks)
9
10
11
Fig. 2.2 Various stock levels, with constant lead time and
constant rate of consumption.
2.8
Material Cost
Figure 2.2 shows the various stock levels. This is based on the assumption of
constant lead time and constant rate of consumption with no interruption in production.
However, in actual practice, both lead time and rate of consumption may not remain
uniform.
Lead time is the duration time between placing an order and receipt of materials.
When purchased materials are received, the maximum level is reached. As materials
are consumed, the stock level starts coming down. Fresh supplies are received when
stock reaches minimum level.
Illustration 2.1
Two materials A and B are used as follows:
Minimum usage
50 units per week each
Maximum usage
150 units per week each
Normal usage
100 units per week each
Reorder quantity
A—600 units, B—1000 units
Delivery period
A—4 to 6 weeks, B—2 to 4 weeks.
Calculate various stock levels.
Solution
Reorder level
Minimum
level
= Maximum consumption × Maximum reorder period
A = 150 units × 6 weeks
= 900 units
B = 150 units × 4 weeks
= 600 units
=

Reorder  Normal
 Normal delivery 
level   consumption
period

A = 900 – (100 units × 5 weeks)
= 400 units
B = 600 – (100 units × 3 weeks)
= 300 units
Average reorder period has been taken as normal reorder period.
Maximum
level
=
Reorder Reorder  Minimum
Minimum 



level
quantity  consumption
delivery time
A = 900 units + 600 units – (50 units × 4 weeks)
= 1,300 units
B = 600 units + 1,000 units – (50 units × 2 weeks) = 1,500 units
Average stock level
= ½ (Minimum level + Maximum level)
A = ½ (400 units + 1,300 units)
B = ½ (300 units + 1,500 units)
= 850 units
= 900 units
Illustration 2.2 Reorder quantity of material X is 5,000 kg, maximum level 8,000 kg,
minimum usage 50 kg per hour, minimum reorder period 4 days. Daily working hours in
the factory are 8. Calculate reorder level of material X.
(C.A.)
Solution
Maximum Reorder Reorder  Minimum
Minimum 





level
quantity  usage
level
reorder period 

Reorder Maximum Reorder  Minimum
Minimum 





level
level
quantity  usage per day
reorder period 
2.9
Material Cost
= 8,000 kg – 5,000 kg + (50 kg × 8 hrs × 4 days)
= 8,000 – 5,000 + 1,600
Reorder level
= 4,600 kg
Reorder Quantity (Economic Order Quantity or EOQ)
Reorder quantity is the quantity for which order is placed when stock reaches reorder
level. By fixing this quantity, the purchaser doesn’t have to recalculate the quantity to
be purchased each time he orders for materials.
Reorder quantity is known as Economic Order Quantity because it is the quantity
which is most economical to order. In other words, economic order quantity is that
size of the order which gives maximum economy in purchasing any material and
ultimately contributes towards maintaining the material at the optimum level and at
minimum cost.
While setting economic order quantity, two types of costs should be taken into
account:
1. Ordering cost This is the cost of placing an order with the supplier. Because of
so many factors involved, it is quite difficult to quantify this cost. It mainly includes the
cost of stationery, salaries of those engaged in receiving and inspection, salaries of those
engaged in placing orders, etc.
2. Cost of carrying stock This is the cost of holding the stock in storage. It includes
the following:
(a) Cost of operating the stores, (salaries, rent, stationery, etc.)
(b) The incidence of insurance cost
(c) Interest on capital locked up in store
(d) Deterioration and wastage of materials
Note: At EOQ, ordering cost and cost of carrying stock are equal, i.e., when the total
of the two types of costs is the lowest.
Cost (`)
800–
600–
To
ta
l c
os
400–
t
Cos
200–
Orde
0
250
EOQ
t o
r in g
500
f c
in
arry
g s
costs
750
Units per order
Fig. 2.3
Economic order quantity.
toc
k
2.10
Material Cost
The above two types of costs are of opposing nature. If, for instance, an attempt
is made to reduce the costs of carrying stock by keeping stocks as low as possible, the
cost of ordering will go up because the number of replenishment orders will automatically
rise. On the other hand, if in order to save ordering costs, order is placed for a larger
quantity at one time, the stock will remain longer in stores and the cost of carrying
stock will go up. The problem is, therefore, to balance these two types of costs and the
economic order quantity is fixed at a point where the aggregate cost is the minimum.
This is shown in Figure 2.3, in which the line of cost of ordering has been shown sloping
downward indicating lower cost when large quantity is purchased and the line
representing cost of carrying stock going upward indicating higher costs for holding
larger stocks. The economic order quantity, which is the ideal order size, is at a point
where total cost curve is at its lowest point.
Mathematical Formulae of EOQ
The above graphic methods of determining economic order quantity may not provide
the most accurate answer. Economic order quantity can also be calculated with the
help of a formula as given below:
EOQ =
where
2.A.B
C.S
EOQ = Economic Order Quantity
A = Annual consumption in units
B = Buying or ordering cost per order
C = Cost per unit
S = Storage or carrying cost as a percentage of average inventory
Alternatively,
where
Illustration 2.3
2.A.B
S
S = Storage cost per unit per annum
EOQ =
Estimated requirement for the year
Cost per unit
`20
Ordering cost (per order)
`12
Carrying cost (% of average inventory)
20%
600 units
Solution
EOQ =
2  600  12
= 60 units
20  20%
In this illustration, if carrying cost is given as `4 per unit per annum, EOQ will be
calculated as follows:
EOQ =
2.A.B
2  600  12

= 60 units
S
4
Illustration 2.4 The annual demand for a product is 6,400 units. Inventory carrying
cost is `1.50 per unit per annum. If the cost of one procurement is `75, determine:
2.11
Material Cost
(a) Economic order quantity
(b) No. of orders per year
(c) Time between two consecutive orders
Solution
2.A.B
=
S
(a) EOQ =
2 × 6,400 × 75
1.50
(b) No. of orders per year
= 800 units
= Annual demand ÷ EOQ
= 6,400 ÷ 800 = 8 orders in a year
(c) Time between two consecutive orders
12 months ÷ 8 orders
= 1½ months
Tabular Method
Economic order quantity can also be determined with the help of a table prepared for
this purpose. This method is particularly used when prices vary according to the quantity
to be purchased. A table is prepared to show the various costs for different ordering
quantities thus, enabling one to find out the most economic size of the quantity to order,
i.e., where the total cost is the least of all. This is illustrated below:
Illustration 2.5
Determine EOQ from the following information using tabular mathod:
Annual consumption
—
Cost of ordering
— `15 per order
12,000 units
Cost of material
— `1.25 per unit
Carrying cost
—
Solution
20 per cent of average inventory
The following table may be prepared to determine the economic order quantity:
No. of orders
per year
Units per
order
Value per
order ( ` )
Ordering
cost (` )
Carrying
cost (` )
Total
cost (` )
1
2
3
4
5
6
7
8
9
12,000
6,000
4,000
3,000
2,400
2,000
1,714
1,500
1,333
15,000
7,500
5,000
3,750
3,000
2,500
2,142
1,875
1,667
15
30
45
60
75
90
105
120
135
1,500
750
500
375
300
250
214
188
167
1,515
780
545
435
375
340
319
308
302
10
11
12
13
14
15
1,200
1,091
1,000
923
857
800
1,500
1,364
1,250
1,154
1,071
1,000
150
165
180
195
210
225
150
136
125
115
107
100
300
301
305
310
317
325
2.12
Material Cost
The above table shows that 1,200 units is the ideal size of the order because total
cost at this level is the least of all. This means the number of orders per year should be
ten. Other order quantities (more than or less than 1,200 units) are not so economical
because total cost is higher than this level. The result of this table can be verified with
the help of mathematical formula as shown below:
EOQ =
2.A.B
=
C.S
2  12, 000  15
= 1,200 units
1.25  20%
INVENTORY TURNOVER
Inventory or stock turnover ratio tells us how many times in a year stock is used up
and replaced. The greater the stock turnover, the more efficient is the stock policy. An
example will clarify this point. Suppose two firms A and B are both selling the same
product at the same price and both realize `1 crore a year in sales income. Neither of
these firms has any cash and both have to borrow at say, 10 per cent interest rate. A
has an average stock of `25 lakh at sales value whereas B’s average stock is only `1
lakh. A’s stock turnover ratio is 4 (i.e., 1 crore ÷ 25 lakh), and B’s is 100 (i.e., 1 crores
÷ 1 lakh), A needs to avail of overdraft of `25 lakh and B needs only `1 lakh. A has to
pay interest of `2.5 lakh a year, B only `10,000 @ 10%. This example makes it clear
that high stock turnover requires less investment in stock and saves money and is thus
an indicator of efficiency of stock management.
Stock turnover rate is the ratio which the cost of materials consumed per annum
bears to the average stock of raw materials. Thus
Cost of materials consumed during the period
Average stock of materials during the period
Stock turnover ratio is an indicator of the rate of consumption, i.e., whether materials
are moving fast or slowly. A high stock turnover ratio indicates fast moving materials
and a low ratio indicates slow moving materials. The turnover of different materials
may be compared to detect those items which do not move regularly. This will enable
the management to avoid keeping capital locked up in undesirable items of materials.
Stock turnover rate may also be calculated in terms of days. This is done by dividing
365 days by the inventory turnover ratio. Thus:
Stock Turnover Ratio =
Days of the period
Stock turnover rate
If the length of the stock turnover period is short, the material is considered to be
fast moving.
Stock Turnover in terms of days =
Illustration 2.6
The following information relates to the year 2011–12:
Material A (` )
Opening stock
Closing stock
Purchases
25,000
15,000
1,90,000
Material B (` )
87,500
62,500
1,25,000
Calculate stock turnover ratios of A and B and give your comments.
2.13
Material Cost
Solution
Average stock
=
Opening stock + Closing stock
2
Material A
Material B
25,000  15,000
=
2
87,500  62,500
=
2
Opening stock
Add: Purchases
= `20,000
`
25,000
1,90,000
= `75,000
`
87,500
1,25,000
Less: Closing stock
2,15,000
15,000
2,12,500
62,500
Cost of materials consumed
2,00,000
1,50,000
Average stock
Stock turnover ratio
=
Material A
=
2,00,000
= 10
20,000
Material B
=
1,50,000
= 2
75,000
Cost of materials consumed
Average stock
Stock turnover ratio expressed in number of days =
Material A
=
365
= 37 days (approx.)
10
Material B
=
365
= 183 days (approx.)
2
365 (No. of days in year)
Stock turnover ratio
Thus, material A is fast moving as compared to material B as it takes only
37 days to consume the average stock, whereas in the case of B, it takes 183 days to
consume the average stock. Considering the low turnover ratio of B, its stock level should
be refixed and if its rate of consumption does not change, its purchases may be reduced.
The stock turnover is a good measure of the efficiency of material utilization.
SLOW, NON-MOVING AND OBSOLETE MATERIALS
Many businesses have problems of slow-moving, non-moving and obsolete materials.
Slow moving materials are those which have a low turnover ratio, i.e., their rate of
consumption or sale is low compared to their stock-holding. Stocks of such materials
should be maintained at the lowest levels.
Dormant materials or non-moving materials are those which have no demand at
present, say, due to seasonal demand. Such materials may be required in future.
Obsolete materials represent those materials which have become useless with the
passage of time, say, due to change in the design of the product or methods of
manufacture. These materials are no longer in demand because a better substitute has
2.14
Material Cost
been found or the product in which these materials were required is no longer in
production. Failure of the store-keeper to report on slow moving materials and
recommend their use as substitute where they could be so used is another factor causing
obsolescence.
The main reasons for slow-moving, non-moving and obsolete materials are:
1. Failure of the production control department to notify contemplated change in
material requirements to material control department.
2. Technical changes and use of substitute materials.
3. Failure of the purchasing department to cancel outstanding orders for such materials.
4. Purchase of items of obsolete and surplus materials.
5. Failure of store-keeper to report on slow moving items and recommend their
use as substitutes.
6. No review of the stores ledger.
Detection of Slow and Non-moving Materials
In order to detect the slow and non-moving materials, a standard stock turnover rate
should be computed for each item of material. This may be computed as follows:
Standard stock turnover rate =
Budgeted consumption
Average stock level
This standard rate should be compared with actual stock turnover rate. If the actual
turnover rate is less than standard, it implies that its actual rate of consumption is less
than the stipulated rate and the item is thus slow moving.
Monthly or quarterly reports on such materials should be prepared for presentation
to the management. These reports should show turnover rate, purchases and consumption
of these items in quantities as well as values. This will help in not only detecting but
also controlling slow and non-moving items.
PURCHASE OF MATERIALS
Purchasing is the function of buying raw materials, general supplies, tools, office
stationery and other items. The essentials of efficient purchasing are right quantity, right
quality, right time, right price, right source and delivery at the right place.
Just-in-time (JIT) Purchasing
Just-in-time purchasing is the purchase of materials immediately before these are
required for use in production. According to CIMA, London JIT purchasing is ‘matching
receipts of materials closely with usage so that raw material inventory is reduced
to near zero level.’ This means that materials purchased should directly go to the
assembly line i.e., to the production department. The purpose of JIT purchasing is to
reduce stock levels to the minimum through creating closer relationship with suppliers
and arranging frequent deliveries of materials in smaller quantities. It results in enormous
savings in storage costs, material handling costs, spoilage, obsolescence etc. An important
effect of JIT purchasing is that with frequent purchasing the issue price is likely to be
closer to market prices. In order to save on ordering costs, long term agreements may
be entered into with suppliers.
Material Cost
2.15
Advantages of JIT Purchases
1. JIT Purchasing minimises the requirement of storage space.
2. It reduces the inventory obsolescence loss.
3. As very little inventory is maintained, the working capital requirement is also
reduced.
Centralized and Decentralized Purchasing
Broadly speaking, purchase function may be organized in two ways, i.e., centralized
purchasing and decentralized purchasing.
Centralization Centralization of purchasing means that all purchases are made by a
single purchase department. Head of this department is designated as Purchase Manager
or Chief Buyer.
Decentralization In decentralized purchasing, each branch or department makes its
own purchases. If the branches or plants are located at different places, the decentralized
purchasing can better meet the situation by making purchases in the local market by
plant or branch managers.
Advantages of Centralized Purchasing
1. Specialized and expert purchasing staff can be concentrated in one department.
2. A firm policy can be initiated which may result in favourable terms of purchase,
e.g., higher trade discount or easy terms of payment
3. Standardization of quality of raw material is facilitated.
4. Better control over purchasing is possible because reckless buying by various
individuals is avoided. Keeping all records of purchase transactions at one place
also helps in control.
Disadvantages of Centralized Purchasing
1. The creation and maintenance of a special purchasing department leads to higher
administration costs which small concerns may not be in a position to afford.
2. Centralized purchasing is not suitable for plants or branches located at different
places which are far apart.
PURCHASE PROCEDURE
Although the details of a purchase procedure may differ from firm to firm, the important
steps in purchasing and receiving of materials are as follows, assuming that purchases
are centralized:
1. Purchase Requisition
Purchases of materials are initiated through purchase requisitions. A purchase requisition
is a formal request by the head of a department or an authorized officer to the purchase
manager to purchase the specified materials (Fig. 2.4). Such requisitions are received
from certain authorized persons as follows:
(i) Storekeeper When materials reach ordering level, the storekeeper should initiate
purchase procedure.
2.16
Material Cost
(ii) Production planner for special materials required for the manufacture of a new
product.
(iii) Plant engineer for repairs and maintenance materials.
(iv) Department heads (e.g., office manager) for any materials required for his
department, like filing cabinets, stationery and office sundries.
Purposes A purchase requisition
serves the following purposes:
1. It initiates the purchase and sets
Steps in Purchase Procedure
the purchasing process in motion.
1. Initiation of purchase procedure by
means of a Purchase Requisition
2. It provides a written record of
details
like
quantities,
2. Inviting tenders and selecting suppliers
specification, etc., of materials to
3. Preparation and execution of
be purchased.
purchase orders
4. Receipt of materials
3. It provides dates for reference,
e.g., date when materials are
5. Inspection and testing of materials
required. Dates are particularly
6. Debit note upon the supplier in respect
important in case responsibility
of rejected materials
for stoppage in production due to
7. Passing invoices for payment.
shortage of materials is to be
determined.
XYZ CO. LTD
PURCHASE REQUISITION
Department................................
To be delivered at .....................
.......................................................
......................................... No.
Date .......................................
Date required ......................
Please purchase the items listed below:
Item No.
Quantity
Description and Code No.
For use of purchase department only
Purchase order No. ......................
Supplier ...........................................
Delivery date ..................................
Fig. 2.4
Purpose
Requisition by ......................
Approved by .........................
Purchase requisition.
2.17
Material Cost
Generally two copies of purchase requisition are prepared. The original copy is
sent to the purchasing department and carbon copy is retained and filed by the
requisitionist for his own reference. (A note of caution: Purchase Requisition should
not be confused with Stores or Materials Requisition).
2. Selection of Suppliers
When the purchasing department receives a duly authorized purchase requisition, a source
of supply has to be selected. The purchase department generally maintains a list of
suppliers for each type of material and selects a particular supplier after inviting tenders.
The important rule is to buy the best quality materials at the lowest possible price after
giving due consideration to delivery dates and other terms of purchases. Purchases
should be made from dependable sources of supply and ethical standards should be
maintained in dealing with suppliers.
In many industries, long term contracts are entered into with suppliers. For example,
a car manufacturer may contract ahead for the supply of tyres and tubes for a year’s
requirement at a time. Such an arrangement has the advantage of not having to keep
large stocks if the continuity of supply can be relied upon. Moreover, the supplier gets
a regular customer and may offer favourable terms. Periodic withdrawals against the
contract are made by raising a purchase order.
3. Purchase Order and Follow-up
When the supplier has been selected, the most common procedure is the preparation
of a purchase order. The purchase order is the form used by the purchasing department
authorizing the suppliers to supply the specified materials at the price and terms stated
XYZ CO. LTD
PURCHASE ORDER
Supplier ..................................
...................................... No.
....................................................
Date ....................................
Please supply the following materials subject to the terms and
conditions given on the reverse side of this purchase order:
Quantity
Description
Rate
`
Amount
`
Please quote Purchase Order No. on all advice notes and invoices.
Place of delivery ..........................
Date of delivery ............................
Terms of payment ........................
Purchase Manager ..........
Fig. 2.5
Purchase order.
2.18
Material Cost
therein. A purchase order should be carefully prepared as it forms a basis of legal
contract between the parties concerned. For this reason, authority to sign purchase orders
should also be restricted to selected responsible officials. Form of Purchase Order is
given in Fig. 2.5.
Large companies generally prepare five copies of the purchase order. The original
is sent to the supplier. Second copy is retained by the purchase department for its own
file. Third copy is sent to the receiving department as an advance intimation to expect
the materials. Fourth copy is sent to the cost accounting department for entry in the
ordered column of the appropriate stores ledger account. The last copy is sent to the
department requisitioning the material as an intimation of the order and expected date
of receipt of materials.
It is very important to follow up purchase orders so as to ensure timely delivery.
Lack of follow-up measures may cause delay in arrival of materials resulting in stoppage
in production for want of materials.
4. Receipt of Materials
All incoming materials should be received by the Receiving Department. This department
performs the functions of unpacking the goods received and verifying their quantities
and conditions. The quantity is checked against the purchase order copy and the
supplier’s advice note which is normally received along with the goods.
Full particulars of the goods received are entered in a Goods Received Note (Fig.
2.6). Goods Received Note serves the following purposes:
XYZ CO. LTD
GOODS RECEIVED NOTE
Supplier ..........................................
No. .......................................
.........................................................
Advice Note No. ............................
Date ....................................
Purchase Order No. ........
Quantity
Description
No. of packages
Gross weight
Inspection report
Quantity
passed
Quantity
rejected
Reasons for
rejection
Received by
Inspected by .....................
Date.................
Fig. 2.6
............................
Goods received note.
Material Cost
2.19
1. It informs the storekeeper and the requisitionist of the receipt of materials.
2. It notifies the accounting department that the materials have been received and
that a voucher can be prepared.
3. When it includes columns of cost, it can serve as a source of entry in the stores
ledger.
Original copy of the Goods Received Note is sent to the purchase department to
be marked completed. Second copy is sent to the storekeeper or the requisitionist along
with the goods. Third copy is sent to the accounting department for entry in the stores
ledger and the last copy is retained by the receiving department for its own file.
5. Inspection and Testing of Materials
Goods received should be inspected for quality to ensure that they comply with the
specifications stated on the purchase order. Where technical or laboratory inspection is
necessary, the goods are passed to a laboratory which will provide a report on the quality
of goods.
An inspection report is prepared to show the results of the inspection. This report
is either prepared separately or incorporated in the Goods Received Note as shown in
Fig. 2.6. In either case, the report is forwarded to the purchasing department.
6. Return of Rejected Materials
Where materials received are damaged or are not in accordance with the specifications,
these are usually returned to the supplier along with a Debit Note, informing him that
his account has been debited with the value of materials concerned. When such a claim
is accepted by the supplier, he signifies his acceptance by the issue of a Credit Note.
The rejected materials may be returned to the supplier immediately or they may be held
pending his instructions. Specimen of a Debit Note is given in Fig. 2.7.
This Debit Note may be prepared by the purchase department on the basis of the
inspection report. Original copy is sent to the supplier. One copy is sent to accounts
department for adjustment entry and one copy is retained for purchase department file.
7. Passing Invoices for Payment
When the invoices are received by the purchasing department, the process of assembling
the business papers connected with each purchase and preparation of voucher begins.
Invoices are numbered serially and entered in the Invoice Register. The following
documents are assembled in support of the invoice: (a) Purchase Order; (b) Goods
Received Note; (c) Inspection Report, if not incorporated in the Goods Received Note
and (d) Debit or Credit Note.
After comparing these documents with the invoice, if it is found that the invoice is
in order, the purchase manager will sign it and pass it to the accounts department for
payment. All calculations are checked before a voucher authorizing payment is prepared.
All related documents like Purchase Order, Goods Received Note are marked with the
invoice number to preclude the passing of a possible duplicate invoice.
2.20
Material Cost
XYZ CO. LTD
DEBIT NOTE
To (Supplier) ............................
No. .......................................
....................................................
Date ....................................
We are debiting your account with the value of under-mentioned
materials for the reasons stated. Meanwhile we wait for your instructions.
Quantity
Description
Rate
`
Reasons ....................................
....................................................
....................................................
Date received
............................................
Purchase Order No. ..................
...
Supplier’s Invoice No. ...............
Fig. 2.7
Amount
`
Goods Received Note No.
Signature ...............................
Debit note.
PURCHASE PRICE
The invoice received from the supplier provides a base figure of purchase price. The
following adjustments have to be made in this figure to arrive at the real material cost.
Quantity discount This is an allowance made by the supplier to the purchaser to
encourage large orders. The discount often varies according to the size of the order,
i.e., the larger the quantity ordered, the higher is the discount, within fixed limits. Quantity
discount is allowed by a supplier as a measure of the savings in his cost which arise
from the production and distribution on a large scale. Part of these savings enjoyed by
the supplier is passed on to the purchaser in the form of quantity discount. The amount
of the quantity discount is deducted from the purchase price to arrive at the material
cost.
Trade discount This is an allowance made by the supplier to a purchaser who has
to re-sell the material, e.g., discount allowed by the manufacturer to the wholesaler.
The idea is to cover the expenses (e.g., storage, re-packing) and profit of the dealer
who is providing a service to help the original supplier to distribute his goods. This
discount is also deducted from the purchase price to arrive at the material cost.
Cash discount This discount is allowed by the supplier to a purchaser to encourage
prompt payment of invoice, e.g., 2% discount may be allowed if payment is made within
30 days and 4% discount if payment is made within 7 days. As cash discount is a form
of interest on capital, its treatment is a subject of debate among cost accountants.
Generally, it is considered a financial and non-costing item and thus is not included in
cost accounts.
Material Cost
2.21
Sales tax and other levies Items, like sales tax, excise duty, customs duty and octroi,
should be added to the purchase price.
Transport charges These include sea, land and air freight, dock charges, insurance,
etc. on materials purchased. Sometimes the purchase price quoted by the supplier
includes all these charges, but where the price does not include these charges, these
should be added to the purchase price. Where it is impracticable to do so (e.g., where
such costs are too small or invoices are received late) these may be charged as factory
overheads.
Cost of containers The supplier may or may not charge separately for containers.
If no such charge is made, no adjustment is required in the purchase price. However,
if containers are separately charged, all such costs should be included in the purchase
price i.e. (i) the cost of containers if these are not returnable; and (ii) the difference
between the cost of container and the amount refunded when container is returned,
where containers are returnable.
STOREKEEPING
Storekeeping is the function of receiving of materials, storing them and issuing these to
workshops or departments. As a substantial amount of a company’s working capital is
invested in stores, storekeeping acquires special importance. The stores department is
under the control of a person known as ‘storekeeper’ or stores superintendent. He should
be a man of undoubted integrity, suitably trained and experienced and well versed in
the principles of good storekeeping.
Objectives of Good Storekeeping
Good storekeeping should achieve the following objectives:
1. Protection of materials from losses due to fire, evaporation, obsolescence, etc.
2. Avoiding over-stocking and under-stocking
3. Economical use of storage space
4. Up-to-date stores records
5. Immediate location of materials required
6. Facilitating perpetual inventory
7. Speedy receipts and issues of stores
8. Minimize storage cost
Functions and Duties of Storekeeper
Various functions and duties of a storekeeper are as follows:
1. Maintaining materials in a tidy manner
2. Proper maintenance of records of materials received, issued to production and
in stock
3. Accepting materials into the stores after having ascertained that the delivery
complies with specifications detailed on Goods Received Note
4. Issuing materials against duly authorized Stores Requisitions
5. Requisitioning further supplies from the purchasing department when reorder
level is reached on any material
6. Preventing the entry of unauthorized persons in the storeroom
7. Periodic comparison of bin card balances with physical quantities in the bins
8. Advising management on obsolete and slow-moving stocks
2.22
Material Cost
Stores Organization
There are mainly two types of stores organization, i.e., central stores and departmental
sub-stores. From control point of view, it is ideal to have one central store for receiving
and issuing all materials. However, this is not always practicable because in large
factories, where there are many production departments, the location of the central store
may not be convenient to all such departments.
Thus, where it is not advantageous to keep central stores, departmental sub-stores
should be maintained. It is recommended that control over all sub-stores should be
centralized and storekeeper of each sub-store should be responsible to the chief
storekeeper. This will ensure a uniform policy of purchasing, storing and issuing
materials.
Advantages and Disadvantages of Central Stores
The advantages of central stores as compared to departmental sub-stores are as follows:
1. Smaller stocks are required and overall capital tied up is reduced. A number of
departmental stores inevitably lead to higher stock holding cost.
2. Specialized and expert staff can be concentrated in one department.
3. Stocks may be checked with greater care.
4. Better supervision and control is ensured.
5. Clerical costs are reduced because of centralization of stores records.
6. Bulk buying is facilitated as purchase requisitions are made out by the concern
as a unit and not on a departmental basis.
7. It results in fewer obsolete articles.
The disadvantages of central stores are:
1. Transportation costs are increased particularly when departments requiring
materials are located at a considerable distance from the central store.
2. Inconvenience and delay is caused in delivering goods to departments.
3. Production stoppage in departments is possible because of breakdowns in
transport or hold ups in central stores.
Imprest System
Sometimes large organizations use the imprest system of stores management. This is
similar in operation to imprest system of petty cash. Under this system, a number of
sub-stores exist, each drawing their supplies from the central store. Each sub-store is
given, as a commencing stock, sufficient supplies for a little more than the re-stocking
period. At the end of the period, the storekeeper of each sub-store will requisition from
the central stores the number of articles required to bring the stock upto the
predetermined quantity.
For example, let us assume the imprest amount set for a material is 400 kgs. During
the week ending on 24 February, issues of materials have reduced the stock to
140 kgs. The sub-storekeeper will issue a requisition from the central store for
260 kgs to ensure that at the beginning of the next week, 400 kgs are in stock.
This system combines the advantages of central buying and storing with the benefits
of having stocks conveniently available at several issuing points. The system also helps
2.23
Material Cost
in exercising an excellent control over sub-stores as over-issues will not be re-imbursed
and the sub-storekeeper will have to explain discrepancies, if any.
MATERIALS CODES
Names and descriptions of materials are often long and vague. In order to avoid length
and ambiguity in description and names of materials, a symbol may be assigned to each
item of material which is known as a code. Codification is the procedure of systematic
assignment of symbols for each item of store. Such codes may be either numeric,
alphabetic or a combination of numerical and alphabetical symbols. Such codes are
secret and short names of materials. The codes being shorter, considerable time and
effort may be saved by substituting a code for a longer name and or a cumbersome
description.
Examples of material codes:
Numeric
Alpha numeric
copper
– 23
copper strips of 2 metre length – C 52 m
copper sheets
– 23.1
copper bar grade 1
– CB 1G
copper bars
– 23.2
copper bar grade 2
– CB 2 G
copper wire
– 23.3
copper wire grade 1 – 23.3.1
Advantages The advantages to be derived from the use of a satisfactory system of
codification of materials are as follows:
1. Ambiguity in description is avoided as a particular code can refer to only one
type of item
2. Clerical effort is reduced as length in description is minimized
3. Secrecy of materials used in production is maintained
4. Coding is essential in mechanized accounting
STORES RECORDS
The stores records are of two types:
1. Perpetual Inventory Records These records show the movement of stores, i.e.,
the receipt of materials, issues of materials to production department and also balance
in stock. Bin card and stores ledger are the two basic perpetual inventory records.
2. Documents The documents are used to authorize movement of materials into and
out of stores. These documents include Goods Received Note, Bill of Materials, Materials
Requisition Note, Materials Return Note and Material Transfer Note.
Bin Card (Stock Card)
A bin is a container in which material is kept. Separate bin cards are maintained by the
storekeeper for each item of material in store. The bin cards show the details of receipts
and issues of materials and the balance in stock at any time. This record is of immense
help to the storekeeper in controlling the stock position.
2.24
Material Cost
A bin card is attached to the bin, drawer or any other container in which material
is stored. An entry is made at the time of each receipt or issue and the new balance in
stock is calculated. All these entries of receipts and issues are supported by documents,
such as Goods Received Note, Materials Return Note, Stores Requisition Note, etc.
Alternatively, bin cards are kept on a table in trays.
Fig. 2.8
General purpose bins.
A bin card is a quantitative record of receipts, issues and closing balances of material
items in store. It does not contain information about the prices of materials. A specimen
bin card is given in Fig. 2.9.
Two Bin System In this system, two bins are maintained for each item of material.
One bin constitutes the main or the regular bin from which materials are issued and the
other bin contains the minimum stock from which issues are made only when stock in the
regular bin is exhausted. At the time of stock verification, it is usually sufficient to verify
stock in the regular bin as the stock in the minimum stock bin is already known.
XYZ CO. LTD
BIN CARD
Bin No. .......................................
Description ..................................
Code No. ....................................
Stores Ledger Folio ..................
Date
Receipts
Ref. No.
Quantity
Minimum Level ....................
Reorder Level .....................
Reorder Quantity ................
Issues
Ref. No.
Quantity
Fig. 2.9
Bin card.
Balance
Stock Verification
Quantity
Date
Initials
2.25
Material Cost
The idea of two bin system is to provide automatic information about reaching
minimum stock level so that issue of materials for regular production is stopped. At this
stage, materials are issued only for urgent orders till fresh supplies of materials are
received.
Illustration 2.7 The following are the receipts and issues of material X in a factory
during December.
Dec. 1 Opening stock 200 kg
Dec. 5 Received from supplier S 1 400 kg (GRN No. 448)
Dec. 8 Issued to production department 240 kg (S.R. No. 883)
Dec. 10 Issued to production department 160 kg (S.R. No. 897)
Dec. 12 Received from supplier S 2 500 kg (GRN No. 455)
Dec. 15 Issued to production department 400 kg (S.R. No. 912)
Dec. 16 Received from supplier S 3 250 kg (GRN No. 461)
Dec. 19 Received from supplier S 1 500 kg (GRN No. 462)
Dec. 21 Issued to production department 250 kg (S.R. No. 940)
Dec. 24 Issued to production department 260 kg (S.R. No. 950)
Dec. 27 Issued to production department 340 kg (S.R. No. 974)
(GRN denotes Goods Received Notes. SR denotes Stores Requisition).
The minimum stock level of material X is 200 kg. Reorder level is 350 kg and
reorder quantity is 500 kg. Code No. of material is MN 240.
Prepare a Bin Card No. 148 for material X with all necessary details showing the
transactions in December.
Solution
BIN CARD
Bin No.
148
Description X
Code No. MN 240
Stores Ledger Folio
Date
Dec. 1
Dec. 5
Dec. 8
Dec.10
Dec.12
Dec.15
Dec.16
Dec.19
Dec.21
Dec.24
Dec.27
Min. Level
200 kg
Re-order Level 350 kg
Re-order Qty. 500 kg
Receipts
Issues
Balance
Ref. No.
(GRN No.)
Quantity
kg
Ref. No.
(SR No.)
Quantity
kg
Quantity
kg
—
448
—
—
455
—
461
462
—
—
—
—
400
—
—
500
—
250
500
—
—
—
—
—
883
897
—
912
—
—
940
950
974
—
—
240
160
—
400
—
—
250
260
340
200
600
360
200
700
300
550
1,050
800
540
200
Stock
Verification
2.26
Material Cost
Stores Ledger
The stores ledger is maintained in the cost accounting department and is one of the
basic records for material accounting in a cost system. This record gives the same
information regarding stores as bin card and in addition, it gives the monetary values of
materials. Separate ledger folios are maintained in it for each item of material. The
ledger sheets may be in loose leaf form or separate bindings may be used for each
type of material. Speciman of Stores Ledger is given in Fig. 2.10.
There are mainly three sections in this ledger, i.e., receipts, issues and balance,
each of these with appropriate sub-divisions showing date, quantity, unit price and total
cost. Two additional sections are usually included, i.e., On Order and Materials Reserved
columns. The ‘On Order’ column prevents placing of duplicate orders and ‘Reserve’
column indicates the materials reserved for a specific job order.
Bin Card and Stores Ledger—Distinction
The main points of difference between bin card and stores ledger are as follows:
1. Bin card is a record of quantities only, whereas stores ledger records both
quantities and money values of materials.
2. Bin card is maintained by the storekeeper, whereas stores ledger is kept by the
cost office.
3. Posting in bin card normally takes place before a transaction occurs, while in
stores ledger, it is posted after the transaction.
DOCUMENTS AUTHORIZING MOVEMENTS OF MATERIALS
Goods Received Note
A reference was made to this note in the purchase procedure discussed earlier. It was
stated that a copy of Goods Received Note is sent to the storekeeper along with the
materials for his records. The storekeeper uses this document for posting on the receipt
side of the bin card.
Stores Requisition Note (or Materials Requisition Note)
It is a document which is used to authorize and record the issue of materials from store.
The storekeeper should issue materials on the presentation of duly authorized stores
requisition note (See Fig. 2.11). It should be appreciated that this is a key document in
virtually all costing systems and serves the dual purpose of:
(a) authorizing the storekeeper to issue material
(b) providing a written record of usage of materials
A separate requisition may be prepared for each item of material or a single
requisition may be prepared to cover the issuance of a number of items. The stores
requisition note may be prepared in duplicate or triplicate. The original copy is passed
to the stores department while duplicate is retained by the department requisitioning
materials. When only two copies are prepared, the stores department copy is also routed
to the costing department. However, if the requisition is prepared in triplicate, two copies
are sent to the stores department out of which it sends one to the costing department
for necessary accounting entries. The stores requisition note is used for making entries
in bin card, stores ledger, materials abstract, etc.
Note:
Qty
Date Ref.
No.
Qty
Reserved
Date Ref.
No.
Qty
Ref.
No.
Qty
Rate
`
Issues
Amt
`
Minimum ..............................
Maximum .............................
Rate Amt.
`
`
Receipts
Location .............................
Unit ......................................
Qty
Rate
`
Balance
Amt
`
Date Initials
Stock
Verification
Ordering Quantity .............
Ordering Level ..................
Fig. 2.10
Stores ledger account.
Stores Ledger Account has been prepared in Problems and Solutions at the end of this chapter without ‘On Order’ and ‘Reserved’ columns because questions generally do
not provide information for these columns.
Date Ref.
No.
On Order
Bin No. ............................
Code No. ........................
Description .....................
STORES LEDGER ACCOUNT
Material Cost
2.27
2.28
Material Cost
XYZ CO. LTD
STORES REQUISITION NOTE
Materials required for job No. ...................
No. .......................................
Department ....................................................
Date ....................................
Quantity
Description
Code No.
Rate
Cost Office
Amount
`
Bin No. .......................................
Stores ledger folio ..................
....................................................
Fig. 2.11
`
Issued by ...........................
Received by ......................
Priced by ...........................
Stores requisition note.
Bill of Materials (Specification of Materials)
It is a master requisition which lists all the materials required for the completion of a
job. So, a bill of materials is a special form of stores requisition note which is generally
used by departments having standard materials requirements or a comparatively fixed
list of materials. For instance, in assembly type production, there will be no variation in
the amount of materials which are used. In such a case, much time would be saved if
a bill of materials (on which names or codes of all materials required are pre-printed)
is used because then only quantity is to be indicated against the code or name of material
required (See Fig. 2.12).
Where the job is of a special nature, a special bill of materials must be prepared
and a copy of this is generally passed to the stores department in advance to enable it
to arrange for materials not in stock.
The main advantages of using bill of materials are:
1. A bill of materials eliminates the need for preparing separate material requisition
notes for various types of materials required for a particular job. This saves
time and promotes efficiency.
2. The storekeeper can be given advance warning of requirements of materials
usually not available in store. It thus avoids delay in production.
3. When pre-printed forms of bill of materials are used in standard type of output,
it saves a lot of clerical labour and risk of error is also reduced.
4. Costing of jobs becomes easier and speedier.
2.29
Material Cost
XYZ CO. LTD
BILL OF MATERIALS
Job No. ......................................
No. .......................................
Department ...............................
Date ....................................
Item No. Quantity
Office
Amount
Description
Code No. Remarks
Cost
Rate
`
`
Prepared by..... ........................
Date of issue ....................
Checked by .... ........................
Issued by ...........................
Fig. 2.12
Bill of materials.
Materials Return Note
When materials issued are in excess of requirements, the unused materials are returned
to stores together with a Materials Return Note. This note is similar to Materials
Requisition Note, but is normally printed in a different colour for easy identification.
When materials are received in the stores, these should be placed in appropriate bins
and entries made in the bin card (See Fig. 2.13).
Materials Return Note is usually prepared in triplicate by the stores clerk. One
copy is sent to the department that is returning materials. Second copy is sent to the
cost office for appropriate entries and the third copy is retained by the stores
department for entry in the bin card.
Materials Transfer Note
Materials may have to be sometimes transferred from one job to another. This may be
either because excess materials were issued to a job and surplus materials are directly
transferred to another job or because materials issued to a less urgent job are transferred
to a more urgent job.
When such transfers are not permitted, the surplus materials are returned to the
stores and then re-issued to another job. This results in extra transport costs. Thus,
when materials are bulky, such transport costs may be heavy, which can be avoided if
direct transfers are permitted.
Where such transfers are permitted, these should be supported by a special
document known as a Material Transfer Note (See Fig. 2.14). Failure to record transfer
of costs would result in incorrect costs of the jobs concerned.
2.30
Material Cost
XYZ CO. LTD
MATERIALS RETURN NOTE
Credit job No. ...............................................
No. .......................................
Department ....................................................
Date ....................................
Quantity
Description
Code No.
Rate
`
Bin No. .......................................
Stores Ledger folio .................
Authorized by ...........................
Fig. 2.13
Cost Office
Amount
`
Received by ......................
Priced by ...........................
Materials return note.
XYZ CO. LTD
MATERIALS TRANSFER NOTE
No. .......................................
Dated ..................................
The following materials have been transferred:
From job No. .................
Quantity
Description
Authorized by ...........................
Delivered by .............................
Fig. 2.14
To job No. ..........................
Cost Office
Rate
Amount
`
`
Code No.
Received by ......................
Priced by ...........................
Material transfer note.
Material Cost
2.31
INVENTORY SYSTEMS
There are mainly two inventory systems, viz., Periodic Inventory System and Perpetual
Inventory System.
Periodic Inventory System
Under this system, stock-taking is undertaken at the end of the accounting year. As the
stock-taking involves verifying the physical quantities of stores in hand, some firms
temporarily suspend plant operations when this is done. This is because it is rarely
feasible to take stocks while production continues. Thus, the annual stock-taking should
be organized well in advance to minimize production hold-ups.
Perpetual Inventory System
The periodic inventory system has certain serious disadvantages which the perpetual
inventory system overcomes. A perpetual inventory system is defined as ‘the method
of recording stores balances after each receipt and issue to facilitate regular
checking and obviate closing down for stock-taking.’ 1 Thus, under this system,
current balance of stores is always shown in records, any receipts being added to and
any issues being deducted from the balance after each transaction. As stated earlier,
the records used for perpetual inventory are bin card and stores ledger. The operation
of the system is given in Illustration 2.7 where Bin Card is prepared on perpetual
inventory system; i.e., balance in stock has been calculated after each entry, in receipts
or issues columns.
Perpetual inventory system is operated by taking the following steps:
1. Reconciliation of bin cards and stores ledger accounts As we have seen
earlier, the records of each item of store are kept simultaneously at two places i.e., bin
card and stores ledger, which are the perpetual inventory records. The balance of an
item of store as shown in the bin card should agree with that shown in the stores ledger.
Any difference between these two figures may be due to: (a) some arithmetic error in
working out the balance; and/or (b) wrong posting or non-posting in bin card or stores
ledger. The balances of the two records should be reconciled after passing rectifying
entries.
2.
Continuous
stockMain Features of Continuous Stock-taking
taking In any perpetual
inventory system, the book
(i) A few items are physically counted daily
balances as shown by bin cards
or at frequent intervals.
and stores ledger should agree
(ii) All items are checked within a definite
with actual physical balance in
period such as, one month or two months,
store. This is best done by
so that each item is checked a specific
continuous stock-taking, which is
number of times in each year.
an integral part of the per-petual
(iii) The checking is carried out by special
inventory system. The primary
staff, having no other responsibility for
objectives of continuous stockphysical stocks or stock records.
taking are to confirm that the
(iv) All differences are recorded in approperpetual inventory system is
priate reports.
functioning properly and to bring
1. Wheldon’s Cost Accounting and Costing Methods.
2.32
Material Cost
records into line with the physical stocks. Under this system, a few items of stores are
counted daily or at frequent intervals and compared with the bin cards and stores ledger
by the stores auditor. Whenever there is a difference between the recorded balance
and actual stocks, an enquiry is made and the difference is adjusted in the records to
make them correspond with the physical count.
It should be noted that perpetual inventory system is not the same as continuous
stock-taking. Whereas, perpetual inventory is a system of keeping up-to-date records,
the continuous stock-taking is physical checking of records with actual stock. Continuous
stock-taking is only a part of perpetual inventory system.
The difference between book balance and physical balance may arise due to:
(a) Clerical errors in posting and working out balances in bin card and stores ledger
(b) Pilferage and breakages
(c) Over or under-issues or wrong issues
(d) Variations in weight caused by evaporation or absorption of moisture
(e) Breaking the bulk, i.e., issuing materials in smaller quantities
(f) Placing materials in the wrong bin
Advantages of Perpetual Inventory System
Perpetual inventory system has the following advantages:
1. The system helps in avoiding the long and costly work of physical checking of
all the stocks at the end of the year.
2. It also avoids dislocation in production which arises in the case of periodic stock
taking at the end of the year.
3. As stock figures are readily available at all times, the Profit and Loss Account
and Balance Sheet can be easily prepared at interim periods.
4. The system acts as a moral check on part of the staff of the stores department,
and compels them to work honestly and to maintain up-to-date records.
5. A system of internal check remains in operation all the time.
6. Discrepancies are readily discovered and rectified. This gives an opportunity
for preventing a recurrence in future.
7. The system helps in keeping the stocks within the limits decided upon by the
management so that excessive working capital is not sunk in the stocks.
8. A detailed and reliable check on stores is obtained.
Materials Abstract (Materials Issue Analysis Sheet)
This is ‘a document which is a classified record of material issues, returns and
transfers.’2 In other words, all materials requisitions, materials return notes and material
transfer notes are analysed periodically by the cost accounting department to ascertain
the material cost of each job. This is done on a document known as Materials Abstract.
METHODS OF PRICING MATERIAL ISSUES
When materials are issued from stores to production department, a question arises
regarding the price at which materials issued are to be charged. This is because the
2. CIMA terminology.
2.33
Material Cost
same type of material may have been purchased in different lots at different times at
several different prices. This means that actual cost can take on several different values
and some method of pricing the issue of materials must be selected. This basic problem
of pricing the issue of materials is illustrated in the following stores ledger account.
(Figures are assumed).
Stores Ledger Account
Date
Receipts
Ref.
Qty
(GRN) units
Issues
Balance
Rate
`
Amt.
`
Ref.
(SR)
Qty. Rate
units
`
Amt.
`
Qty.
units
Rate
`
Amt.
`
200
5
1,000
200
500
5
6
1,000
3,000
200
500
800
5 1,000
6 3,000
6.5 5,200
600
?
1 July
—
—
—
—
—
—
—
—
4 July
430
500
6
3,000
—
—
—
—
8 July
310
800
6.50 5,200
—
—
—
—
10 July
—
—
—
115
900
?
?
—
{
{
?
How to price the issue of 900 units on 10 July and how to value the stock of 600
units in hand on this date? Various alternative issue prices that could possibly be charged
are `6 per unit, i.e., the price paid on 4 July or `6.50 per unit, i.e., the price paid on 8
July, or `5 per unit, i.e., the price of opening stock or an average of these prices or
some other price. The question is whether it
Important Methods of Pricing
should be the original purchase price or the
1. First-in, First-out Price (FIFO)
current market price on the date of issue or
2. Last-in, First-out Price (LIFO)
should some other price be used for this
purpose. The question is important because
3. Simple Average Price
the pricing directly affects the amount of
4. Weighted Average Price
profit or loss reported for the accounting
5. Replacement Price
period. If the method chosen puts higher
6. Standard Price
value to closing stock, it will result in higher
profit, and vice versa, lower valuation of closing stock will result in lower profits.
It should be noted that methods discussed below are methods of pricing the issue
of materials and not the methods of physically issuing materials.
These methods are discussed and illustrated below.
First-in, First-out (FIFO) Method
This method is based on the assumption that materials which are purchased first are
issued first. It uses the price of the first batch of materials purchased for all issues
until all units from this batch have been issued. After the first batch is fully issued, the
price of the next batch received becomes the issue price. Upon this batch also getting
fully used, the price of the still next batch is used for pricing and so on. In other words,
the materials are issued at the oldest cost price listed in the stores ledger account and
thus, the materials in stock are valued at the price of the latest purchases.
2.34
Material Cost
Three important effects of using FIFO method are:
(a) Materials are priced at the actual cost
(b) Charge to production for material cost is at the oldest prices of materials in
stock
(c) Closing stock is valued at the latest price paid
Illustration 2.8
FIFO method:
From the following transactions, prepare a Stores Ledger Account using
500 units @ `20 each
400 units @ `21 each
600 units
800 units @ `24 each
500 units
300 units
500 units @ `25 each
400 units
1 July
Opening stock
4 July
Purchased
GRN
574
6 July
Issued
SR
251
8 July
Purchased
GRN
578
9 July
Issued
SR
258
13 July
Issued
SR
262
24 July
Purchased
GRN
584
28 July
Issued
SR
269
GRN = Goods Received Notes; SR = Stores Requisition
(These transactions have also been used to illustrate other methods of pricing).
Solution
FIFO Method
Stores Ledger Account
Date
1 July
4 July
6 July
8 July
9 July
Receipts
Issues
Balance
Ref.
GRN
Qty. Rate
units `
Amt.
Ref.
(SR)
Qty.
units
Rate
Amt.
`
`
`
—
574
—
400
—
8,400
—
—
—
—
—
—
—
—
500
100
—
20 10,000
21 2,100
—
—
300
200
300
—
21
24
24
—
6,300
4,800
7,200
—
300
100
24
25
7,200
2,500
—
578
—
—
800
—
—
21
—
—
24 19,200
—
—
251
258
—
584
—
500
—
—
25 12,500
262
—
28 July
—
—
—
269
* Closing stock is 400 units @ `25 = `10,000.
{
—
13 July
24 July
—
600
500
{
400
{
Qty. Rate
units
`
Amt.
`
{
500
500
400
20
20
21
10,000
10,000
8,400
{
300
300
800
21
21
24
6,300
6,300
19,200
{
600
300
300
500
24
24
24
25
14,400
7,200
7,200
12,500
400*
25
10,000
Material Cost
2.35
It should be noted that the assumption of FIFO is only for accounting purpose, i.e.,
the physical flow of materials need not necessarily be in the order of the flow of cost,
though normally materials would be expected to move out of stock on a FIFO basis
because oldest stocks are usually used up first.
Advantages The following advantages are claimed for FIFO method:
1. It is based on a realistic assumption that materials are issued in the order of
their receipts.
2. Materials are issued at actual cost and thus no unrealized profit/loss arises from
the operation of this method.
3. Valuation of closing inventory is at cost as well as at the latest prices paid.
4. This method is easy to understand and simple to operate.
Disadvantages The main disadvantages of this method are:
1. As materials are charged to production at the old prices, the cost of production
may lag behind the current economic values.
2. This method does not permit comparison of the costs of similar jobs or cost units
because similar jobs simultaneously started may be charged materials at different
prices.
3. When prices are subject to frequent changes, this method involves cumbersome
records and calculations.
In periods of rising prices, the FIFO method produces higher profits and results
in higher tax liability because lower cost is charged to production. Conversely, in periods
of falling prices, the FIFO method produces lower profits and results in lower taxes
because they are derived from a higher cost of goods sold.
Last-in, First-out (LIFO) Method
This method operates in just the reverse order of FIFO method. It is based on the
assumption that the last materials purchased are the first materials to be issued. Thus,
the price of the last batch of the materials purchased is used first for all issues until all
units from this batch have been issued, after which the price of the previous batch of
materials purchased is used. It should be noted that physical flow of materials may not
conform to LIFO assumption.
Three points should be noted regarding this method:
(a) Material issues are priced at actual cost
(b) Charge to production for material cost is at latest prices paid
(c) Closing stock valuation is at the oldest prices paid and is completely out of line
with the current prices
Illustration 2.9 Prepare a Stores Ledger Account, showing pricing of materials on LIFO
basis, from the data given in Illustration 2.8.
2.36
Material Cost
Solution
LIFO Method
Stores Ledger Account
Date
Receipts
Ref.
GRN
Qty. Rate
units `
1 July
—
—
4 July
574
6 July
—
Issues
Balance
Amt.
`
Ref.
(SR)
Qty.
units
Rate
Amt.
`
Qty. Rate
units `
—
—
—
—
—
—
500
20
10,000
400
21
8,000
—
—
—
—
500
400
20
21
10,000
8,400
—
—
—
251
400
200
21
20
8,400
4,000
300
20
6,000
—
300
800
20
24
6,000
19,200
300
300
20
24
6,000
7,200
300
`
{
Amt.
`
600
{
8 July
578
800
24 19,200
—
—
—
9 July
—
—
—
—
258
500
24 12,000
{
{
13 July
—
—
—
—
262
300
24
7,200
20
6,000
24 July
584
500
25 12,500
—
—
—
—
300
500
20
25
6,000
12,500
28 July
—
—
—
269
400
25 10,000 * 300
100
20
25
6,000
2,500
—
{
{
* Closing stock is 300 units @ `20 = `6,000 + 100 units @ `25 = `2,500.
Total 400 units at `8,500.
Advantages The main advantages of this method are:
1. Materials are charged to production at the latest prices paid. In times of rising
prices, quotation of prices for company’s product will be safe and profitable.
2. This method, like FIFO, does not result in any unrealized profit or loss.
3. This method is also quite simple to operate, particularly when prices are
fairly steady.
Disadvantages This method suffers from the following disadvantages:
1. This method is not realistic as it does not conform to the physical flow of
materials.
2. The closing stock is valued at the old prices and does not represent the current
economic values.
3. Like FIFO method, in this method as well, the material cost of similar jobs may
differ because materials were issued from different lots and thus, at different
prices. This renders comparisons difficult.
4. This method is cumbersome when prices are subject to frequent fluctuations.
In periods of rising prices, profit and tax liability under LIFO would be lower
than under FIFO method because cost will be charged at current prices which are at
higher level. Conversely, in periods of falling prices, closing stock is valued at old
prices which are at higher level and thus, profit would also be higher resulting in higher
tax liability.
2.37
Material Cost
Illustration 2.10 The following is the record of receipts and issues of a certain material
in the factory during a week:
April
1 Opening Balance
....50 tonnes
Issued
@ `10 per tonne
....30 tonnes
2 Received
....60 tonnes
@ `10.20 per tonne
3 Issued
....25 tonnes
(Stock verification reveals loss of 1
tonne)
4 Received back from orders
....10 tonnes (Previously issued at `9.15 per tonne)
5 Issued
....40 tonnes
6 Received
....22 tonnes
7 Issued
....38 tonnes
@ `10.30 per tonne
At what prices will you issue the materials? Use FIFO and LIFO methods for this
purpose and show the comparative results.
Solution
FIFO Method
Stores Ledger Account
Date
Receipts
Issues
Balance
April
Qty.
Units
Rate
`
Amt.
`
Qty.
Units
Rate
`
Amt.
`
Qty.
Units
Rate
`
Amt.
`
1
1
—
—
—
—
—
—
—
30
—
10.00
—
300
50
20
10.00
10.00
500.00
200.00
2
60
10.20
612
—
—
—
{ 2060
10.00
10.20
200.00
612.00
3
—
—
—
25 20
5
{
10.00
10.20
200
51
55
10.20
561.00
1 (Loss)
10.20
10.20
54
10.20
550.80
{ 5410
{ 1410
10.20
9.15
550.80
91.50
10.20
9.15
142.80
91.50
14
10
22
10.20
9.15
10.30
142.80
91.50
226.60
8
10.30
82.40
3
4
10
(Return)
9.15
91.50
—
—
—
5
—
—
—
40
10.20
408
6
22
10.30
226.60
—
—
—
7
—
—
—
38 14
10
14
10.20
9.15
10.30
142.80
91.50
114.20
{
{
* Closing stock = 8 tonnes @ `10.30 = `82.40.
Note: Received back from orders on 4 April has been treated as a new purchase.
2.38
Material Cost
LIFO Method
Stores Ledger Account
Date
Receipts
Issues
Balance
April
Qty.
Units
Rate
`
Amt.
`
Qty.
Units
Rate
`
Amt.
`
Qty.
Units
Rate
`
Amt.
`
1
—
—
—
—
—
—
50
10.00
500.00
1
—
—
—
30
10.00
300
20
10.00
200.00
2
60
10.20
612
—
—
—
10.00
10.20
200.00
612.00
3
—
—
—
25
10.20
255
10.00
10.20
200.00
357.00
3
—
—
—
1 (Loss)
10.20
10.20
10.00
10.20
200.00
346.80
4
10
(Return)
9.15
91.50
—
—
—
20
34
10
10.00
10.20
9.15
200.00
346.80
91.50
5
—
—
—
40 10
30
9.15
10.20
91.50
306.00
{ 204
10.00
10.20
200.00
40.80
6
22
10.30
226.60
—
—
—
20
4
22
10.00
10.20
10.30
200.00
40.80
226.60
7
—
—
—
10.30
10.20
10.00
226.60
40.80
120.00
8*
10.00
80.00
{
{
38
22
4
12
{ 2060
{ 2035
{ 2034
{
{
* Closing stock 8 tonnes @ `10 each = `80.
AVERAGE PRICE METHODS
These methods are based on the assumption that when materials purchased in different
lots are stored together, their identity is lost, and therefore, issues should be charged at
an average price. Basically, average prices are of two types—simple average and
weighted average.
Simple Average Method
Simple average price is calculated by adding all the different prices of materials in stock,
from which the materials to be priced could be drawn, by the number of prices used in
that total. This method does not take into account the quantities of materials in stock
while calculating the average. Suppose, the following three lots of materials are in stock
when material is to be issued:
500 units purchased @ `20
200 units purchased @ `21
700 units purchased @ `22
20  21  22
= 21
3
While calculating the simple average, the price of lots of materials which are
assumed to have been completely issued on FIFO basis are not taken into account.
Simple Average Price =
2.39
Material Cost
Illustration 2.11 Prepare Stores Ledger Account by Simple Average Method from the
transactions given in Illustration 2.8.
Solution
Simple Average Price Method
Stores Ledger Account
Date
1 July
4 July
6 July
8 July
9 July
13 July
24 July
28 July
Receipts
Issues
Balance
Ref. Qty. Rate
GRN Units `
Amt.
`
Ref.
SR
Qty.
Units
Rate
`
Amt.
`
Qty. Rate
Units
`
Amt.
`
—
574
—
578
—
—
584
—
—
8,400
—
19,200
—
—
12,500
—
—
—
251
—
258
262
—
269
—
—
600
—
500
300
—
400
—
—
20.50
—
22.50
24.00
—
24.50
—
—
12,300
—
11,250
7,200
—
9,800
500
900
300
1,100
600
300
800
400
10,000
18,400
6,100
25,300
14,050
6,850
19,350
9,550
—
400
—
800
—
—
500
—
—
21
—
24
—
—
25
—
20
—
—
—
—
—
—
—
Working Notes: Various issue prices are computed as follows:
On
6 July = (20 + 21) ÷ 2
= `20.50
On
9 July = (21 + 24) ÷ 2
= `22.50
On
13 July = (24 ÷ 1)
= `24.00
On
28 July = (24 + 25) ÷ 2
= `24.50
Advantages and Disadvantages of Simple Average Method The only
advantage that this method enjoys is its simplicity. No more can be said in favour of
this method as it pays no consideration to the relative quantities held at each price. For
this reason, this method is considered unscientific and it usually produces unsatisfactory
results. The value of closing stocks may be sometimes negative, which is quite absurd.
For instance, if 100 units at `10 each and 1,000 units at `2 each are held in stock at a
total value of `3,000, when 600 units are issued at a simple average price of `6, i.e., (10
+ 2) ÷ 2, the closing stock of 400 units will be valued at a negative value of `600, which
is absurd. These figures have been exaggerated to illustrate the point. Another
disdvantage of this method is that it does not charge materials at actual cost and thus,
may result in unrealized profit or loss.
Weighted Average Method
This method gives due weightage to the quantities held at each price when calculating
the average price. The weighted average price is calculated by dividing the total cost
of material in stock, from which the material to be priced could have been drawn, by
the total quantity of material in that stock. The simple formula is that weighted average
price at any time is the balance value figure divided by the balance units figure.
Illustration 2.12 From the transactions given in Illustration 2.8, prepare Stores Ledger
Account assuming pricing according to Weighted Average Method.
2.40
Material Cost
Solution
Weighted Average Method
Stores Ledger Account
Date
Receipts
Issues
Balance
Ref. Qty. Rate
GRN units
`
Amt.
`
Ref.
SR
Qty.
units
Rate
`
Amt.
`
Qty. Rate
units
`
Amt.
`
—
574
—
578
—
—
584
—
—
8,400
—
19,200
—
—
12,500
—
—
—
251
—
258
262
—
269
—
—
600
—
500
300
—
400
—
—
20.444
—
23.030
23.030
—
24.261
—
—
12,267
—
11,515
6,909
—
9,705
500
900
300
1,100
600
300
800
400
10,000
18,400
6,133
25,333
13,818
6,909
19,409
9,704
1 July
4 July
6 July
8 July
9 July
13 July
24 July
28 July
—
400
—
800
—
—
500
—
—
21
—
24
—
—
25
—
20.000
20.444
20.444
23.030
23.030
23.030
24.261
24.261
Notes: The issue prices are calculated as follows:
On
4 July `18,400
÷
900 units = `20.444
On
8 July `25,333
÷
1,100 units = `23.030
On
24 July `19,409
÷
800 units = `24.261
The fresh issue rate is determined after each purchase and not at the time of each
issue. Thus, as soon as fresh supply is received, a new price is calculated and all issues
are then valued at that price until the next supply is received when a new issue price
will be calculated.
Advantages This method has the following advantages:
1. This method smoothens out the effect of fluctuations in purchase price. It is
thus, particularly advantageous where price variations are wide so that extreme
prices are ironed out.
2. The new issue price is calculated at the time of each new purchase and not at
the time of each issue. Since receipts are much less frequent than issues, the
work of making calculations is reduced.
3. No unrealized profit or loss arises by the use of this method.
Disadvantages
1. Issue prices may not be at the current market prices.
2. The method calls for many calculations where purchases are made frequently.
3. To avoid errors, the average price must be calculated to a sufficient number of
decimal points. This makes the operation of the method somewhat tedious.
4. Excessively high or low prices paid in the past are reflected in the average for
a considerable time after the expensive (or inexpensive) material has been
consumed.
Illustration 2.13
Jan.
Jan.
Feb.
Feb.
Feb.
March
2
20
5
10
12
2
The following transactions occur in the purchase and issue of a material:
Purchased
Purchased
Issued
Purchased
Issued
Issued
4,000
500
2,000
6,000
4,000
1,000
units @ `4.00 per unit
units @ `5.00 per unit
units
units @ `6.00 per unit
units
units
2.41
Material Cost
March
5
Issued
2,000
units
March 15
Purchased
4,500
units @ `5.50 per unit
March 20
Issued
3,000
units
From the above, prepare the Stores Ledger Account using the Weighted Average Price.
Solution
Weighted Average Price
Stores Ledger Account
Date
Jan. 2
Jan. 20
Feb. 5
Feb. 10
Feb. 12
Mar. 2
Mar. 5
Mar.15
Mar.20
Receipts
Issues
Balance
Qty.
units
Rate
`
Amt.
`
Qty.
units
Rate
`
Amt.
`
Qty.
units
Rate
`
Amt.
`
4,000
500
—
6,000
—
—
—
4,500
—
4.00
5.00
—
6.00
—
—
—
5.50
—
16,000
2,500
—
36,000
—
—
—
24,750
—
—
—
2,000
—
4,000
1,000
2,000
—
3,000
—
—
4.111
—
5.445
5.445
5.445
—
5.486
—
—
8,222
—
21,780
5,445
10,890
—
16,457
4,000
4,500
2,500
8,500
4,500
3,500
1,500
6,000
3,000
4.000
4.111
4.111
5.445
5.445
5.445
5.445
5.486
5.486
16,000
18,500
10,278
46,278
24,498
19,053
8,163
32,913
16,456
Closing stock: 3,000 units, value `16,456.
Working Notes:
Weighted Average Price on Jan. 20 = `18,500 ÷ 4,500 units = `4.111
On Feb. 10 = `46,278 ÷ 8,500 units = `5.445
On March 15 = `32,913 ÷ 6,000 units = `5.486
Replacement Price Method
Replacement price is the price at which materials would be replaced, i.e., the market
price on the date of issue. This method is used when it is desired to reflect the current
prices in cost. It is most suitable for businesses that buy large quantities of materials
well in advance of requirements to take advantage of cheap prices the benefit of which
is not desired to be passed on to the customer.
Advantages The main advantages of this method is that it is simple to operate as no
calculations are required to be made of the issue prices as is done in average, LIFO,
FIFO methods, etc. Secondly, material cost is charged at the current market prices.
Disadvantages However, the shortcomings of this method are also of a serious nature
as described below:
1. It involves considerable work of finding out the replacement price at the time of
each issue. Sometimes, replacement price is not easily available or not available
at all. In such cases, it has to be estimated, which may not be quite reliable.
2. The stock valuation is not at the current prices.
3. As issues are not priced at actual cost, it results in unrealized profit or loss.
Illustration 2.14 From the transactions given in Illustration 2.8, you are required to
prepare a Stores Ledger Account when issues are priced according to Replacement Price
Method. Further, assume that the replacement prices are as under:
July 6—`22; July 9—`23; July 13—`24; July 28—`26.
2.42
Material Cost
Solution
Replacement Price Method
Stores Ledger Account
Date
Receipts
Ref. Qty. Rate
GRN Units `
Issues
Amt.
`
Ref.
SR
Qty.
Units
Balance
Rate
`
Amt.
`
Qty. Rate
Units
`
Amt.
`
1 July
4 July
6 July
8 July
9 July
13 July
24 July
—
574
—
578
—
—
584
—
400
—
800
—
—
500
—
—
21 8,400
—
—
24 19,200
—
—
—
—
25 12,500
—
—
251
—
258
262
—
—
—
600
—
500
300
—
—
—
500
—
—
900
22 13,200
300
—
— 1,100
23 11,500
600
24 7,200
300
—
—
800
20
—
—
—
—
—
—
10,000
18,400
5,200
24,400
12,900
5,700
18,200
28 July
—
—
—
269
400
26 10,400
—
7,800
—
400
Note: Balance amount is calculated by deducting issue amount from the previous balance amount.
Standard Price Method
Standard price is a predetermined price which is fixed for a definite period, such as a
year. It takes into account factors like probable trend of prices over that period, market
conditions, discounts, etc. Thus, standard price is a notional price and not the actual
cost price. Standard prices are fixed for each item of material and where prices of
materials fluctuate heavily, standard prices should be fixed for a short period and revised
as and when required.
Under this method, all receipts are posted in the Stores Ledger Account at actual
cost and issues are priced at standard price. The difference between actual and standard
prices, is transferred to Material Price Variance Account.
While this method is used mainly in connection with standard costing, it can be
employed in practically any other costing system.
Illustration 2.15 Again using the transactions given in Illustration 2.8, prepare Stores
Ledger Account under Standard Price Method. Assume standard price is `24 per unit.
Solution
Standard Price Method
Stores Ledger Account
Date
Receipts
Ref. Qty. Rate
GRN units
`
1 July
4 July
6 July
8 July
—
574
—
578
—
400
—
800
Issues
Amt.
`
Ref.
SR
Qty.
units
—
—
21 8,400
—
—
24 19,200
—
—
251
—
—
—
600
—
Rate
`
Balance
Amt.
`
Qty.
units
Amt.
`
—
—
—
—
24 14,400
—
—
500
900
300
1,100
10,000
18,400
4,000
23,200
(Contd.)
2.43
Material Cost
9 July
13 July
24 July
—
—
584
—
—
500
—
—
—
—
25 12,500
258
262
—
500
300
—
24 12,000
24 7,200
—
—
600
300
800
11,200
4,000
16,500
28 July
—
—
—
269
400
24
400
6,900
Note:
—
9,600
The value of closing stock of 400 units at the standard price of `24 should be `9,600. The difference
of `2,700 (i.e., `9,600 – 6,900) represents favourable price variance and to this extent the closing stock
is undervalued. This favourable variance may be partly due to the efficiency in purchasing and partly
due to other factors.
Pricing of Materials Returned
Sometimes, materials may be returned by production department to stores for some
reason or the other. Such return of materials may be treated by one of the following
two methods:
1. The returned materials may be entered in the Receipts column of Stores Ledger
Account at the price at which these were originally issued at if they were a
new purchase. These materials are re-issued for production at a price according
to the method of pricing in vogue.
2. The returned materials are recorded in the Receipts column of the Stores Ledger
Account at the price at which these were originally issued and issued at the
immediately next stores requisition at the same price.
Choice of Method of Pricing
The various factors affecting choice of a method are:
1. The extent of price fluctuations
2. Frequency of receipts and issues of materials
3. Type of costing system in use, i.e., job or process costing
4. The proportion of material cost in total cost
5. Degree of accuracy required
6. Whether issues can be identified with purchased lots
7. Whether standard costing system is in use
8. The need for maintaining uniformity in costs within the industry
9. The nature of material, i.e., whether it is subject to some losses like evaporation,
breaking the bulk, etc.
10. Managerial policy regarding valuation of closing stock
MATERIAL LOSSES
Losses of materials may arise during handling, storage or during process of manufacture.
Such losses or wastages are classified into two categories—normal loss and abnormal
loss.
Normal Loss This is that loss which has necessarily to be incurred and thus is
unavoidable. Examples are:
(i) Loss by evaporation in case of liquid materials.
2.44
Material Cost
(ii) Loss due to loading and unloading of material, say, in case of coal and other
materials of such nature.
(iii) Loss due to breaking the bulk. When materials are purchased in large quantity
and issued to production in small lots, some difference is likely to arise.
Normal losses of material cannot be completely eliminated but may be controlled
to a limited extent.
Abnormal Loss This is that loss which arises due to inefficiency in operations, bad
luck, mischief, etc. Examples are:
(i) Theft or pilferage
(ii) Breakage
(iii) Fire, accident, flood, etc.
(iv) Use of inaccurate weighing instruments
(v) Improper storage resulting in deterioration of materials
Control of Material Losses
The following steps are suggested to control the loss of materials:
1. Proper storage conditions should be provided, particularly in case of perishable
materials.
2. The store room should be well guarded and protected to avoid the risks of fire
or theft, etc.
3. In order to reduce losses due to obsolescence, materials should be issued on
first-in, first-out basis.
4. Accuracy of weighing instruments should be periodically checked.
5. A systematic procedure should be developed regarding movement of materials
from one place to another and no unauthorized movement of materials should
be permitted.
6. Specialized material handling equipment should be employed so as to minimize
losses in materials handling.
Accounting Treatment
It is a principle of costing that all normal losses which are necessarily to be incurred
are treated as a part of the cost and abnormal losses which are really avoidable should
not be included in the cost. Therefore, in order to absorb normal material losses in cost,
the rates of usable materials in stock are inflated so that such losses are covered.
Alternatively, normal material loss is transferred to factory overhead.
Abnormal material losses, such as those due to breakage, theft, fire, flood and
abnormal evaporation, are charged to Costing Profit and Loss Account.
WASTE, SCRAP, SPOILAGE AND DEFECTIVES
Material losses may arise in the form of waste, scrap, spoilage or defectives. These
are explained below:
Waste
Meaning Waste has been defined as ‘that portion of a basic raw material lost in
processing, having no recovery value.’ 3 In fact, waste is a material loss during
3. CIMA, London.
Material Cost
2.45
production or storage due to various factors, such as evaporation, chemical reaction,
shrinkage, contamination, unrecoverable residue, which has little or no value. Waste may
be visible or invisible. Visible waste is that which is physically present, e.g., ash and
saw dust. An invisible waste, on the other hand, is the disappearance of basic raw
material in the form of evaporation, smoke, etc. Waste in certain industries creates
problems of disposal. Usually this is disposed of in the easiest and cheapest manner,
e.g., liquid wastes may be poured into nearby rivers.
Control of waste Waste has the effect of reducing the quantity of output. Thus, waste
should be reduced to the minimum. Allowance for normal waste should be made on the
basis of past experience, technical factors and any special features of the material,
product and process, etc. Responsibilities should be assigned for any waste over and
above the normal waste.
A Waste Report should be prepared periodically to compare the actual waste with
the predetermined level.
Accounting of waste Waste usually has no realizable value. If waste is a part of
the normal process loss, the cost will be absorbed by the good production. On the other
hand, if it is a part of the abnormal process loss, it is transferred to Costing Profit and
Loss Account.
However, if waste has any sale value at all, then the small amount received should
be treated as ‘other income’.
Scrap
Meaning This is defined as ‘the incidental residue from certain types of
manufacture usually of small amount and low value, recoverable without further
processing.’4 According to Cost Accounting Standard-6 (CAS-6), issued by ICAI,
‘scrap is the “discarded material having some value in a few cases and which is
usually either disposed of without further treatment (other than reclamation and
handling) or re-introduced into the process in place of raw materials.” ’ Scrap has
the following features:
(a) Scrap is incidentally produced from the manufacturing process.
(b) Scrap is usually of small value.
(c) No further processing is required to realize its saleable value.
(d) Scrap may be used in place of raw material, in some cases.
(e) Unlike waste, scrap is always physically available.
Examples of scrap are trimmings in timber industries; cuttings, pieces, etc., in leather
and readymade garments factory and cut pieces of metal sheets.
Control of scrap Like waste, scrap also increases the cost of production. Although
scrap might realize a nominal amount, the sale value will mostly be much lower than
the cost of raw materials. Therefore, scrap should be kept as low as possible and a
proper control should be exercised on this loss of materials.
Control of scrap is possible by setting standards for scrap, determining the
responsibility for scrap and by keeping proper records of scrap. A Scrap Report should
be prepared at regular periods whereby a comparison should be made between actual
scrap and standard allowance for scrap and remedial measures should be taken for
any adverse variances that may be detected.
4. Cost Accountant’s Handbook—Lang (ed).
2.46
Material Cost
Accounting of scrap The problem of scrap is more complex than that of waste. It
may be treated in any of the following ways:
(a) As other income Sales of scrap may simply be treated as ‘other income’ and
credited to Profit and Loss Account. This method is particularly suitable when
the scrap has a relatively small realisable value, after taking into account the
cost of its disposal and marketing.
(b) Credit to overheads The net value of scrap, i.e., after adjusting selling and
distribution costs, may be credited to production overheads of the department
producing the scrap. An alternative to this method is that net realisable value is
credited to the material cost.
(c) Credit to job or process The realisable value of scrap may be credited to the
job or process which yields the scrap. This method is suitable when scrap is
identifiable with a particular job or process and is of significant value.
Spoilage
Meaning Spoiled work results when materials are damaged in manufacturing
operations is such a way that they cannot be rectified and brought back to normal
specifications. Spoilage differs from scrap in that scrap unavoidably arises as a result
of manufacturing operations, whereas spoilage occurs due to some defect in materials
or manufacturing operations which could have been avoided. Spoiled work may have a
realisable value and in certain cases, it is sold as ‘seconds’.
Control of spoilage Normal spoilage should be determined in advance and it should
be periodically compared with actual spoilage in the Spoilage Report. Causes of any
abnormal spoilage should be investigated and remedial measures immediately taken.
Accounting of spoilage For accounting purposes, spoiled work should be divided into
normal and abnormal. The cost of normal spoilage should be borne by good production.
This can be done by charging the loss due to spoilage to production and spreading it
over the good units produced.
Abnormal spoilage, caused due to inefficiency and treated as controllable should
be transferred to Costing Profit and Loss Account.
Defectives
Meaning Defective work may be defined as ‘that production which is below standard
specifications or quality and can be rectified by incurring additional expenditure (of
material, labour, etc.) known as rectification costs.’ The main difference between
spoilage and defective is that whereas the former cannot be rectified and sold as good
units, the latter can be rectified by incurring additional costs and brought back to the
level of standard product. Sometimes, when defectives cannot be rectified as standard
product, they may be sold as ‘seconds’.
Control of defectives This should cover not only control over the quantity of
defective production but also control over rectification costs. On the basis of past
experience, standards for defective work and rectification costs should be fixed. Reasons
for any defectives over and above the normal or standard defective work should be
fully investigated and corrective steps should be taken. If, for example, defective output
is due to bad workmanship, suitable incentives may be provided to workers for minimizing
the defective work. A report on defective work should be periodically prepared.
Accounting of defective work The main problem in accounting of defective work
is the problem of treatment of rectification or rework costs. Where defective work is
2.47
Material Cost
easily identifiable with specific jobs, the rectification costs should be debited to the
jobs concerned. Where, however, such work cannot be conveniently identified with
jobs, the rectification costs may be debited to overheads. In the case of abnormal
type of defective work, the rectification costs may be transferred to Costing Profit
and Loss Account.
PROBLEMS AND SOLUTIONS
Problem 2.1 A factory uses 4,000 varieties of inventory. In terms of inventory holding
and inventory usage, the following information is compiled:
No. of varieties
of inventory
%
% value of inventory
holding (average)
% of inventory usage
(in end-product)
3,875
110
15
96.875
2.750
0.375
20
30
50
5
10
85
4,000
100.00
100
100
Classify the items of inventory as per ABC analysis with reasons.
(CA Inter)
Solution
ABC Classification
Category
No. of items
% of value
A
B
C
15
110
3,875
50
30
20
% of usage
85
10
5
Reasons
‘A’ items: 15 items constituting 0.375% of the total number of items represent 50
per cent of the total inventory value and 85 per cent of the total usage in the final product.
These are classified as ‘A’ items because of their highest value in the total material
cost.
‘B’ items: 110 items representing 2.75 per cent of the total number of items
represent 30 per cent of the total inventory value and only 10 per cent of the total usage.
These are thus classified as ‘B’ items because of their moderate value.
‘C’ items: These are 3,875 items which constitute 96.875 per cent of the total
items. These represent 20 per cent of the total value but only 5 per cent of the usage
in final product. These are classified as ‘C’ items because of their low value.
Problem 2.2 In a manufacturing company, a material is used as follows:
Maximum consumption
12,000 units per week
Minimum consumption
4,000 units per week
Normal consumption
8,000 units per week
Reorder quantity
48,000 units
Time required for delivery—Minimum: 4 weeks; Maximum: 6 weeks.
Calculate: (a) Reorder level; (b) Minimum level; (c) Maximum level; (d) Danger level;
and (e) Average stock level.
2.48
Material Cost
Solution
Reorder Level
= Maximum consumption × Maximum reorder period = 12,000 × 6 = 72,000 units
Minimum Level
= Reorder level – (Normal consumption × Normal reorder period)
= 72,000 – (8,000 × 5) = 32,000 units
Maximum Level
= Reorder level + Reorder Qty – (Min. consumption × Min. reorder period)
= 72,000 + 48,000 – (4,000 × 4) = 1,04,000 units
Danger Level
= Average consumption × Max. reorder period for emergency purchases
= 8,000 × 2 weeks (assumed) = 16,000 units
Average Stock Level
= Minimum level + ½ of Reorder Qty = 32,000 + ½ (48,000) = 56,000 units
Problem 2.3 A.S. Ltd. produces a product ‘Red’ using two components X and Y. Each
unit of ‘Red’ requires 0.4 kg of X and 0.6 kg of Y. Weekly production varies from 350
units to 450 units averaging 400 units. Delivery period for both the components is 1 to
3 weeks. The economic order quantity for X is 600 kg and for Y is 1,000 kg. Calculate:
(i) Re-order level of X;
(ii) Maximum level of X;
(iii) Minimum level of Y.
Solution
(i) Re-order level of X
(B.Com. Hons., Delhi)
= Max. consumption × Max. reorder period
= (450 × 0.4) × 3 weeks
= 540 kg.
(ii) Maximum level of X
= Reorder level + Reorder quantity –
(Min. consumption × Min. reorder period)
= 540 + 600 – [(350 × 0.4) × 1]
= 1,000 kg.
(iii) Minimum level of Y
= *Reorder level – (Average consumption × Average
reorder period)
= 810 – [(400 × 0.6) × 2]
= 330 kg.
= (450 × 0.6) × 3 weeks
= 810
*Reorder level of Y
Problem 2.4 In manufacturing its products, a company uses three raw materials A, B
and C, in respect of which the following apply:
Raw
materials
A
B
C
Usage
per unit
of product
kg
Re-order
quantity
Delivery
period
(weeks)
Order
level
Minimum
level
kg
Price
per
kg
Re
10
4
6
10,000
5,000
10,000
0.10
0.30
0.15
1 to 3
3 to 5
2 to 4
8,000
4,750
—
—
—
2,000
2.49
Material Cost
Weekly production varies from 175 to 225 units, averaging 200. What would you
expect the quantities of the following to be:
(a) Minimum stock of A
(b) Maximum stock level of B
(c) Reorder level of C
(d ) Average stock level of A?
(B. Com. Hons., Delhi, C.A. Inter)
Solution
(a) Minimum Stock of A
= Reorder level – (Normal consumption × Normal reorder period)
= 8,000 – (200 units × 10 kg × 2 weeks) = 4,000 kg
(b) Maximum Stock of B

Minimum reorder 
Reorder Reorder
–  Minimum ×
+

level
quantity
period
 consumption
= 4,750 + 5,000 – (175 units × 4 kg × 3 weeks) = 7,650 kg
(c) Reorder Level of C
Maximum consumption × Maximum reorder period
= 225 units × 6 kg × 4 weeks = 5,400 kg
(d) Average Stock Level of A
Minimum level + ½ (Reorder quantity)
4,000 + (½ × 10,000) = 9,000 kg
Or Average stock level of A
=
Minimum stock level + Maximum stock level 4,000+16,250*
=
= 10,125 kg
2
2
* Maximum stock of A
=
 Minimum

Reorder
Reorder
– 
× Minimum
+
level
quantity
 consumption reorder period 
= 8,000 + 10,000 – (175 units × 10 kg × 1 week) = 16,250 kg
Problem 2.5 About 50 items are required every day for a machine. A fixed cost of `50
per order is incurred for placing an order. The inventory carrying cost per item amounts
to `0.02 per day. The lead period is 32 days. Compute:
(i) Economic Order Quantity
(ii) Reorder Level
(B.Com. Hons., Delhi, CA Inter)
Solution
2.A.B
S
A = Annual consumption (50 items × 365 days) = 18,250
(i) Economic order Quantity =
where
B = Buying (ordering) cost = `50
S = Storage cost per item per annum (0.02 × 365 days) = `7.30
EOQ =
2 ×18, 250 × 50
= 500 items
7.30
2.50
Material Cost
(ii) Reorder Level = Max. consumption per day × Max. lead time
= 50 × 32 = 1,600 items
Problem 2.6 The average annual consumption of a material is 18,250 units at a price
of `36.50 per unit. The storage cost is 20% on an average inventory and the cost of
placing an order is `50. How much quantity is to be purchased at a time?(CA PE-II)
Solution
EOQ =
2AB
2  18, 250  50

CS
36.50  20%
=
2,50,000 = 500 units.
Problem 2.7 Medical Aids Co. manufactures a special product A. The following
particulars were collected for the year 2017:
(a) Monthly demand of A
1,000 units
(b) Cost of placing an order
`100
(c) Annual carrying cost per unit
`15
(d) Normal usage
50 units per week
(e) Minimum usage
25 units per week
(f) Maximum usage
75 units per week
(g) Reorder period
4 to 6 weeks
Compute from the above: (1) Reorder Quantity; (2) Reorder Level; (3) Minimum Level;
(4) Maximum Level; (5) Average Stock Level.
(CA Inter)
Solution
1. Reorder Quantity
=
2.A.B
C
where A = Annual usage
B = Ordering cost
C = Carrying cost per unit
=
2  2,600 * 100
= 186 units (Approx.)
15
* Normal usage is 50 units per week. So, for one year it is 52 weeks × 50 = 2,600 units.
2. Reorder Level
= Maximum usage × Maximum reorder period
= 75 × 6 = 450
3. Minimum Level
= Reorder level – (Normal usage × Normal reorder period)
= 450 – (50 × 5) = 200 units
4. Maximum Level
= Reorder level + Reorder quantity – (Min. usage × Min. reorder period)
= 450 + 186 – (25 × 4) = 536 units
5. Average Stock Level
= ½ (Minimum level + Maximum level)
= ½ (200 + 536) = 368 units
2.51
Material Cost
Problem 2.8 ABC Co. buys in lots of 125 boxes, which is a three month’s supply. The
cost per box is `125 and the ordering cost is `250 per order. The inventory carrying cost
is estimated at 20% of unit value per annum. You are required to ascertain:
(i) The total annual cost of existing inventory policy?
(ii) How much money would be saved by employing the economic order quantity?
(B.Com. Hons., Delhi)
Solution
(i) Total annual cost
Cost of boxes (125 boxes × 4 orders × ` 125)
`
62,500
 125 boxes + 0 
 × `125 × 20%
2
Carrying cost 
1,562.50
Ordering cost ( ` 250 × 4 orders)
1,000
Total
(ii) EOQ =
2AB
CS
65,062.50
where A = Annual supply (125 × 4)
B = Ordering cost (`250)
C = Cost per unit (`125)
S = Carrying cost (20%)
=
2 × 500 × 250
125× 20%
= 100 boxes (5 orders p.a.)
=
`62,500
 100 + 0 
Carrying cost 
 × 125 × 20%
2 
=
1,250
Ordering cost 5 × `250
=
Total cost = Cost of boxes (500 × 125)
Total
1,250
` 65,000
Saving by employing EOQ = `65,062.50 – 65,000 = ` 62.50
Problem 2.9 Charlie Pump Company uses about 75,000 valves per year and the usage
is fairly constant at 6,250 per month. The valves cost `1.50 per unit and carrying cost
is estimated to be 20% of average inventory investment on an annual basis. The cost to
place an order and to process the delivery is `18.
It takes 45 days to receive delivery from the date of an order and a safety stock of
3,250 valves is desired. You are required to determine:
(i) the most economical order quantity and frequency of orders.
(ii) the reorder level.
(iii) the most economical order quantity if valves cost `4.50 each instead of `1.50 each.
(B.Com. Hons., Delhi Adapted, CS Inter)
Solution
(i) Economic order quantity
EOQ =
2.A.B
C.S
where A = Annual consumption
B = Cost of ordering per order
C = Cost per unit
S = Storage cost or carrying cost
2.52
Material Cost
EOQ =
2  75,000  18
= 3,000 units per order
1.50  20%
No. of orders per year
= Annual consumption ÷ EOQ
= 75,000 ÷ 3,000 = 25 orders per year
(ii) Reorder level
= Min. stock + (Normal usage × Normal delivery time)
= 3,250 + (6,250 units per month × 1.5 month)
= 12,625 units
(iii) When cost is ` 4.50 per unit
EOQ =
2  75,000  18
= 1,732 units
4 .50  20%
No. of orders per year = 75,000 ÷ 1,732 = 43 orders per year.
Problem 2.10 The annual carrying cost of materials ‘X’ is `3.6 per unit and its total
carrying cost is `9,000 per annum. What would be the econmic order quantity for
material ‘X’ if there is no safety stock of material ‘X’?
(B. Com. Hons., Delhi)
Solution
No. of units in stores during the year =
Annual carrying cost
Carrying cost per unit
=
`9,000
= 2,500 units
`3.60
Average number of units is ½ of units purchased
 The number of units purchased (EOQ) = 2,500 × 2 = 5,000 units.
Problem 2.11
From the details given below, calculate:
(i) Reordering level
(iii) Minimum level
(ii) Maximum level
(iv) Danger level
Reordering quantity is to be calculated on the basis of following information:
Cost of placing a purchase order is `20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is `50
Annual cost of storage per unit is `5
Details of lead time: Average 10 days, Maximum 15 days, Minimum 6 days
For emergency purchase 4 days.
Rate of consumption: Average: 15 units per day, Maximum: 20 units per day.
(CA Inter)
Solution
Reorder quantity
(i) Reordering Level
=
2.A.B
2  5,000 units  ` 20
=
S
`5
=
40,000 = 200 units
= Max. consumption × Max. reorder period
= 20 × 15 = 300 units
2.53
Material Cost
(ii) Maximum Level
=
Reorder + Reorder   Minimum × Minimum 
 consumption reorder period 
level
quantity
= 300 + 200 – (10 × 6) = 440 units
Notes: Minimum consumption is calculated as follows:
Average
consumption
15
Min. consumption
(iii) Minimum Level
(iv) Danger Level
=
Min. consumption + Max. consumption
2
=
Min. consumption + 20
2
= 10

Average 
= Reorder level   Average 
reorder period 
 consumption
= 300 – (15 × 10) = 150 units
Average
Reorder period in
= consumption  emergency conditions
= 15 × 4 = 60 units
Problem 2.12 (a) EXE Limited has received an offer of quantity discounts on its order
of materials as under:
Price per tonne
Tonnes
`
Nos.
1,200
Less than 500
1,180
500 and less than 1,000
1,160
1,000 and less than 2,000
1,140
2,000 and less than 3,000
1,120
3,000 and above
The annual requirement for the material is 5,000 tonnes. The ordering cost per
order is `1,200 and the stock-holding cost is estimated at 20% of material cost
per annum. You are required to compute the most economical purchase level.
(b) What will be your answer to the above question if there are no discounts offered
and the price per tonne is `1,500?
(CA Inter)
Solution
(a) Annual Requirement = 5,000 tonnes
Order
size
A
Price
per
tonne
`
B
Purchase
cost of
5,000
`
C = 5,000 × B
Ordering
cost
Carrying
cost
Total cost
`
5000
D =
× 1,200
A
`
A
E =
× B × 20%
2
`
400
500
1,200
1,180
60,00,000
59,00,000
15,000
12,000
48,000
59,000
60,63,000
59,71,000
1,000
1,160
58,00,000
6,000
1,16,000
59,22,000
2,000
3,000
1,140
1,120
57,00,000
56,00,000
3,000
2,000
2,28,000
3,36,000
59,31,000
59,38,000
(C + D + E)
2.54
Material Cost
From the above table, it may be concluded that the total cost is the least (i.e.
`59,22,000) when the ordering quantity is 1,000 tonnes. Thus, 1,000 is the most
economical purchase level.
(b) When price is `1,500 per tonne with no discounts:
EOQ =
=
2 A.B
C.S
2  5,000  `1,200
1,500  20%
where EOQ = Economic order quantity
A = Annual consumption
B = Buying cost per order
C = Cost per unit of material
S = Storage cost
= 200 tonnes
Problem 2.13 A manufacturer purchased three chemicals A, B and C from Mumbai.
The invoice gave the following information:
`
12,600
19,000
9,500
2,055
1,000
Chemical A 3,000 kg @ `4.20 per kg
Chemical B 5,000 kg @ `3.80 per kg
Chemical C 2,000 kg @ `4.75 per kg
Sales Tax
Railway Freight
Total cost
44,155
A shortage of 200 kg in Chemical A, of 280 kg in chemical B and of 100 kg in
Chemical C was noticed due to breakages. At Surat, the manufacturer paid octroi duty of
`0.10 per kg. He also paid cartage of `22 for Chemical A, `63.12 for Chemical B and
`31.80 for Chemical C. Calculate the stock rate that you would suggest for pricing issue
of chemicals assuming a provision of 5 per cent towards further deterioration. (CA Inter)
Solution:
Calculation of Quantity Available for Use
Quantity purchased
Less: Shortages
kg
Less: Loss 5%
Materials available for use
kg
A
B
C
3,000
200
5,000
280
2,000
100
2,800
140
4,720
236
1,900
85
2,660
4,484
1,815
Calculation of Issue Rate of Chemicals
Items
A
`
B
`
C
`
Purchase price
Sales tax (in the ratio of purchase price)
12,600
630
19,000
950
9,500
475
(Contd.)
2.55
Material Cost
Railway freight (in the ratio of quantity, i.e., 3:5:2)
Octroi (@ 10 paise per kg of quantity received)
Cartage
300
280
22
500
472
63.12
200
190
31.80
Total cost
13,832
20,985.12
10,396.80
Quantity available for use
Issue rate (Total cost ÷ Qty. available)
2,660 kg
` 5.20
4,484 kg
` 4.68
1,815 kg
` 5.73
Problem 2.14 Show how the items given ahead relating to purchases and issues of a
raw material will appear in the Stores Ledger using LIFO, FIFO and Weighted Average
Methods of pricing the materials issues:
Feb.
Feb.
Feb.
Feb.
Feb.
Feb.
Feb.
1
5
11
22
24
28
28
Price per unit ( ` )
20
22
?
23
?
?
?
(B. Com. Hons., Delhi)
Units
300
200
150
200
150
200
5
Opening balance
Purchases
Issue
Purchases
Issue
Issue
Shortage
Solution
Stores Ledger Account (LIFO)
Receipts
Issues
Date
Units
Rate
`
Amount
`
Feb. 1
—
—
—
Feb. 5
200
22
4,400
Feb. 11
Feb. 22
Feb. 24
Feb. 28
Feb. 28
—
200
—
—
—
—
23
—
—
—
—
4,600
—
—
—
Units
Balance
Rate
`
Amount
`
Units
Rate
`
Amount
`
—
—
—
300
20
6,000
—
—
—
 300

 200
 300

 50
300
20
6,000
22
4,400
150
22
—
—
150
23
200 50

 50
 100
5
(Shortage)
3,300
—
3,450
23
1,150
22
1,100
20
2,000
20
100
20
6,000
22
1,100

 50
200
20
6,000
22
1,100
23
4,600
300
 50
 50
20
6,000
22
1,100
23
1,150
200
20
4,000
195
20
3,900
2.56
Material Cost
Stores Ledger Account (FIFO)
Receipts
Date
Units
Feb. 1
Issues
Balance
Rate Amount
`
`
Units
Rate Amount
`
`
Units
Rate
`
Amount
`
—
—
—
—
—
—
300
20
6,000
Feb. 5
200
22
4,400
—
—
—
20
22
6,000
4,400
Feb. 11
—
—
—
150
20
3,000
 300
 200

 150
 200

150
20
3,000
22
4,400

 200
 200
20
3,000
22
4,400
23
4,600
22
4,400
23
4,600
23
4,600
23
4,485
Feb. 22
Feb. 24
200
—
23
—
4,600
—
—
—
150
20
—
3,000
Feb. 28
—
—
—
200
22
4,400
 200

 200
200
Feb. 28
—
—
—
5
23
115
195
(Shortage)
Stores Ledger Account (Weighted Average Price)
Receipts
Date
Feb.
Units
Issues
Rate Amount
`
`
Units
Balance
Rate Amount
`
`
Units
Rate
`
Amount
`
1
—
—
—
—
—
—
300
20.00
6,000
Feb. 5
Feb. 11
200
—
22
—
4,400
—
—
150
—
20.80
—
3,120
500
350
20.80*
20.80*
10,400
7,280
Feb. 22
200
23
4,600
—
—
—
550
21.60*
11,880
Feb. 24
—
—
—
150
21.60
3,240
400
21.60
8,640
Feb. 28
—
—
—
200
21.60
4,320
200
21.60
4,320
Feb. 28
—
—
—
5
21.60
108
195
21.60
4,212
(Shortage)
*Working Note:
Weighted average price on
Feb. 5, 2016
`10,400
= 500 units
= `20.80
Feb. 22, 2016
`10,880
= 550 units
= `21.60
Problem 2.15 The Stores Ledger Account of Material Z in the books of Chemical
Producer Ltd revealed the following transactions for the month of Nov.:
1 Nov.
5 Nov.
8 Nov.
10 Nov.
12 Nov.
15 Nov.
16 Nov.
Opening stock 200 kg @ `7.50 per kg
Received from supplier S 1 400 kg @ `7.75 per kg (GRN No. 448)
Issued to production department 240 kg (SR No. 833)
Issued to production department 160 kg (SR No. 897)
Received from supplier S 2 500 kg @ `7.90 per kg (GRN No. 455)
Issued to production department 400 kg (SR No. 912)
Received from supplier S 3 250 kg @ `8.00 per kg (GRN No. 461)
2.57
Material Cost
19 Nov.
Received from supplier S 1 600 kg @ `8.25 per kg (GRN No. 469)
21 Nov.
Issued to production department 350 kg (SR No. 946)
24 Nov.
Issued to production department 260 kg (SR No. 959)
27 Nov.
Issued to production department 340 kg (SR No. 974)
(GRN denotes Goods Received Note; SR denotes Stores Requisition)
You are required to price the issues and draw out the closing balances in the Stores Ledger
Account under the pricing method suitable for any one of the following two alternatives: (a)
The closing balances should be closely related to the current prices. (b) The material costs
charged to production should be closely related to current prices.
(ICWA Inter)
Solution
(a) When it is desired that closing balances should be closely related to current prices,
first in first out (FIFO) method should be applied as shown below:
FIFO Method
Stores Ledger Account
Date
Receipts
Issues
Nov.
GRN
No.
Qty Rate
kg
`
Amt.
`
SR
No.
Qty.
kg
1
5
—
448
—
—
—
—
455
—
—
—
461
—
460
—
—
400
—
—
—
—
500
—
—
—
250
—
600
—
—
7.75
—
—
—
—
7.90
—
—
—
8.00
—
8.25
—
—
3,100
—
—
—
—
3,950
—
—
—
2,000
—
4,950
—
—
—
—
883
—
897
—
—
912
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
946
—
959
—
974
350 300
— 50
260 200
— 60
— 340
8
10
12
15
16
19
21
24
27
Amt.
`
Qty.
kg
Rate
`
Amt.
`
— —
— —
— —
240 200
— 40
— 160
— —
— —
400 200
— 200
— —
— —
— —
— —
—
—
—
—
—
—
7.50 1,500
7.75
310
7.75 1,240
—
—
—
—
7.75 1,550
7.90 1,580
—
—
—
—
—
—
—
—
200
200
400
7.50
7.50
7.75
1,500
1,500
3,100
360
200
200
500
—
300
300
250
300
250
600
7.75
7.75
7.75
7.90
2,790
1,550
1,550
3,950
7.90
7.90
8.00
7.90
8.00
8.25
2,370
2,370
2,000
2,300
2,000
4,950
{
{
7.90 2,370
8.00
400
8.00 1,600
8.25
495
8.25 2,805
{
{
Rate
`
Balance
{
{
{
{
8.00 1,600
{ 200
600 8.25 4,950
540
200
8.25 4,455
8.25 1,650*
* Closing stock is 200 kg @ 8.25 = `1,650
(b) When it is desired that material cost charged to production should be closely related
to current prices, then last in first out (LIFO) method should be used. Students
are advised to prepare a Stores Ledger Account using LIFO method and compare
the results under this method. Closing stock is 200 units @ `7.50, i.e., `1,500.
Problem 2.16 Prepare a Stores Ledger Account from the following details using LIFO
method of pricing the issue of materials.
2.58
Material Cost
Opening balance
10,850 kg @ `130 per kg
Purchased
20,000 kg @ `134 per kg
Issued
6,750 kg to production
Issued
8,500 kg to production
Received back
550 kg from production being surplus
Purchased
17,550 kg @ `128 per kg
Issued
11,250 kg to production
Physical verification revealed a loss
250 kg
Issued
8,950 kg to production
Issued
6,300 kg to production
Purchased
10,000 kg @ `132 per kg
Issued
7,750 kg to production
(ICWA Inter)
April 1
2
3
5
6
7
8
9
10
12
15
16
Solution
LIFO Method
Stores Ledger Account
Date
Receipts
Issues
April
Qty.
kg
Rate
`
Amt.
`
1
2
—
20,000
—
134
—
26,80,000
3
—
—
—
5
—
—
—
6
134
73,700
7
550
(Return)
17,550
128
8
—
9
10
12
Balance
Qty.
kg
Rate
`
—
—
—
—
—
—
22,46,400
—
—
—
—
—
11,250
128
14,40,000
—
—
—
250
(Loss)
128
32,000
—
—
—
8,950
6,050
2,900
6,300
2,400
3,900
—
{
128
134
7,74,400
3,88,600
{
134
130
—
3,21,600
5,07,000
—
—
—
—
15
10,000
132
13,20,000
16
—
—
—
Amt.
`
Qty.
kg
Rate
`
Amt.
`
10,850
10,850
20,000
10,850
13,250
10,850
4,750
10,850
5,300
10,850
5,300
17,550
10,850
5,300
6,300
10,850
5,300
6,050
130
130
134
130
134
130
134
130
134
130
134
128
130
134
128
130
134
128
14,10,500
14,10,500
26,80,000
14,10,500
17,75,500
14,10,500
6,36,500
14,10,500
7,10,200
14,10,500
7,10,200
22,46,400
14,10,500
7,10,200
8,06,400
14,10,500
7,10,200
7,74,400
{ 10,850
2,400
130
134
14,10,500
3,21,600
6,950
6,950
10,000
6,950
2,250
130
130
132
130
132
9,03,500
9,03,500
13,20,000
9,03,500
2,97,000
9,200
—
12,00,500
{
6,750 134
9,04,500
{
8,500 134
11,39,000
{
—
—
—
{
{
{
{
{
7,750 132
10,23,000
{
Closing Stock
Note: Students are advised to prepare another Stores Ledger Account using FIFO method and compare the
results for better understanding of the two methods.
Closing stock under FIFO method is 9,200 units at `12,14,400.
2.59
Material Cost
Problem 2.17 ABC Limited provides you the following information. Calculate the cost
of goods sold and ending inventory, applying the LIFO method of pricing raw materials
under the perpetual and periodical inventory control systems.
Particulars
Per unit cost `
1
Opening stock
200
10
10
Purchases
400
12
12
Withdrawals
500
–
16
Purchases
300
11
19
Issued
200
–
30
Receipts
100
15
Also explain, in brief, the reason for a difference in profit, if any.
Date
January
Solution
I
Perpetual Inventory System
(a) Cost of goods sold
(i) 400 units @ `12 = 4,800
100 units @ `10 = 1,000
`
5,800
200 units @ `11
2,200
(ii)
Cost of Goods Sold
8,000
(b)Ending Inventory
100 units @ `10
100 units @ `11
100 units @ `15
1,000
1,100
1,500
300 units
3,600
II Periodic Inventory System
Ending Inventory
200 units @ `10
100 units @ `12
300 units
2,000
1,200
3,200
Cost of goods sold
= Opening stock + Purchases – Withdrawals = Ending inventory
= (200 × 10) + (400 × 12) + (300 × 11) + (100 × 15) – Withdrawals = 3,200
= 11,600 – Withdrawals (i.e. cost of goods sold) = 3,200
Cost of goods sold = 11,600 – 3,200
= `8,400
Comments Profit under perpetual inventory system will be higher by `400 because
cost of goods sold is higher by `400 (i.e. 8,400 – 8,000).
Problem 2.18 The following information is provided by Sunrise Industries for the
fortnight of April 2018:
Material Exe:
Stock on 1–4–2018, 100 units at `5 per unit.
2.60
Material Cost
Purchases:
Issues:
5–4–2018
300 units at `6
6–4–2018
250 units
8–4–2018
500 units at `7
10–4–2018
400 units
12–4–2018
600 units at `8
14–4–2018
500 units
You are required to calculate using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period, and
(b) the value of stock of materials on 15–4–2018.
You need not draw up the Stores Ledgers.
(CA, Adapted)
Solution
FIFO Method
Date
Description
Qty.
Units
Rate
`
Amount
`
1–4–2018
5–4–2018
6–4–2018
Opening balance
Purchased
Issued
8–4–2018
10–4–2018
Purchased
Issued
12–4–2018
14–4–2018
Purchased
Issued
15–4–2018
Balance
100
300
100
150
500
150
250
600
250
250
350
5
6
5
6
7
6
7
8
7
8
8
500
1,800
500
900
3,500
900
1,750
4,800
1,750
2,000
2,800
(a) Value of materials consumed = 500 + 900 + 900 + 1,750 + 1,750 + 2,000= ` 7,800
(b) Stock on 15–4–2018
= ` 2,800
LIFO Method
Date
Description
Qty.
Units
Rate
`
Amount
`
1–4–2018
5–4–2018
6–4–2018
8–4–2018
10–4–2018
12–4–2018
14–4–2018
15–4–2018
Opening balance
Purchased
Issued
Purchased
Issued
Purchased
Issued
Balance
100
300
250
500
400
600
500
350
5
6
6
7
7
8
8
—
500
1,800
1,500
3,500
2,800
4,800
4,000
2,300
(a) Total value of material consumed = 1,500 + 2,800 + 4,000 = `8,300
(b) Stock on 15–4–2018
100 units @ `5
50 units @ `6
100 units @ `7
100 units @ `8
350 units
500
300
700
800
Total ` 2,300
2.61
Material Cost
Problem 2.19 The following are the details of receipts and issues of a material of
stores in a manufacturing company for the period of three months ending 30 June 2018:
Receipts:
Date
April
April
May
May
May
June
June
10
20
5
17
25
11
24
Quantity (kg)
Rate per kg. ( ` )
1,600
2,400
1,000
1,100
800
900
1,400
5.00
4.90
5.10
5.20
5.25
5.40
5.50
There were 1,500 kg in stock at 1 April 2018 which was valued at `4.80 per kg.
Issues:
Date
April
April
May
May
June
June
Quantity (kg)
4
24
10
26
15
21
1,100
1,600
1,500
1,700
1,500
1,200
Issues are to be priced on the basis of weighted average method. The stock verifier of
the company reported a shortage of 80 kg on 31 May 2018 and 60 kg on 30 June 2018.
The shortage is treated as inflating the price of remaining material on account of shortage.
You are required to prepare a Stores Ledger Account.
(CA Adapted)
Solution
Stores Ledger Account for the three months ending 30 June 2018
(Weighted Average Method)
Receipts
Rate
Amount
`
`
Date
Qty.
Kg
April 1
April 4
April 10
April 20
April 24
May 5
May 10
May 17
May 25
May 26
May 31
–
–
1,600
2,400
–
1,000
–
1,100
800
–
–
–
–
5.00
4.90
–
5.10
–
5.20
5.25
–
–
–
–
8.000
11,760
–
5,100
–
5,720
4,200
–
–
June
June
June
June
June
900
–
–
1,400
–
5.40
–
–
5.50
–
4,860
–
–
7,700
–
11
15
21
24
30
Qty.
Kg
Issues
Rate
`
–
–
1,100
4.80
–
–
–
–
1,600
4.93
–
–
1,500
4.97
–
–
–
–
1,700
5.09
80
–
Shortage
–
–
1,500
5.29
1,200
5.29
–
–
60
–
Shortage
Balance
Rate
Amount
`
`
Amount
`
Qty.
Kg
–
5,280
–
–
7,888
–
7,455
–
–
8,653
–
1,500
400
2,000
4,400
2,800
3,800
2,300
3,400
4,200
2,500
2,420
4.80
4.80
4.96
4.93
4.93
4.97
4.97
5.05
5.09
5.09
5.25
7,200
1,920
9,920
21,680
13,792
18,892
11,437
17,157
21,357
12,704
12,704
–
7,935
6,348
–
–
3,320
1,820
620
2,020
1,960
5.29
5.29
5.29
5.40
5.60
17,564
9.629
3,281
10,981
10,981
2.62
Material Cost
Problem 2.20 The Stock Ledger Account of Material X in a manufacturing concern
reveals the following data for the quarter ended 30 September 2018.
Receipts
July
July
July
August
August
August
Sept.
Sept.
Sept.
1 Balance b/d
9
13
5
17
24
11
27
29
Issues
Quantity
units
Price
`
Quantity
units
Amount
`
1,600
3,000
—
—
3,600
—
2,500
—
—
2.00
2.20
—
—
2.40
—
2.50
—
—
—
—
1,200
900
—
1,800
—
2,100
700
—
—
2,556
1,917
—
4,122
—
4,971
1,656
Physical verification on 30 Sept. 2018 revealed an actual stock of 3,800 units. You
are required to:
(a) indicate the method of pricing employed in the above.
(b) complete the above account by making entries you would consider necessary
including adjustments, if any, and giving explanations for such adjustments.
(ICWA Inter)
Solution
(a) A scrutiny of the values of issues applied in the problem shows that Weighted
Average Method of pricing has been employed.
Stores Ledger Account
(Weighted Average Method)
Date
Qty.
units
Receipts
Rate Amount
`
`
Qty.
units
Issues
Rate
`
Amount
`
Qty
units
Balance
Rate Amount
`
`
July 1
July 9
July 13
Aug. 5
Aug. 17
Aug. 24
Sept. 11
Sept. 27
Sept. 29
Sept. 30
1,600
3,000
—
—
3,600
—
2,500
—
—
—
2.00
2.20
—
—
2.40
—
2.50
—
—
—
—
—
1,200
900
—
1,800
—
2,100
700
*200
—
—
2.13
2.13
—
2.29
—
2.37
2.37
2.37
—
—
2,556
1,917
—
4,122
—
4,971
1,656
473
1,600
4,600
3,400
2,500
6,100
4,300
6,800
4,700
4,000
3,800
2.00
2.13
2.13
2.13
2.29
2.29
2.37
2.37
2.37
2.37
3,200
6,600
—
—
8,640
—
6,250
—
—
—
3,200
9,800
7,244
5,327
13,967
9,845
16,095
11,124
9,468
8,995
Closing stock: 3,800 units @ 2.37 = `8,995.
*Conclusion: On 30 Sept., Stores Ledger Account shows a balance of 4,000 units, whereas physical verification
shows a stock of only 3,800 units. It may thus be concluded that there is a shortage of 200 units. Appropriate
entry in Stores Ledger Account has been made on 30 Sept.
Note: Small discrepancies in stock values are due to approximations in the calculation of issue rates. This is
quite common in weighted average method.
2.63
Material Cost
Problem 2.21 From the records of an oil distributing company, the following summarized
information is available for the month of March 2018:
Sales for the month
`19,25,000
Opening stock on 1–3–2018
1,25,000 litres @ `6.50 per litre
Purchases (including freight and insurance)
March
5
1,50,000 litres @ `7.10 per litre
March 27
1,00,000 litres @ `7 per litre
Closing stock on 31–3–2018
1,30,000 litres
General administrative expenses for the month `45,000.
On the basis of the above information, work out the following using FIFO and LIFO
methods of inventory valuation, assuming pricing of issues is being done at the end of
the month after all receipts during the month:
(a) Value of closing stock as on 31–3–2018.
(b) Cost of goods sold during March 2018.
(c) Profit or loss for March 2018.
(ICWA Inter, Adapted)
Solution
FIFO Method
`
7,00,000
2,13,000
(a) Value of Closing stock:
1,00,000 litres @ `7
30,000 litres @ `7.10
9,13,000
(b) Cost of Goods sold:
Opening stock 1,25,000 litres @ `6.50
Purchased:
1,50,000 litres @ `7.10
1,00,000 litres @ `7
8,12,500
10,65,000
7,00,000
25,77,500
9,13,000
Less: Closing stock
16,64,500
(c) Profit:
Sales
Less:
19,25,000
Cost of goods sold
General adm. costs
16,64,500
45,000
17,09,500
2,15,500
LIFO Method
(a) Closing stock:
1,25,000 litres @ `6.50
5,000 litres @ `7.10
`
8,12,500
35,500
8,48,000
(b) Costs of goods sold:
Value of opening stock + Purchases
Less: Closing stock
25,77,500
8,48,000
17,29,500
2.64
Material Cost
(c) Profit:
Sales
Less:
19,25,000
Cost of goods sold
General adm. cost
17,29,500
45,000
17,74,500
1,50,500
Problem 2.22 Show the effect of using LIFO and FIFO methods on profit with the
help of the following figures:
1
Opening balance 10 units (Purchased on 28 Dec.) @ `30
12
Purchases 10 units @ `33
25
Issues 10 units
31
Closing balance 10 units
Feb.
3
Purchases 10 units @ `36
13
Issues 10 units
28
Purchases 10 units @ `40
Sales during the period of above two months amounted to `1,000.
(ICWA Inter)
Jan.
Solution
Statement of Valuation of Issues and Profit
Jan. 25
Feb. 13
Issued 10 units
Issued 10 units
Cost of materials issued
690
Sales
Profit
LIFO ( ` )
FIFO ( ` )
330
360
300
330
630
1,000
310
1,000
370
Effect on Profit
(a) LIFO Under this method, the issues are valued at the latest prices, and therefore,
when prices are showing a rising trend, profit will be correctly shown lower as
compared to FIFO method. In this case, profit is `310 as compared to `370 under
FIFO method.
(b) FIFO This method values issues at the old prices and therefore when prices are
rising, profit will be a higher figure. The profit is `370 under this method which
is due to increasing trend of prices.
Problem 2.23 At what price per unit would Part No. A32 be entered in the Stores
Ledger, if the following invoice was received from a supplier:
Invoice
200 units of Part No. A 32 @ `5
Less: 20% discount
`
1,000.00
200.00
Add: Excise duty @ 15%
800.00
120.00
Add: Packing charges (5 non-returnable boxes)
920.00
50.00
970.00
2.65
Material Cost
Notes:
(i) A 2 per cent discount will be given for payment in 30 days.
(ii) Documents substantiating payment of excise duty is enclosed for claiming MODVAT credit.
(CA Inter)
Solution
Computation of Price to be entered in Stores Ledger
(of Part No. A32)
Cost of 200 units less trade discount (1,000 – 200)
Add: Packing charges
`
800
50
To t a l
850
Cost per unit = `850 ÷ 200 units = ` 4.25
Notes:
1. On account of MODVAT credit claim, excise duty is not included in cost.
2. Cash discount of 2% is not considered in cost.
Problem 2.24 The following data are available in respect of material X for the year
ended 31 March 2016:
Opening stock
`90,000
Purchases during the year
`2,70,000
Closing stock
`1,10,000
Calculate
(i) Inventory turnover ratio
(ii) Number of days for which average inventory is held.
(CA Inter)
Solution
Average inventory
Cost of goods sold
=
Opening stock + Closing stock
2
=
90,000  1,10,000
=`1,00,000
2
= Op. stock + Purchases – Cl. stock
= 90,000 + 2,70,000 – 1,10,000 = `2,50,000
(i) Inventory turnover ratio=
Cost of goods sold
2,50,000
=
Average inventory
1,00,000
(ii) No. of days for which average inventory is held
365 (No. of days in the year) 365
=
=
Average inventory
2.5
= 2.5 times
= 146 days
Problem 2.25 The annual demand for a particular item of inventory is 10,000 units.
Inventory carrying cost is 20% and ordering cost is `40 per order. The price quoted by
the supplier is `4 per unit. However, the supplier is willing to give discount of 5% for
orders of 1500 units or more. Is it worthwhile to avail the discount offer?
(CS Inter, Adapted; B. Com. Hons. Delhi)
2.66
Material Cost
Solution
Computation of Total Cost
Without discount
Selling price per unit
Carrying Cost
EOQ
2 A.B
C
`4
20% of `4 = `0.80
With discount
`3.80
20% of `3.80 = `0.76
2  10,000  40
0.80
Total cost of purchase
= 1,000 units
10,000 units @ `4 =
`40,000
= 1,500 units
10,000 units @ `3.80 =
`38,000
Ordering cost
10,000
= 10 orders
1,000
10,000
= 7 orders
1,500
10 orders @ `40 = `400
7 orders @ `40 = `280
1,000
 0.80 = ` 400
2
40,000 + 400 + 400 = `40,800
1,500
 0.76 = ` 70
2
38,000 + 280 + 570 = `38,850
Carrying cost
Total Cost (Cost of
Purchase + Ordering
Cost + Carrying Cost)
Saving if discount offer is accepted = `40,800 – 38,850 = `1,950
Conclusion Discount offer of 5% should be accepted as it results in saving of `1,950.
Problem 2.26 From the following particulars, work out the issue rate per 1,000 of first
class and second class bricks:
(a) Paid for the supply at the kiln site for 30 lakh first class bricks @ `30 per 1,000 bricks.
(b) Paid for the supply at the kiln site for 60 lakh second class bricks @ `25 per
1,000 bricks.
(c) Paid carriage charges for carrying all bricks from kiln to stockyard @ `1.50 per
1,000 bricks.
(d) Paid unloading charges `90 (lump sum).
(e) Paid for stocking in stockyard `180 (lumpsum).
(f) Breakage in handling — 1% for first class bricks and 2% for second class bricks.
(I.C.W.A., Inter)
Solution
Computation of Issue Rate per 1,000 Bricks
First Class
bricks
`
Second Class
bricks
`
Purchase Price
(a) 30 lakh bricks @ `30 per 1,000 bricks
90,000
(b) 60 lakh bricks @ `25 per 1,000 bricks
Carriage @ `1.50 per 1,000 bricks 4,500
Unloading charges
1,50,000
9,000
`90
(Contd...)
2.67
Material Cost
`180
Stocking charges
`270
90
180
94,590
1,59,180
30,00,000
30,000
60,00,000
1,20,000
29,70,000
58,80,000
31.85
27.07
(Apportioned between first and second class
bricks in the ratio of number of bricks, i.e., 1 : 2)
Total cost
Total bricks
Less: Breakage (1% and 2%)
Good bricks
Issue Rate for 1,000 bricks
 Total cost

×1,000 


Good bricks
SUMMARY AND KEY TERMS

Material refers to tangible items that can be stored, stacked or stockpiled.

Quite often material is the most important element of cost, and as such, an
efficient system of material control (or inventory control) leads to a
significant economy in the total cost.

An efficient system of material control should be comprehensive enough to
cover purchase system, storage system, issue to production and
determination of stock levels for each item of material.

ABC technique is a value based system of material control in which materials
are analysed according to their value so that costly and more valuable
materials are given greater attention and care.

In order to guard against under-stocking and over-stocking, companies fix
stock levels , such as: (i) maximum level; (ii) minimum level; (iii) reorder
level; and (iv) reorder quantity.

Economic order quantity (EOQ) is that size of the purchase order which
gives maximum economy in purchasing. EOQ should be fixed at a point
where the aggregate of ordering cost and storage cost is the minimum.

While purchasing materials, 6 ‘R’s to be kept in mind are Right quantity, Right
quality, Right time, Right price, Right source and delivery at the Right place.

Just-in-time (JIT) Purchasing helps to reduce stock levels to the minimum
and results in enormous savings in storage costs, material handling costs,
spoilage and obsolescence.

Various documents used to authorize movement of materials into and out
of stores include Goods Received Note, Bill of Materials, Materials
Requisition Note, Materials Return Note, Material Transfer Note, etc.

Separate bin cards are maintained by the storekeeper for each item of
material in store to show the details of receipts and issues of materials and
the balance in stock at any time.

In the cost accounting department, a stores ledger is maintained which
gives the same information regarding stores as bin card and in addition, it
gives the monetary values of materials.
2.68
Material Cost

Under perpetual inventory system of inventory control, bin cards and stores
ledger records show stores balances after each receipt and issue so that current
balance of stores is shown at any point of time, any receipts being added to
and any issues being deducted from the balance after each transaction.

The balance of an item of store as shown in the bin card should agree with that
shown in the stores ledger. This should also agree with actual physical balance
in store. Any differences should be reconciled after passing the rectifying entries.

When materials are issued for production, a question arises regarding the
price at which materials issued are to be charged. This is because the same
type of material may have been purchased in different lots at different
times at several different prices. The question is important because the
pricing directly affects the amount of profit or loss reported for the
accounting period.

Several methods have been devised which are based on different
assumptions. First-in, First-out (FIFO) method is based on the assumption
that materials which are purchased first are issued first.

Last-in, First-out (LIFO) method operates in just the reverse order of FIFO
method, i.e., the last materials purchased are issued first.

Average Cost methods are based on the assumption that when materials
purchased in different lots are stored together, their identity is lost, and
therefore, issues should be charged at an average price.

Losses of materials may arise during handling, storage or during process
of manufacture. Such losses or wastages are classified into two categories—
normal loss and abnormal loss.

Waste is that form of material loss whereby ‘ basic raw material is lost in
processing, having no recovery value.’

Scrap is defined as ‘the incidental residue from certain types of manufacture
usually of small amount and low value, recoverable without further processing.’
EXAMINATION QUESTIONS
Objective Type Questions
I. Fill in the blank spaces:
1.
2.
3.
4.
5.
6.
7.
8.
In ABC analysis, A stands for ........................... materials.
Bin card is maintained by ...........................
........................... is a document which initiates the purchase procedure.
Two important opposing factors in fixing the economic order quantity are
........................... cost and ........................... cost.
The method of regular physical checking of materials throughout the year is known as
...........................
........................... is that portion of the basic raw materials that is lost in processing
having no recovery value.
Abnormal loss of materials is charged to ...........................
..........................is a method of recording stores balances after each receipt and issue
to facilitate regular checking and obviate closing down for stock-taking.
Material Cost
2.69
9. ........................... is a master requisition of materials which lists all the materials
required for a job.
10. In ........................... method of pricing, closing stock is valued at the oldest price paid.
II. True or False: Indicate whether each of the following statements is True or
False. Give reason in brief.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
In ABC technique, A items are those which are used in largest quantities.
Value of closing stock under FIFO and LIFO methods is the same.
Perpetual inventory system means continuous stock-taking.
Bill of materials is an invoice received from the supplier of material.
Slow moving materials are those which have a low inventory turnover ratio.
Simple average method of pricing is a more scientific method than weighted average method.
When prices are showing a rising tendency, FIFO method results in higher profits.
Reorder level is normally fixed between minimum and maximum levels.
Purchase requisition note is prepared by the purchasing department.
Defective work is that production which is below the standard specification but which
can be rectified.
Waste has no realizable value while scrap has small value.
Normal loss of material is transferred to Costing Profit and Loss Account.
Bin card is maintained by the cost accounting department.
In manufacturing a product, electricity accounts for 40 per cent of the total cost.
Therefore it is a direct material cost.
In LIFO method, closing stock is valued at oldest prices of materials in stock.
Theoretical Questions
1. What do you understand by ‘Inventory Control’? State its objects.
2. What are the important requirements of every system of material control?
3. Explain the concept of ‘Material Control’. State how perpetual inventory system helps
in achieving the objectives of material control.
4. Write short notes on any three of the following:
(i) Reorder quantity (ii) Reorder level (iii) Maximum level (iv) Minimum level.
5. Explain the terms ‘minimum level’, maximum level and ‘ordering level’ with regard to
maintenance of stocks. What are the factors to be taken into account in fixing these
levels? Discuss the relevance of these concepts in a manufacturing organization.
6. What do you understand by economic order quantities? How are they calculated?
7. What do you understand by ABC analysis? What are its advantages?
8. What is the prime objective of material control? It is said that in any system of
material control, there are always two counter-acting or opposing factors. What are
these and why do they arise?
9. Describe the procedure of purchasing materials from outside.
10. From the ordering of materials to its issue to different shops, enumerate and explain
the important documents and forms you would like to introduce so as to ensure effective
control of material cost.
11. Describe the routine for control of the purchases and receipt of materials from suppliers.
12. What are (a) Bin Card and (b) Stores Ledger? State what purposes do they serve and
bring out the distinction between the two.
2.70
Material Cost
13. What is meant by perpetual inventory system? Describe its advantages.
14. Describe a system that will quickly give you the value of closing stock and work-inprogress at the end of a financial year with least possible delay.
15. What is a Bill of Material? Give a specimen of bill of material.
16. Explain the Material Abstract with an example.
17. What are the various methods of pricing material issues? When do you advocate pricing
the issues at cost price based on the ‘Last-in, first-out’ method?
18. Give the advantages and disadvantages of actual cost and market price bases of pricing
issues of materials.
19. Explain the FIFO and LIFO methods of valuing material issues. Discuss the effect of
rising prices and falling prices on these two methods of pricing of material issues.
20. Under what circumstances do you advocate the method of valuing material requisitions
by the use of standard prices? When this method is not accepted, suggest the method
you would use to measure the results of material consumption.
21. Discuss the importance of good store-keeping in an organization. What are the duties
of a storekeeper?
22. What are the advantages and disadvantages of centralized storage?
23. What technique would you follow to detect and prevent slow and non-moving
materials?
24. Explain the accounting treatment and control of the following in cost accounts:
(a) Waste, (b) Scrap, (c) Defective, (d) Spoilage.
Practical Questions
1. Two components X and Y are used as follows:
Normal usage
— 600 units per week each
Maximum usage
— 900 units per week each
Minimum usage
— 300 units per week each
Reorder quantity — X 4,800 units, Y 7,200 units
Reorder period
— X 4 to 6 weeks, Y 2 to 4 weeks
Calculate for each component: (a) Reorder level, (b) Minimum level, (c) Maximum
level, (d) Average stock level.
(B. Com., Delhi, Bangalore)
2. In manufacturing its product Z, a company uses two types of raw materials A, and B,
in respect of which the following information is supplied.
One unit of Z requires 10 kgs of A and 4 kgs of B materials. Price per kg of A
material is `10 and that of B is `20. Reorder quantities of A and B materials are 10,000
kgs and 5,000 kgs. Reorder level of A and B materials are 8,000 kgs and 4,750 kgs
respectively. Weekly production varies from 175 units to 225 units averaging 200 units.
Delivery period of A material is 1 to 3 weeks and B material 3 to 5 weeks.
Compute:
(i) Minimum Stock Level of A
(ii) Maximum Stock Level of B
(B. Com. Delhi)
3. Orkay Co. uses three types of material X, Y and Z for production of ‘K’ product. The
following information is given to you:
2.71
Material Cost
Materials
Normal usage units
Minimum usage units
Maximum usage units
Reorder quantity units
Reorder period (months)
X
Y
Z
200
100
300
750
2 to 3
150
100
250
900
3 to 4
180
90
270
720
2 to 3
Calculate for each material (a) Reorder level, (b) minimum level, (c) Maximum level,
(d) Average stock level.
(ICWA Inter)
4.
A company uses 10,000 units per annum of an item costing `5 each. The cost of
processing the order is `100 and stockholding cost amounts to 20% per year of the
average value of inventory. How much should the company buy at a time (in a single
order) to minimize the inventory costs?
(ICWA Inter)
5. From the following particulars, find out the Economic Order Quantity:
(i) Annual demand
12,000 units
(ii) Ordering cost
`90 per order
(iii) Inventory carrying cost per annum
`15 per unit
(ICWA Inter)
6. Following information relating to a type of raw material is available:
Annual demand
Unit price
Ordering cost per order
Storage cost
Interest rate
Lead time
2,400 units
`2.40
`4.00
2% per annum
10% per annum
Half month
Calculate Economic Order Quantity and total annual inventory cost in respect of the
said raw material.
(ICWA Inter)
7. Zee is a product manufactured out of three raw materials, M, N and O. Each unit of
Zee requires 10 kg, 8 kg and 6 kg of M, N and O respectively. The re-order levels of
M and N are 15,000 kg and 10,000 kg respectively while minimum level of O is 2,500
kg. The weekly production of Zee varies from 300 to 500 units while weekly average
production is 400 units. You are required to compute:
(i) Minimum stock level of M,
(ii) Maximum stock level of N, and
(iii) Reorder level of O
The following additional data is given:
M
N
O
Reorder quantity (in kg)
20,000
15,000
20,000
Delivery (in weeks)
Minimum
2
4
3
Average
3
5
4
Maximum
4
6
5
(ICWA Inter)
2.72
Material Cost
8. Your factory buys and uses a component for production at `10 per piece. Annual
requirement is 2,000 numbers. Carrying cost of inventory is 10% p.a. and the ordering
cost is `40 per order. The purchase manager agrees that as the ordering cost is very
high, it is advantageous to place a single order for the entire annual requirement. He
also says that if we order 2,000 at a time, we get a 3% discount from the supplier.
Evaluate this proposal and make your recommendation.
(ICWA Inter; CS Inter)
9. A firm is able to obtain quantity discounts on its orders of material as follows:
Price per tonne `
6.00
5.90
5.80
5.70
5.60
Tonnes
Less than 250
250 and less than 800
800 and less than 2,000
2,000 and less than 4,000
4,000 and over
The annual demand for the material is 4,000 tonnes. Stockholding costs are 20% of
material cost per annum. The delivery cost per order is `6.00.
You are required to calculate the best quantity to order.
(CA Inter)
10. Flex Ltd has been buying a given item in lots of 1,200 units in a six months supply. The cost
per unit is `12. Ordering cost is `8 per order and carrying cost is 25%. You are required to
calculate the savings per year by buying in economical lot quantities.
(ICWA Inter)
11. A consignment consisted of two chemicals A and B. The invoice gave the following data:
`
Chemical A = 4,000 kg @ `2.50 per kg
10,000
Chemical B = 3,200 kg @ `3.25 per kg
10,400
Sales Tax
816
Railway Freight
384
`21,600
Total cost
A shortage of 200 kgs, in A and 128 kgs in B was noticed due to breakages. What
is the stock rate you would adopt for pricing issues assuming a provision of 5%
towards further deterioration.
(B. Com. Hons., Delhi, Adapted)
12. A lorry load of materials of mixed grade were purchased for `9,000. These were
sorted into the following grades whose market rate is shown against each.
Units
Selling price per unit
Grade A
5,000
`1.20
Grade B
3,000
`1.00
Grade C
2,000
`0.50
Find out the purchase rate per unit of each grade of the material assuming all grades
yield the same rate of profit.
(ICWA Inter)
13. The following transactions occur in the purchase and issue of a material:
2
20
5
10
12
2
Jan.
Jan.
Feb.
Feb.
Feb.
Mar.
Purchased
Purchased
Issued
Purchased
Issued
Issued
4,000
500
2,000
6,000
4,000
1,000
units @ `4.00 per unit
units @ `5.00 per unit
units
units @ `6.00 per unit
units
units
2.73
Material Cost
5 Mar.
15 Mar.
20 Mar.
Issued
Purchased
Issued
2,000 units
4,500 units @ `5.50 per unit
3,000 units
From the above, prepare the Stores Ledger Account in two ways: (a) FIFO method of
charging material issues; and (b) LIFO Method. What would be the value of stock in hand
at the end of the period according to each of the two methods? (B. Com. Hons., Delhi)
14. The following is a history of the receipts and issues of material in a factory, during
February. Prepare stores ledger account using FIFO and LIFO methods.
Feb.
units @ `25.00
1
Opening balance
500
2
Issued
70 units
4
Issued
100
units
7
Issued
80 units
13
Received from vendor
200
units @ `24.50
units @ `24.00
14
Refund of surplus from a work order
15
16
Issued
180 units
units @ `24.37
22
Received from vendor
240
24
Issued
304 units
25
Received from vendor
320
26
Issued
112 units
27
Refund of surplus from a work order
12
28
Received from vendor
100
units @ `24.00
28
Returned to vendor
50
units
units @ `24.31
units @ `24.50
The store verifier of the factory noted that on 15 Feb., he had found a shortage of
5 units and on 27 Feb. another shortage of 8 units.
(B. Com., Delhi, ICWA Inter)
15. Draw a Stores Ledger Card recording the following transactions that took place in a
month under the two methods: FIFO and LIFO.
1 Jan.
5 Jan.
10 Jan.
20 Jan.
2 Jan.
7 Jan.
12 Jan.
28 Jan.
Opening stock
Purchases
Purchases
Purchases
Issues
Issues
Issues
Issues
200
100
150
180
150
100
100
200
pieces
pieces
pieces
pieces
pieces
pieces
pieces
pieces
@ `2 each
@ `2.20 each
@ `2.40 each
@ `2.50 each
(B. Com., Delhi)
16. The following transactions took place in respect of a material item:
Receipt
Rate
quantity
2 March 2018
200
`2.00
10 March 2018
300
`2.40
15 March 2018
—
—
18 March 2018
250
`2.60
20 March 2018
—
—
Issue
quantity
—
—
250
—
200
2.74
Material Cost
Prepare priced ledger sheet using
(a) Simple average price, and
(b) Weighted average price.
(B. Com., Delhi, ICWA Inter)
17. Show the Stores Ledger entries as they would appear when using:
(a) Weighted average method
(b) LIFO method of pricing issues in connection with following transactions:
Units
Value `
April 1 Balance b/f
300
600
2 Purchased
200
440
4 Issued
150
6 Purchased
200
460
11 Issued
150
19 Issued
200
22 Purchased
200
480
27 Issued
250
In a period of rising prices such as above, what are the effects of each method?
(ICWA Inter)
18. From the following details of stores receipts and issues of material X, prepare a Stores
Ledger Account using weighted average price method.
Dec. 1 Opening Stock
2,000 units @ `5 each
3 Issued
1,500 units to production
5 Received
4,500 units @ `6 each
8 Issued
1,600 units to production
10 Returned to stores
100
units by production (from issue of Dec. 3)
16 Received
2,400 units @ `6.50 each
18 Returned to supplier
200 units (out of receipt on Dec. 5)
20 Received
1,000 units @ `7 each
24 Issued
2,100 units to production
28 Received
1,200 units @ `7.50 each
30 Issued
2,800 units to production
(Calculate issue rate upto two decimal points)
(ICWA Inter, Adapted)
19. The following information for the three months ended Nov. 30, in respect of a certain
material, has been extracted from the Stores Ledger Account of manufacturing company.
Receipts
Sep. 1 Bal. b/d
Sep. 12
Sep. 18
Oct. 10
Oct. 16
Oct. 18
Oct. 20
Nov. 2
Nov. 6
Nov. 15
Issues
Quantity
Units
Price
`
Amount
`
Quantity
Units
Price
`
Amount
`
1,500
2,000
—
—
—
2,400
—
5,000
—
—
1.500
1.525
—
—
—
1.600
—
1.625
—
—
—
—
—
—
—
—
—
—
—
—
—
—
1,100
800
1,000
—
900
—
900
2,400
—
—
—
—
—
—
—
—
—
—
—
—
1,650
1,210
1,525
—
1,395
—
1,440
3,800
2.75
Material Cost
At the physical stock-taking on 30 Nov. 3,600 units were in stock.
You are required to:
(a) State the method of pricing you consider was employed.
(b) Calculate the value of the transactions given and make any entries you consider
necessary to complete the account for the three months. An explanation should be
given of the adjustments included.
(ICWA, Inter)
20. An abstract of a Stores Ledger Account is given below:
Receipts
Issues
Date
Quantity
Units
Price
`
Amount
`
Quantity
Units
Price
`
Amount
`
Jan. 2
6
15
20
22
25
31
4,000
2,000
—
—
3,000
3,000
—
1.80
1.75
—
—
1.85
1.90
—
7,200
3,500
—
—
5,550
5,700
—
—
—
10,000
5,000
—
—
10,000
—
—
—
—
—
—
—
—
—
19,500
9,750
19,200
Opening stock on Ist Jan. was 20,000 units valued at `40,000. Closing stock as per
physical verification on 31st Jan. was 6,950 units.
Work out the method of pricing which you consider to have been used for the issue of
materials and show the working of the issue rate. Complete the Stores Ledger Account
of the material and find out the value of closing stock.
(ICWA)
21. From the data given below, answer the following:
(a) What is the simple average price of the four weeks’ receipts of material A?
(b) What is the weighted average price of the four weeks’ receipts of material B?
(c) What is the value of the balance of material A in stock at the close of the fourth
week if issues are priced on LIFO basis?
(d) What is the value of the fourth week’s issues of material B, if they are priced on FIFO basis?
Raw material received
A
Issued
B
A
B
Week
kg
`
kg
`
kg
`
1st
2nd
3rd
4th
250
300
200
250
1,000
1,260
880
960
1,250
1,400
750
1,600
1,690
1,960
1,050
2,400
175
250
300
300
1,500
1,200
1,300
1,100
Stores opening stocks: A–200 kg, `720; B–2,000 kg, `2,900.
(ICWA Inter)
22. At the beginning of October 2018, Quality Brush Company had in stock 10,000 brushes
values at `10 each.
Further purchase were made during the month as follows:
7th Octorber 4,000
14th Octorber 6,000
24th Octorber 8,000
brushes @
brushes @
brushes @
Issues to shop floor were as follows:
16th Octorber 16,000 brushes
28th Octorber 10,000 brushes
`12.50.
`15.00.
`16.50.
2.76
Material Cost
You are required:
(a) To prepare a Stores Ledger Card for the month of Octorber on the assumption
that materials were issued on the first in first out principle; and
(b) To state the value of closing stock at the end of October if issues are priced by the
weighted average method.
(B Com)
23. Oil India is a bulk distributor of high octane petrol. A periodic inventory of petrol on
hand is taken when the books are closed at the end of each month. The following
summary of information is available for the month of June 2018.
`
Sales
9,45,000
General Administrative cost
25,000
Opening stock:
1,00,000 litres @ `3 per litre
3,00,000
Purchases (including freight):
1 June
2,00,000 litres @ `2.85 per litre
30 June
1,00,000 litres @ `3.03 per litre
Closing stock 30 June 1,30,000 litres
Compute the following data by: (i) FIFO and (ii) LIFO and (iii) Weighted average method
(a) Value of inventory on 30 June
(b) Amount of the cost of goods sold for June
(c) Profit or loss for June
(CA Inter, Adapted)
24. The following transactions is respect of material A occurred during the six months
ended 30 June 2018:
Month
Purchased
(units)
Price per unit
`
Issued
units
January
February
March
April
May
June
200
300
425
475
500
600
25
24
26
23
25
20
Nil
250
300
550
800
400
The chief accountant argues that the value of closing stock remains the same no
matter which method of pricing of material issues is used. Do you agree? Why or why
not? Detailed stores ledgers are not required.
(CA Inter)
25. After inviting tenders, two quotations are received as under:
Supplier A—`2.20 per unit
Supplier B—`2.10 per unit + `2,000 as fixed charges irrespective of the number
of units ordered.
Required:
(i) Calculate the order size for which the purchase price per unit will be the same.
(ii) Select the supplier if the purchase order quantity is 15,000 units.
(C.S., Inter)
2.77
Material Cost
ANSWERS
Objective Type Questions
I. Fill in the blank spaces.
1. Costliest; 2. Storekeeper; 3. Purchase Requisition Note; 4. Ordering, storage; 5.
Continuous stock taking; 6. Waste; 7. Costing P&L A/c; 8. Perpetual inventory system;
9. Bill of Materials; 10. Last-in, first-out.
II.True or False: Indicate whether each of the following statements is True or False.
Give reason in brief.
True — 5, 7, 8, 10, 11, 15;
False — 1, 2, 3, 4, 6, 9, 12, 13, 14
Practical Questions
1. (a) X 5,400, Y 3,600; (b) X 2,400, Y 1,800; (c) X 9,000, Y 10,200; (d) X 4,800, Y 5,400
2. (i) 4,000 kgs, (ii) 7,650 kgs
3.
X
(units)
(a)
900
(b)
400
(c)
1,450
(d)
925
4. EOQ 1,414 units
[Hint: See Problem 2.3 and tabulate the data]
Y
Z
(units)
(units)
1,000
810
475
360
1,600
1,350
1,038
855
5. 379 units
6. EOQ 258 units; Annual cost `5,837.15
7. (i) 3,000 kg, (ii) 15,400 kg, (iii) 15,000 kg.
8. EOQ 400 units, Discount proposal should not be accepted because total of ordering
cost and carrying cost is `1,010 which after discount of `600 (3% of `20,000) is
`410. This is higher than carrying cost and ordering cost of `400 when EOQ is 400
units. This is ascertained by tabular method
9. EOQ—800 tonnes; Cost `23,694
10. EOQ—113 units, Saving due to buying in EOQ = `1,478
11. Issue Rate A `2.93; B `3.76
12. A–`1.08, B–`0.90, C–`0.45
13. Closing stock: 3,000 units, FIFO `16,500; LIFO `14,250
14. Closing stock: 478 units, FIFO `11,594.22, LIFO `11,754.48
15. Closing stock: 80 units, FIFO `200; LIFO `172
16. Closing stock: 300 units; (a) `720, (b) `726
17. Closing stock: (a) `342; (b) `300
18. Closing stock = 3,000 units @ `6.52 = `19,558
19. (a) FIFO method, (b) There is a shortage of 200 units on 30 Nov. Closing stock 3,600
units @ `1.625 = 5,850
20. (a) Weighted average method was employed. (b) Loss of 50 units is assumed
21. (a) `4.11; (b) `1.42; (c) 175 kg valued at `630; (d) 1,100 kg valued at `1,540
22. Closing stock 2,000 units, (a) `33,000 (b) `30,000
2.78
Material Cost
23. FIFO (a) `3,88,500, (b) `7,84,500; (c) Profit `1,35,500; LIFO (a) `3,93,000,
(b) `7,80,000, (c) Profit `1,40,000 Weighted average (a) `3,90,000 (b) `7,83,000
(c) `1,37,000
[Hint: Under LIFO, it is assumed that purchases on 30 June could not be issued in
June. It thus becomes a part of closing inventory]
24. [Hint: Up to May, total units purchased and total units issued are equal at 1,900 units.
Thus there was no stock on 1 June 2016]
25. (i) 20,000 units (i.e., `2,000  `0.10)
(ii) Supplier A is economical when order size is less than 20,000 units
CHAPTER
3
LABOUR COST
(Employee Cost)
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of direct labour and its importance
• Discuss the meaning and causes of labour turnover and the methods of its
measurement
• Know the various methods of time keeping and time booking
• Explain idle time and overtime and their effect on cost
• Understand the important methods of labour remuneration
Introduction
Labour or manpower represents human resources used in production. After material
cost, labour cost is the second major element of cost. Despite large scale use of
machinery and advanced technologies in manufacturing, the role of labour in production
cannot be under-estimated. So significant is the role of labour that productivity of all
other resources depends on the productivity of human resources. In other words, higher
efficiency of labour helps in lowering the cost per unit of production. There is, therefore,
a special need for proper organization for accounting and control of labour cost.
According to Cost Accounting Standard-7 (CAS-7) issued by ICAI, employee cost
is ‘the aggregate of all kinds of consideration paid, payable and provision made
for future payments, for the services rendered by employees of an enterprise
(including temporary, part time and contract employees). Consideration includes
wages, salaries, contractual payments and benefits, as applicable, or any payment
made on behalf of the employee. This is also known as labour cost.’
Labour cost is of two kinds:
(i) Direct labour cost
(ii) Indirect labour cost
Labour Cost (Employee Cost)
3.2
Direct and Indirect Labour Costs
Direct labour cost is ‘the cost of employees which can be attributed to a cost object
in an economically feasible way.’ Direct labour is expended in altering the construction,
composition or condition of the product. It is directly engaged in production work and
can be conveniently identified or attributed wholly to a particular job, process or cost
unit. Wages of a machine operator is a direct labour cost. In a factory of readymade
garments, wages paid to a tailor are direct wages. Similarly, in a textile mill, wages
paid to a weaver are direct wages.
Indirect labour cost, on the other hand, is the wages paid to those workers who are
not directly engaged in converting raw materials into finished products. Such costs cannot
be conveniently identified with a particular cost object. Supervisors, inspectors, clerks,
instructors, peons, watchmen and cleaners are examples of indirect workers.
Organization for Accounting and Control of Labour Cost
There are mainly five departments in an organization which deal with labour. These
are as follows:
Personnel department This is a service department and is mainly concerned with
the proper selection and training of workers and placing them on jobs for which they
are best suited.
Engineering department This department prepares and plans specifications of jobs
makes job analysis, conducts time and motion studies, makes provision for safe working
conditions and supervises production activities.
Time-keeping department This department is concerned with recording of
workers’s time. The recording of time put in by workers is required not only for
attendance and wage calculation purpose but also for the purpose of cost analysis and
apportionment of labour cost over various jobs.
Payroll department This department maintains a record of job classification and wage
rate of each employee and performs the function of computation of wages payable to
them by preparing payroll or wage sheet. It is also responsible for disbursement of wages.
Cost accounting department This department accumulates and classifies all cost
data of which labour is one important element. It analyses the payroll and prepares
routine and special labour cost reports for submission to management so that proper
control may be exercised on labour cost.
The functions and scopes of these various departments have been discussed in detail,
later in this chapter.
PERSONNEL DEPARTMENT
This department is concerned with recruitment, discharge and transfer, etc., of labour.
On engaging a new worker, the personnel office will prepare an Employee’s Record
Card. This card will show full personal details of the employee, particulars of previous
employment, wage rate payable and his medical category.
The following departments are notified about the engagement of a new employee:
(a) The department where the worker has to report for duty, a notification is made
that the worker is expected to report on a certain date.
3.3
Labour Cost (Employee Cost)
(b) The payroll department is informed about the new employee’s name, the name
of the former employee whom he replaces, clock number, rate of pay, date of
commencement, etc.
(c) The time office, for recording the employee’s attendance.
LABOUR TURNOVER
In all business organizations, it is a common feature that some workers leave the
employment and new workers join in place of those leaving. This change in work force
is known as labour turnover. Labour turnover is thus defined as ‘the rate of change
in the composition of the labour force in an organization.’ Labour turnover varies
greatly between different trades and industries. For example, where part-time and
seasonal labour is employed, the rate will be higher.
Measurement of Labour Turnover
To facilitate comparisons between different periods and different undertakings, labour
turnover may be expressed in a rate.
There are three alternative methods by which this rate is computed. Once a
particular method is used, it should be consistently followed for comparative analysis.
The methods are:
1. Separation method This method takes into account only those workers who have
left during a particular period. Its formula is:
Labour Turnover Rate =
No. of workers who have left during a period
× 100*
Average no. of workers during the period
No. of workers + No. of workers at the
in the beginning
end of the period
Average Number =
2
*Multiplication by 100 in the given formulae indicates that the rates are in percentage.
2. Replacement method This method takes into account only those new workers
who have joined in place of those who have left. Its formula is:
Labour Turnover Rate =
No. of workers replaced during the period
× 100
Average no. of workers during the period
If new workers are engaged for expansion programme or any other such purpose,
they are not considered for this computation.
3. Flux method This shows the total change in the composition of labour force due
to separations and replacement of workers. Its formula is:
Labour Turnover Rate =
No. of workers who left + No. of workers replaced
× 100
Average no. of workers
Labour Turnover due to New Recruitment It has been stated above that
workers joining the organization on account of opening of new departments or due to
Labour Cost (Employee Cost)
3.4
any type of expansion programme should be excluded while calculating the labour
turnover rate. But these new workers recruited are certainly responsible for a change
in the composition of labour force. Therefore, some cost accountants measure turnover
rate for these new workers (excluding replacements) by the following method:
No. of new workers joining in the period
(excluding replacement)
Labour Turnover Rate =
× 100
Average no. of workers
Total number of workers joining, including replacements, is called accession. The
labour turnover rate in such a case may be calculated in respect of workers joining
(accession) the organization during the period which includes all workers joining due to
replacements and also due to expansion. It is calculated as follows:
Labour Turnover Rate =
No. of accessions during a period
× 100
Average no. of workers
When labour turnover rate is computed by taking into account the number of
accessions, the flux method rate will be calculated as follows:
No. of
No. of
+
+ No. of new workers
replacements
recruited
Labour Turnover Rate = Separations
× 100
(Flux Method)
Average no. of workers
or
=
No. of Separations + No. of accessions
× 100
Average no. of workers
Equivalant Annual Labour Turnover Rate Labour turnover rate, as explained
above, may be computed for a month, a quarter or for any period other than a year. It
may be converted into an equivalant annual labour turnover rate by using the following
formula:
Turnover rate for the period
Equivalent annual
=
× 365 days
labour turnover rate
No. of days in the period
Illustration 3.1 From the following data given by the Personnel Department, calculate
the labour turnover rate by applying:
(a) Separation method
(b) Replacement method
(c) Flux method
No. of workers on the payroll:
At the beginning of the month
900
At the end of the month
1,100
During the month, 10 workers left, 40 persons were discharged and 150 workers
were recruited. Of these, 25 workers are recruited in the vacancies of those leaving, while
the rest were engaged for an expansion scheme.
(ICWA Inter)
Solution
Average No. of workers =
900 + 1,100
2
= 1000
3.5
Labour Cost (Employee Cost)
No. of workers left
= 10 + 40
= 50
1. Separation Rate
=
50
× 100 = 5%
1,000
2. Replacement Rate
=
25*
× 100 = 2.5%
1,000
50  25
× 100 = 7.5%
1,000
*Note: Additional workers engaged on expansion plan have not been considered.
3. Flux Rate
=
Alternative methods produce the following rates:
125
Labour turnover rate for new workers=
× 100
1,000
(excluding replacements)
= 12.50%
25 + 125
× 100
= 15%
1,000
50 + 25 + 125
× 100 = 20%
=
1,000
Labour turnover rate (for accessions) =
Labour turnover rate (Flux Method)
Causes of Labour Turnover
Labour turnover reports should be prepared regularly to be placed before the
management, giving a breakdown of the causes as to why the workers left. The causes
may be classified in two broad categories: (i) Avoidable causes; and (ii) Unavoidable
causes.
Avoidable causes These include:
1. Low wages and allowances
2. Unhappy relations with co-workers and supervisors
3. Unsatisfactory working conditions
4. Trade union rivalry
5. Lack of medical facilities, transport facilities, etc.
6. Inadequate job security and retirement benefits
Unavoidable causes These include:
1. Death or retirement
2. Illness or accident
3. Domestic problems
4. Discharge on disciplinary grounds
5. Seasonal nature of business
6. Change in plant location
7. Personal dislike for job or environment
8. Marriage—particularly in the case of women workers
9. Change of job for betterment
Effect of Labour Turnover
A certain amount of labour turnover will always take place. To a limited extent this
may be welcome, particularly at the lower management level as it creates vacancies
3.6
Labour Cost (Employee Cost)
for internal promotions which acts as motivation for young and ambitious workers.
Moreover, new workers bring new ideas and methods of doing work from other
organizations.
Labour turnover is expensive and generally it should be minimized because it leads
to increased cost of production for reasons stated below.
Cost of Labour Turnover
The cost of labour turnover may be broadly classified into two broad categories:
(i) Preventive costs; and (ii) Replacement costs.
Preventive costs These costs are those which are incurred to keep the work force
satisfied and to prevent or discourage them from leaving the organization. These include:
1. Cost of personnel management—only that portion of this cost which can be
attributed to the efforts of the personnel department in maintaining good relations
between management and workers
2. Cost of welfare activities and services, e.g., canteen meals, co-operative stores,
educational and transport facilities and housing schemes
3. Cost of medical services
4. Pensions schemes—to provide security and retirement benefits
5. Extra bonus and other perquisites (in excess of those given by other similar
concerns) to discourage their defecting to other undertakings
Replacement costs These costs include all such losses and wastages arising because
of the inexperienced new labour force replacing the existing one as well as the cost of
recruitment and training of the new workers. These include:
1. Cost of recruitment and selection of new employees
2. Cost of training of new workers
3. Loss of output due to some time gap in recruiting new workers
4. Loss due to inefficiency of new workers
5. Cost of accidents due to lack of experience of new workers
6. Cost of extra scrap and defective work of new workers
7. Cost of tools and machine breakdown due to faulty handling by new workers
Reduction and Control of Labour Turnover
Labour turnover may be reduced by taking action on the basis of avoidable causes given
earlier. The following steps may be taken in this regard:
1. Devising a suitable and satisfactory wage policy
2. Providing working conditions conducive to health and efficiency
3. Impartial and sympathetic attitude of personnel management
4. Introducing financial and non-financial incentive plans
5. Providing promotional opportunities
6. Encouraging labour participation in management
7. Introducing an effective grievance procedure
8. Strengthening the welfare measures
Treatment of Cost of Labour Turnover The preventive cost of labour turnover
should be apportioned to various departments on the basis of number of workers in each
department.
Labour Cost (Employee Cost)
3.7
Regarding the replacement costs, if the replacement is due to the fault of a particular
department, it should be directly charged to that department. If labour turnover is due
to the defective management policy, the replacement cost should be apportioned to
various departments on the basis of number of workers in each department.
TIME-KEEPING DEPARTMENT
The time-keeping department is an important part of a firm’s system of accounting and
control of labour cost. The main function of this department is to accurately record
each worker’s time of arrival and departure in the factory and also the time spent on
different jobs or processes. Thus it embraces two functions:
(a) Time keeping, i.e., recording arrival and departure time of workers for
attendance purpose and for calculation of wages; and
(b) Time booking, i.e., recording time spent by workers on different jobs or
processes for determining labour cost of jobs/processes.
The purpose of time recording is to provide basic data for:
(i) Preparation of payroll
(ii) Attendance records, to meet statutory requirements
(iii) Computing labour cost of a job or process
(iv) Computing overhead cost of jobs, if based on wages or labour hours
(v) Statistical analysis of labour records for determining productivity and control of
labour cost
Methods of Time Keeping
There are mainly three methods for recording attendance of workers.
1. Attendance register In this method, attendance of each worker is recorded in
the register maintained for this purpose. This register provides sufficient number of
columns for attendance of each worker. Entries in the arrival and departure columns
may be made by the foreman or the worker himself. If workers are literate, they should
be required to sign against their entries to avoid any dispute later on. Separate attendance
register may be maintained in each department if the number of workers is large,
otherwise one register will serve the purpose.
This method is quite simple and cheap. But it can be used only when the number of
workers is small. In such cases, generally there is no need for a separate time keeper
as the work is done by the foreman.
2. Token or disc method Each worker is allotted an identification number is suitably
painted or engraved on a round metal token (or disc) with a hole in it. All such tokens
are hung in a serial order on a board at the factory gate. As the worker arrives, he
removes his token from the board and puts it in a box kept nearby or hangs it on another
board which is specially kept for this purpose. After the fixed time, the box or the second
board is removed. Those coming late have to hand over their tokens personally at the
time office so that exact time of their arrival can be noted.
The time office records attendance on the basis of tokens in the box. The absentees
are indicated by the missing tokens. Similar procedure is followed at the departure time
in the evening.
Labour Cost (Employee Cost)
3.8
This method is not fool-proof as a worker may try to get his absentee friends marked
present by dropping their tokens in the box.
3. Time-recording clocks Unlike the first two methods, this is a mechanical method
of recording attendance and proves quite useful when the number of workers is fairly
large.
Each worker is allotted a Clock Card which bears his identification number, name,
department, etc. These cards are kept in a rack in a serial order. There are usually
two racks—an 'In' rack and an 'Out' rack. On arrival, the worker will pick up his card
from the ‘Out’ rack, put it in the slot of the clock, press a button and the exact time is
printed on the card. After this the card is put in the ‘In’ rack. An inspection of the
‘Out’ racks will reveal absentees.
A similar procedure is followed if workers leave the factory at mid-day for lunch
or in the evening at close time. Clocks are adjusted so that late arrivals, early or late
leavings, overtime, etc., are automatically printed in red. The time keeper must take
care to ensure that no worker places friend’s card in the clock in addition to his own,
so as to avoid proxy.
CLOCK CARD
Name. ..............................................
Department ............................
No. ...................................................
Week ending ..........................
Day
Forenoon
In
Out
Afternoon
In
Overtime
Out
From
To
Total hours
Normal
Overtime
Mon.
Tue.
Wed.
Thu.
Fri.
Sat.
Total
Wage rate ` ....................................................
Total wages ` ....................................................
Less: Deductions ` .........................................
Net pay
` .........................................
Fig. 3.1
Time-keeper
..........................
(Signature)
Clock/Time card.
At the end of each week, the cards are sent to the pay office and a fresh set of
cards for the ensuing week is placed in the racks.
Advantages The main advantages of installing time-recording clocks are:
1. The method is quite economical for large concerns as the initial heavy capital
expenditure in installing clocks is recovered by savings in operating expenses,
i.e., economy in wages of time recording staff
Labour Cost (Employee Cost)
3.9
2. Chances of disputes are reduced as clocks provide more authentic records than
hand-written documents
3. Work in connection with the preparation of wage sheets becomes easier because
clock cards may be utilized for calculation of wages
The main shortcoming of this method is that heavy initial capital investment is
required which small concerns may find difficult to afford
4. Biometric Attendance System A biometric attendance machine is an electronic
device which is used to verify the identity of a person. The characteristics used to identify
a person include fingerprints, voice patterns, iris, face recognition, and hand measurements.
This machine is used to record attendance of employees. For recording his
attendance, the employee simply places his finger or hand on the fingerprint reader
sensor or hand reader, the time is recorded in the device and rest of the work is done
by the machine. It is a new generationsystem which is fast replacing the typical time
recording clock used to track employee attendance. This device renders an accurate
clock-in and clock-out time of employees in any firm to achieve functional excellence.
Advantages. The main features and advantages of this system are as under:
1. The biggest advantage of this systems is that it prevents employees from clocking in
for one another. In other words, proxies are avoided.
2. Such attendance systems are easy to install and use. It is user friendly and help
companies save money.
3. It is ideal for accurate payroll calculations
4. It has a great capacity and can store and verify a large number of employees' fingerprints.
5. It is intelligently designed to ensure minimum errors.
6. It eliminates unauthorised overtime.
7. It minimises time spent on payroll computations.
Time Booking
In addition to recording worker’s time of arrival and departure, it is necessary to
record the details of work done by the workers and the time spent on each job or
process. Recording of worker’s time spent on different jobs is known as time booking.
The objectives of time booking are:
(i) to ensure that the time for which a worker is paid is properly utilized;
(ii) to ascertain the labour cost of work done;
(iii) to provide a basis for apportionment of overheads;
(iv) to ascertain the idle time so as to control it.
Methods of Time-booking
The following are the common methods of time booking:
1. Job Ticket Job tickets or job cards are very commonly used for recording the
time spent on each job. A card is prepared for each job and is allotted to the worker
who takes up that particular job. The worker enters in this card the time of starting as
well as finishing the job. After finishing the job, the worker submits his work along with
his job ticket. He is then issued another job ticket for the next job (See Fig. 3.2). Thus,
Labour Cost (Employee Cost)
3.10
Job Ticket/Card
Worker’s No. ................................
Worker’s Name .............................
Department .....................................
Machine No. ..........................................
Operation No. .......................................
Time allowed .........................................
Job Description
Job. No. .................................
Dated .......................................
Time started ..........................................
Time finished ........................................
Hours taken ...........................................
Hours
Workman ........................................
Rate
`
Amount
`
Foreman ..................................
Cost clerk ......................................
Fig. 3.2
Job Ticket/Card.
only one job ticket is issued to a worker at a time. Such job tickets also serve the
purpose of authorizing the worker to carry out the job stated therein.
However, if there is a loss of time between finishing of one job and beginning of
the next job, it should be entered on the idle time card so that the record of his day’s
activities may be complete and the time lost is not unduly charged against production.
Such idle time card should also show the reasons for idle time, like machine breakdown,
waiting for instructions or lack of tools or materials.
2. Combined Time and Job Card This card combines the two in one—the clock
card and job card, i.e., it records both the attendance time as well as time spent on
different jobs. Idle time is automatically revealed as the difference between attendance
time and work time. (Format of Time and Job Card is given in Fig. 3.3.)
3. Daily Time Sheet Each worker is daily issued a time sheet in which the time spent
on each job during the day is recorded. This sheet must be completed on the same day
and handed over to the foreman for signature (See Fig. 3.4).
The main drawback of this method is that it needs a lot of paperwork as considerable
amount of time will be taken in preparing time sheets and in consolidating these records
for purposes of ascertaining labour cost. However, it is suitable where the workers have
to frequently change their jobs in a day, e.g., maintenance workers.
4. Weekly Time Sheet Weekly time sheets record almost the same information as
the daily time sheet. The main difference is that instead of recording the work done
for a day only, record of work carried out is entered on a weekly basis. Thus, weekly
time sheets need less paperwork as compared to daily time sheets. This method proves
useful where the jobs are big and their number is small, e.g., building and construction
work and interior decoration.
3.11
Labour Cost (Employee Cost)
Time and Job Card
Worker’s No.. ...............................
Department ............................
Worker’s Name .............................
Week ending ..........................
Clock time
Day
Job time
Job No.
From
To
From
To
Ordinary
time
(Hrs.)
Overtime
(Hrs.)
Job
time
(Hrs.)
Idle
time
(Hrs.)
Mon.
Tue.
Wed.
Thu.
Fri.
Sat.
Total
Rate of pay ` .....................................
Cost clerk
Total wages ` ...............................
.......................................
Fig. 3.3
Time and job card.
Time-keeper..............
Foreman..............
Daily Time Sheet
Worker’s No.. ...............................
Date .........................................
Worker’s Name .............................
Department ............................
Work
Order
No.
Time
Total hours
Details of work done
From
Workman.................................
clerk....................
To
Ordinary
Overtime
Foreman..........................
Fig. 3.4
Amount
Rate
`
Ordinary
`
Overtime
`
Cost
Daily time sheet.
The entries in the weekly time sheets may not be accurate as some workers may
make entries for two/three days together at one sitting and in the process may forget
time spent on certain jobs. A specimen of Weekly Time Sheet is given in Fig. 3.5.
Labour Cost (Employee Cost)
3.12
Weekly Time Sheet
Worker’s No.. ...............................
Week ending ..........................
Worker’s Name .............................
Department ............................
Job Details of
No. Work done
Days of the week
Mon. Tue. Wed. Thu.
Workman.................................
clerk....................
Fri.
Total
hours
Sat.
Ordi- Over Rate nary
nary time
`
`
Foreman..........................
Fig. 3.5
Amount
Ordi- Over
time
`
Cost
Weekly time sheet.
5. Piece Work Card This card is allotted to a worker who is paid on piece basis.
This card may be made either for each individual job or for recording the work done
on several jobs. If group system of piece work is in vogue, the card may be allotted to
each group of workers. A specimen form of Piece Work Card is given in Fig. 3.6.
Though piece rate workers are paid on the basis of number of units produced and
not on the basis of time taken, recording their time spent on different jobs is essential,
Piece Work Card
Worker’s No.. ...............................
Week ending ..........................
Worker’s Name .............................
Department ............................
Job
No.
Description
of Job
Hours
taken
Units
produced
Units
rejected
Units
passed
Inspected by
Piece
rate
`
Amount
`
Total wages..........................
Fig. 3.6
Piece work card.
Labour Cost (Employee Cost)
3.13
particularly where overheads are absorbed on the basis of labour hours. Moreover, it
ensures that piece workers do not cause any interruption in production by their late
arrival or early departure.
PAYROLL DEPARTMENT
The payroll department is responsible for the important task of computation and
disbursement of wages payable to workers. It records hours worked and wages earned,
makes payroll deductions, determines the net amount due, maintains a permanent
earnings record for each employee and provides the treasurer’s office with necessary
records to make payments.
Functions
The important functions of the payroll department in the accounting and control of labour
costs may be listed as follows:
1. To maintain a record of job classification, department and wage rate for each
employee.
2. To verify and to summarize the time of each worker as shown on the daily
time cards.
3. To prepare the payroll and compute the wages earned by each employee.
4. To compute the payroll deductions.
5. To maintain permanent payroll record of each employee.
6. To make wage payments.
Wages Sheet
The main function of payroll department is to prepare payroll sheet, also known as wages
sheet. Wages sheet is a statement which lists the workers’ wages showing gross wages
earned by them for a particular period and actual wages payable to them after making
necessary deductions. Time or clock cards are the basis for the preparation of wages
sheets. Departmental wages sheets are summarized in a master wages sheet which
forms the basis for the preparation of the payroll voucher entry in the general ledger in
cost control accounts. A pro forma of wages sheet is given in Fig. 3.7.
Pay Slip
Some companies have a practice of preparing a pay slip of each worker, which may be
handed over to the worker in advance of the actual payment of wages. Pay slip shows
basic wages and details of various allowances like house rent allowance, dearness
allowance and other payments like bonus, overtime pay, etc., and various deductions
on account of P.F. contribution, income tax, recovery of loans, and any other deduction.
The net amount payable is shown after making all these adjustments. Specimen of pay
slip is given in Fig. 3.8.
Worker’s
No.
Worker’s
Name
Rate
`
Hours Reguworked lar
Days /
Department ......................................
`
Over
time
`
`
D.A.
Fig. 3.7
Bonus
Earnings
`
Gross
wages
Pay-roll sheet.
Other
allowances
`
Payroll Sheet/Wages Sheet
`
PF
`
ESI
`
I.Tax
`
Others
Deductions
`
Total
`
Wages
paid
Net
`
Remarks
Week/ Month-ending .....................................
3.14
Labour Cost (Employee Cost)
3.15
Labour Cost (Employee Cost)
Pay Slip
Name of Worker ..........................
Department ............................
Worker’s No. ................................
Wage period ...........................
Basic wages
Overtime pay
Dearness allowance
House rent allowance
Bonus
`
....................................
....................................
....................................
....................................
....................................
Other allowances
....................................
Gross wages
....................................
....................................
....................................
....................................
....................................
Net amount payable `
....................................
Less: P.F. contribution
E.S.I. contribution
Income tax
Other deductions
Dated.......................
.............................
Signature
Fig. 3.8
Pay slip.
Frauds in the Payment of Wages
One of the problems associated with payment of wages is the possibility of frauds
perpetrated by those concerned with calculations and disbursement of wages.
Types of fraud The following types of frauds are commonly seen:
1. Inclusion in the payroll of fictitious or dummy workers, i.e., non-existent workers
whose names are fraudulently entered in the payroll.
2. Inclusion of wrong hours of duty/overtime.
3. Showing absent workers as present.
4. Ignoring to mark late arrival or early departure.
5. Use of wrong rate of pay in the payroll.
6. Inclusion of bonus not due.
7. Intentionally failing to record deductions.
8. Manipulation in the payment of wages.
Prevention of frauds The following steps and internal checks are recommended to
prevent frauds in wage payment.
1. Each employee should be issued an identity card containing such particulars as
name, identification number, department and photograph. This card should be
required to be produced at the time of wage payment. When the worker leaves
the employment, he/she should surrender his identity card.
3.16
Labour Cost (Employee Cost)
2. To detect dummy workers, names in the wages sheet should be compared with
job cards and time-keeper’s records. Special care should be taken to see that
names of ex-employees are not included in the wages sheet.
3. The wages sheet should be properly signed by all those persons responsible for
its preparation.
4. Wages sheet of the previous months should be compared with that of current
month and any increase in the number of workers should be inquired into.
5. When wages are paid on piece basis, the quantities produced should be certified
by a competent inspector and countersigned by the foreman.
6. Overtime should be properly authorized and no overtime payment should be made
without proper sanction.
7. The work of preparation of wages sheet should be distributed among a number
of persons in such a way that the work of each person is automatically checked
by another. All calculations in the payroll should be checked by an independent
responsible person.
8. Payment of wages should be made by some responsible person. The foremen
should also be present to identify the workers. Signatures and thumb impressions
of some of the workers should be compared with the previous months.
9. The exact amount of total wages payable should be drawn from the bank and
exact cash payable to each worker should be put in pay-packets. Before handing
over the pay-packet, its contents should be recounted by another individual.
10. Payment of wages should be made on fixed dates only. The unclaimed wages
should be disbursed on stipulated dates under strict supervision.
Casual Workers
The casual or ‘badli’ workers are temporary workers who are not on the regular
payroll of the factory. They are appointed on a daily basis to meet additional workload
or to stand in for absentee workers.
The appointment of casual workers is a very common source of fraud in the payment
of wages. It is, therefore, very important to have a proper control over their
appointments, their time of work and payment of their wages. If proper control is not
exercised, some dummy or bogus names may be shown as casual workers and the wages
so paid fraudulently misappropriated. The following steps should be taken for accounting
and control of casual workers:
(a) Full records regarding appointment and discharge of such workers should be
maintained.
(b) The appointment of such workers should be sanctioned by a competent executive.
(c) Payment of wages should be made by a person other than the one who appointed
them.
(d) When they are appointed as indirect workers, time sheets should be issued to
them.
(e) When casual workers are employed at site for some contract work, surprise
visits should be paid to check their number.
3.17
Labour Cost (Employee Cost)
Out-workers
These are the workers who work outside the factory premises on behalf of the
undertaking. Out-workers are classified into two categories as given below:
(a) Workers who work from their own homes They are supplied with raw
materials and they work either with their own tools or tools supplied by the concern.
Such workers are usually paid on piece basis. Control over such workers should be
exercised in the following manner:
(i) All materials supplied should be accounted for and there should be no undue
wear and tear of tools supplied by the concern.
(ii) The work should be delivered within the stipulated time.
(iii) The quality of finished work should be carefully inspected.
(b) Workers sent to site Some workers may be sent to site or customer’s premises
for performing work. For example, some companies supplying engineering products
provide after sales service and workers are sent to customer’s place when so required.
Such out workers may while away their time when they go out for work. Job cards
should be issued to them so that labour cost of work done can be ascertained. Surprise
visits by supervisors at the place of work will have a salutary effect on discipline and
help in controlling such costs.
IDLE TIME
Idle time represents time lost by workers who are paid on time basis. When workers
are paid on time basis, some difference between the time for which they are paid and
that which they actually spend on production is bound to arise. This difference is
known as idle time. Idle time is defined as ‘the difference between the time for which
employees are paid and the employees’ time booked against the cost object.’ It
represents the time for which they are paid but no production is obtained. For example,
time lost between factory gate and the department, time when production is interrupted
by machine maintenance, allowable time-offs such as rest intervals, tea breaks, etc.
Causes
Idle time may occur owing to productive, administrative or economic causes.
1. Productive causes The productive causes are those which result in loss of
production. These include:
(a) Idle time due to machine breakdown
(b) Power failures
(c) Waiting for tools and/or raw materials
(d) Waiting for work
(e) Waiting for instructions
Idle time due to productive causes is usually controllable by proper planning, strict
supervision and proper maintenance of plant and machinery.
2. Administrative causes Idle time is sometimes caused by administrative decisions.
Thus, when there is surplus capacity of plant and machinery, which the management
decides not to utilize, there may be some idle time due to administrative decisions. This
usually happens during depressions when some of the machines have got to work below
normal capacity and the regular workers are paid full amount of wages. This is because
3.18
Labour Cost (Employee Cost)
the management does not want to discharge trained workers temporarily. Such idle time
arises out of abnormal situations and is generally not controllable.
3. Economic causes Idle time may also be caused by fall in the demand of products,
say due to severe competition, seasonal nature of certain industries like woollen goods,
ice-cream, etc., where production cannot be evenly distributed throughout the year. In
such cases, it is not possible to get rid of workers during slack season. Such surplus
labour force is usually utilized for doing some other jobs and if such complementary
jobs cannot be found, there will be some idle time which is beyond control.
Treatment of Idle Time
From the point of view of treatment in cost accounts, idle time is classified as normal
and abnormal.
Normal idle time This is that wastage of labour time which cannot be avoided and
has to be borne by the employer. For example:
(a) The time which elapses between the completion of one job and the
commencement of the next.
(b) The time taken in going from the factory gate to the department in which the
worker is engaged.
(c) Personal needs, tea breaks, rest intervals, etc.
(d) Time spent in setting machines, etc.
The cost of normal idle time may be treated in one of the following two ways:
(i) As overhead cost It may be charged to factory overheads. For this purpose,
idle time is allotted a separate standing order number. This helps in its effective
control.
(ii) As direct wages The wage rate may be inflated to make allowance for normal
loss of labour time. Thus, if a worker’s production time is only 7 hours during
an 8 hours day and his hourly rate of pay is `20, the inflated wage rate will be:
8 hrs
× `20 = `22.86 per hour.
7 hrs
The second method is not considered very desirable as the cost of idle time
should be treated separately instead of being absorbed as a part of direct labour
cost. In this way, it can prove more helpful for the purpose of controlling and
reducing it to the minimum.
Abnormal idle time This is that idle time which arises due to reasons in no way
connected with the usual routine of manufacture and for which employer must pay.
For example:
(a) Time lost due to breakdown of machinery
(b) Strikes and lockouts
(c) Time lost in waiting for tools and/or raw materials
(d) Accidents, etc.
Abnormal idle time is attributed to defective planning, inefficiency or bad luck.
Payment for such idle time is not included in cost and is transferred to Costing Profit
and Loss Account.
3.19
Labour Cost (Employee Cost)
Control of Idle Time
From control point of view, idle time should be divided into controllable and
uncontrollable. Idle time arising due to controllable causes should be properly analysed
and responsibility should be fixed on appropriate individuals. It is advisable to prepare
an Idle Time Card showing the analysis of idle time so that action may be taken, where
necessary. It may be prepared as shown in Fig. 3.9.
The following steps may be taken to control idle time:
(a) Production should be properly planned so that imbalances in production are
avoided or reduced.
(b) Repairs and maintenance of plant and machinery should be regularly undertaken
to avoid breakdown.
(c) Raw materials, tools and instructions should reach the worker well in time so
that no time is wasted in waiting for them.
(d) Supervision should be tightened.
Idle Time Card
Worker’s No. ................................
Date .........................................
Worker’s Name .............................
Department ............................
Reasons for idle time
Standing
Order No.
From
Time
To
No. of
hours
Rate
`
Cost
Amount
`
1. Machine breakdown
2. Accidents
3. Power failure
4. Waiting for tools
5. Waiting for materials
6. Waiting for instructions
7. Strikes
8. Other reason:
(i) .............
(ii) .............
Total
Fig. 3.9
Idle time card.
OVERTIME
Overtime occurs when a worker works beyond normal working hours. The normal
working hours are laid down in the Factories Act. Accordingly, any worker working
for more than 9 hours per day or more than 48 hours per week is entitled to overtime
payment. The Factories Act also provides for payment of overtime wages at double
the normal rates of wages. Overtime is defined ‘as the time spent beyond normal
working hours, which is usually paid at higher rate than the normal time rate.’
3.20
Labour Cost (Employee Cost)
The extra amount beyond normal wages and salaries is called overtime premium. The
overtime work is, therefore, a costly affair and should be avoided as far as possible
due to the following disadvantages attached to it.
Disadvantages of Overtime
(a) It leads to excessive labour cost.
(b) During overtime hours, labour productivity is decreased because of diminishing
labour efficiency.
(c) It puts an extra strain on plant and machinery.
(d) It has a bad effect on the health of workers.
(e) Certain overheads, like lighting cost, increase because of work in the evening.
(f) Workers may develop a tendency to work in overtime and take overtime wages
as a part of their normal earnings.
(g) If overtime work is not properly distributed among the workers, it may lead to
discontent.
Treatment of Overtime
Payment for overtime consists of two elements:
(a) Normal amount of wages, salaries, etc.
(b) Additional amount expended on overtime work, i.e., overtime premium. This is
over and above the normal amount of wages and salaries.
The normal amount of wages is charged to the cost unit or production order on
which the worker is working. The difficulty lies in the treatment of overtime premium.
This overtime premium is charged differently, under different circumstances, as follows:
1. When overtime is job specific When overtime is spent on a specific job at the
request of a customer due to urgency of work and the customer agrees to the entire
charge of overtime premium, it should be charged to the job or work order concerned.
2. When overtime is due to general pressure When a business receives more
orders than it can cope with in the normal working hours and there is general pressure
of work, it may be treated by one of the following two methods:
(i) Treat overtime premium as direct labour cost by inflating the wage rate and
charging to different jobs at the inflated/average rate.
(ii) Alternatively, it may be treated as indirect wages and included in overheads.
3. When overtime is due to abnormal reasons Overtime arising due to abnormal
factors, like accident, power failure, fire and machine breakdown, or due to factors like
defective planning or faulty management, it should not be included in the cost of products
and it should be charged to costing Profit and Loss Account.
Control of Overtime
In order to keep the overtime premium to the minimum, proper control must be exercised
on it. The following steps should be taken for this purpose:
Labour Cost (Employee Cost)
3.21
(a) All overtime work should be duly authorized by the Works Manager.
(b) Overtime cost should be separately recorded for each department for proper
planning in future.
(c) Total overtime premium should be regularly reported to the Works Manager.
(d) When overtime becomes a permanent feature, say, due to shortage of plant
capacity, steps may be taken to install additional plant and machinery or introduce
an additional shift to cope with additional work.
METHODS OF WAGE PAYMENT (LABOUR REMUNERATION)
The term ‘remuneration’ is used to cover the total monetary earnings of employees.
It includes wages according to time or piece basis and other financial incentives.
Efficiency in production can be increased by using improved equipment, by more
efficient utilisation of plant and by adopting better methods of production, but the most
important contribution must come from labour. Accordingly, the methods of remuneration
of labour should be designed so as to encourage workers to do their best.
Requisites of a Satisfactory System of Labour Remuneration
Before deciding on a particular system of labour remuneration, the following factors
should be taken into account:
1. The system should be such as will produce the best quality and quantity of work.
2. It should be satisfactory from the point of view of both employer and employee
and reward should be related to effort.
3. The scheme should be clearly defined and intelligible to workers. The workers
should be able to calculate wages on their own. If the workers do not understand
the system, they may view it with suspicion.
4. It should guarantee a minimum living wage to each worker irrespective of his efficiency.
5. No maximum limit should be placed on the amount of individual earnings.
6. The earnings of the workers should not be affected by matters beyond their
control. They should, for example, be compensated for power failure, machine
breakdown, etc., for which they are not responsible.
7. It should reduce labour turnover and labour absenteeism.
8. The system should be flexible so that changes may be introduced, if necessary.
9. The system should be capable of operation without excessive clerical work. Those
methods should be avoided which demand much detailed recording of time, quantity
of output, etc.
10. If possible, the system adopted should be one which is in vogue in that particular
industry or in that particular locality.
Methods: There are mainly three methods of labour remuneration :
(a) Time Rate System; (b) Piece Rate System; and (c) Incentive Schemes.
Time Rate System
This is the oldest of the wage payment systems. In this system, time is made the basis
of payment. Labour is paid for the time worked irrespective of the volume of production
during that time. The formula for calculating wages under this system is:
3.22
Labour Cost (Employee Cost)
Wages = Hours worked × Rate per hour
or
= Days worked × Rate per day
Payment may be based upon the hour, the day or the week, or it may be at the fixed
salary rate. For example, a worker is paid at `8 per hour, if he works 10 hrs. during
the day, his wages for the day will be 10 hrs. × `8 = `80.
Situations in which Time Rate System is Suitable
(i) Where quality of work is more important than quantity, e.g., high class tailoring.
(ii) Where output cannot be measured in quantitative terms, e.g.. in the case of
indirect workers like watchmen, cleaners and sweepers, etc.
(iii) Where output is beyond the control of worker, e.g., in process industries the flow
of work is regulated by the speed of conveyor belt or where the work of a
worker is dependent on the work of other workers.
(iv) Where work is being done on a small-scale so that close supervision is possible.
(v) Where the worker is a learner or an apprentice.
Advantages of Time Rate System
1. Simplicity. The system is simple and calculation of wages is easily understood
by the workers.
2. Security to workers. Workers are assured of a certain amount of wages
payable even if there is stoppage of work due to power failure, machine
breakdown, etc. This gives security of wages to workers.
3. Quality of work. As this method does not consider quantity of work done,
workers can concentrate on the quality of goods produced. Thus the quality of
work under this method is better.
4. Accepted by trade unions. Trade unions generally favour this method because
it treat all workers alike and does not make any distinction between efficient and
inefficient workers.
5. Economical method. This method does not require detailed records to be
maintained of work done by workers. This results saving in clerical costs.
Moreover, workers avoid over-speeding and cause less damage to plant and
machinery and also materials. This also results in economy.
Disadvantages of Time Rate System
1. No incentive. It does not offer any inducement to workers to improve
performance because it does not make a distinction between efficient and
inefficient workers.
2. Low quantity. When workers are paid on time basis, they tend to be slow in
work. This results in lower production quantity.
3. Extra supervision costs. Under this method extra supervision is needed so that
workers do not waste time. Appointment of additional supervisors increases cost.
4. Costing difficulties. From costing point of view, it creates difficulties in the
calculation of labour cost per unit because the output is quite fluctuating.
5. Idle time. Workers waste a lot of time resulting in increase in idle time.
Piece Rate System
Wages under this system are paid according to the quantity of work done. A rate is
fixed per unit of production and wages are calculated by the following formula:
Wages = Rate per unit × No. of units produced
Labour Cost (Employee Cost)
3.23
For instance, if rate per unit is `17 and during a day a worker has completed 10
units, then his wages will be `17 × 10 units = `170.
This method does not give any consideration to the time taken by the worker in
completing the work. Only quantity of work is taken into account for calculating
wages.
Situations in which Piece Rate System is Suitable. Conditions under which piece
rates may be usefully employed are :
(a) Where production is standardised and repetitive in nature.
(b) Where the aim is continuous maximum production.
(c) Where the output of workers can be measured.
(d) Where workers continue at the same job for long periods.
(e) Where the standard time required to complete a job can be measured accurately.
Advantages. Piece rate system has the following advantages :
1. Incentive to efficient workers. As remuneration is in proportion to the worker’s
effort, the method provides a strong incentive to work more.
2. Increase in production. Each worker tries his best to produce more to earn
more wages. This results in increase in production.
3. Lower cost. On account of increase in production, fixed cost per unit is decreased
because of higher production.
4. Equitable. This system is more equitable than time rate system because wages
are paid according to the efficiency of each worker.
5. Decrease in supervision. Strict supervision is not necessary because the
workers are themselves interested in maximising their earnings through the
maximisation of output.
6. Simplifies costing. As wages are paid at a rate per unit, this method simplifies
cost ascertainment because labour cost per unit is known in advance.
7. Simple and easy. This method is simple and is easily understood by the workers.
Disadvantages. Piece rate system suffers from the following limitations:
1. Poor quality of work. This method lays too much emphasis on quantity of
production and ignores quality of work. In order to maximise their wages, workers
try to produce more and more without caring for the quality of production.
2. No security of wages. This system does not guarantee a minimum wage to a
worker. If a worker is not able to complete his day’s work, for any reason, he
is paid less wages. Thus, earnings of workers are uncertain.
3. Misuse of materials and equipment. In the greed to produce more, workers
cause extra wastage of materials and damage plant and machinery.
4. Injurious to health of workers. In an effort to earn more wages, workers try
to work excessively with speed. This proves injurious to the health of workers.
5. Opposed by trade unions. Piece rate system is generally opposed by trade
unions because it creates inequality in the wages of workers. Slow and inefficient
workers feel jealous of the higher wages of their fellow workers.
6. Difficulties in fixing piece rate. Fixing equitable piece rate is quite a difficult
task and may require considerable amount of work in the form of time studies.
Labour Cost (Employee Cost)
3.24
7. Unsuitable in certain cases. This method does not suit where work is of
artistic and refined nature.
Incentive Schemes
Both time rate and piece rate systems have their own strong points and drawbacks.
Incentive schemes or bonus system is a compromise between the two, combining the
good points of each system. Under incentive schemes, time rate and piece rate systems
are combined in such a way that workers are induced to increase their productivity.
The gains arising from the efficiency of a worker are shared between the worker and
the employer in agreed proportion. In this way, both the employers and the employees
benefit from these incentive plans. Incentive plans are, however, used in various forms
and with different names. In these systems, standard time for each work is predetermined and bonus is given to those workers who finish their work within or less
than the time specified.
Some of the principal incentive plans are discussed below :
l. Halsey Plan
Introduced by F.A.Halsey, it is a simple combination of time and piece methods of
wage payment. Under this plan, amount of bonus depends upon the time saved by the
worker. A standard time is fixed for each job and if a worker completes the job in less
than the standard time, he gets wages for the time worked plus a bonus equal to 50%
of the value of time saved. But if a worker completes the job in full standard or more
than standard time, he gets wages at the time rate. Thus wages according to time
basis are guaranteed. Calculation of bonus and total earnings is done by the following
formulae :
Bonus
Total earnings
where
= 50% (Time saved × Rate per hour
= (Time taken × Rate/hour) + 50% (Time saved × Rate / hour)
Time saved = Standard time – Time taken
Advantages
(a) This plan is easy to understand and workers can calculate their own wages.
(b) It guarantees minimum wages according to time rate and thus provides a sense
of security to workers.
(c) The benefit of time saved is equally distributed between workers and employers.
(d) It provides a strong incentive to increase production.
(e) This plan provides scope to earn bonus on each individual job and the time saved
on one job is not set off against extra time taken on some other job.
Disadvantages
(a) Workers do not like to share the benefits of their efforts in saving time with the
employer.
(b) The workers may be encouraged to rush through work and thus neglect the
quality of production in order to earn extra bonus.
(c) The incentive is not so strong as with piece rate system.
Illustration 3.3 Standard time allowed for a job is 20 hours at the rate of `2 per hour.
Actual time taken by a worker is 15 hours. Calculate his earnings and effective wage rate
under Halsey Plan.
3.25
Labour Cost (Employee Cost)
Solution
Time saved
20 hrs. – 15 hrs. = 5 hrs.
Calculation of earnings
`
Wages for time taken (15 hrs. × `2)
30
Bonus (5 hrs. × `2) × 50%
5
Total earnings
`35
Effective wage rate per hour = `35  15 hours = `2.33 Ans.
2. Rowan Plan
This plan was introduced by David Rowan. It is similar to Halsey Plan, except in the
calculation of the amount of bonus. In this plan, bonus is that proportion of wages of
the time taken which the time saved bears to the standard time. Its formula is:
Bonus =
Time saved
× Time taken × Rate per hour
Standard time
Total earnings = (Time taken × Rate per hour) + Bonus.
Thus, Rowan plan also assures wages according to time basis. To solve Illustration
3.3 under this plan
5 hrs
 = `30 + 7.5 = `37.50
Total earnings = 15 hrs × `2 + 
 20 hrs × 15 hrs  ` 2 
Effective wage rate per hour = `37.50  15 hrs. = `2.50
Advantages
(a) It guarantees wages according to time basis.
(b) Upto 50% of the time saved, it provides a higher bonus than does Halsey plan.
(c) It offers protection to the employer when standard has not been properly fixed.
(d) As the bonus increases at a decreasing rate, at higher levels of efficiency, the
worker is not induced to rush through the work.
Disadvantages
(a) It is a complicated method and is not easily understandable by the workers.
(b) Where time saved is more than 50% of the standard time, the total earnings start
decreasing.
Illustration 3.4 A workman’s wages for a guaranteed 44 hour week is `0.75 per hour.
The estimated time to produce one article is 30 minutes and under an incentive plan, the
time allowed is increased by 20%. During a week, a worker produced 100 articles.
Calculate the wages under: (a) Time Rate, (b) Rowan System, and (c) Halsey System.
Solution
(a) Time Rate System:
Wages for 44 hours @ `0.75
(b) Rowan System:
St. time per article
Add: 20% increase
Time allowed under incentive plan
Actual output
Time allowed
Time taken
Time saved
= `33
= 30 minutes per article
= 6 minutes per article
= 36 minutes per article
= 100 articles
= 100 × 36 min = 3600 min or 60 hr
= 44 hours
= 60 hrs. – 44 hrs. = 16 hours
Labour Cost (Employee Cost)
3.26
= 44 hrs. @ `0.75 = `33.00
Wages for time taken
Bonus =
(c)
44
Time taken
× Time saved × Hourly rate =
× 16 × 0.75 = `8.80
60
Time allowed
Total earnings
Halsey Plan:
Wages for time taken
Bonus 50% of 16 hrs. @ `0.75
Total earnings
= `41.80
= 44 hrs. @ `0.75 = `33
= `06
= `39 Ans.
Comparisons between Halsey and Rowan Plans
The following example clearly brings out the comparative features of Halsey and
Rowan plans.
Example:
Standard time = 10 hours for 10 articles
Rate per hour = `1
With this information a table has been prepared below which shows the comparative
earnings under Halsey and Rowan plans under different times saved.
Table showing comparative earnings and bonus under Halsey and Rowan Plans
Time
Time
allowed taken
(Hrs.) (Hrs.)
10
10
10
10
10
10
10
10
10
10
12
10
9
8
7
6
5
4
3
2
Time Rate per
saved
hour
(Hrs.)
`
Basic
pay
`
Halsey
Rowan
Bonus
Total
Per hour Bonus
Total
Per hour
`
earnings earnings
`
earnings earnings
`
`
`
`
Nil
Nil
1
2
3
4
5
6
7
8
12
10
9
8
7
6
5
4
3
2
Nil
Nil,
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
1
1
1
1
1
1
1
1
1
1
12
10
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
1.00
1.00
1.06
1.13
1.21
1.33
1.50
1,75
2.17
3.00
Nil
Nil
0.9
1.6
2.1
2.4
2.5
2.4
2.1
1.6
12
10
9.9
9.6
9.1
8.4
7.5
6.4
5.5
3.6
1.00
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.83
1.80
Comparative Features. Calculations shown in the table bring out the following
comparative features of Halsey and Rowan plans.
(i) Bonus. When time saved increases, bonus under Halsey plan also keeps on
increasing. But under Rowan Plan, when time saved increases, bonus increases only
when time saved is up to 50% of the standard time or allowed time, thereafter amount
of bonus starts declining. At 50% time saved, bonus under both the plans is the same.
Before 50% of standard time saved, bonus under Rowan Plan is higher than that of
Plan and after 50% of the time saved, bonus under Rowan Plan is lower than that of
Halsey Plan. It is interesting to note that under Rowan Plan, a person who has saved
60% of time allowed earns the same amount of bonus if he saves 40% of the time
allowed.
(ii) Earnings per hour. Under Halsey Plan and Rowan Plan, earnings per hour of
workers keep in increasing. But rate of earnings under the two plans differ. When time
saved is less than 50% of time allowed, the rate of increase in per hour earnings is
Labour Cost (Employee Cost)
3.27
higher in Rowan plan whereas when time saved is more than 50% of time allowed,
the rate of increase in per hour earnings is higher in Halsey plan. At 50% time saved,
earnings per hour under both the schemes is the same.
(iii) Effect on labour cost. Labour cost per unit decreases as production increases
up to the standard, thereafter it continues to decrease but not so rapidly. Rowan cost
per unit is higher than under Halsey plan until time saved is 50% of time allowed.
Thereafter, it is lower and soon becomes substantially lower. At 50% time saved,
labour cost per unit is the same under both the plans.
3. Taylor’s Differential Piece Rate System
Taylor’s differential system was devised by F.W. Taylor as a part of the scheme of
scientific management. Under this system, the standard task is established after careful
time and motion study and two piece rates are set. The low rate is for sub-standard
performance and high rate for standard and above standard performance.
The main features of the scheme may be given as below :
(1) Day wages are not guaranteed.
(2) A standard time for job is established.
(3) Two piece rates are fixed. If the worker does the work within the standard time,
he receives the higher piece rate, whereas if he takes longer time he receives
the lower piece rate.
Usually these rates are 80% of the piece work rate for inefficient workers and
120% of the piece rate for efficient workers.
Illustration 3.5 Using a Taylor ’s plan, calculate the eamings of workers from the
following information. Normal rate per hour
= `12
Standard time per piece = 20 minutes
In a 9-hourday, A produces 26 units and B produces 30 units
Solution
60 minutes
Standard production per hour =
= 3 units
20 minutes
Standard production per day
= 3 units × 9 hrs. = 27 units
Piece rate
= `12  3 units = `4 per unit
Lower price rate
= `4 × 80% = `3.20
Higher piece rate
= `4 × 120% = `4.80
26 units
Efficiency of worker A =
× 100 = 96.30%
27 units
It is less than 100% and thus will be paid at lower piece rate of `3.20 per unit.
Wages of A = 26 units × `3.20 = `83.20
30 units
= 111.11%
Efficiency of B =
27 units
It is more than 100% hence will be paid at the higher piece rate of `4.80 per unit.
Wages of B = 30 units × 4.80 = `144
Advantages
(1) Taylor’s plan is not difficult to understand and operate.
(2) It is advantageous from the point of view of the employer since it helps him in
increasing production by offering higher rates to more efficient workers.
(3) It attracts efficient workers.
Labour Cost (Employee Cost)
3.28
(4) Where the overheads are high, its incidence per unit cost is reduced because of
increased production.
Disadvantages
(1) It penalises very severely the slow or inefficient workers as a slight fall in
production will considerably affect their earnings.
(2) It makes wide discrimination between efficient and inefficient workers and thus
creates rivalry and disturbance among workers.
(3) It does not guarantee the minimum day wages and this insecurity affects the
morale of workers.
(4) Labour cost will differ between the two levels of performance because of two
different rates.
This system has never been widely practised as the disadvantages of the system
outweigh its advantages.
TREATMENT OF SPECIAL ITEMS
Leave with Pay
According to the Factories Act, workers are entitled to annual leave with full pay, for
a specified number of days in a year. This may include casual leave, medical leave,
special leave, etc. The cost of paid leave cannot be charged to any work order or cost
unit since no work is done during this period. It is, therefore, treated as indirect labour
cost and charged to overheads.
Alternatively, leave wages may be treated as direct labour cost in which case the
wage rate is inflated. This is done by estimating in advance the amount of leave
wages and spreading it over the actual number of working hours to give an inflated
hourly rate.
Holiday with Pay
Workers are also entitled to certain holidays like Diwali, Id, Republic Day, Independence
Day, etc. Like leave wages, payment of wages for these holidays is also unproductive
in the sense that no production work is done on these days. Payment for such holidays
should, therefore, be treated in the same way as leave pay.
Profit Sharing Bonus
Under the Payment of Bonus Act, a minimum amount of bonus is payable to workers,
even if no profits are earned during a period. The bonus should, therefore, be charged
to cost of production. The amount of such bonus in respect of direct labour should be
included in the direct labour cost and that in respect of indirect labour should be
charged to overheads of the department concerned.
According to Cost Accounting Standard-7 (CAS-7) issued by ICWA of India,
‘Bonus, whether payable as a statutory minimum or on a sharing of surplus, shall be
treated as part of employee cost. Ex-gratia, payable in line of or in addition to bonus,
shall also be treated as part of employee cost.’
3.29
Labour Cost (Employee Cost)
Fringe Benefits
Industrial workers usually enjoy certain benefits in addition to their wages, salaries and
other allowances. These benefits, known as fringe benefits, are costs incurred by the
employers, which are not related to the quantity of work done by workers. These can
be monetary as well as non-monetary. List of such benefits is given below:
Fringe Benefits (Individual) — Monetary
Dearness Allowance
Providend Fund
Night Shift Allowance
Employee State Insurance
Sick Leave Pay
Annual Bonus
Holiday Pay
Maternity Leave Pay
Gratuity, Pension
Fringe Benefits (Group) — Non-Monetary
Subsidized Conveyance
Medical Care
Subsidized Canteen Facilities
Free Housing
Education for Workers’ Children
Total cost of employing each worker should be calculated after taking into account
various elements of remuneration, contribution to P.F. and other fringe benefits. Inflated
cost should be charged to the unit of production on appropriate basis. Another course
is to treat all the expenses on these benefits as overheads and allocate them.
As regards expenditure on non-monetary benefits, it should be aggregated and
allocated or apportioned over departments on the basis of quantum of benefits received.
PROBLEMS AND SOLUTIONS
Problem 3.1
rate:
From the following information, calculate labour turnover rate and flux
No. of workers as on 01.01.2021 = 7,600
No. of workers as on 31.12.2021 = 8,400
During the year, 80 workers left while 320 workers were discharged, 1,500 workers
were recruited during the year of whom 300 workers were recruited because of exits
and the rest were recruited in accordance with expansion plans.
(CA Inter)
Solution
Labour Turnover Rates
(i)
Separation Method
=
Wor ker s left + Discharged
× 100
Average number
80 + 320
400
= (7,600 + 8,400)  2 = 8,000  100 = 5%
(ii) Replacement Method =
=
Workers replaced
× 100
Average number
300
 100
8,000
= 3.75%
Labour Cost (Employee Cost)
3.30
(iii) Flux Rate
=
Separations + Replacements
× 100
Average number
=
400 + 300
 100
8,000
=
Separations + Accessions
× 100
Average number
=
400 + 1500
8,000
= 8.75%
Alternatively,
Flux Rate
= 23.75%
Problem 3.2 The following information relates to workforce in a factory during the
year 2021–22:
Number of workers on 1 April 2021
Number of workers on 31 March 2022
Number of workers who quit on their own
Number of workers who availed golden handshake opportunity
Number of workers employed during 2021–22 including those
employed due to expansion
2,350
2,850
200
100
800
Calculate annual labour turnover rate and equivalent monthly turnover rate under
different methods.
(B.Com. Hons., Delhi)
Solution
Average No. of workers =
2,350  2,850
= 2,600
2
1. Separation Rate
=
No. of workers separated
Average No. of workers × 100
=
200  100
× 100
2,600
Monthly Rate
= 11.54%
11.54
= 12 months = 1% (approx.)
2. Replacement Rate =
=
No. of workers replaced*1
Average No. of workers × 100
200
× 100
2,600
Monthly Rate
7.7
= 12 months
3. Flux Rate
=
= 7.7% (approx.)
= 0.64% (approx.)
Number of workers separated + Number of workers replaced
× 100
Average No. of workers
3.31
Labour Cost (Employee Cost)
=
Monthly Rate
300  200
× 100
2,600
= 19.23%
19.23
= 12 months
= 1.6% (approx.)
Assumptions
1. All workers who quit on their own have been replaced.
2. Workers employed due to expansion are not taken into account for the computation
of turnover rate.
Problem 3.3 The cost accountant of Y Ltd has computed labour turnover rates for the
quarter ended 31 March 2021 as 10%, 5% and 3% under Flux method, Replacement
method and Separation method, respectively. If the number of workers replaced during
that quarter is 30, find out the number of (1) workers recruited and joined, and (2)
workers left and discharged.
(B.Com. Hons., Delhi, CA Inter)
Solution
Labour turnover rate
No. of replacements
= Average No. of workers
30
5
= Average No. of workers
100
Average No. of workers
= 30 ×
100
= 600.
5
1. Calculation of workers recruited and joined
Labour turnover rate (Flux method) =
10
100
No. of separations + No. joined
Average No. of workers
=
*18 + No. joined
600
6,000
– 18 = 42
100
Thus number of workers recruited and joined = 42
No. joined
=
2. *No. of workers left and discharged
Labour turnover rate
(Separation method)
3
100
No. of separations
= Average No. of workers
=
No. of separations
600
No. of separations
= 18
Thus, the number of workers left and discharged = 18.
Labour Cost (Employee Cost)
3.32
Problem 3.4 Calculate the normal and overtime wages payable to a workman from the
following data:
Days
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Normal working hours
Normal rate
Overtime rate
Hours worked
8
10
9
11
9
4
8 hours a day
`10 per hour
Up to 9 hours in a day at single rate and
over 9 hours in a day at double rate
Or
Up to 48 hours per week at single rate and
over 48 hours at double rate, whichever is
more beneficial to the workman.
(B.Com., Madras, Adapted)
Solution
Calculation of Normal and Overtime Wages
Total
hours
worked
Normal
hours
`
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Total
Days
Hrs. at
double
`
Hrs. at
wages
Overtime
rate
Normal
wages
@ ` 10
single
rate
Overtime
8
10
9
11
9
4
8
8
8
8
8
4
80
80
80
80
80
40
—
1
1
1
1
—
—
1
—
2
—
—
—
30
10
50
10
—
51
44
440
4
3
100
Total wages under this plan = `440 + `100
= `540
Normal wages (48 hrs × `10)
= `480
Overtime wages (3 hrs × `20)
= `60
Problem 3.5
An employee of XYZ Co. gets the following emoluments and benefits:
(a) Salary
........ `250 pm
(b) Dearness Allowance
On 1st `100 of salary
........ `400
On next `100 of salary
........ `100
On balance of every `100
........ `50 or part thereof
3.33
Labour Cost (Employee Cost)
(c) Employer’s contribution
—to Provident Fund
........ 8% of salary and D.A.
—to ESI
........ 4% of salary and D.A.
(d) Bonus
........ 20% of salary and D.A.
(e) Other allowances
........ `2,725 per annum
A works for 2,400 hours per annum, out of which 400 hours are non-productive but treated
as normal idle time. A worked for 18 effective hours on job No. 13 where the cost of direct
materials equals A's earnings and the overheads applied are 100% of prime cost. The sale value
of the job is quoted to earn a profit of 10% on such value. You are required to find out:
(a) Effective hourly cost of ‘A’ and
(b) Effective sale value of job No. 13.
(B.Com. Hons., Delhi, ICWA Inter)
Solution
(a) Computation of Effective Hourly Cost A
` per month
Salary of A
Dearness allowance (400 + 100 + 25)
Salary + D.A.
Salary + D.A. per annum (775 × 12)
Employer's contribution to P.F. (8%)
To ESI (4%)
Bonus (20%)
Other allowances
Total emoluments
250
525
775
9,300
744
372
1,860
2,775
15,001
Working hours (gross)
Less: Normal idle time
Effective working hours
2,400
400
2,000
Effective hourly cost of A = `15,001 ÷ 2,000 = ` 7.50 per hour
(b) Computation of Sale Value of Job No. 13
Direct material
Direct labour (18 hr @ ` 7.50)
135
135
Prime Cost
270
270
Total Cost
Profit (10% of sales or 1/9 of cost)
Sale Value
540
60
600
Overhead (100% of prime cost)
Problem 3.6
A company's basic wage rate is `6 per hour and its overtime rates are:
Evening – time and one-third
Weekends–double the time
Labour Cost (Employee Cost)
3.34
During the previous year, the following hours were worked:
Normal time
2,20,000 clock hours
Time plus one-third
20,000 clock hours
Double time
10,000 clock hours
The following times have been worked on three jobs:
Job I
Clock hr.
Job II
Clock hr.
Job III
Clock hr.
Normal time
3,000
5,000
4,000
Evening overtime
300
600
1,050
Week-end overtime
100
50
300
You are required to calculate the labour cost chargeable to each job in each of the
following circumstances:
1. Where overtime is worked regularly throughout the year as the policy of the
company due to labour shortage;
2. Where overtime is worked specifically at the request of the customer.
Solution
Basic rate
– `6 per hour
Evening overtime
– (`6 plus `2) `8 per hour
Week-end overtime
– `12 per hour
Wages of the previous year:
Normal time
2,20,000 hours @ `6/hr
Evening overtime
20,000 hours @ `8/hr
Week-end overtime
10,000 hours @ `12/hr
2,50,000 hours
=
=
=
`13,20,000
`1,60,000
`1,20,000
`16,00,000
Average or inflated rate per hour = `16,00,000 ÷ 2,50,000 hrs =
`6.40
1. Where overtime is worked regularly throughout the year as the policy of the
company due to labour shortage, it becomes a part of labour cost. Each job will
be charged with the labour cost for the total number of hours worked at the inflated
rate. Thus:
I
3,400 hours @ `6.40 = `21,760
Job No. II
5,650 hours @ `6.40 = `36,160
Job No. III
5,350 hours @ `6.40 = `34,240
Job No.
2. Where overtime is worked specifically at the request of the customer, overtime is
to be charged to the job to be borne by the customer. In this case, each job will
be charged as follows:
Job No.
I
`6 per hour
=
`18,000
300 hours @
`8 per hour
=
`2,400
100 hours @
`12 per hour
=
`1,200
3,000 hours @
`21,600
Total
Job No.
II
5,000 hours @
`6 per hour
=
`30,000
600 hours @
`8 per hour
=
`4,800
50 hours @
`12 per hour
=
`600
Total
`35,400
3.35
Labour Cost (Employee Cost)
Job No. III
4,000 hours @
`6 per hour
=
`24,000
1,050 hours @
`8 per hour
=
`8,400
300 hours @
`12 per hour
=
`3,600
Total
`36,000
Problem 3.7 In a factory, Ram and Sham produce the same product using the same
input of same material and at the same normal wage rate.
Bonus is paid to both of them in the form of normal time wage rate adjusted by the
proportion which time saved bears to the standard time for the completion of the product.
The time allotted to the product is fifty hours. Ram takes thirty hours and Sham takes
forty hours to produce the product. The factory cost of the product for Ram is `3,100
and for Sham `3,280. The factory overhead rate is `12 per man hour.
Calculate (i) Normal wage rate; (ii) Cost of materials used for the product; and
(iii) Input of material, if the unit material cost is `16.
(B. Com. Hons., Delhi)
Solution
Ram
`
3,100
Factory cost
Less: Factory overheads
Ram (30 hrs × `12)
Sham (40 hrs × `12)
Sham
`
3,280
360
480
Prime cost
2,740
2,800
Difference in wages = 2,800 – 2,740 = `60
Calculation of wage rate
Suppose wage rate = x
20 

Wages of Ram = 30x +  30 x × 
50
10 

Wages of Sham = 40x +  40 x × 
50
Thus the following equation is made:
10  
20 

 40x + 40x 
 –  30x + 30x 
  60
50  
50 
Solve this equation and derive the value of x,
(40x + 8x) – (30x + 12x) = 60
48x – 42x = 60
6x = 60
x = 10
Thus wage rate = ` 10 per hour
20 

Wages of Ram = 30 hrs × 10 +  30 × 10 ×

50 
= `420
10 

Wages of Sham = 40 hrs × 10 +  40 × 10 ×

50 
= `480
Labour Cost (Employee Cost)
3.36
Material cost – Ram's job = `2,740 – 420 = `2,320
Sham's job = `2,800 – 480 = `2,320
Material input = `2,320 ÷ `16 = 145 units
Problem 3.8 Standard time fixed for a job in a manufacturing concern is 40 hours. Time
rate is 60 paise per hour. The actual time taken by the workers A, B and C is 20 hr, 15 hr
and 30 hr respectively. Calculate total remuneration of A, B, C for Halsey and Rowan plans.
Solution
Calculation of Total Wages
A
Standard time (Hrs.)
40
Less: Actual time (Hrs.)
20
Time saved (Hrs.)
20
(A) Time wages (@ 60 paise per hour for actual time)
` 12
(B) Bonus — Halsey plan (50% of time saved @ 60 paise per hour) 6
 Time taken

× Time saved × 60 paise
6
(C) Bonus — Rowan plan 
 St. time

Total wages:
Halsey Plan (A + B)
18
Rowan Plan (A + C)
18
Workers
B
C
40
40
15
30
25
10
` 9 ` 18
7.50 3
5.63 4.50
16.50 21
14.63 22.50
Problem 3.9 A worker takes 9 hours to complete a job on daily wages and 6 hours on a
scheme of payment by results. His day rate is 75 paise an hour, the material cost of the
product is `4 and the overheads are recorded at 150% of the total direct wages. Calculate
the factory cost of the product under : (a) Piece Work Plan, (b) Rowan Plan, (c) Halsey Plan.
Solution
Calculation of Direct Labour Cost:
(a) Piece-work Plan. Worker shall be paid for 6 hours @ 75 paise an hour = `4.50
(b) and (c) Rowan and Halsey Plans
Rowan
Halsey
Standard time
9 hours
9 hours
Actual time taken
6 hours
6 hours
Time saved
3 hours
3 hours
Wages for 6 hours @ 75 p. per hr.
` 4.50
` 4.50
3 hours
× 0.75
1.50
Rowan Bonus = 6 hours ×
9 hours
Halsey Bonus for 50% of time saved, i.e., ½ (3 hrs. × 0.75)
1.12
Total
6.00
5.62
Factory cost under three plans :
Materials
Direct Labour
Factory Overheads (150% of direct labour)
Factory Cost
Piece-work
4.00
4.50
6.75
15.25
Halsey
4.00
5.62
8.43
18.05
Rowan
4.00
6.00
9.00
19.00
Problem 3.10 Mr. X, the proprietor of a small engineering workshop producing speciality
products by employing 5 skilled workers, is considering the introduction of some incentive
3.37
Labour Cost (Employee Cost)
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 earning of the workers, it could act as sufficient incentive for
them to produce more and he has accordingly given this assurance to the workers.
As a result of this assurance, the increase in productivity has been observed as
revealed by the following figures for the current month:
Hourly rate of wages (guaranteed)
`2.00
Average time for producing 1 piece / worker at previous performance
2 hours
(Mr. X desires that this time be considered as time allowed for purpose of incentive scheme)
No. of working days in the month
25
No. of working hours per day for each worker
8
Actual production during the month
625 Nos.
Calculate: (a) effective rate of earnings per hour under Halsey Scheme and Rowan
Scheme, (b) the savings to Mr. X in terms of direct labour cost per piece under me
above schemes. (c) Advise Mr. X about the selection of the scheme to fulfil his assurance.
Solution
(a) Time allowed per unit (given)
=
No. of units produced during the month =
So, total time allowed (625 × 2)
=
Actual time taken by 5 workers (25×8×5) =
Time saved (1250 – 1,000)
=
Bonus as per Halsey Scheme
=
=
Per worker
=
Total wages per worker
=
=
Effective rate per hour
=
Bonus as per Rowan Scheme
=
=
Total wages per worker
Effective rate per hour
=
=
2 hours
625
1,250 hours
l,000
250 hours
50% (Time saved × Time rate)
50% of 250 hrs. × `2 = 250
`250  5 =50
Hours taken × Time rate + Bonus
200 × 2 + `50 = `450
450  200 = `2.25
Time saved
×Time wages
Time allowed
250
× 200 × 2 + `80 per worker
1,250
200 × 2 + ` 80 = `480
480  200 = `2.40
(b) Labour cost per piece (without incentive) = 2 × 2 = `4
Labour cost per piece (Halsey Scheme)
Saving per piece = 4.00 – 3.60
450  5
= `3.60
625
= `0.40
=
480  5
= `3.84
625
Saving per piece
= 4.00 – 3.84 = `0.16
(c) So far as labour cost per unit is concerned, it is clear that Halsey Scheme brings about
more saving than Rowan Scheme. But Halsey Scheme does not fulfil assurance to the workers
about 20% increase in their earnings as it secures only (50/400), i.e., 12½% increase.
Rowan Scheme, on the other hand, secures (80/400), i.e., 20% increase in the earning
of the worker and it fulfils the assurance. Therefore, Rowan Scheme may be adopted.
480×5 Labour cost per piece (Rowan)
=
Problem 3.11 The existing incentive system of a certain factory is:
Normal working week
5 days of 9 hours plus 3 late shifts of 3 hr each
Rate of payment
Days work = `1 per hour
Late shift = `1.50 per hour
Labour Cost (Employee Cost)
3.38
`2.50 per day shift
`1.50 per late shift
Additional bonus payable
Av. output per operative for
54-hr week, i.e., incl. 3 late shifts 120 articles
In order to increase output and eliminate overtime it was decided to switch on to a
system of payment by results. The following information is obtained:
Time rate (as usual)
`1 per hour
Basic time allowed for 15 articles 5 hours
Piece work rate
Add 20% to piece
Premium
Add 50% to time
You are required to show : (i) hours worked ; (ii) weekly earnings ; (iii) number of
articles produced; (iv) labour cost per article for one operative under the following
Systems: (a) Existing time rate, (b) Straight piece-work, (c) Rowan system, (d) Halsey
system.
Assume that 135 articles produced in a 45-hour week under (b), (c) and (d) and that
the worker earns half time saved under the Halsey System. The additional bonus under
the existing system will be discontinued in the proposed incentive scheme.
Solution
(a) Existing Time Rate
Weekly wages
45 hrs. @ `1 per hour
9 hrs.@ Re, 1.50
Day shift bonus 5 × 2.50
Late shift bonus 3 × 1.50
(b) Piece Rate System
Basic time: 5 hours for 15 articles
Cost of 15 articles
Add 20%
Rate per article `6.00  15 = `0.40
Articles produced in a week = 45 ×
Hence, earnings = 135 ×
0.40
45.00
13.50
12.50
4.50
75.50
5.00
1.00
6.00
45
= 135
15
= `54.00.
(c) Rowan Premium System
Basic time
Adding 50%
Time for producing one article
Time allowed for 135 articles
Actual time taken for 135 articles
Time saved
Earnings
= 5 hrs. for 15 articles
= 7½ hrs. for 15 articles
= 7½ hrs.  15 = 30 minutes
= 67½ hrs.
= 45 hrs.
= 67½ – 45 = 22'/2 hrs.
Time saved
= Time wages +
× Time wages
Standard time
= 45 × 1 +
22½
× 45 = 45 + 15 = `60
67½
(d) Halsay Premium System
Earnings
= Time Wages + 50% [Time Saved x Time Rate]
= 45 × 1 + 50% (67½ – 45) × 1 = 45 + 11.25 = `56.25.
3.39
Labour Cost (Employee Cost)
The other requirements of the problem have been shown in the following table:
(i) Hours worked
(ii) Weekly earnings
(iii) Articles produced
(iv) Labour cost per article
(a)
54
`75.50
120
`0.629
(b)
45
54.00
135
0.400
Methods
(c)
45
60.00
135
0.444
(d)
45
56.25
135
0.417
Problem 3.12 On the basis of the following information, calculate the earnings of worker
X and Y on: (i) Straight piece basis, and (ii) Taylor’s differential piece rate system
Standard production— 8 units per hour
Normal time rate — `4 per hour
Differentials to be applied:
(a) 80% of piece rate below standard, (b) 120% of piece rate at or above standard.
In a 9 hour day, X produced 54 units and Y produced 75 units.
Solution
Standard output
— 8 units per hour
Time rate
— `4 per hour
Piece rate
— `4  8 units = 50 paise per unit
(i) Straight Piece Rate System
Wages of X = 54 units @ `50 paise = `27.00
Wages of Y = 75 units @ `50 paise = `37.50
(ii) Taylor’s Differential Piece Rate System
Lower piece rate — 80% of 50 paise = 40 paise
Higher piece rate — 120% of 50 paise = 60 paise
At the standard rate of 8 units per hour, standard output for a 9 hours day should
be 72 units. Output of X is 54 units (below standard) and therefore a lower piece rate
is given. For Y, higher piece of rate is given because at 75 units his output is above
standard. Thus:
Wages of X = 54 units @ 40 paise = `21.60
Wages of Y = 75 units @ 60 paise = `45.00
Problem 3.13 The three workers Govind, Ram and Shyam produced 80, 100, and 120
pieces respective of a product ‘X’ on a particular day in May in a factory. The time
allowed for 10 units of Product X is 1 hour and their hourly rate is `4. Calculate for
each of these three workers: (1) Earnings for the day, and (2) Effective Rate of Earnings
per hour under: (a) Straight piece-rate, (b) Halsey Premium Bonus (50% Sharing), and
(c) Rwan Premium Bonus methods of labour remuneration.
Solution
Govind
Ram
(i) Production (units)
80
100
8
10
(ii) Time allowed (Hours @ 10 pieces per hour)
(iii) Piece rate (s. 4  10)
0.40
0.40
(iv) Time taken (Assumed 1 day = 8 hours)
8
8
(v) Time saved
0
2
Earnings per day (`)
(a) Straight Piece Rate
80 × 0.4 100 × 0.40
(b) Halsey Premium Bonus (See Note)
32
36
(c) Rowan Premium Bonus (See Note)
32
38.40
Shyam
120
12
0.40
8
4
120 × 0.40
40
42.67
Labour Cost (Employee Cost)
3.40
Effective Rate of Earning per hour (Earning  Hours)
(a) Straight Piece Rate
` 4.00
(b) Halsey Premium Bonus
` 4.00
(c) Rowan Premium Bonus
` 4.00
` 5.00
` 4.50
` 4.80
` 6.00
` 5.00
` 5.33
Notes:
1.
Halsey Premium Bonus
Wages = (Time taken+ 50% of time saved) × Time rate
Govind = (8 + 0) × `4 = `32
Ram = (8 + 1) × `4 `36
Shyam = (8 + 2) × `4 = `40
2.
Rowan Premium Bonus
Time saved
Wages = Time taken × Rate + Time allowed  Time taken  Rate
FG
H
IJ
K
FG 0  8  4IJ = `32; Ram = 8 × 4 + FG 2  8  4IJ = `38.40
H8
K
H 10
K
F4
I
Shyam = 8 × 4 + GH  8  4JK = `42.67
10
Govind = 8 × 4 +
Problem 3.14 In a factory, Ram and Sham produce the same product using the same
input of same material and at the same normal wage rate.
Bonus is paid to both of them in the form of normal time wage rate adjusted by the
proportion which time saved bears to the standard time for the completion of the product.
The time allotted to the product is fifty hours. Ram takes thirty hours and Sham takes
forty hours to produce the product. The factory cost of the product for Ram is `3,100
and for Sham `3,280. The factory overhead rate is `12 per man hour.
Calculate (i) Normal wage rate; (ii) Cost of materials used for the product; and
(iii) Input of material, if the unit material cost is `16.
Solution
Ram
`
3,100
Factory cost
Less: Factory overheads
Ram (30 hrs × `12)
Sham (40 hrs × `12)
Sham
`
3,280
360
480
Prime cost
Difference in wages = 2,800 – 2,740 = `60
Calculation of wage rate
Suppose wage rate = x
20 

Wages of Ram = 30x +  30x  

50 
10 

Wages of Sham = 40x +  40x  
50
Thus the following equation is made:
2,740
2,800
3.41
Labour Cost (Employee Cost)
10 
20 


 40x + 40x   –  30x + 30x   = 60
50
50
Solve this equation and derive the value of x,
(40x + 8x) – (30x + 12x) = 60
48x – 42x = 60
6x = 60
x = 10
Thus wage rate = ` 10 per hour
20
Wages of Ram = 30 hrs × 10 +  30  10   = `420

50 
10 

Wages of Sham = 40 hrs × 10 +  40  10  
50
= `480
Material cost – Ram's job = `2,740 – 420 = `2,320
Sham's job = `2,800 – 480 = `2,320
Material input = `2,320 ÷ `16 = 145 units
Problem 3.15 On the basis of following information, calculate the earnings of worker X
and Y on:
(i) Straight piece basis, and
(ii) Taylor's differential piece rate system.
Standard production
– 8 units per hour
Normal time rate
– `4 per hour
Differentials to be applied:
(a) 80% of piece rate below standard
(b) 120% of piece rate at or above standard
In a 9 hour day, X produced 54 units and Y produced 75 units.
Solution
Standard output
Time rate
Piece rate
– 8 units per hour
– `4 per hour
– `4 ÷ 8 units = 50 paise per unit
(i) Straight Piece Rate System
Wages of X = 54 units @ `50 paise = ` 27.00
Wages of Y = 75 units @ `50 paise = ` 37.50
(ii) Taylor's Differential Piece Rate System
Lower piece rate
Higher piece rate
– 80% of 50 paise = 40 paise
– 120% of 50 paise = 60 paise
At the standard rate of 8 units per hour, standard output for a 9 hours day should be
72 units. Output of X is 54 units which is below standard and therefore, a lower piece
rate will be used. For Y, higher piece rate will be used because his output is 75 units
which is above standard. Thus:
Wages of X
=
54 units @ 40 paise = ` 21.60
Wages of Y
=
75 units @ 60 paise = ` 45.00
Labour Cost (Employee Cost)
3.42
Problem 3.16 Calculate the earnings of workers A and B from the following particulars
for a month and allocate the earnings of each to jobs X, Y and Z.
A
B
(a) Basic wages (`)
100
100
(b) Dearness Allowance
50%
55%
(c) Provident Fund
8%
8%
(d) Employees State Insurance
(e) Overtime
(f)
2%
2%
10 hours
—
—
16 hours
Idle time and leave
The normal working hours for the month are 200 hours, overtime is paid for at double
the normal rate plus D.A. Employer's contributions to State Insurance and Provident Fund
are at equal rate with the employees’ contributions. This month has 25 working days and
one paid holiday. Overtime was done on job Y.
The two workers were employed on jobs X, Y and Z in the following proportion:
Job
A
B
X
Y
Z
40
50
30
20
30
30
(BCom Hons Delhi, Adapted; CA Inter)
Solution:
Statement of Earnings of Workers A and B
A
B
`
`
Basic Wages
Dearness Allowance
Provident Fund
State Insurance
Overtime
100
50
8
2
15
100
55
8
2
–
Total earnings
175
165
Hours Worked:
Worker A—Normal
Add: Overtime
200 hours
10 hours
210 hours
Hourly rate:
Worker A—Normal (`175 – `15)
Overtime
Worker B—Normal
B—Normal
200 hours
Less: Idle time and leave 16 hours
184 hours
`160 ÷ 200 hours = `0.80
` 15 ÷ 10 hours = `1.50
`165 ÷ 184 hours = `0.90
3.43
Labour Cost (Employee Cost)
Allocation of hours worked:
Jobs
Working hours of A
Normal 4:3:3
Overtime
Working hours of B
Normal 5:2:3
Total
X
Y
Z
200
10
80
–
60
10
60
–
184
92
37
55
394
172
107
115
X
`
Y
`
Z
`
160
15
165
64.00
—
82.20
48.00
15.00
33.10
48.00
—
49.50
340
146.20
96.30
97.50
Allocation of Labour Cost:
Total
`
A—Normal
Overtime
B—Normal
`0.80 per hour
`1.50 per hour
`0.90 per hour
Total
Problem 3.17 An employee working under a bonus scheme saves 10 hours in a job for
which the standard time is 60 hours. Calculate the rate per hour worked and wages payable
to a worker, if incentive bonus of 10% on the hourly rate is payable when standard time
(namely 100% efficiency) is achieved and a further incentive bonus of 1% on hourly rate
for each 1% in excess of that 100% efficiency is payable. Assume that the normal rate of
payment is `5 per hour.
(CA Inter, Adapted)
Solution
Standard time allowed
Actual time taken
60 hours
50 hours
Time saved
10 hours
Percentage efficiency =
60
Std time allowed
× 100 =
× 100 = 120%
Actual time taken
50
Calculation of wages payable
Basic wage rate per hour
Bonus
(i) 10% at 100% efficiency
(ii) Additional 1% bonus for every additional 1% efficiency
(20% of `5.00)
Hourly rate payable
Total wages payable = Actual hours × hourly rate = 50 × 6.50 = ` 325
`
5.00
0.50
1.00
6.50
Labour Cost (Employee Cost)
3.44
SUMMARY AND KEY TERMS









Labour cost, representing human resources, is the second most important
element of cost.
On account of high share of labour cost in total production cost, there is a
special need for proper accounting and control of labour cost. Companies
should take special care to reduce labour turnover.
The labour turnover is the rate of change in the composition of the labour
force in an organization. There are three methods of measurement of
labour turnover, i.e., separation method, replacement method and flux
method.
For a system of accounting and control of labour cost, a company should
accurately record each worker’s time of arrival and departure in the factory
(known as time keeping) and also the record of the time spent on different
jobs or processes (known as time booking) so that labour cost of each job
can be ascertained. The problems of idle time and overtime also needs
serious thought so as to keep these in control.
The idle time represents time lost by workers, i.e., the time for which they
are paid but no production is obtained. Normal idle time is included in
cost but abnormal idle time is not included in cost and is transferred to
Costing Profit and Loss Account.
Overtime occurs when a worker works beyond normal working hours. It
is a costly affair as it is payable at double the normal rate of wages and
should be avoided as far as possible.
Basically, there are two methods of labour remuneration: (a) Time Rate
System; and (b) Piece Rate System. Both of these systems have their own
merits and demerits, time rate system is generally suitable in cases where
quality of work is more important and where output cannot be measured
in quantitative terms.
Piece rate system is usefully employed where production is standardized
and repetitive in nature.
In order to combine the good points of both time rate and piece rate
systems, certain incentive plans have been devised.
EXAMINATION QUESTIONS
Objective Type Questions
I. State whether True or False.
1.
2.
3.
4.
5.
Salary paid to factory supervisor is indirect wages.
Direct wage is a variable cost.
Purpose of time booking is to compute the wages payable to workers.
Cost of labour turnover is transferred to costing Profit and Loss Account.
When overtime arises due to general pressure of work, overtime premium should
be charged to overhead.
6. Personnel department is responsible for computation and payment of wages of
workers.
7. Cost of normal idle time may be charged to overhead.
8. Job card is used for time keeping.
Labour Cost (Employee Cost)
3.45
9. All overtime is unusual.
10. Idle time arises when workers are paid on piece basis.
II. Fill in the blank spaces.
1.
2.
3.
4.
5.
6.
......................... department is concerned with selection and training of workers.
Payroll sheet is prepared by the ......................... department.
......................... is the rate of change in the labour force of an organization.
Time not spent on productive work is known as ..........................
Cost of abnormal idle time is charged to ..........................
Workers who are appointed on day-to-day basis and are not on the payroll sheet
are called ......................... workers.
7. The workers who are sent to site or customers’ premise for performing work are
known as ......................... .
Theoretical Questions
1. Explain the difference between direct and indirect labour, highlighting the
importance of such a distinction.
2. (a) Give a brief outline of the organization for accounting and control of labour
cost.
(b) How are payments to workers in respect of 'overtime' and 'set-uptime' treated
in cost accounts?
3. What do you understand by labour turnover? Enumerate the causes of such labour
turnover and indicate some steps which may reduce labour turnover.
4. What is the meaning of labour turnover? How is it measured? By what measures
do you reduce labour turnover.
5. Discuss two types of costs associated with labour turnover.
6. Explain the methods and records of time keeping. What are the functions of time
keeping records?
7. What are the various methods of time booking? State the advantages and
disadvantages of each method?
8. How will you treat overtime wages in cost accounts?
9. Distinguish between time keeping and time booking.
10. What do you understand by overtime premium in cost accounts? Suggest a
procedure for control of overtime work.
11. What is idle time? Give reasons for idle time. How do you treat idle time in cost
accounts?
12. Is idle time labour cost a direct cost? How is idle time cost ascertained and how
is the same included in the cost of production of a product?
13. Distinguish between normal and abnormal idle time.
14. Distinguish between idle time and idle capacity. Give your suggestions for their
effective managerial control.
15. What are the essential features of a good wage system?
16. Compare and contrast time rate and piece rate systems of wage payment.
17. Explain Halsey system of paying incentive wages to workers.
18. How is bonus calculated under Rowan and Halsey schemes of wage payment?
19. What are the merits and demerits of time rate and piece rate systems of wage
payment? State the situations where each of these systems is effective and
useful.
20. Compare and contrast Halsey Plan and Rowan Plan of labour remuneration.
Labour Cost (Employee Cost)
3.46
Practical Questions
1. The following information is collected from the personnel department of ST limited
for the year ending 31 March 2021:
Number of workers at the beginning of the year
8,000
Number of workers at the end of the year
9,600
Number of workers left the company during the year
500
Number of workers discharged during the year
100
Number of workers replaced due to left and discharges
700
Additional workers employed for expansion during the year
1,500
You are required to calculate labour turnover rate by using separation method,
replacement method and flux method.
(CA PE-II)
2. The time card of a worker shows that in a normal week of 40 hours, he worked
for 52 hours at the rate of `15 per hour. Taking overtime premium at 100% of
time rate, calculate the amount of gross wages.
3. Calculate the amount of wages and bonus for a workman from the following
particulars.
Job commenced: Monday, 24th March at 8.00 A.M.
Job finished Saturday, 29th March at 1.00 P.M.
Quantity of work turned out: 638 pieces; Quantity of pieces passed: 600;
Worker’s rate: `50 per hour; Time allowed: 10 pieces per hour;
Bonus: 40% of time saved.
Assume that the employee worked for 9 hours a day and there is no overtime
(B.Com. Bengaluru, Madras)
4. Calculate total monthly remuneration of three workers A, B and C from the following
data:
(a) Standard production per month per worker 1,000 units. Actual production
during the month: A 850 units, B 750 units, C 950 units
(b) Piece work rate is 10 paise per unit of actual production
(c) Additional production bonus is `10 for each percentage of actual production
exceeding 80 per cent of standard production. (Examples: 79 per cent—nil, 80
per cent—nil, 81 per cent—`10, 82 per cent—`20, and so on)
(d) Dearness pay fixed: `50 per month.
5. From the following particulars, ascertain the labour cost per day of 8 hours:
(a) Basic pay—`200 per month
(b) Leave pay—5%
(c) Employer's contribution to Provident Fund—8% of (a) and (b)
(d) Employer's contribution to ESI—2½% of (a) and (b)
(e) Prorata amenities—`17.95 per head per month
( f ) Working hours in a month—200
6. From the particulars given below, prepare the labour cost per man-day of 8 hours.
(a) Basic salary
. . . `2 per day
(b) Dearness allowance
. . . 25 paise per every point over 100 of cost of
living index for working class—Current cost of
living index is 700 points
(c) Leave salary
. . . 10% of (a) and (b)
(d) Employer's contribution to
provident fund
. . . 8% of (a), (b) and (c)
3.47
Labour Cost (Employee Cost)
(e) Employer's contribution
to State Insurance
. . . 2.5% of (a), (b) and (c)
(f ) Expenditure on amenities
to labour
. . . `20 per head per mensem
(g) Number of working
days in a month
. . . 25 days of 8 hours each
7. From the following information, calculate the labour turnover rate and labour
flux rate:
Number of workers at the beginning of the year
3,800
Number of workers at the end of the year
4,200
During the year, 40 workers leave while 160 workers are discharged. 600
workers are recruited during the year. Of these, 150 workers are recruited because
of leavers and the rest are engaged in accordance with an expansion scheme.
8. From the following data provided to you, find out the Labour Turnover Rate by applying:
(a) Flux Method
(b) Replacement Method
(c) Separation Method
No. of workers on the payroll:
At the beginning of the month — 500
At the end of the month
— 600
During the month, 5 workers left, 20 persons were discharged and 75 workers
were recruited. Of these, 10 workers were recruited in the vacancies of those
leaving and while the rest were engaged for an expansion scheme. (ICWA Inter)
9. From the following data tabulate the total earnings per hour of each worker
separately under (i) Halsey and (ii) Rowan schemes of incentive payment:
(a) Worker
A
B
C
D
E
F
(b) Time allowed—hours
3
4
5
6
7
8
(c) Actual—hours
5
3
4
5
3
3
(d) Basic wages per hr.—` 2
2
2
2
2
2
10. From the information given below calculate the earnings of each employee, under
the following two methods of wage payment:. (i) Halsey Premium Bonus Scheme;
(ii) Rowan Premium Bonus Scheme.
Employee
A
B
C
Time allowed—hours per 100 units
35
40
42
Wages per unit
`2
3
4
Hourly rate
`7
8
10
Actual time taken in hours
50
48
46
Actual units produced
200
150
125
11. From the following information, calculate earnings of each worker under ‘Rowan’
plan:
Standard time allowed
.........
10 hours
Actual time taken:
Worker A
12 hours
Worker B
10 hours
Worker C
07 hours
Hourly rate of wages `2.
12. The following particulars apply to a job:
Standard time: 10 hours;
Time rate: `2 per hour
Calculate earnings under Halsey and Rowan plans if the time taken is 6 hours and
4 hours. State at least one point of distinction between Halsey Plan and Rowan
Plan in the light of your calculations.
Labour Cost (Employee Cost)
3.48
ANSWERS
Objective Type Questions
I. State whether True or False.
True — 1, 2, 5, 7
False — 3, 4, 6, 8, 9, 10
II.Fill in the blank spaces.
1. Personnel;
5. Costing P&L A/c;
2. Payroll;
6. Casual;
3. Labour turnover;
7. Out-workers
4. Idle time;
Practical Questions
1. Separation rate 6.82%; Replacement rate 7.95%; Flux rate 14.77%
2. `840
3. Total wages `2,700
4. A `185; B `125; C `295
5. `10
6. `10.52
7. Replacement rate 3.75%; Flux rate 8.75%
8. (a) 6.36%, (b) 1.82%, (c) 4.54%
9. Halsey
`10
Rowan
`10
10.
7
9
7.50
9.60
A
11
11.67
B
10
11
9.43
9.75
C
Halsey
`420
432
492
Rowan
`450
460.80
516.95
11. A gets `24, B `20 and C `14 + bonus `4.20
12. Halsey `16, `14; Rowan `16.80, `12.80
(Conclusion : When time saved is more than 50%, Halsey system pays higher bonus.
When time saved is less than 50% of the time allowed. Rowan plan pays higher bonus.
At, 50% saving both the plans pay the same amount of bonus.)
CHAPTER
4
OVERHEAD COST
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of overheads and the methods of their classification
• Describe the meaning of allocation, apportionment, re-apportionment and
absorption of overheads
• Know the various methods of absorption of overheads
• Explain machine hour rate method of absorption of overhead and understand
its computation
• Understand under or over-absorbed overheads and their accounting treatment
• Understand the costing treatment of certain special items of overheads
• Understand activity based cost allocation of overhead
MEANING OF OVERHEAD COST
It was explained in Chapter 1 that total cost may be classified into direct cost and indirect
cost. The total of all direct costs (i.e., direct material cost, direct labour cost and direct
expenses) is known as Prime cost and the total of all indirect costs (i.e., indirect material
cost, indirect labour cost and indirect expenses) is termed as Overhead cost. Various
other names of overhead are: (a) oncost; (b) supplementary cost; (c) burden; (d) nonproductive cost, etc.
Some of the authoritative definitions of overheads are reproduced below:
1. ‘Overhead is the aggregate of indirect materials, indirect wages and
indirect expenses.’
—CIMA, London
2. ‘Overhead may be defined as the cost of indirect materials, indirect labour
and such other expenses, including services as cannot conveniently be
charged direct to specific cost units. Alternatively, overheads are all
expenses other than direct expenses.’
—Wheldon
3. ‘Overheads are those costs which do not result from existence of individual
cost units.’
—Harper
4. ‘Overhead costs are the operating costs of a business enterprise which cannot
be traced directly to a particular unit of output.’
—Blocker and Weltmer
Overhead Cost
4.2
Thus, overhead cost is the total of all indirect expenditure. It comprises those costs
which the cost accountant is either unable or unwilling to allocate to particular cost
units.
Accounting and control of overhead costs is more complex than that of other
elements of cost, i.e., direct materials and direct labour. This is because overheads by
definition, are indirect costs which cannot be conveniently allocated to cost units. Hence,
there arises the knotty problem of apportioning these indirect costs to cost centres and
cost units.
CLASSIFICATIONS OF OVERHEAD COSTS
Overhead costs may be classified according to:
1. Functions
2. Elements
3. Behaviour
Classification of Overheads
By Functions
By Elements
By Behaviour
• Production overheads
• Administration overheads
• Selling overheads
• Distribution overheads
• Indirect materials
• Indirect labour
• Indirect expenses
• Fixed overheads
• Variable overheads
• Semi-variable overheads
Fig. 4.1
Classification of overheads.
1. Classification according to Functions
The main groups of overheads on the basis of this classification are as follows:
(a) Production overheads Also termed as factory overheads, works overheads or
manufacturing overheads, they are indirect expenditures incurred in connection with
production operations. They are the aggregate of factory indirect material cost, indirect
wages and indirect expenses. Unlike direct materials and direct labour, production
overheads are an invisible part of the finished product. Examples of these overheads
are: lubricants, consumable stores, indirect wages, factory power and light, depreciation
of plant and machinery, depreciation of factory building, insurance of plant and factory
building, storekeeping expenses, repairs and maintenance.
(b) Administration overheads These overheads are of general nature and consist
of all costs incurred in the direction, control and administration (including secretarial,
accounting and financial control) of an undertaking, which are not related directly to
production or selling and distribution function. Examples are: general management
salaries, audit fees, legal charges, postage and telephone, stationery and printing, office
rent and rates, office lighting and salaries of office staff. These overheads are also
known as office overheads or general overheads.
(c) Selling and distribution overheads Selling overheads are the cost of seeking
to create and stimulate demand or of securing orders. Examples: advertising, salaries
and commission of sales personnel, showroom expenses, travelling expenses, bad debts,
catalogues and price lists.
Overhead Cost
4.3
Distribution overheads comprise all expenditures incurred from the time product
is completed in the factory till it reaches its destination or customer. It includes packing
cost, carriage outward, delivery van expenses, warehousing costs, etc.
Selling overheads and distribution overheads are both related to sales function and
thus are combined into one category of selling and distribution overheads. These are
often referred to as ‘after production costs’ because these costs are incurred after
production work is over.
2. Element-wise Classification
Under this method, the classification is done according to the nature and sources of the
expenditure. This method follows logically from the definition of overhead costs.
On this basis, expenses are classified under three main groups given below:
(a) Indirect materials They are material costs, which cannot be allocated but which
are to be apportioned to or absorbed by cost centres or cost units. Examples are
stationery, coal, lubricants and tools for general use.
(b) Indirect wages Indirect wages are those which cannot be allocated but which
are to be apportioned to or absorbed by cost centres or cost units. Examples are wages
of sweeper, idle time wages, maintenance and repair wages, foreman’s pay and
chowkidar’s pay.
(c) Indirect expenses Expenses which cannot be allocated but which are to be
apportioned to or absorbed by cost centres or cost units are indirect expenses. For
example, power, depreciation, insurance, taxes and rates and rent.
3. Classification according to Behaviour or Variability
Different overhead costs behave in different ways when volume of production changes.
On the basis of behaviour, overheads may be classified into: (a) Fixed overheads; (b)
Variable overheads; and (c) Semi-fixed or semi-variable overheads.
Fixed overheads These overheads remain unaffected or fixed in total amount by
fluctuations in volume of output. Examples are rent and rates, managerial salaries,
building depreciation, postage, stationery and legal expenses.
Variable overheads This is the cost which, in aggregate, tends to vary in direct
proportion to changes in the volume of output. Variable overheads per unit remain fixed.
Examples are indirect materials, indirect labour, salesmen’s commission, power, light,
fuel, etc.
Semi-variable overheads These overheads are partly fixed and partly variable. In
other words, semi-variable overhead costs vary in part with the volume of production
and in part they are constant, whenever there is a change in volume of production.
Examples are supervisory salaries, depreciation, repairs and maintenance, etc.
Fixed, variable and semi-variable costs have been explained in detail, with the help
of diagrams, in Chapter 1.
Importance of Classifying Costs into Fixed and Variable
The fixed-variable cost classification is of great importance in planning, decision making
and control as discussed below:
Overhead Cost
4.4
1. Preparation of budgets This classification helps in the preparation of budgets.
Forinstance, when flexible budgets are prepared for different levels of activity, the fixed
cost remains constant at all levels of activity, whereas variable cost varies according to
the actual level of output.
2. Decision making As most problems of decision making relate to changes in
volume, this classification acquires a special importance in managerial decision
making. This is so because fixed and variable costs behave in different ways when
volume of output changes.
3. Control of costs From control point of view, cost may be controllable or
uncontrollable. The fixed costs are mostly uncontrollable and if any control can be
exercised, it can be done by the top management. Variable costs, on the other hand,
are mostly controllable. For example, rent of building (fixed) is not easily controllable
but cost of materials (variable) may be controlled by purchasing in economical lots,
seasonal purchasing, etc. Classifying costs into fixed and variable, therefore, helps
in the effective control of costs by pointing out where management should concentrate
to control costs.
4. Marginal costing and break-even analysis This technique is totally dependent
on segregation of cost into fixed and variable.
5. Absorption of overheads By classifying costs into fixed and variable, separate
rates of absorption of overheads may be used for fixed and variable overheads. The
under/over-absorption arising out of two types of overheads are different in nature and
need different managerial action. For example, under-absorption of fixed overheads
means the existence of surplus or idle capacity so suitable steps may be taken to
effectively utilize idle capacity.
6. Other uses In addition to points stated above, fixed-variable cost classification
is useful in many other areas. For example, while planning capital expenditure, effect
of the proposed project on total fixed and variable costs should be studied. Moreover,
differential and comparative cost analysis are based on this classification.
SEGREGATION OF SEMI-VARIABLE COSTS
The main purpose of classifying overhead costs into fixed and variable is to help the
management in decision making and control of expenditure As such, the semi-variable
costs may present some problems and thus the cost accountant must split them into
fixed and variable components. In other words, the extent to which an item of semifixed or semi-variable cost is fixed or variable has to be determined. The following
methods are used for this purpose:
1. High and Low Points Method
Under this method, semi-variable costs at various level of output are considered The
difference between the highest and the lowest volume of output and the difference
between the corresponding costs are worked out. Then the variable element per unit
of output is calculated by applying the following formula:
Variable element per unit =
Difference in semi-variable costs (` )
Difference in output (units)
4.5
Overhead Cost
Illustration 4.1
Segregation of Semi-variable Costs into fixed and variable elements.
Month
Output (units)
Semi-variable cost ( ` )
January
February
March
April
May
June
80
40
120
160
200
140
2,200
1,600
2,800
3,400
4,000
3,100
Solution
Highest production is 200 units in May and lowest is 40 units in February.
Thus:
Output
Semi-variable cost
units
`
May
200
4,000
February
40
1,600
Difference
Variable element per unit =
160
2,400
` 2,400
= `15 per unit.
160 units
Variable element in February
Fixed element in February
= 40 units × `15 = `600.
= Semi-variable cost – Variable cost
= 1,600 – 600 = `1,000
Thus, out of a total semi-vartable cost of `1,600 in February, fixed element is `1,000
and variable element `600.
In this way fixed and variable contents in semi-variable cost can be calculated for
each of the six months.
2. Method of Averages
Under this method, data given is divided into two parts. In the Illustration 4.1, it may
be divided into: first part—January to March and second part—April to June. (If data
given is for, say, seven months, then the middle month may be ignored). Then average
of output and cost is separately computed for these two parts. Variable element in the
cost is then calculated by the following method:
Variable element per unit =
Difference in the average costs
Difference in average output
Using data given in Illustration 4.1, calculations are made as follows:
First average
(Jan., Feb., March)
Output (units)
(80 + 40 + 120) ÷ 3=80
Semi-variable cost
(2,200 + 1,600 + 2,800)
÷ 3 = `2,200
Second average
(April, May, June)
Output (units) Semi-variable cost
(160 + 200 + 140)
(3,400 + 4,000
÷ 3 = 500/3
+ 3,100) ÷ 3
= `3,500
Overhead Cost
4.6
`3,500  2, 200
= `15
500 3  80
Variable element in January = 80 units × `15 = `1,200
Fixed element in January
= 2,200 – 1,200
= `1,000
In this way, these may be calculated for each month.
Variable element per unit
=
3. Scatter Diagram Method
This is a graphic method. Under this method, the semi-variable costs incurred at levels
of output are plotted on a graph, the X-axis of which represents the volume of production
and Y-axis, the amount of expenditure. After plotting the points on the graph, a straight
line is drawn in such a way as to represent an average of all those points. This is known
as the line of best fit or line of regression. The point where this line of best fit
interacts the X-axis, marks the fixed cost. A line from this point is drawn which is parallel
to X-axis. This is fixed cost line (shown as dotted line in Fig. 4.2). The difference
between semi-variable cost line and fixed cost line represents variable component.
The following graph is prepared with the data given in Illustration 4.1.
Semi-variable cost (`’000)
6
5
4
3
Lin
e
b
of
es
t fi
i
em
t (S
-va
ria
ble
co
sts
)
Variable element
2
1
Fixed element (`1,000)
40
80
120
Fig. 4.2
160
200
Output (in units)
240
280
Scatter diagram.
4. Simultaneous Equations Method
In this method, overhead costs are segregated by means of an equation. This equation
for a straight line is:
Y = mX + c
where
Y = Total semi-variable cost
X = Volume of output
c = Fixed cost
m = Slope of variable cost line, i.e., variable cost per unit of output.
Overhead Cost
4.7
For the purpose of separating fixed and variable components of the cost, the
overhead cost is determined at various levels of output and pairs of values of X and Y
are fitted in the above formula in order to compute the values of m and c. For example:
From the data in Illustration 4.1, we take any two months and find out fixed and
variable components.
Let us take January and February and make two equations.
Y = mX + c
For January 2,200 = 80 m + c
... (i)
For February 1,600 = 40 m + c
... (ii)
Subtracting equation (ii) from (i)
We get 600 = 40 m
600
m=
= 15
40
\ Variable cost per unit = `15
Put the value of m in equation (i), we get
2,200 = 80 × 15 + c
c = `1,000
Thus, fixed cost is `1,000 and variable cost in January is `1,200 (i.e., 2,200 – 1,000).
In this way, we can place the value of m in any month’s equation and derive the
variable and fixed components.
This method provides a simple and accurate means of separating fixed and variable
overhead costs.
STANDING ORDER NUMBERS (Codification of Overheads)
After overheads are classified, it is found useful to allot a number or symbol to each
group of expenses so that each such group is easily distinguished from others. Such
numbers or symbols are codes for overheads and are called standing order numbers.
Each standing order number denotes a particular type of expenditure so that items of
expenses of similar nature, as and when they are incurred, are appropriately classified
into one of these. A schedule or manual is maintained enlisting all standing order numbers.
There cannot be a standard list of standing order numbers as the number and type under
which overheads may be sub-grouped vary with the: (a) size of the factory; (b) type of
expenses; and (c) the extent of control necessary.
Utility
Use of code numbers is preferred to lengthy names of overhead items because of the
following reasons:
1. It is convenient to write a code number in place of an overhead item.
2. Use of code numbers helps in maintaining secrecy because item name is not
revealed at the time of posting and processing of cost data.
3. Clerical effort is reduced as length in description is minimized.
4. Coding is essential in mechanized accounting.
Overhead Cost
4.8
OVERHEADS DISTRIBUTION
Basic Problem
Direct costs are charged direct to the cost centres or cost units without difficulty. But
this is not possible in overhead costs. Distribution of overhead costs to cost units is one
of the most complex problems of cost accounting. This is because overhead costs cannot
be identified with individual cost units and there are no accounting means of exact
distribution. Therefore, such costs are analysed and distributed to various cost centres
and cost units on arbitrary basis. For example, it is not possible to exactly calculate the
amount of rent that should be charged to a particular cost unit and thus, it has to be
distributed on some arbitrary basis. The cost accountant is constantly searching for
equitable bases to distribute overhead costs to units and divisions of business enterprise
and quite often he needs to exercise his own judgement in this regard. For instance, he
may apportion rent to various departments of the factory on the basis of area occupied
by each such department. Similarly, labour welfare expenses may be apportioned on
the basis of number of workers in each department. The procedure of distribution of
overhead costs is discussed below.
Steps in Overheads Distribution
Unlike direct materials and direct wages, overheads cannot be charged to cost units
directly. The various steps taken for distribution of overhead costs are as follows:
1. Classification and collection of overheads
2. Allocation and apportionment of overheads to production departments and
service departments
3. Re-apportionment of service department costs to production departments
4. Absorption of overheads of each production department in cost units
These steps are explained in detail in the following sections.
COLLECTION OF OVERHEADS
The procedure of classification of production overheads and of assigning standing order
(code) numbers has already been discussed. Such classification and codification is prerequisite for the collection of overheads.
Production overheads should be collected under standing order numbers. The main
sources from which overhead costs are collected are as follows:
(a) Invoice—for collection of indirect expenses, like rent, insurance, etc.
(b) Stores Requisitions—for collection of indirect materials.
(c) Wages Analysis Sheet—for collection of indirect wages.
(d) Journal entries—for collection of those overhead items which do not result in
current cash outlay and need some adjustment, e.g., depreciation, charge in lieu
of rent, outstanding rent, etc.
ALLOCATION AND APPORTIONMENT OF OVERHEADS
(Primary Distribution)
Departmentalization of Overheads
After overhead costs have been collected under various standing order numbers, the
next step is to allocate and apportion the overheads to production and service
Overhead Cost
4.9
departments. Such allocation and apportionment is known as departmentalization or
primary distribution of overheads.
Departmentalization of overheads is the process of allocation and apportionment
of overheads to different departments or cost centres. For smooth and efficient working,
a factory is sub-divided into a number of departments, each of which denotes a particular
activity of the factory, e.g., purchase department, stores department, time-keeping
department, personnel department, crushing department and melting shop. These
departments are mainly of two types:
(a) Production departments; and
(b) Service departments.
These are discussed in the later pages.
Objectives of Departmentalization
Departmentalization of overheads serves the following purposes:
1. Ensures greater accuracy in cost ascertainment Departmentalization helps in
achieving greater accuracy by proper allocation and apportionment of overheads. For
accurate costing of each function or operation, overhead absorption rates should be
determined separately for each cost centre. This is possible only with the help of
departmentalization.
2. Control of overhead costs Effective control of overhead costs is possible because
departmentalization makes the incurrence of costs in a department or cost centre the
responsibility of someone who heads the department or the cost centre. Thus, with the
help of departmentalization, responsibility accounting can be effectively introduced for
control purposes.
3. Use of different methods of absorption Basis of absorption of overheads may
be different for different cost centres, e.g., machine hour rate may be suitable for one
cost centre whereas direct labour hour rate may be more appropriate for another cost
centre. Different basis may be used for different cost centres only when overheads
are departmentalized.
4. Valuation of work-in-progress Correct cost of work-in-progress cannot be
ascertained unless overheads are departmentalized.
5. Cost of service of departments Departmentalization helps in ascertaining the
cost of various service departments which is useful for making estimates and submitting
quotations for those items which make use of the services of various cost centres.
6. Forecasting and estimating Because of greater accuracy in cost ascertainment
and cost control, departmentalization ensures more accurate forecasting and estimating
and decision making.
Allocation
Certain items of overhead costs can be directly identified with a particular department
or cost centre as having been incurred for that cost centre. Allotment of such costs to
departments or cost centres is known as allocation. Thus, allocation may be defined as
‘the assignment of whole items of cost directly to a cost centre.’ In other words,
allocation is charging to a cost centre those overheads that result solely from the
existence of that cost centre. A point to be clearly understood is that allocation can be
made only when exact amount of overheads incurred in a cost centre is definitely known.
For example, rent cannot normally be allocated since rent is payable for the factory as
4.10
Overhead Cost
a whole and exact amount of rent for each department cannot be known. Indirect
materials, on the other hand, can be easily allocated to various departments in which
they are incurred. Other items which are allocated include indirect wages, overtime
and idle time cost, power (when sub-metres are installed in departments), depreciation
of machinery, supervision, etc.
In brief, in order that an overheads can be allocated, they should meet both of the
following conditions:
(a) The cost centre must have caused the overhead cost to be incurred; and
(b) The exact amount incurred in a cost centre must be known.
Apportionment
Certain overhead costs cannot be directly charged to a department or cost centre. Such
costs are common to a number of cost centres or departments and do not originate
from any specific department. Distribution of such overhead costs to various departments
is known as apportionment. Thus, apportionment may be defined as ‘the distribution
of overheads to more than one cost centre, on some equitable basis.’ In other words,
it is charging a fair share of an overhead cost to a cost centre. Where an item of
overhead cost is common to various cost centres, it is allotted to different cost centres
proportionately. Again taking the cases of rent, as it cannot be allocated, it is apportioned
to various departments on some equitable basis, i.e., in the ratio of area occupied.
Similarly salary of a general manager cannot be allocated wholly to any one department
as he attends in general to all the departments. It should, therefore, be apportioned to the
required departments on some equitable basis. Other items which generally cannot be allocated
but are apportioned include fire insurance, lighting and heating, time keeping expenses, canteen
expenses, medical and other welfare expenses, etc.
Distinction between Allocation and Apportionment
The distinction between allocation and apportionment is important to understand. As
seen above, the purpose of both cost allocation and cost apportionment is the
identification or allotment of items of cost to cost centres or cost units. However, the
main difference between the two procedures is that while allocation deals with whole
items of costs, apportionment deals with proportions of the items of cost. Allocation
is a direct process but apportionment may be made only indirectly and for which
suitable bases are to be selected. Whether an item of cost can be allocated or
apportioned does not depend upon the nature of cost but upon its relation with the
cost centres or cost units to which it is to be charged.
Overheads should always be allocated, as far as possible. If an overhead cost
cannot be allocated, it is apportioned. This involves finding some basis of apportionment
that will enable the overhead cost to be equitably distributed over various production
and service departments.
Production and Service Departments
Departments are classified into production and service departments. A production
department is one that is engaged in the actual manufacture of the product by changing
the shape, form or nature of material worked upon or by assembling the parts into finished
product. A service department, on the other hand, is one which is rendering a service
to production departments. It contributes in an indirect manner to the manufacture of
4.11
Overhead Cost
the product but it does not itself change the shape, form or nature of material that is
converted into the finished product. Examples are given here.
Production Departments
• Weaving department
• Spinning department
• Crushing department
• Mixing department
• Grinding department
• Annealing department
• Polishing department
• Finishing department
• Melting shop
Service Departments
• Purchasing department
• Stores department
• Time-keeping department
• Personnel department
• Inspection department
• Canteen
• Labour welfare department
• Internal transport department
• Accounting department
Principles of Apportionment
Apportionment of overheads to various production and service departments is based on
the following principles:
1. Service or use This is the most common principle of apportionment of overhead
costs. It is based on the theory that greater the amount of service or benefit received
by a department, the larger should be the share of the cost to be borne by that
department. For example, rent is apportioned to various departments according to the
floor space occupied; telephone cost according to the number of extension telephones
in each department, and so on.
2. Survey method This method is used for those overhead costs that are not directly
related to departments and whose remoteness necessitates an arbitrary distribution. For
example, salary of a general manager of a company may be apportioned on the basis
of the results of a survey which may reveal that 30% of his salary should be apportioned
to sales, 10% to administration and 60% to various producing departments. Similarly,
lighting expenses may be apportioned on the basis of a survey of the number of light
points, size, estimated hours of use, etc.
3. Ability-to-pay method This is based on the theory of taxation which holds that
those who have the largest income should bear the highest proportion of the tax
burden. In overhead cost distribution, those departments which have the largest income
may be charged with the largest amount of overheads. This method is generally
considered inequitable because it penalizes the efficient and profitable departments to
the advantage of inefficient ones.
Bases of Apportionment
The following are some of the common bases of apportionment of overheads:
Overhead cost
1.
(i) Rent and other building expenses
(ii) Lighting and heating
(iii) Fire precaution service
(iv) Air-conditioning
Bases of apportionment
Floor area or
volume of department
(Contd...)
Overhead Cost
4.12
2.
3.
(i) Fringe benefits
(ii) Labour welfare expenses
(iii) Time keeping
(iv) Personnel office
(v) Supervision
Number of workers
(i) Compensation to workers
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Fringe benefits
Direct wages
4.
General overheads
5.
(i) Depreciation of plant and machinery
(ii) Repairs and maintenance of
plant and machinery
(iii) Insurance of stock
Capital values
(i) Power/steam consumption
(ii) Internal transport
(iii) Managerial salaries
Technical estimates
6.
Direct labour hours, or
Direct wages, or Machine hours
7.
Lighting expenses
No. of light points, or Area
8.
Electric power
Horse power of machines, or
Number of machine hours, or
Value of machines
9.
(i) Material handling
(ii) Stores overheads
Weight of materials, or Volume of
materials, or Value of materials
It should be noted that some overheads in the above list can be apportioned on
more than one basis. The choice of an appropriate basis is really a matter of judgement.
For example, welfare expenses may be apportioned on the basis of number of employees
or total wages. Similarly lighting expenses may be apportioned on the basis of number
of light points in each department or on the basis of floor area.
For allocation and apportionment of overheads, a statement called of ‘Overheads
Distribution Summary’ is prepared as shown in Illustration 4.2.
Illustration 4.2 Mosich Co. Ltd, has three production departments A, B and C and two
service departments D and E. The following figures are extracted from the records of
the company:
`
`
Rent and rates
5,000
General lighting
600
Indirect wages
1,500
Power
1,500
Depreciation of machinery
10,000
Sundry expenses
10,000
The following details are further available.
Floor space (sq. ft.)
Light points
Direct wages (`)
H.P. of machines
Value of machinery (`)
Total
20,000
120
10,000
150
2,50,000
A
4,000
20
3,000
60
60,000
B
C
5,000
6,000
30
40
2,000
3,000
30
50
80,000 1,00,000
D
4,000
20
1,500
10
5,000
E
1,000
10
500
—
5,000
4.13
Overhead Cost
Apportion the costs to various departments on the most equitable basis and prepare
Overhead Distribution Summary.
Solution
Overheads Distribution Summary
Items
deptts.
Basis of
apportionment
Total
Producing deptts.
Service
A
`
B
`
C
`
D
`
E
`
Actual
2,000
Floor space
5,000
Light points
600
Direct wages
1,500
H.P. of machines 1,500
Value of
machines
10,000
Direct wages
10,000
—
1,000
100
450
600
—
1,250
150
300
300
—
1,500
200
450
500
1,500
1,000
100
225
100
500
250
50
75
—
2,400
3,000
3,200
2,000
4,200
3,000
200
1,500
200
500
30,600
7,550
7,200
9,650
4,625 1,575
`
Direct wages
Rent and rates
General lighting
Indirect wages
Power
Depreciation of
machinery
Sundry expenses
Total
Note: It should be noted that direct wages have been charged only for service departments because for
service departments, all costs are indirect.
RE-APPORTIONMENT OF SERVICE DEPARTMENT COSTS
(Secondary Distribution)
Once the overheads have been allocated and apportioned to production and service
departments and totalled, the next step is to re-apportion the service department costs
to production departments. This is necessary because our ultimate objective is to charge
overheads to cost units, and no cost units are produced in service departments.
Therefore, the costs of service departments must be charged to production departments
which directly come in contact with cost units. This is called secondary distribution.
The method of re-apportionment of service department costs is similar to
apportionment of overheads discussed earlier. Some of the important bases of
apportionment of service department costs to production departments are as follows:
Service department
1. Store-keeping department
2. Purchase department
3. Time-keeping department and payroll
department
4. Personnel department
5. Canteen, welfare and recreation
services
Bases of apportionment
Number of material requisitions, or value/
quantity of materials consumed in each
department
Value of materials purchased for each
department, or number of purchase orders
placed
Number of employees, or total labour or
machine hours
Rate of labour turnover, or number of
employees in each department
Number of employees, or total wages
(Contd...)
Overhead Cost
4.14
6. Maintenance department
7. Internal transport service
Number of hours worked in each department
Value or weight of goods transported, or
distance covered
Direct labour hours or machine operating
hours
No. of drawings made or man hours worked
8. Inspection department
9. Drawing office
Thus, the costs of service departments are apportioned on the basis of service
rendered, i.e., the benefits received by the beneficiary departments.
The various methods of apportionment of service department costs are summarized
in the following chart:
Apportionment of Service Department Overheads
Apportionment to
production departments only
Apportionment to production
and other service departments
Non-reciprocal
Simultaneous
equations methods
Fig. 4.3
Reciprocal
Repeated
distribution method
Trial and
error method
Distribution of service department overheads.
Apportionment to Production Departments Only
In this case, cost of each service department is apportioned only to production
departments without apportioning it to other service departments.
Illustration 4.3 The following data were obtained from the books of S N Engineering
Company for the half-year ended 30 September 2021. Prepare a Departmental Distribution
Summary.
Production departments
Direct wages
Direct materials
Employees
Electricity
Light points
Assets values
Area occupied
`
`
No.
kWh
No.
`
sq. yds.
Service departments
A
B
C
X
Y
7,000
3,000
400
8,000
10
50,000
800
6,000
2,500
300
6,000
15
30,000
600
5,000
2,000
300
6,000
15
20,000
600
1,000
1,500
100
2,000
5
10,000
200
1,000
1,000
100
3,000
5
10,000
200
4.15
Overhead Cost
The overheads for 6 months were as under:
`
Stores overhead
400
Depreciation
Motive power
1,500
Repairs and maintenance
Electric lighting
200
General overheads
Labour welfare
3,000
Rent and taxes
`
6,000
1,200
10,000
600
Apportion the expenses of Department X in the ratio of 4 : 3 : 3 and that of
department Y in proportion to direct wages, to departments A, B and C, respectively.
Solution
Overheads Distribution Summary
Basis of
apportionment
Total
Item
Direct wages
Actual
Direct materials
Actual
Stores overheads Direct materials
Motive power
kWh
Lighting
No. of points
Labour welfare
No. of employees
Depreciation
Assets value
Repairs and
maintenance
Assets value
General
overheads
Direct wages
Rent and taxes
Area occupied
Total
Department X
4 : 3 : 3 (Given)
Department Y
Direct wages (7 : 6 : 5)
Total
Production dept.
Service dept.
`
A
`
B
`
C
`
X
`
Y
`
2,000
2,500
400
1,500
200
3,000
6,000
—
—
120
480
40
1,000
2,500
—
—
100
360
60
750
1,500
—
—
80
360
60
750
1,000
1,000
1,500
60
120
20
250
500
1,000*
1,000*
40
180
20
250
500
1,200
500
300
200
100
100
10,000
600
27,400
3,500
200
8,340
1,640
1,416
3,000
150
6,220
1,230
1,213
2,500
150
5,100
1,230
1,011
500
50
4,100
(–) 4,100
500
50
3,640
27,400
11,396
8,663
7,341
—
(–) 3,640
—
*Note: Direct wages and direct materials of service departments are indirect costs.
Apportionment to Production as well as Service Departments
Quite often, a service department renders services not only to production department
but also to other service departments. For example, maintenance department looks after
not only the plant and machinery of production department but also the equipment of
other service departments like power house, material handling, etc. Similarly, power house
supplies electricity not only to production departments but also to service departments
like canteen, maintenance departments, etc.
This type of inter-service department apportionment may be either on reciprocal
basis or non-reciprocal basis.
Apportionment on non-reciprocal basis (Step-ladder Method) This method is
used when a service department renders services to other service departments but does
not receive services of the other service departments, i.e., when service departments
are not inter-dependent. In this method, the service departments are arranged in
Overhead Cost
4.16
descending order of their serviceability. The cost of the most serviceable department,
i.e., the department which serves the largest number of departments is first apportioned
to other service departments. The service department which serves the next largest
number of departments is taken up next and its cost (including the prorated cost of the
first service department) is apportioned to other service and production departments
excepting the first service department. In the same way, while apportioning the cost of
the third service department in this order, the first two service departments are ignored.
This process is continued till the cost of the last service department is apportioned. It
should be noted that the cost of the last service department is apportioned only to
production departments.
Illustration 4.4 Madras Manufacturing Ltd has three departments, which are regarded
as production departments. Service departments, costs are distributed to these production
departments using the ‘Step ladder Method’ of distribution. Estimates of factory overhead
costs to be incurred by each department in the forthcoming year are as follows. Data
required for distribution is also shown against each department:
Department
Production:
X
Y
Z
Service:
P
Q
R
S
Factory overhead
`
Direct labour
hours
No. of
employees
Area in
sq. m.
1,93,000
64,000
83,000
4,000
3,000
4,000
100
125
85
3,000
1,500
1,500
45,000
75,000
1,05,000
30,000
1,000
5,000
6,000
3,000
10
50
40
50
500
1,500
1,000
1,000
The overhead costs of the four service departments are distributed in the same order,
viz., P, Q, R and S respectively on the following bases:
Department
P
Q
R
S
Basis
—
—
—
—
Number of employees
Direct labour hours
Area in square metres
Direct labour hours
You are required to prepare a schedule showing the distribution of overhead costs
of the four service departments to the three production departments.
(CA Inter)
—
—
—
Cost of Dept. ‘R’ Area
Cost of Dept. ‘S’ Labour hours
Total
24,000
4,000
1,05,000
`
R
—
—
— (–) 66,000
19,000
12,000
5,000
30,000
`
S
18,000
28,500
12,000
12,500
64,000
`
Y
24,000
28,500
16,000
8,500
83,000
`
Z
3,00,000 1,35,000 1,60,000
24,000
57,000
16,000
10,000
1,93,000
`
X
Production Deptts.
Note: Students should note that in the Service Deptts. column, ‘steps’ are formed. This is the reason why this method
is known as ‘Step Ladder Method’.
—
—
— (–) 1,33,000
— (–) 80,000
Cost of Dept. ‘Q’ Labour hours
5,000
`
`
Cost of Dept. ‘P’ No. of employees(–) 45,000
Q
P
Service Deptts.
75,000
Basis of
apportionment
45,000
Overhead costs
Items
Overhead Distribution Summary
Service department P is the most serviceable department, i.e. it renders services to the largest number of production as well as other service
departments. It does not receive any service from other service departments. Therefore, cost of `45,000 of service department P is
apportioned to all other departments in the ratio of number of employees. The next most serviceable department is Q which renders its
services to all other departments except P. Therefore, its cost of `80,000, i.e. `75,000 + `5,000 (apportioned share of dept. P) is apportioned
to all departments except service department P. Then R department’s cost is apportioned to all departments except P and Q and lastly cost
of department S is apportioned to only production department. as given below:
Solution
Overhead Cost
4.17
Overhead Cost
4.18
Apportionment on reciprocal basis This method is used when service departments
are mutually dependent. This means a service department not only provides its services
to other service departments but also receives services of other service departments.
For example, boiler house and pump room are the two service departments. Boiler house
has to depend upon pump room for supply of water and pump room has to depend upon
the boiler house for supply of steam power for driving the pump. Thus, both boiler house
and pump room depend upon each other for their services.
The following methods may be used for apportionment of overhead costs on a
reciprocal basis:
1. Simultaneous Equations Method
2. Repeated Distribution Method
3. Trial and Error Method
1. Simultaneous Equations Method In this method, the following algebraic
equations help in finding out cost of service departments.
X = a + bY
Y = a + bX
This is illustrated below.
Illustration 4.5 The following particulars relate to ADM Manufacturing Company which
has three production departments A, B and C and two service departments X and Y.
Departments
A
B
C
X
Y
Total overheads as per
primary distribution `
6,300
7,400
2,800
4,500
2,000
The Company decided to apportion the service department costs on the following
percentages:
A
B
C
X
Y
X
40%
30%
20%
—
10%
Y
30%
30%
20%
20%
—
Find the total overheads of production departments using simultaneous equations
method.
Solution
Let X denote the total overheads of service deptt X
Y denote the total overheads of service deptt Y
X = a + bY
...(i)
Y = a + bX
...(ii)
where
a = Overheads of a department before re-apportionment
b = Share of overheads of one service department to be
distributed to the other.
Thus
X = 4,500 + 20% of Y
...(i)
Y = 2,000 + 10% of X
...(ii)
or
X = 4,500 + 0.2Y
...(i)
Y = 2,000 + 0.1X
...(ii)
4.19
Overhead Cost
To solve the equations, re-arrange these and multiply by 10 to eliminate decimals.
10X –
2Y = 45,000
...(i)
–X + 10Y = 20,000
…(ii)
Again multiplying equation (ii) by 10 and adding
10X –
2Y = 45,000
...(i)
–10X + 100Y = 2,00,000
…(ii)
By adding, we get
98Y = 2,45,000
2,45,000
98
Y = 2,500
Putting the value of Y in equation (i), we get
X = 4,500 + 20% of 2,500
X = 5,000
Thus,
X = 5,000, and Y = 2,500
These amounts, i.e., `2,500 and `5,000 are then apportioned to production
departments in the specified percentages.
Y=
Secondary Distribution Summary
Total
Production departments
`
A
`
B
`
C
`
Total as per primary summary
16,500
6,300
7,400
2,800
Department X (90% or 5,000)
4,500
2,000
1,500
1,000
Department Y (80% of 2,500)
2,000
750
750
500
Total
23,000
9,050
9,650
4,300
Note: The amount of service deptt X to be distributed to production departments A, B and C is only
90% as the remaining 10% belongs to service deptt Y. Similarly, only 80% of service deptt Y is
to be distributed to A, B and C.
This method of simultaneous equations gives accurate results. But when the number
of service departments exceeds two, calculations become cumbersome.
2. Repeated Distribution Method In this method the following steps are taken
to apportion the service departments costs:
(a) The costs of the first service department are apportioned in the normal way
according to the given percentages. This will close the account of the first
service department.
(b) Then apply the given percentages for the apportionment of second service
department costs which include their own cost plus amount apportioned from
the first service department. This closes the account of the second service
department but reopens the account of the first service department.
(c) The same procedure should be followed in the case of all other service
departments. This completes the first cycle of apportionment.
Overhead Cost
4.20
(d) The procedure should be repeated again starting with the first service department
whose total now consists only of amounts apportioned from other service
departments. In this way, service department costs keep on reducing with each
cycle of distribution because each time, a substantial amount is charged to the
production departments.
(e) This process is continued until the amounts involved become insignificant.
Example. Illustration 4.5 is solved below with Repeated Distribution Method.
Repeated Distribution Method:
Secondary Distribution Summary
Items
Total as per primary distribution
Department X
Department Y
Department X
Department Y
Department X
Total
Production deptts.
Service deptts.
A
`
B
`
C
`
X
`
Y
`
6,300
1,800
735
196
15
4
7,400
1,350
735
147
15
3
2,800
4,500
2,000
900 (–) 4,500
450
490
490 (–) 2,450
98
(–) 490
49
10
9
(–) 49
2
(–) 9
—
9,050
9,650
4,300
—
—
Working Notes:
In the above solution, first of all the cost of service department X is apportioned to A, B, C and Y in the
ratio given. Then the cost of service department Y, `2,450 (i.e. 2,000 + 450) has been apportioned to
department A, B, C and X in the given percentage. The account of department X is again open with `490
which is distributed to A, B, C and Y in the given ratio. Then `49 allotted to department Y is distributed
to departments A, B and C and X. Then `9 allotted to department X is distributed to A, B and C. Nothing
has been allotted to department Y as the share of department Y is quite negligible. In this way the entire
costs of service departments X and Y are apportioned to production departments A, B and C.
It should be noted that unlike Simultaneous Equations Method, this method produces
approximate results. But the advantage of this method is that it can be conveniently
applied where the number of service departments is more than two.
3. Trial and Error Method In this method the cost of first service department is
apportioned to other service departments only in the given percentage. The cost of the
second service department then is apportioned to the first and other service
departments. In this way, when the cost of all service departments has been
apportioned, the process is repeated till the service department costs are reduced to
negligible amounts. In this way, the total cost of each service department is found
out by trial and error.
Example. Taking the figures of Illustration 4.5, Trial and Error Method is applied
here.
4.21
Overhead Cost
Computation of Service Department Costs
Service departments
X
`
Y
`
Total as per primary summary
Service Dept. X (10% to Y)
Service Dept. Y (20% of 2,450 i.e. 2,000 + 450)
Service Dept. X (10% to Y)
Service Dept. Y (20% to X)
Service Dept. X (10% to Y)
4,500
—
490
—
10
—
2,000
450
—
49
—
1
Total
5,000
2,500
Thus, the total costs of service departments X and Y are `5,000 and `2,500,
respectively. Now a Secondary Distribution Summary can be prepared in the same way
as was done in Simultaneous Equations Method.
It will be seen that this is a modification of repeated distribution method where
production departments are initially ignored for the purpose of redistribution. Like
Repeated Distribution Method, this method may also give approximate results.
It is important to note that all the three methods have produced the same result.
Illustration 4.6 A company has three production departments and two service
departments. Distribution summary of overheads is as follows:
Production departments
Service departments
A
`3,000
1
`234
B
`2,000
2
`300
C
`1,000
The expenses of service departments are charged on a percentage basis which is as
follows:
A
B
C
1
2
1.
20%
40%
2.
40%
20%
30%
—
10%
20%
20%
—
Find out the total overheads of production departments using the following methods:
(a) Simultaneous Equations Method (b) Repeated Distribution Method
Solution
(a) Simultaneous Equations Method
Let
x denote total overheads of service department 1
y denote total overheads of service department 2
Therefore,
x = 234 + 0.2y
y = 300 + 0.1x
…(i)
…(ii)
To solve the equations, re-arrange these and multiply by 10 to eliminate decimals.
Overhead Cost
4.22
10x –
2y = 2,340
– x + 10y = 3,000
Multiplying second equation by 10 and adding
10x –
2y = 2,340
– 10x +
…(i)
…(ii)
100y = 30,000
98y = 32,340
y = 32,340 ÷ 98
y = 330;
and x = 300
Secondary Distribution Summary
Production departments
Total
Rs
A
`
B
`
C
`
Total as per primary summary
Service Dept. 1 (90% of 300)
Service Dept. 2 (80% of 330)
6,000
270
264
3,000
60
132
2,000
120
66
1,000
90
66
Total
6,534
3,192
2,186
1,156
(b) Repeated Distribution Method
Production deptts.
Items
Total as per primary summary
Service Dept. 1
Dept. 2
Dept. 1
Dept. 2
Total
Service deptts.
A
`
B
`
C
`
X
`
Y
`
3,000
47
129
14
2
2,000
94
65
25
2
1,000
70
65
19
2
234
(–) 234
64
(–) 64
—
300
23
(–) 323
6
—
3,192
2,186
1,156
—
—
ABSORPTION OF OVERHEADS
Once departmentalization of overheads has been completed, the total cost of each
production department comprises the following:
(i) Costs allocated and apportioned to production departments.
(ii) Costs of service departments re-apportioned to production departments.
The total overhead cost pertaining to a production department or cost centre is then
charged to or absorbed in the cost of the products or cost units passing through that
centre. This is known as absorption.
The absorption of overheads is the last step in the distribution plan of overheads.
It is defined as charging of overheads to cost units. In other words, overhead
absorption is the apportionment of overheads of the cost centres over cost units.
Absorption of overheads is also known as levy, recovery or application of overheads.
There are two steps in the absorption of overheads:
4.23
Overhead Cost
1. Computation of overheads absorption rate; and
2. Application of these rates to cost units.
1. Computation of Overheads Absorption Rate Absorption rates are computed
for the purpose of absorption of overheads in costs of the cost units. There are mainly
six methods for determining absorption rates which have been described later in this
chapter. In all these methods, the overhead rate is computed by dividing the total amount
of overheads of department or cost centre by the number of units in the base, such as
number of cost units, machine hours, labour hours, direct labour cost, price cost, etc.
This is shown below:
Total overheads of cost centre
Total units in base
It should be noted that only one rate is computed for any single group of overheads.
Overheads absorption rate =
2. Application of rates to cost units In order to arrive at the overhead cost of
each cost unit, the overhead rate is multiplied by the number of units of base in the
cost unit. Thus:
Overhead absorbed = No. of units of base in the cost unit × Overhead rate
For example, machine hour rate is `25 and a cost units has used 12 hours of the
machine, overheads absorbed will be = 12 hours × `25 = `300.
Methods of Absorption of Production Overheads
Various methods of absorption discussed below are used to determine the overheads
absorption rate for production overheads.
1. Direct Materials Cost
Methods of Absorption
Percentage Rate Under this
1. Direct material cost percentage rate
method, the amount of overheads to
2. Direct labour cost percentage rate
be absorbed by a cost unit is
3. Prime cost percentage rate
determined by the cost of direct
4. Direct labour hour rate
materials consumed in producing it.
5. Machine hour rate
This rate is computed by dividing the
6. Rate per unit of output
total overheads by the total cost of
direct materials consumed in the
department. Thus,
Overhead rate =
Production overheads
× 100
Direct materials
Example Production overheads
`40,000
Direct materials
`200,000
40,000
Overhead rate =
× 100 = 20%
200,000
Thus, if the direct material cost of a job or cost unit is `1,200, the overheads to be
absorbed by it will be `240, i.e., 20% of `1,200.
Advantages The main advantages of this method are:
1. Calculation of this rate is simple because cost of direct materials is readily
available and no additional records are required to be maintained for this purpose.
Overhead Cost
4.24
2. This method produces fairly accurate rates where material prices do not
fluctuate widely and where output is uniform, i.e., only one type of article is
produced using the same raw material.
Disadvantages The disadvantages of this method are:
1. Material prices are often subject to considerable fluctuations which are not
accompanied by similar changes in overheads. This causes misleading results.
2. This method is quite illogical and inaccurate because overheads are in no way
related to the cost of materials consumed. The amount of overheads does not
change because the work is being done on copper instead of iron. Both metals
are quite different in prices and by applying the same percentage for both will
obviously be incorrect.
3. This method ignores the importance of time factor that two jobs using the same
raw materials would absorb the same amount of overheads even though one
may occupy a machine fur much longer period than the other.
4. This method does not distinguish between work done by machines and manual
labour and also between work done by skilled and unskilled workers.
2. Direct Labour Cost Percentage Rate The overhead rate under this method is
computed by dividing the production overheads by the direct labour cost.
Production overheads
× 100
Direct labour cost
Production overheads = `40,000
Direct labour cost
= `1,00,000
Overhead rate =
Example
40,000
× 100 = 40%
1,00,000
Thus a job for which direct wages are `200 will absorb production overheads of
`80, i.e., 40% of `200.
Advantages The main advantages of this method are:
1. It gives stable results as labour rates are far more constant than material prices.
2. Automatic consideration is given to the time factor, as higher the charge to a
job for wages, the longer will have been the time spent on that job.
3. This method is simple and easy to use as all the data required are easily available
without keeping any extra records.
4. This method can be used with advantage where rates of workers are same,
where workers are more or less of equal skill and where types of work
performed by workers is uniform.
Overhead rate =
Disadvantages This method suffers from the following defects:
1. When workers are paid on piece basis, inaccuracies are likely to creep in due
to the time factor not being given full consideration. The question of overtime
also disturbs the position because higher rates are payable for overtime.
2. No distinction is drawn between work done by skilled and unskilled workers.
As unskilled workers take more time and utilize factory facilities for a longer
period, their work should bear a higher charge for factory overheads. But reverse
happens in the case of this method because work done by skilled workers has to
absorb larger amount of overheads as they are paid at a higher rate.
4.25
Overhead Cost
3. It also does not distinguish between production of hand workers and that of
machine workers. Machines give rise to certain overheads like depreciation,
power, etc., which should be charged only to the work done on machines.
3. Prime Cost Percentage Rate This method is based on the premise that both
materials and labour give rise to factory overheads and thus the total of the two, i.e.,
prime cost should be taken as the base for absorption of factory overheads. In a way,
this is a combination of the material cost and labour cost methods.
Overhead rate in this method is calculated by dividing the production overheads by
prime cost.
Overhead rate
=
Production overheads
×100
Prime cost
= `40,000
= `2,50,000
40,000
× 100 = 16%
Overhead rate
=
2,50,000
Thus, if prime cost of a job is `500, production overheads to be absorbed by that
job should be `80, i.e., 16% of `500.
The advantages and limitations of this method are more or less the same as those
of material cost and labour cost methods discussed earlier.
Although overheads are related more to labour cost than material costs, this method
gives equal importance to both material and labour. When the cost of materials is
predominating item of prime cost, the time factor will be ignored. This is shown below:
Example
Production overhead
Prime cost
Direct materials
Direct labour @ ` 5 per hour
Prime Cost
Production overhead (40% of prime cost)
Works Cost
Job I
`
1,000
100
1,100
440
1,540
Job II
`
100
1,000
1,100
440
1,540
It is seen that although Job II takes much longer time than Job I, the charge to
both the jobs for production overheads is the same. The above illustration also shows
that this method is likely to degenerate into either material cost method or labour cost
method. This is because in Job I direct material is the main constituent of prime cost
and in Job II labour cost is the main constituent but the charge to both the jobs is the
same.
4. Direct Labour Hour Rate This is a rate per hour and not a percentage rate. It is
obtained by dividing the total production overheads by the total number of direct labour
hours for the period.
Production overhead
Overhead rate =
Direct labour hours
Example
Production overhead
Direct labour hours
Overhead rate
= `40,000
= 50,000 hours
` 40,000
=
= 80 paise per hour
50,000 hours
Overhead Cost
4.26
Thus, if a job takes 20 labour hours for production, `16 (i.e., 20 hours @ 80 paise)
will be charged to that job for production overhead.
Advantages Direct labour hour rate method has the following advantages:
1. It gives full consideration to time factor.
2. This method gives very satisfactory results in majority of cases, except where
machinery represents the predominating factor of production.
3. This is not affected by the method of wage payment, i.e., time rate or piece
rate system.
Disadvantages This method suffers from the following disadvantages:
1. This method necessitates the recording and analysing of time spent on each job by
each worker and thus involves additional clerical labour.
2. It does not take into account factors other than labour.
In brief, this is an all round method as it ensures precise costing and affords better
opportunities for exercise of control. The use of this method is recommended unless
there is a reason for selecting a different one.
In order to eliminate the effect of seasonal fluctuations, it is desirable to calculate
the labour hour rate for a period of one full year.
Illustration 4.7 Aggarwal and Co. has three production departments—A, B and C and
one service department S. The following particulars are available for one month of 25
working days of 8 hours each. All departments work all days with full attendance.
Total
Power and lighting
`1,100
Supervisor’s salary
`2,000
Rent
`500
Welfare
`600
Others
`1,200
Number of workers
10
Floor area in sq. ft.
500
Service rendered by service
department to production departments
Service
deptt.
S
Production
deptt.
A
Production
deptt.
B
Production
deptt.
C
240
20%
200
30%
300
30%
360
20%
200
30
600
200
40
800
400
20
600
400
50%
30%
20%
Calculate the 'Labour Hour Rate' of each of the departments A, B and C.
Solution
Computation of Labour Hour Rate
Power and lighting
Supervisor's salary
Rent (floor area)
Welfare (No. of workers)
Service
deptt.
S
`
Production
deptt.
A
`
Production
deptt.
B
`
240
400
100
60
200
600
120
180
300
600
160
240
Production
deptt.
C
`
360
400
120
120
(Contd...)
4.27
Overhead Cost
Others
Total
Share of Service deptt.
200
200
400
400
1,000
(–) 1,000
1,300
500
1,700
300
1,400
200
1,800
2,000
1,600
6,000
`0.30
8,000
`0.25
4,000
`0.40
(A) Total overheads
(B) Labour hours
(No. of days × Hrs. × No. of workers)
Labour Hour Rate (A) ÷ (B)
5. Machine Hour Rate Machine hour rate is the overhead cost of running a machine
for one hour. This rate is obtained by dividing the amount of factory overheads
apportioned to a machine by the number of machine hours for the period under
consideration.
Example Production overheads of Machine I
= `25,000
No. of machine hours = 2,000
Machine hour rate
=
25,000
Production overhead
=
= `12.50
2,000
No. of machine hours
If Machine I has been used for a job for 30 hours, overheads to be absorbed by
that job will amount to `375, i.e., 30 hrs × `12.50.
Computation of Machine Hour Rate
computation of machine hour rate:
The following steps are taken for the
(i) The factory overheads are first apportioned to production departments as
discussed earlier under allocation and apportionment.
(ii) Overheads of the department are further apportioned to different machines or
groups of machines. For this purpose each machine or a group of machines is
treated as a cost centre or a small department. Bases of apportionment of
different expenses are given here.
(iii) Specific overheads, like power, depreciation, etc., should be directly allocated
to the machine.
(iv) The overheads relating to the machine should be divided between (a) Fixed or
standard charges, and (b) Variable charges. Fixed charges are those which
remain constant irrespective of the use of the machine, e.g., rent, supervisor’s
salary, etc. Variable charges vary with the use of machines, e.g., power,
depreciation, etc.
(v) The working hours of a machine are estimated for the period.
(vi) Overheads pertaining to the machine are totalled and divided by the number of
effective machine hours. The resultant figure will be machine hour rate. The
time required for setting the machine (unless it is treated as producing time)
should be deducted from the total working hours to arrive at effective hours.
Treatment of depreciation Depreciation is a semi-variable item. In the
computation of machine hour rate, some accountants treat it as a fixed cost while
others treat it as a variable cost. In fact, whether it is to be treated as fixed or variable
cost, depends upon the method of computing depreciation. In this chapter, it has been
mostly treated as a variable item.
Overhead Cost
4.28
Bases of Apportionment of Different Overheads to Machines
Items of overheads
1. Rent and rates
2. Insurance
3. Supervision
4. Lighting
5 Depreciation
6. Repairs and maintenance
7. Lubricating oil and other
consumable stores
Basis of apportionment
Ratio of floor area occupied by each machine
Insured value of each machine
Estimated time devoted by the supervisor to each
machine
No. of light points used for each machine, or floor
area occupied by each machine
Capital values/machine hours or multiple of both
Capital values/machine hours
Capital values/machine hours
Comprehensive (or composite) machine hour rate When the direct wages of
machine operators are included in machine hour rate, it is known as comprehensive
machine hour rate. Thus in a comprehensive machine hour rate, overheads and direct
wages are absorbed by a single rate.
Advantages The main advantages of machine hour rate method are:
1. From costing point of view, this is an accurate method of absorption of
overheads.
2. It gives due consideration to the time factor and thus produces more equitable
results.
3. This is an ideal method of absorption where production is carried out on
machines.
4. When separate rates are calculated for fixed and variable overheads, the cost
of idle machines can be measured without difficulty.
Disadvantages This method suffers from the following limitations:
1. This method is not universally applicable and can be used only for those cost
centres where machine work is predominant.
2. Certain additional records like details of machine time taken by various jobs have
to be maintained which results in additional clerical labour.
3. Correct estimation of the number of machine hours much in advance of
production is quite a difficult task. Any wrong estimate in this regard will produce
misleading results.
Illustration 4.8 From the following information compute the machine hour rate in respect
of machine No. 10 for the month of January:
Cost of machine `32,000
Estimated scrap value `2,000
Effective working life 10,000 hours
Repairs and maintenance over the life period of machine `2,500
Standing charges allocated to this machine for January, `400
Power consumed by the machine @ `0.30 per unit, `600
The machine consumes 10 units of power per hour.
4.29
Overhead Cost
Solution
Computation of Machine Hour Rate
` per hr
2.00
Standing charges (400 ÷ 200*)
Variable Charges:
1. Repairs and Maintenance (` 2,500 ÷ 10,000 hrs)
2. Power (10 units @ 30 Paise)
 32,000  2,000 

3. Depreciation 
 10,000 hrs. 
0.25
3.00
3.00
Machine Hour Rate8.25
*Working Notes: No. of machine hours during the month of January is computed below:
No. of power units consumed in January = `600 ÷ `0.30 = 2,000 units
No. of machine hours = 2,000 units ÷ 10 units = 200 hours.
Illustration 4.9
The following particulars relate to a new machine purchased:
`
Purchase price of machine
4,00,000
Installation expenses
1,00,000
Rent per quarter
15,000
General lighting for the total area
1,000 p.m.
Foreman’s salary
30,000 p.a.
Insurance premium for the machine
3,000 p.a.
Estimated repairs for the machine
5,000 p.a.
Estimated consumable stores
4,000 p.a.
Power–2 units per hour at `50 per 100 units
Estimated life of the machine is 10 years and the estimated value at the end of the
10th year is `1 lakh. The machine is expected to run 20,000 hours in its life time. The
machine occupies 25 per cent of the total area. The foreman devotes 1/6 of his time for
the machine. Calculate the machine hour rate for the machine.
Solution
Computation of Machine Hour Rate
Standing Charges:
Rent (15,000 × 4 × 1/4)
Lighting (1,000 × 12 × 1/4)
Foreman’s salary (30,000 × 1/6)
Insurance premium
Total
Standing charges per hour (26,000 ÷ 2000 hrs.)
Variable Charges:
Per annum
`
15,000
3,000
5,000
3,000
26,000
Per hour `
13.00
` 4,00,000+1,00,000  1,00,000
20,000 hrs.
20.00
Repairs (`5,000 ÷ 2,000 hrs.)
Power (2 units @ `0.50)
Consumable stores (`4,000 ÷ 2,000 hrs.)
Machine Hour Rate
2.50
1.00
2.00
38.50
Depreciation
Overhead Cost
4.30
Illustration 4.10
The following information is given:
(i) The original cost of the machine used (purchased in June 2017) was `10,000. Its
estimated life is 10 years, the estimated scrap value at the end of its life is `1,000
and the estimated working time per year (50 weeks of 44 hours) is 2,200 hours,
of which machine maintenance, etc., is estimated to take up 200 hours.
(ii) Setting-up time of 100 hours is estimated.
(iii) Electricity used by the machine during production is 16 units per hour, at a cost
of 20 paise per unit. No current is taken during maintenance or setting up.
(iv) The machine requires a chemical solution which is replaced at the end of each
week at a cost of `20 each time.
(v) The estimated cost of maintenance per year is `1,200.
(vi) Two attendants control the operation of the machine together with five other
identical machines. Their combined weekly wages, insurance, and the employer’s
contributions to holidays pay amount to `120.
(vii) Departmental and general works overheads allocated to this machine for the year
2017 amount to `2,000.
Calculate machine hour rate when—
(a) Setting-up time is unproductive
(b) Setting-up time is productive
(B. Com. Hons. Delhi Adapted)
Solution
(a) When setting-up time is unproductive
Effective working hours are computed as shown below:
Annual working hours (50 × 44)
Less: Maintenance time
2,200 hrs
200 hrs
2,000 hrs
Less: Set-up time
100 hrs
Effective working hours
1,900 hrs
Machine hour rate has been computed on the basis of these 1,900 hours.
Computation of Machine Hour Rate
Per annum
`
Per hour
`
Standing Charges:
Departmental and general works overhead
2,000
Wages of attendants (`120 × 50 weeks) ÷ 6 machines
1,000
Total
3,000
Standing charges per hour (` 3,000 ÷ 1,900 hrs )
1.58
Variable Charges:
 `10,000  1,000 

Depreciation 
 1,900 hrs  10 years 
0.47
 ` 20  50 weeks 
Chemical 

1,900 hrs


0.53
(Contd...)
4.31
Overhead Cost
Maintenance (` 1,200 ÷ 1,900 hrs)
0.63
 1,900 hrs × 16 units × ` 0.20 

Electricity 
1,900 hrs


Machine Hour Rate
3.20
6.41
(b) When setting-up time is to be treated as productive
Effective hours will be 2,000 hrs, i.e., 2,200 hrs less 200 hrs for maintenance.
Computation of Machine Hour Rate
Per annum
`
Standing Charges:
Departmental and general works overhead
Wages of attendants (`120 × 50 weeks) ÷ 6 machines
Per hour
`
2,000
1,000
3,000
Standing charges per hour (`3,000 ÷ 2,000 hrs)
1.50
Variable Charges:
 `10, 000  1,000 
Depreciation 

 2, 000 hrs  10 years 
0.45
Chemical (`20 × 50 weeks) ÷ 2,000 hrs
0.50
 1, 900 hrs  16 units  ` 0.20 
Electricity 

2, 000 hrs


3.04
Maintenance (`1,200 ÷ 2,000 hrs)
0.60
Machine Hour Rates
Illustration 4.11
expenses.
6.09
A department has three machines. The figures indicate the departmental
`
12,000
2,880
4,000
800
6,000
6,000
800
4,200
Depreciation of machinery
Depreciation of building
Repairs to machinery
Insurance of machinery
Indirect wages
Power
Lighting
Miscellaneous expenditure
36,680
Direct wages `
Power units
Machine I
Machine II
Machine III
1,200
30,000
2,400
10,000
2,400
20,000
(Contd...)
Overhead Cost
4.32
Number of workers
Light points
Space sq. ft.
Cost of machine `
Hours worked
4
8
400
3,00,000
200
8
24
800
1,20,000
300
From the above information calculate:
(i) Simple machine hour rate
(ii) Composite or comprehensive machine hour rate
8
48
800
1,80,000
300
(ICWA Inter)
Solution
Computation of Machine Hour Rates
Items
Basis
Dep. of machinery
Dep. of building
Machine repairs
Insurance
Indirect wages
Power
Lighting
Misc. expenses
Machine value 1,2000
Space
2,880
Machine value
4,000
-do800
No. of workers 6,000
Power units
6,000
Light points
800
Direct wages
4,200
6,000
576
2,000
400
1,200
3,000
80
840
2,400
1,152
800
160
2,400
1,000
240
1,680
3,600
1,152
1,200
240
2,400
2,000
480
1,680
36,680
14,096
9,832
12,752
200
70.48
6.00
76.48
300
32.77
8.00
40.77
300
42.51
8.00
50.51
Total (A)
Total
`
Hours worked (B)
Machine hour rate (simple) (A ÷ B)
Wages per hour (Direct wages ÷ Hours)
Comprehensive machine hour rate
(including direct wages)
Machine I Machine II
`
`
Machine III
`
6. Rate per Unit of Output It is the simplest of all the methods. This rate is
determined by dividing the total overheads of a department by the number of units
produced.
Example
Production overheads
=
`22,000
No. of units produced
=
1,000
Amount of overheads
22,000
=
= `22 per unit
No. of units
1,000
Thus, each unit produced will absorb `22 for production overheads. Though this
method has the advantage of simplicity, but unfortunately it can be advantageously used
only when all the cost units produced are identical. Stated conversely, this method cannot
be applied where a number of products of different sizes, grades, qualities, etc., are
produced according to customer’s specifications and which consume different amounts
of time in production.
Overheads rate =
Illustration 4.12 Following particulars related to the production department of a factory
for the month of June.
4.33
Overhead Cost
Material used
`80,000
Direct wages
`72,000
Direct labour hours worked
20,000
Hours of machine operation
25,000
Overhead charges allocated to the department
`90,000
Cost data of a particular work order carried out in the above department during June
are given below:
Material used
`8,000
Direct wages
`6,250
Labour hours booked
3,300
Machine hour booked
2,400
What would be the factory cost of the work order under the following methods of
charging overheads.
(i) Direct labour cost rate
(ii) Machine hour rate
(iii) Direct labour hour rate
Solution
Computation of Factory Overheads Rates:
(i) Direct Labour Cost Rate:
(ii) Machine Hour Rate:
Overheads
90,000
× 100 =
× 100 = 125%
Direct wages
72,000
`90,000
Overheads
=
25,000 hrs
No. of machine hours
(iii) Direct Labour Hour Rate:
`90,000
Overheads
=
20,000 hrs
No. of labour hours
= `3.60 per hour
= `4.50 per hour
Statement of Factory Cost
Direct material
Direct wages
Prime Cost
Factory overhead:
(i) 125% of `6,250
(ii) @ `3.60 for 2,400 hrs
(iii) @ `4.50 for 3,300 hrs
Factory Cost
Direct labour cost
rate
`
Machine hour
rate
`
Direct labour
hour rate
`
8,000
6,250
14,250
8,000
6,250
14,250
8,000
6,250
14,250
7,812.50
—
—
22,062.50
—
8,640
—
22,890
—
—
14,850
29,100
TYPES OF OVERHEAD RATES
Overhead rates may be: (i) actual or predetermined; and (ii) blanket or multiple.
These are described below.
Overhead Cost
4.34
Actual and Predetermined Rates
Overheads absorption rate may be based on actual figures or estimated figures.
Actual Rate It is calculated by dividing the actual overheads by actual base.
Thus:
Actual overhead rate =
Actual amount of overheads
Actual base
On account of certain limitations of actual rate, it is not always desirable to use it
for the absorption of overheads. These limitations are:
1. Actual rate cannot be computed until the end of the accounting period. This
results in delay in computing cost.
2. When costs are used to calculate the selling prices for quotations and tenders,
there is bound to be a considerable delay before the sales department can invoice
customers due to delay in information from costing department.
3. Actual rate may vary from period to period due to fluctuations in the amount of
overheads, the volume of output and efficiency of operations. This makes
comparisons difficult.
4. These rates do not provide any basis for cost control.
Predetermined Rate This rate is determined in advance of the period in which it is
to be used. It is computed by dividing the estimated or budgeted amount of overheads
by the budgeted base. Thus:
Predetermined rate =
Budgeted amount of overhead
Budgeted base
As compared to actual rate, a predetermined rate is of greater practical utility. This
is because a predetermined rate enables prompt preparation of tenders and quotations
and fixation of selling prices. Cost control is also facilitated by comparing the actual
overheads with the predetermined overheads recovered. The use of predetermined rates
thus, helps in deriving some of the benefits of standard costing and budgetary control.
Blanket and Multiple Rates
A blanket overhead rate is a single overhead rate for the entire factory. It is computed
as follows.
Blanket rate =
Total overheads for the factory
Total number of units of base for the factory
Blanket overhead rate should not be used except when output is uniform. Otherwise
it will result in overcosting or undercosting of certain cost units. Moreover, when a
blanket rate is used, performance of individual departments or cost centres cannot be
properly assessed and exercise of control becomes difficult. Blanket rate is also known
as Plant-wide or Plant-wise rate.
Multiple rates means a number of separate rates for each department, cost centre,
etc. For instance, separate rates may be calculated for each of the following:
4.35
Overhead Cost
(a) Production department
(b) Service department
(c) Cost centre
(d) Product
(e) Fixed overheads and variable overheads
The following formula is used to calculate the multiple rates:
Overhead rate =
Overhead of department or cost centre
Corresponding base
Blanket rates have a very limited application and can be usefully employed in
(i) small firms, or (ii) when one single product is produced, or (iii) when a firm is
producing more than one product and all of these products pass through all the
departments and the incidence of overheads is uniform. Except in these situations, use
of blanket overhead rate may result in distortion of cost. The main disadvantages of
blanket rates are as follows:
1. The use of blanket rate gives misleading and erroneous results, particularly where
a firm is producing several products and all of theses products pass through a
number of production departments or cost centres.
2. When a blanket rate is used, performance of individual departments or cost
centres cannot be properly assessed and exercise of control becomes difficult.
3. The use of blanket rate may produce an erroneous work-in-progress valuation
because products included in work-in-progress might not have passed through
all the departments and if a blanket rate is charged for its valuation, the workin-progress will be over-valued to the extent of facilities not used in it.
Multiple rates are of more practical utility and should always be preferred over
blanket rate for the sake of accuracy and control.
Requisites of a Good Method of Absorption
A satisfactory method of absorption should have the following characteristics:
1. It should be simple and easy to operate.
2. It should give accurate results and provide an equitable basis for overheads
absorption.
3. Time factor should be given due consideration.
4. The method should distinguish between work done by skilled and unskilled
workers.
5. It should also make a distinction between work done by hand labour and
machines.
6. It should be economical in application and should not require maintenance of
unnecessary clerical records.
7. Multiple rates should be preferred to blanket rates.
Illustration 4.13 Billy & Co. is manufacturing pumps which pass through three
departments—Foundry, Machine shop and Assembling. The manufacturing expenses are
as follows:
Overhead Cost
4.36
Foundry
Machine
Assembling
Total
shop
`
`
`
`
Direct wages
10,000
50,000
10,000
70,000
Works overhead
5,000
90,000
10,000
1,05,000
The factory cost of manufacturing “X” type of pump is prepared by the company as
follows:
`
`
Material
16
Direct wages— Foundry
2
Machine shop
4
Assembling
2
8
Works overhead (150% of direct wages)
12
Total cost
36
It seems that there is some fallacy. Try to correct it.
Solution
It is apparent that the company has charged works overhead as a % of wages on the
basis of blanket (single) rate computed as follows:

Total works overhead
1,05,000
 100 
× 100 = 150%
Total direct wages
70,000
And here lies the fallacy. When information is available regarding various departments,
overhead absorption rates should always be computed separately for each department.
This will produce more accurate costs. The overhead rates for each of the department
will be as follows:
Foundry =
5,000
× 100 = 50%
10,000
Machine shop =
90,000
× 100 = 180%
50,000
Assembling =
10,000
× 100 = 100%
10,000
On the basis of the above overhead rates, revised cost sheet will appear as follows:
Revised Cost Sheet
`
Material cost
Direct wages—Foundry
Machine shop
Assembly
`
16.00
2
4
2
Prime Cost
Works Overhead:
Foundry—50% of direct wages of `2
Machine shop—180% of direct wages of `4
Assembling—100% of direct wages of `2
Correct Factory Cost
8.00
24.00
1.00
7.20
2.00
10.20
34.20
4.37
Overhead Cost
CAPACITY UTILIZATION AND OVERHEADS
Capacity of a factory refers to its ability to produce with the resources and facilities
available at its disposal. If, for instance, with all the resources of men, materials and
machines available at its command, a company can produce 500 units of a product per
day, the capacity of the factory is said to be 500 units of production per day. Plant
capacity may be expressed in terms of any of the following:
(a) Units of products For example tonnes of steel, meters of cable, number of
cars or scooters, number of passenger kilometres, etc.
(b) Production hours or machine hours For example, if in a factory there are
40 machines and each of these machines can be operated for 8 hours per day, the plant
capacity in terms of production hours will be 40 × 8 = 320 production hours per day.
Capacity Levels
The various types of capacity levels are:
1. Licenced Capacity It is the production capacity of the plant for which licence
has been issued by an appropriate authority.
2. Installed or Maximum Capacity This is the maximum production capability of a
plant which can be achieved only under perfect conditions, i.e., when there is no loss of
operating time. As some loss of time is bound to occur, this capacity can never be achieved
in practice and it is for this reason that it is also known as a Theoretical Capacity.
3. Practical Capacity Also known as operating capacity, this is the maximum capacity
less output or time lost due to unavoidable factors like plant repairs and maintenance,
setting up time, holidays, etc., and other normal losses.
4. Capacity Based on Sales Expectancy This is a capacity which is based on expected
sales and is determined after a careful study of the market conditions. A concern may
not be able to sell the entire output which it is capable of producing. This capacity level
is usually less than practical capacity because of lack of orders from the customers.
5. Actual Capacity This is the capacity actually achieved during a particular period.
This is known only after the period is over and may be below or above the practical
capacity or capacity based on sales expectancy.
6. Normal Capacity This is the long-term average of the capacity based on sales
expectancy. In other words, the concept of normal capacity is based on the average
utilization of plant capacity over a long period. An overhead rate based on normal
capacity does not fluctuate much because the long-term average levels out highs and
lows that occur in a business. Normal capacity is thus also known as average
capacity.
Capacity Levels and Overhead Rates
The capacity level that is selected for calculating the fixed overhead rate may
significantly affect the overhead absorption rate and thus affect the product cost and
selling price.
It was stated earlier that overhead rates can be actual or predetermined.
Determination of actual rates is based on the actual level of capacity and thus presents
no difficult. However, when predetermined rates are to be used, capacity level selected
will affect the overhead rate. For example, annual fixed overheads are `10 lakh and
annual capacity is 10,000 labour hours. The overhead rate for charging to the cost of
Overhead Cost
4.38
products is `100 per hour (i.e., `10 lakh ÷ 10,000 hours). Suppose there is a decline in
the demand and actual work done is only 8,000 labour hours, the revised overhead rate
will be `125 per hour (i.e., `10 lakh ÷ 8,000 hrs). If the demand falls further to work
only for 5,000 hours, the overhead rate will increase further to `200 per hour (i.e., `10
lakh ÷ 5,000 hours). It is thus recommended that companies use normal capacity level
to calculate overhead rate so that cost of products are not distorted by short-term
changes in demand. Overhead rates based on normal capacity provide a better
approximation of long-term average costs.
Illustration 4.14 A company has a maximum capacity of working 5,000 direct labour
hours, at 100 per cent capacity. Practical capacity is 90 per cent and normal capacity 80
per cent. At 100 per cent capacity, overheads are budgeted as follows:
`20,000
`10,000
Fixed overheads
Variable overheads
Show the effect of various capacity levels on the overhead absorption rates.
Solution
Effect of Various Capacity Levels on Predetermined
Overheads Absorption Rates
Maximum
capacity
Practical
capacity
Normal
capacity
Percentage of capacity utilisation
Direct labour hours
100%
5,000
90%
4,500
80%
4,000
Budgeted factory overhead:
Fixed
Variable
`
20,000
10,000
`
20,000
9,000
`
20,000
8,000
30,000
29,000
28,000
`
4.00
`
4.44
`
5.00
2.00
2.00
2.00
6.00
6.44
7.00
Total
Fixed overhead rate per direct labour hour
(Fixed overhead ÷ Labour hrs.)
Variable overhead rate per direct labour hour
(Variable overhead ÷ Labour hours)
Total overhead rate per direct labour hour
(Total overhead ÷ Labour hours)
In the above illustration, it should be noted that overhead rates are different at different
capacity levels due to the influence of fixed overheads. When actual capacity utilization
is lower, it results in under-absorption of overheads and vice versa; when actual capacity
utilization is higher, there is over-absorption of overheads.
Idle Capacity
Idle Capacity It is “the difference between installed capacity and the actual capacity
utilization when actual capacity utilization is less than installed capacity”.*
Abnormal Idle Capacity It is “the difference between practical capacity and actual
capacity utilization when actual capacity utilization is less than installed capacity.”*
4.39
Overhead Cost
Excess Capacity Utilization It is “the difference between installed capacity and the
actual capacity utilization when actual capacity utilization is more than installed
capacity.”*
*CAS-2 of Institute of Cost Accountants of India (ICAI)
Suppose maximum capacity of a plant = 500 units per day of 8 hrs each. Normal
loss of time is 10 per cent.
Practical capacity
= Maximum capacity – Normal loss of time
= 100% – 10% = 90%
= 500 units – 50 units
= 450 units per day
360
 90% = 72%
450
= Maximum capacity – Actual capacity
= 500 – 360 units = 140 units per day
= Practical capacity – Actual capacity
= 90% – 72% = 18%
= 450 units – 360 units = 90 units per day
Actual capacity is only 360 units per day or
Idle capacity
Abnormal idle capacity
Idle Capacity and Idle Time
Idle time is the loss of labour time which arises due to waiting for materials, tools, job
instructions or due to machine breakdown or power failure or due to changing from
one job to another. This may be avoidable or unavoidable. Although no work is done
during the period of idle time, wages are paid to the workers for this lost time.
Idle capacity, on the other hand, represents unused production potential and is the
difference between practical capacity and actual capacity. Idle capacity is a wide term
and the cost of idle time forms a part of the cost of idle capacity.
Cost of Idle Capacity
Idle capacity costs are represented mostly by fixed charges of owning and maintaining
plant and machinery and of employee services which are not used at their maximum
potential. This is so because fixed costs continue to be incurred even if the plant is kept
idle.
The cost of idle capacity is clearly brought out if overheads absorption rate is
calculated on practical capacity—as the base. It comes out in the form of underabsorption of overheads. Look at the Illustration 4.14 above, showing the effect of various
capacity levels on overhead rates.
Further assume that actual capacity utilization is 3,500 labour hours, the underabsorbed overheads will amount to `4,444 approx. (`4.44 × 1,000, i.e., fixed overhead
rate at practical capacity × under-utilized direct labour hours.) This under-absorption
represents the cost of idle capacity.
The cost of idle capacity and the reasons due to which capacity remains unutilized
can be found out by computing overheads capacity variance and by preparing idle time
reports, plant utilization reports and idle machine time reports. These reports are prepared
periodically which clearly bring out the period for which plant remained unutilized and
the cost of such capacity that is not utilized.
Overhead Cost
4.40
Illustration 4.15 Flakt India Ltd manufactures component part XE at the rate of 2 units
per hour. The factory normally operates 6 days a week on a single eight-hour shift. During
the year, it is closed for 20 working days for holidays. Normal loss of machine time for
cleaning, oiling, etc., is 160 hours per year. Fixed overhead cost per annum is `37,128.
Normal sales for the component averages 2,500 units per year. The actual sales volume
for the year 2012 was 2,400 units.
Compute the idle capacity cost when overhead rates are based on practical capacity.
Solution
Maximum capacity = Total days in the year × No. of hours worked per day
= 365 × 8 = 2,920 hours
Practical capacity
= Maximum capacity – Normal loss
Maximum capacity
2,920 hrs
Less: Sundays (52 days × 8 hrs)
416
Holidays (20 days × 8 hrs)
160
Loss due to cleaning, oiling, etc.
160
736 hrs
Practical capacity
2,184 hrs
Normal capacity
= Normal sales ÷ Units per hour
= 2,500 units ÷ 2 units per hour = 1,250 hours
Actual capacity
= 2,400 units ÷ 2 units per hour
= 1,200 hours
Absorption rate per hour, based on practical capacity (for fixed cost only)
=
Idle capacity
Fixed overhead cost (` )
`37,128

Practical capacity (hours) 2,184 hours = `17 per hour
= Practical capacity – Actual capacity
= 2,184 – 1,200 = 984 hrs
Cost of idle capacity
= Idle capacity × Overhead rate
= 984 hrs × `17 = `16,728
ADMINISTRATION OVERHEADS (Office or General Overheads)
Office and administration overheads pertain to general management and administration
of business. They may be defined as the indirect expenditures incurred in
formulating the policy, directing the organization and controlling the operations
of an undertaking. These overheads are of a general character and are incurred for
the business as a whole. They have little or no direct connection with production or
sales activities. As production and sales cannot function without some sort of
administrative control, these overheads serve the purpose of such a control. Expenses
of activities of board of directors, accounting, secretarial, audit, legal, financial, etc.,
are included in administrative overheads. These overheads are generally constant in
nature and are not affected by any fluctuations in the volume of production or sales.
4.41
Overhead Cost
Accounting Treatment
Examples of Admn. Overheads
Classification and collection of office and
• Salary of general manager and
administrative overheads is done in the
managing director
same way as that of production overheads.
•
Salaries
of general office staff
Separate standing order numbers are
• Office rent
allotted to each item of such an overhead
• Depreciation of office machines
cost, such as legal charges. travelling
Legal charges
expenses, office rent, audit fees, etc. These
overhead costs are analysed into those
• Accounting and audit expenses
related to production activities and those
which are general, i.e., those not related to production activities.
Absorption of Administration Overheads
Office and administrative overheads generally constitute a small portion of the total cost
as compared to production overheads. For the purpose of absorption of these overheads,
a single (blanket) overhead rate is computed by any one of the following methods:
1. Percentage of works cost Administration overhead cost is generally absorbed
as a percentage of works cost. Such a rate is computed by the following formula:
Admn. overheads
× 100
works cost
For example, if administration overheads are `12,000 and works cost is `2,40,000,
the overhead rate is computed as follows:
12,000
Admn. overhead rate =
= 5%
2,40,000
2. Percentage of sales Sometimes office and administration overheads are absorbed
as a percentage of sales. Its formula is:
Administration overheads
Overhead rate =
× 100
Sales
3. As a percentage of conversion cost Conversion cost is the cost of converting
raw material into finished goods. It includes cost of direct labour and factory overheads.
This method is rarely used.
Overhead rate is calculated by the following formula:
Overhead rate =
Overhead rate =
Administration overheads
× 100
Total conversion cost
SELLING AND DISTRIBUTION OVERHEADS
Selling and distribution costs are usually incurred after the production of products or
services is completed, and therefore, such costs are sometimes known as ‘afterproduction costs.’
Selling cost is the cost of seeking to create and stimulate demand (sometimes termed
marketing) and of securing orders. These costs are thus incurred for increasing sales
to the existing and potential customers. Examples are advertisement, samples and free
gifts, show-room expenses, etc.
Distribution cost is the cost of the sequence of operations which begins with
4.42
Overhead Cost
making the packed product available for dispatch and ends with making the
reconditioned returned empty packages, if any, available for re-use. Thus distribution
costs are incurred in placing the articles in the possession of the customers. Examples
are carriage outwards, insurance of goods-in-transit, maintenance of delivery vans and
werehousing.
For costing purposes, selling costs and distribution costs are generally considered
together, although in some cases these may be dealt with separately.
Difference between selling overheads and distribution overheads Selling
overheads and distribution overheads differ in their nature and purpose. Selling overheads
are incurred for promoting sales and securing orders while distribution overheads are
mainly incurred in moving the goods from the company’s godown to customers’ place.
The object of selling overheads is to solicit orders and to make efforts to find and retain
customers. The object of distribution overheads is the safe delivery of the goods to the
customers.
Special Features of Selling and Distribution Overheads
Selling and distribution overhead costs have certain peculiar features which have a
bearing on the accounting and control of these costs. These features are:
(a) Unlike production costs, most of the selling and distribution costs cannot be
identified with the units of products.
(b) Selling costs are incurred as a matter of policy of management.
(c) Selling costs are not always related to the volume of sales.
(d) The characteristics and attitude of the customers also affect selling costs.
(e) The same product may be sold in near or distant market. This will affect cost
of packing and transportation.
(f) Selling costs vary widely depending upon the degree of competition.
Accounting Treatment
The accounting procedure of selling and distribution cost comprises:
1. Classification, collection and analysis of these expenses
2. Apportionment and allocation to cost centres
3. Absorption by products or product groups
These three stages are discussed below:
1. Classification, collection and analysis This is the first step and is similar to
classification and collection of production overheads. Selling and distribution
overheads may be classified on the basis of products, sales territories, channels of
distribution, salesmen, etc.
When classification of expenses is complete, expenses are collected under standing
order numbers provided for this purpose.
2. Apportionment and allocation to cost centres In this step, selling and distribution
overheads are allocated or apportioned to various products, sales territories or other
cost centres. Some of the common bases used for distribution of selling and distribution
overheads are given below.
4.43
Overhead Cost
Expenses
Basis for distribution
1.
2.
Remuneration of salesmen
Advertising
3.
4.
5.
6.
7.
8.
9.
10.
Catalogues
Showroom expenses
Packing
Collection of overdue accounts
Insurance
Transport—outside carrier
Own transport
Warehousing
Direct allocation
Direct allocation, or
value of sales or space used
Direct allocation or space used
Direct allocation or space used
Direct allocation
No. of orders or sales value
Value of stocks
Direct allocation
Direct allocation or weight of product carried
Cubic ft of product stores × time (days)
3. Absorption of selling and distribution overheads Absorption of selling and
distribution overheads means charging of these overheads to various products, jobs or
orders.
Methods of Absorption
Various methods for absorption of selling and distribution overheads are as follows:
1. A rate per unit of sales This method is employed when the company is selling
one uniform type of product. The total selling and distribution overheads to be absorbed
are divided by the number of units sold to arrive at a rate per unit.
For example, a company is manufacturing only one type of TV picture tube. During
the month of May, its selling and distribution overheads amounted to `75,000 and during
this period, the number of picture tubes sold is 1,000. The rate per unit for the absorption
of selling and distribution overheads will be `75,000 ÷ 1000 = `75.
2. A percentage of selling price This method is recommended when the concern is
selling more than one type of product. A percentage of selling and distribution overheads
to selling price is ascertained from an analysis of past records. Overhead rate is
calculated by the following formula:
Selling and distribution overheads
× 100
Sales
Selling and distribution overheads
`5,000
Total sales
`1,00,000
Overhead rate =
Example
Overhead rate =
5,000
× 100 = 5% of selling price
1,00,000
3. A percentage of works cost In this method, a percentage of selling overheads to
works cost is ascertained. This percentage rate is applied for the absorption of selling
and distribution overheads.
Overhead rate is calculated as follows:
Overhead rate =
Selling and distribution overheads
× 100
Total works cost
Overhead Cost
4.44
Example
Selling and distribution overheads
Works cost
5,000
Overhead rate =
× 100 = 12.50%.
40,000
`5,000
`40,000
UNDER-ABSORPTION AND OVER-ABSORPTION OF OVERHEADS
As stated earlier, overheads may be absorbed either on the basis of actual rates or
predetermined rates. When actual rates are used, the overheads absorbed should be
exactly equal to the overheads incurred. In such a case there is no problem of underor over-absorption of overheads. But when a predetermined rate is employed, overheads
absorbed may not be equal to the amount of actual overheads incurred. Thus, whenever
the overheads absorbed are not equal to the amount of actual overheads, it is a case of
either under-absorption or over-absorption of overheads.
Under-absorption When the amount of overheads absorbed is less than the amount
of overheads actually incurred, it is called under-absorption or under-recovery. This has
the effect of under-stating the cost because the overheads incurred are not fully
recovered in the cost of jobs, processes, etc.
Over-absorption When the amount of overheads absorbed is more than the amount
of actual overheads incurred, it is known as over-absorption or over-recovery. It has
the effect of over-stating the cost of jobs, processes, etc.
Example
Predetermined overhead rate
= `5 per machine hour
Actual machine hours
= 1,500
Actual overheads
= `9,000
Overheads absorbed
= 1,500 hrs × `5 = `7,500
Under-absorption
= `9,000 – `7,500 = `1,500
In this example, if the actual machine hours worked were 1,900, then:
Overheads absorbed
= 1,900 hrs × `5 = `9,500
Overhead over-absorbed
= `9,500 – `9,000 = `500
Causes of Under or Over-absorption
Under or over-absorption of overheads may arise due to one or more of the following
reasons:
1. Faulty estimation of overhead costs
2. Faulty estimation of the quantity of output
3. Seasonal fluctuation in the amount of overheads in certain industries
4. Unforseen changes in the production capacity
5. Unexpected changes in the method of production affecting changes in the amount
of overheads
Whatever be the reason, under- or over-absorption is caused mainly due to wrong
estimation either of the overhead costs or of the base such as machine hours, production
quantity, etc.
Accounting Treatment of Under and Over-absorption
Under or over-absorbed amounts of overheads are disposed of in accordance with any
of the following methods, depending upon the circumstances:
4.45
Overhead Cost
1. Use of supplementary rates Where the amount of under or over-absorbed
overheads is significant, a supplementary overhead absorption rate is calculated to adjust
this amount in the cost. However, adjustment is made in the cost of: (i) work-in-progress;
(ii) finished stock; and (iii) cost of sales. In the case of under-absorption, the overhead
cost is adjusted by a plus rate since the amount is to be added, whereas over-absorption
is adjusted by a minus rate since the amount is to be deducted.
Illustration 4.16 A company absorbs overheads on predetermincd rates. For the year
ending 31 Dec. 2021, factory overheads absorbed were `3,66,250. Actual amount of
overheads incurred totalled `4,26,890. The following figures are also derived from the
trial balance.
`2,30,732
Finished stock
Cost of goods sold
`8,40,588
Work-in-progress
`1,41,480
How would you dispose of under/over-absorbed overheads by use of supplementary
rate method.
(CA Inter Adapted)
Solution
Under-absorbed overheads
= Actual overheads – Absorbed overheads
= `4,26,890 – 3,66,250 = ` 60,640
Total cost incurred
= `230,732 + 840,588 + 1,41,480 = `12,12,800
Supplementary Rate
=
`60,640
Unabsorbed amount
=
Total cost
`12,12,800
100 = 5 %
As there is under-absorption of overheads, it is a plus rate, i.e., the cost of finished
goods, work-in-progress and cost of goods sold will be increased by 5% as shown below:
Finished goods
=
`2,30,732 × 5%
=
`11,536.60
Work-in-progress
=
`1,41,480 × 5%
=
`7,074.00
Cost of goods sold
=
`8,40,588 × 5%
=
`42,029.40
Total
60,640.00
2. Writing off to costing profit and loss account This method is used when the
under or over-absorbed amount is quite negligible and it is not worthwhile to absorb it
by supplementary rate. Under-absorption due to abnormal factors, like idle capacity or
defective planning, is also transferred to Costing Profit and Loss Account.
This method suffers from the shortcoming that stocks of work-in-progress and
finished goods remain under or over-valued and are carried over to the next accounting
period at such values.
3. Carry over to the next year Under this method the under or over-absorbed
amount is transferred to Overhead Reserve Account or Suspense Account for carrying
over to the next accounting year. This procedure is open to criticism on the ground that
it is not logical to carry over the overheads of one year to the subsequent years for
absorption. But, this method can be usefully employed where normal business cycle
extends over more than one year and overheads are determined on a long-term basis.
Overhead Cost
4.46
Illustration 4.17 During the year ending 31 March 2022, the factory overhead costs
of three production departments of an organization are as under—
`48,950
`89,200
`64,500
X
Y
Z
The basis of absorption of overheads is given below:
X
`5 per machine hour for 10,000 hours
Y
75% of direct labour cost of `1,20,000
Z
`4 per piece for 15,000 pieces
Calculate the department-wise under or over-absorption of overheads and present the
data in a tabular form.
(ICWA Inter Adapted)
Department
Solution
Amount of cost absorbed factory overheads is calculated as follows:
X
Y
Z
`
50,000
90,000
60,000
@ `5 per machine hour for 10,000 hours
@ 75% of direct labour cost of `1,20,000
@ `4 per piece for 15,000 piece
Total overheads absorbed
2,00,000
Statement Showing Department-wise Under/Over-absorption
Department
Actual
overhead
`
Absorbed
overhead
`
Underabsorption
`
Overabsorption
`
X
Y
Z
48,950
89,200
64,500
50,000
90,000
60,000
—
—
4,500
1,050
800
—
Total
2,02,650
2,00,000
4,500
1,850
Net under-absorption (`)
or
= 4,500 – 1,850 = 2,650
2,02,650 – 2,00,000 = `2,650
Illustration 4.18 The cost accountant of a newly formed company was asked to establish
a predetermined rate for applying overheads to the jobs moving through a single
manufacturing shop and to check results periodically. After consulting various officials
of the company, he came up with the following estimated data for the year 2021.
Factory supervision
Indirect labour
Inspection
Maintenance
Indirect material
Heat, light and power
Depreciation
Misc. factory overheads
Direct labour hours
`
`
`
`
`
`
`
`
Estimated
Actuals
55,000
1,10,000
70,000
35,000
25,000
20,000
35,000
10,000
1,44,000
51,000
99,000
73,000
39,000
20,000
18,000
35,000
3,000
1,21,500
4.47
Overhead Cost
At the end of 2021, the first year of operations, the actual results were recorded
against each item stated above.
You are required to:
(a) Compute the predetermined overhead rate, based on direct labour hours; also
compute the incurred overhead rate;
(b) Determine the under or over-applied overheads for the year.
(ICWA Inter)
Solution
(a)
Calculation of Overhead Rate
Factory supervision
Indirect labour
Inspection
Maintenance
Indirect material
Heat, light and power
Depreciation
Misc. factory overhead
Total (A)
Direct labour hours (B)
Overhead rate per direct labour hour (A ÷ B)
Estimated
`
Actuals
`
55,000
1,10,000
70,000
35,000
25,000
20,000
35,000
10,000
51,000
99,000
73,000
39,000
20,000
18,000
35,000
3,000
3,60,000
1,44,000
3,38,000
1,21,500
2.50
2.78
(b) Overheads recovered on actual 1,21,500 direct labour hours at `2.50 per hour = `3,03,750
Under-applied overheads: `3,38,000 – `3,03,750 = ` 34,250
Illustration 4.19 In a manufacturing unit, overheads were recovered at a predetermined
rate of `25 per man-day. The total factory overhead expenses incurred and the man-days
actually worked were `41.50 lakh and 1.50 lakh days, respectively.
Out of the 40,000 units produced during a period, 30,000 were sold.
On analysing the reasons, it was found that 60 per cent of the unabsorbed overheads
were due to defective planning and the rest were attributable to increase in overhead costs.
How would under/over-absorbed overheads be treated in cost accounts?
(B. Com. Hons. Delhi, CA Inter)
Solution
Actual overhead incurred
Less: Overhead absorbed (`25 × 1.50 lakh hours)
Under-absorbed overheads
(` in lakh)
41.50
37.50
4.00
60% of this `4 lakh of unabsorbed overheads, which is due to defective Planning
(abnormal reasons), should be charged to Costing Profit and Loss Account and the
remaining 40%, i.e., `1.60 lakh should be charged to the cost of sales and closing stock
by using a supplementary rate.
Overhead Cost
4.48
Charge to Costing Profit and Loss Account (60% of `4 lakhs)
Supplementary Rate = `1.60 lakhs ÷ 40,000 units = `4 per unit.
Charge to cost of sales (30,000 units @ `4)
Charge to closing stock (10,000 units @ `4)
Under-absorbed overhead
`(in lakhs)
2.40
1.20
0.40
4.00
TREATMENT OF SPECIAL ITEMS OF OVERHEADS
Interest on Capital
There is a considerable difference of opinion on the question as to whether interest on
capital should be included in cost or not. This is so because whether a concern pays
interest on capital or not, depends upon its method of capitalization. This means a
company raising finance by equity capital does not have to pay interest whereas a
company raising finance partly through debentures has to pay interest. If interest actually
paid is included in cost, companies not paying any interest will have lower cost and
companies paying interest will show higher cost of production. This makes the
comparison of cost in different companies difficult. Therefore, for the sake of uniformity,
either interest paid should be excluded from cost, or alternatively, interest on the total
capital employed (both equity, and debenture capital) should be included in cost so that
costs become comparable.
The arguments usually advanced for and against the inclusion of interest are
summarized below:
Arguments for inclusion The main arguments in favour of including interest in cost
are as follows:
1. Labour, capital, land, etc., are the different factors of production. Wages are
the reward for labour, rent is the reward for land and interest is the reward for
capital. As we include wages and rent in cost, so should interest be included.
2. Where interest is included in cost, due regard is given to time factor, which is
one of the most important factors in production. For example, construction of
contract A takes two months and that of contract B takes one year. True cost
of these contracts cannot be compared unless interest on capital locked up is
charged to these contracts.
3. It is necessary to include interest if comparisons are to be made between
different processes and operations. For example, cost of products or services
provided by an expensive machine cannot be compared with the costs of
products of a less expensive machine, unless interest is included in cost.
4. Where management has to decide about the replacement of manual labour by
machines, a true comparison of the costs of these two methods cannot be made
unless interest on the cost of machine is take into consideration.
5. Where articles of different values are produced and capital invested in each
varies considerably, the inclusion of interest is of special importance.
6. The true cost of maintaining heavy stocks cannot be ascertained without giving
due consideration to interest on capital locked up in stocks.
Overhead Cost
4.49
Arguments against inclusion The following arguments are usually advanced against
including interest in cost.
1. The argument that interest is the reward for capital as wage is the reward of
labour, and therefore should be included, holds good in economics and not in
costing.
2. Interest is a matter of internal finance and therefore should be excluded from
cost. Whether work is done by owned capital or borrowed capital does not affect
the manufacturing cost. However, it affects the balance of profit.
3. It is quite difficult to determine the exact amount of capital upon which interest
should be calculated. This is because working capital in the form of stock,
debtors, cash, etc., changes every now and then.
4. It is also difficult to determine a fair rate of interest as market rates of interest
vary considerably.
5. Managerial decisions and comparisons involving interest can be best made on
separate statements without introducing interest in cost accounts. Inclusion of
interest in cost accounts creates unnecessary complications.
6. Inclusion of interest inflates the value of work-in-progress and finished stock
which implies an inflation of income to that extent.
Conclusion The arguments in favour of inclusion of interest in cost are mostly
theoretical and they are outweighed by the arguments against inclusion of interest, which
are based largely on expediency and practical difficulties. Accordingly, interest is rarely
taken into account in cost records, though it is sometimes proper to have regard to it in
special reports like the following:
1. Cost estimates, especially in those cases where a job takes a long period to
complete and involves large sums.
2. Statements comparing the profitability between alternative projects like
production by machinery or by hand labour.
3. Statements comparing the cost of making or buying from outside.
4. Statements comparing the relative merits of various means of raising capital.
5. Statements assessing the profitability of holding stocks of items like timber, wine,
etc., which need time to mature.
As a note of caution, for the purpose of cost control, interest paid is just as much
a cost as any other item of cost and should be subject to control in the same manner.
Depreciation
In cost accounting generally machine hour rate method of providing depreciation is used.
In this method, depreciation is charged at a rate per hour of machine operation. This is
calculated by dividing the value of the asset by the estimated number of working hours
of life of the machine.
The formula is:
Depreciation charge
Cost of asset  Residual value

per hour
Estimated number of machine hours during life of machine
Overhead Cost
4.50
For example, a machine costing `19,250 and having a residual value of `1,250
at the end of its working life, is expected to operate for a total of 3,600 hours per year
for 5 years.
Depreciation charge per hour is =
`19, 250 1, 250
18, 000

= `1
3, 600 hrs  5 years 18, 000
Assets Retained in Use after being Fully Depreciated
Sometimes an asset is retained in use after it has been fully written off and it appears
in the records at nil value. Such a situation may arise due to any of the following reasons:
(i) Efficient maintenance leading to longer life of the asset
(ii) Charging depreciation at a higher rate
(iii) Wrong estimate of the working life of the asset
(iv) Shortage of funds for replacement of the asset
As the asset is rendering effective service in production, the same amount of
depreciation should be continued to be charged as was charged before. This will provide
comparable costs. However, if the depreciation charge in the past was excessive, the
rate of depreciation may be revised.
Charging depreciation after it has been fully written off leaves the cost accountant
with the problem of disposing off the excess depreciation. The usual practice is to
transfer the excess depreciation to a reserve account for plant obsolescence or to credit
it to Profit and Loss Account as miscellaneous income.
Rent or a Charge in Lieu of Rent
When rent is paid, this is obviously a cost to be taken into account as production,
administration or selling and distribution overhead, depending upon the use to which the
building is put to. In many cases, however, the premises are owned by the business
and no rent is payable. In such cases, a charge in lieu of rent should be made in cost
accounts so that the true cost may be ascertained. The annual value of premises, as
assessed for rating purposes, is normally a satisfactory amount to charge in lieu of rent.
Unless such a notional charge is made, the costs will fail to be comparable. If premises
are owned by some concerns and rented by others in the same industry, the costs will
vary if no rent for owned premises is charged in the cost accounts.
Cash Discount
This is a form of interest on capital and is generally excluded from costs. In fact, as a
general rule, all financial items are excluded from the costs.
Carriage Inwards
This is directly connected with the purchase of materials and is generally included in
the cost of materials purchased, thereby treating it as a direct cost. Alternatively, it
may be treated as an item of factory overheads.
Overhead Cost
4.51
Packing Material Cost
Packing materials are the “material used to hold, identify, describe, store, protect,
display, transport, promote and make the product marketable and communicate
with the consumer” as per CAS–9 of ICAI. Packing materials are classified into
primary and secondary packing materials.
Primary packing material is that which is essential to hold the product and keep it in
condition in which it can be used by or sold to a customer. Examples are:
 Industrial gases – Cylinders
 Confectionary industry – Butter paper and wrappers.
 Pharmaceutical industry – Foils for strips of tablets/capsules, vials.
Cost of primary packing is a part of cost of production. It is treated as direct
material cost if it can be easily traced to a cost object. Otherwise, it shall be assigned
to cost objects on the basis of quantity consumed.
Secondary packing material is that which enables to store, transport, inform the
customer, promote and otherwise make the product marketable. Examples are:
 Pharmaceutical industry – Cartons and card board boxes used for holding strips
of tablets/medicines.
 Confectionary industry – Cartons containing packs of biscuits, chocolates etc.
Cost of secondary packing is a part of distribution overhead.
Royalties and Patent Fees
Royalties may be payable for:
(a) making use of a patent process or product in the course of manufacture; or
(b) the right to sell the finished product.
Royalties payable for making use of a patent process in manufacture should be
treated as direct expenses (it is payable at a rate per unit) and included in prime cost.
Royalties payable on the basis of sales should be regarded as selling cost.
Drawing and Design Office Costs
Drawing costs may be treated as direct expenses if drawings or designs are prepared
for specific jobs. In case drawings are to be enclosed with sales tenders, it may be
treated as selling overheads. Where drawing and designing office is used as a service
department, its costs should be apportioned to production departments on the basis of
technical estimates of services rendered or on any other suitable basis, like number of
drawings made, man-hours worked, etc.
Canteen Expenses (Subsidy)
Where a canteen runs on a subsidized basis, it is a welfare measure for the staff of
the organization. Such an expenditure on subsidy is an overhead cost and is apportioned
to various departments on the basis of total wages or number of workers. When a
canteen runs on a no profit no loss basis, there is no question of any expenditure being
incurred.
4.52
Overhead Cost
Expenses on Removal and Re-erection of Machinery
Sometimes a machinery is shifted to a new site due to factors like change in the method
of production, an addition or alteration in the factory building, change in the flow of
production, etc. All costs incurred to dismantle the existing installation and its re-erection
are treated as production overheads as they do not add to the value of the asset. When
amount of such costs is large, it may be treated as deferred revenue expenditure and
spread over a period of time, say 3 to 5 years. If removal is due to faulty planning or
some other abnormal factor, it is charged to Costing Profit and Loss Account.
It may not be out of place to mention that when a new machinery is installed, the
entire cost of installation is capitalized along with cost of machinery.
Director’s Fees and Salaries
This is usually a part of administration overheads. Where separate directors are
appointed for different functions, like production, sales, etc., such costs should be
allocated to the respective functional overheads. When there are no separate directors
for different functions, directors’ remuneration may be apportioned to production,
administration and selling and distribution on the basis of time devoted by the directors
on each department.
Set-up Costs
After the completion of a particular job, machines may require setting up with a different
set of tools for taking up the next job. The cost of setting-up time is, therefore, normally
charged to that particular job for which preparation is being made. But when setting up
is frequent and the cost abnormally high, the situation demands proper measurement
and control of set-up costs. In such cases, it may be preferable to treat such costs as
production overheads for booking against all jobs equitably.
Research and Development Costs
On account of certain special features of research and development costs, different
accounting treatments for such expenditure are required for different circumstances. There
is, therefore, no general agreement regarding the treatment of such costs in cost accounts.
The following are the various methods of treating these costs in accounts:
(a) Charging off to costs of current period as revenue expenditure This
method is usually used when such amount is not very heavy. In such a situation,
research and development costs are treated as general overheads and are
apportioned and absorbed accordingly.
(b) Charging off to costs over a number of years When benefits of research
and development are to be derived over a period of two/three years, it is usually
treated as a deferred revenue expenditure and recovered over a period of two
or three years.
(c) Transfer to Costing Profit and Loss Account The research and development
costs are written off to Profit and Loss Account of the period in which
expenditure is incurred. This method is particularly suitable when research and
development proves unsuccessful and does not produce any tangible results.
4.53
Overhead Cost
Bonus Payable to Employees
Under the payment of Bonus Act 1965, it is obligatory to pay a minimum bonus of 8
per cent to employees irrespective of profit or loss in the firm. Such a minimum amount
of bonus may be either treated as an overhead cost or alternatively, bonus payable to
direct workers may be included in their wages and their wage rate inflated to cover
the amount of bonus. Any bonus paid over and above the minimum amount of bonus
should be treated as an appropriation of profit and thus transferred to Costing Profit
and Loss Account of the period.
Some cost accountants prefer to treat the entire amount of bonus as overhead cost
and apportion it to various departments on the basis of wages bill of each department.
Bad Debts
Some cost accountants are of the opinion that bad debts are financial losses and thus
excluded from cost accounts. If, however, bad debts are included in cost, they should
be treated as selling overhead and many be apportioned to various products on the basis
of the credit sales of products. Abnormal amounts of bad debts, which are of exceptional
nature, should not be included in cost accounts.
Cost of Small Tools
Cost of tools may be treated according to any of the following methods:
1. Small tools are charged off as an expense at the time of their purchase. This
method is simple and thus more commonly used as it does not require any record
of tools in stock to be maintained.
2. Cost of small tools is capitalized and debited to Small Tools Account, treating
it as a fixed asset. Depreciation is then charged on annual basis on this fixed
asset. This method is not in common use.
3. Small tools purchased are charged to stores inventory. Whenever any tools are
requisitioned by any department, these are charged to the requisitioning
department as revenue expense.
ACTIVITY BASED COST ALLOCATION
Introduction
It has been explained earlier in this chapter that overhead are common costs which
are not traceable to individual cost objects. Hence in order to ascertain the costs of
cost objects, overhead costs are allocated, apportioned and absorbed in the costs of
products or services on equitable bases. This is a traditional approach of overhead
distribution which is based on the assumption that products consume resources in
proportion to the production volumes. This traditional system was designed when direct
costs were dominant part of the processing costs and overhead were insignificant and
any distortions of cost due to inappropriate distribution of overhead were not significant.
Now in this computer age of advancing technologies and automation, the proportion
and importance of overhead in the manufacturing operations is increasing and direct
costs are being relegated to the background. Therefore, there is a need for a more
sophisticated system of accounting for overhead so that more accurate costs of products
and services may be ascertained.
Overhead Cost
4.54
Allocation,
Apportionment and
Re-apportionment
Products

Overhead
Rate A


Production
Dept. B

Overhead
Rate B

Production
Dept. C

Overhead
Rate C


Production
Dept. A

OVERHEAD
COST
Absorption of
Overhead
Fig. 4.3 Traditional overhead costing.
Activity based costing (ABC) is an alternative to traditional way of overhead
accounting. It is an upcoming and more refined approach of charging overhead to
ascertain more accurate product costs.
Volume based traditional method of costing may prove appropriate in those firms
in which direct costs form the major part of the cost of products/services and activities
supporting the production are relatively simple, low cost and homogeneous across
different product lines.
Traditional Method—Problem of Undercosting and Overcosting
When a company produces a variety of products or services which place varying
demands on resources, traditional costing uses an average overhead rate for all activities
(like labour hour rate or machine hour rate) to allocate costs to cost objects i.e.,
products or services. Such a costing approach that uses broad averages for charging
overhead uniformly to products or services is known as cost smoothing or peanut
butter costing. Cost smoothing leads to undercosting of certain products and overcosting
of other products. Where one product is undercosted, it results in other product being
overcosted because total amount of overhead remain unchanged. This is known as
product cost cross-subsidisation.
However, the fact is that various cost objects (products of service) consume resources
in a non-unform way. The need to measure more accurately how different products
services consume company resources has led to the development of a more refined
costing system known as activity based costing. By defining activities and identifying the
cost of performing each activity, the activity based costing system provides a better and
more logical distribution of overhead resulting in accurate costing.
4.55
Overhead Cost
ACTIVITY BASED COSTING APPROACH
Activity based costing (ABC) is a new and scientific approach developed by Cooper
and Kalpan (1988) for assigning overhead to end products, jobs and processes. It
aims to rectify the problem of inaccurate cost information due to selection of wrong
bases of indirect cost apportionment. In the words of Cooper and Kalpan, “ABC
systems calculate the costs of individual activities and assign costs to cost
objects such as product and services on the basis of activities undertaken to
produce each product or service.” In this system, overheads are assigned to
activities or grouped into cost pools before they are charged to cost objects, i.e.,
jobs or products. According to C.I.M.A., London, activity based costing is “Cost
attribution to cost units on the basis of benefits received from indirect activities,
i.e., ordering, setting up, assuring quality, etc.”
Activity based costing is not an alternative to job costing or process costing. Rather
it is a modern tool of charging overhead costs in which costs are first traced to
activities and then to products or jobs. Its main focus is on activities performed in the
production of goods or services. Thus activities become the focal points for cost
computation. Costs are charged to products or services based on individual products’
consumption of each activity. It recognises that jobs, products, services etc. do not
directly consume resources but consume activities, which consume resources. In brief,
in activity based costing, overheads are first assigned to activities and then absorbed
by cost objects on the basis of activities consumed by these cost objects.
Objectives of Activity Based Costing
The main objectives of ABC are as follows:
1. To reduce distortion in product costs often found in traditional overhead
accounting.
2. To provide more accurate product costs leading to more accurate product and
customer profitability.
3. To help managers in product pricing and other decisions.
4. To identify the high cost activities and value adding activities.
5. To eliminate non-value adding activities.
Terms used in ABC
In order to understand ABC, one should be familiar with the meaning of the following
terms:
Activity: An activity may be defined as a particular task or unit of work with a
specific purpose. Examples of activities are – placing of a purchase order, setting
up of a machine, after sales service, etc.
Cost object: It is an item for which cost measurement is required. For example, a
product, a service, a job or a customer etc. are cost objects.
Resource: A resource is an economic element consumed in performing activities.
For example, salaries and consumable stores are resources used in performing
manufacturing activities.
4.56
Overhead Cost
Cost driver: It is a factor that causes a change in the cost of an activity. Cost
driver is of two types–resource consumption cost driver and activity consumption
cost driver.
Resource consumption cost driver: It is a measure of the quantity of resource
consumed by an activity. For example, number of purchase orders placed will
determine the cost of purchasing the materials. Similarly, the number of times
machines are set up will determine the cost of setting up of machines. Resource
cost driver is used to assign the cost of a resource to an activity or cost pool.
Activity consumption cost driver: It is a measure of the frequency and intensity
of demand placed on the activities by cost objects. It is used for assigning activity
costs to cost objects consuming the activity.
Example of cost drivers for various business functions are as follows:
Business functions
Purchase of materials
Production
Research and development
Customer service
Cost drivers
— Number of orders placed.
— Number of receipts of materials.
— Number of inspections.
— Number of machine set ups.
— Number of units.
— Number of machine hours.
— Number of research projects
— Personnel hours on a project
— Complexities of projects.
— Number of products serviced.
— Number of service calls.
— Number of hours spent on servicing.
Steps in Activity Based Costing
The following are the steps in activity based cost allocation:
1. Identification of the main activities: First of all, major acitivites in the organisation
are identified. The number of activities in an organisation should neither be too large
or too small. Too large a number will be costly and will add to the complexity of the
system while a too small number of activities will compromise with the accuracy of
the cost. Total cost involved in the activity should be significant enough to justify to
give an activity a separate treatment.
2. Creation of cost pool: Cost pool is grouping of individual cost items. A cost pool
or cost bucket should be created for each activity. Cost pool is like a cost centre
around which costs are accumulated. For example, the total cost of machine set ups
might constitute one cost pool for all set up related costs.
3. Determination of the activity cost drivers: The factors that influence the cost of
a particular activity is known as cost drivers. In other words, cost drivers signify the
factors or events that determine the cost of activity. Example of cost drivers as given
above are number of machine set ups, number of purchase orders, number of customer
orders placed, etc.
4.57
Overhead Cost

Activity cost
pools




OVERHEAD
COST
Activity cost
driver rates
Products
Cost Pool
A

Cost driver
rate A

Cost Pool
B

Cost driver
rate B

Cost Pool
C

Cost driver
rate C

Cost Pool
D

Cost driver
rate D

Cost Pool
E

Cost driver
rate E

Fig. 4.4 Activity based costing.
4. Calculation of the activity cost driver rate: Just as an overhead absorption rate
is calculated in traditional costing system, in ABC a cost driver rate is calculated as
follows:
Activity cost driver rate =
Total cost of activity
Cost drivers
5. Charging the costs of activities to products: The costs of activities are traced
to products on the basis of demand by products. The cost drivers are used to measure
product demand of activities. For example, the total cost allocated to cost centre for
machine set up related costs is `50,000 and that there were 100 set ups during the
period. Thus the rate per set up is `50,000 ÷ 100 = `500. If a particular product needs
10 set ups, charge to that product will be `500 × 10 = `5,000. If 20 units of the product
are produced, cost per unit will be `5,000 ÷ 20 units = `250. In this way, cost of other
activities also will be charged to product.
Illustration 4.20 A company manufactures two products, A and B, using common
facilities. The following cost data for a month are presented to you:
A
B
1,000
2,000
2
3
Machine hours per unit
6
1.5
Set-up of machines
15
50
18
70
Units produced
Direct labour hours per unit
Orders
Machines activity expenses
`3,00,000
Set-up related expenses
`30,000
Expenses relating to orders
`35,000
Calculate the overheads per unit absorbed using activity-based costing approach.
(B. Com. Hons., Delhi)
Overhead Cost
4.58
Solution
Calculation of Cost Driver Rates:
1. Machine hour rate
=
Machine activity exp.
`3,00,000

Machine hours
(1,000  6)  (2,000  1.5) hrs
=
3,00,000
3,00,000

6,000  3,000
9,000
2. Rate per machine set-up =
3. Rate per order
= ` 33.333
Set up related exp enses
`30,000

No. of set -ups
15  50 set -ups
=
`30, 000
65
=
Orders related expenses
`35,000

No. of orders
18  70 orders
=
`35, 000
88
= ` 461.538
= ` 397.73
Computation of Overhead Cost per Unit under ABC
Product A
1,000 units
Particulars
Total
`
Machine related cost
per unit
`
6,000 × 33.333
= `2,00,000
Set up related cost
200.00
= `1,00,000
6.923
= `23,076.90
50.00
11.538
70 × 397.73
7.159
= `27,841.10
214.082
Illustration 4.21
follows:
Per unit
`
50 × 461.538
18 × 397.73
= `7,159
Total
`
3,000 × 33.333
15 × 461.538
= `6,923
Order related cost
Product B
2,000 units
13.921
75.458
The budgeted overhead and cost driver volumes of ZAA Ltd are as
Cost pool
Budgeted overhead
Cost driver
Budgeted volume
Material procurement
4,05,000
No. of orders
900
Machine set-up
3,59,100
No. of set-ups
450
Maintenance
2,40,000
Maintains hrs
3,000
Quality control
1,40,000
No. of inspections
700
Machinery
4,80,000
No. of machine hrs
24,000
4.59
Overhead Cost
The company has produced a batch of 2,500 components of AZ-4, its material cost
was `1,10,000 and labour cost `1,90,000. The usage of activities of this batch are as
follows:
Material orders 21, set ups of machine 19, maintenance hours 510, no. of inspections
26, machine hours 1,300.
Calculate cost driver rates that are used for computing appropriate amount of overhead
to this batch and ascertain the cost of the batch of the component using activity based
costing.
(Adapted)
Solution
Computation of Cost Driver Rates
Particulars
Details
Cost driver rate
1.
Material procurement
`4,05,000  900
`450
2.
Machine set-up
`3,59,100  450
`798
3.
Maintainance
`2,40,000  3,000
`80
4.
Quality control
`1,40,000  700
`200
5.
Machinery
`4,80,000  24,000
`20
Statement of Cost of Batch of Component AZ-4
Details
Batch size – 2,500 components `
Direct materials
1,10,000
Direct labour
1,90,000
Prime Cost
3,00,000
Overhead
Materials procurement
21 × 450 = 9,450
Machine set-up
19 × 798 = 15,162
Maintenance
510 × 80 = 40,800
Quality control
Machinery
26 × 200 = 5,200
1,300 × 20 = 26,000
96,612
Total Cost
3,96,612
Illustration 4.22 A company, manufacturing two products, furnishes the following data
for a year.
Products
Annual
output
(units)
Total
machine
hours
Total number
of purchase
orders
Total number
of set-ups
A
B
5,000
60,000
20,000
1,20,000
160
384
20
44
The annual overhead are as under:
`
Volume related activity costs
Set-up related costs
Purchase related costs
5,50,000
8,20,000
6,18,000
Overhead Cost
4.60
You are required to calculate the cost per unit of each product A and B bases on :
(i) Traditional method of charging overheads.
(ii) Activity based costing method.
(B. Com. Hons. Delhi, C.A. P.E. II)
Solution
(i) Traditional Method
Total overhead
Total machine hours
Machine hour rate =
= 5,50,000 + 8,20,000 + 6,18,000 = `19,88,000
= 20,000 + 1,20,000
= 1,40,000
Total overheads
`19,88,000

Total machine hours 1, 40,000 hours
= ` 14.20
Statement of Cost
Products
A
B
(A)
Output (units)
5,000
60,000
(B)
Machine hours
20,000
1,20,000
(C)
Overhead cost @ `14.20 per machine hour
2,84,000
17,04,000
(D)
Overhead cost per unit (C ÷ A) `
56.80
28.40
(ii) ABC Method
1. Machine hour rate =
Total overhead cost for
`5,50,000
volume related activities
=
= ` 3.93 (approx.)
Total machine hours
1,40,000 hours
2. Cost of one set-up (Total set-ups = 20 + 44 = 64)
=
Total costs related to set-ups
Total number of set-ups
=
`8,20,000
64 set-ups
= ` 12,812.50
3. Cost of one purchase order (Total purchase orders = 160 + 384 = 544)
=
Total costs related to purchases
`6,18,000
=
Total number of purchase orders
544 orders
= ` 1,136.03
Statement of Cost
Products
A
(A) Annual output (units)
(B) Cost related to volume related activities
(C)
Cost related to purchase orders
5,000
20,000 hrs
@ `3.93
= `78,600
160 orders
@ `1,136.03
= `1,81,765
B
60,000
1,20,000 hrs
@ `3.93
= `4,71,600
384 orders
@ `1,136.03
= `4,36,235.52
(Contd...)
4.61
Overhead Cost
Products
A
(D)
(E)
Costs related to set-ups
B
20 set-ups
44 set-ups
@ `12,812.50
@ `12,812.50
= `2,56,250
= `5,63,750
Total cost (B + C + D)
`5,16,615
`14,71,586
Cost per unit (E ÷ A)
` 103.323
` 24.526
Advantages of Activity Based Costing
ABC is being implemented by a growing number of companies around the world. It has
primarily developed on account of the limitations of traditional system of charging
overhead. It offers the following advantages:
1. Accurate and reliable: ABC is a more accurate and reliable system of determination
of products costs as it is based on cause and effect relationship is cost incurrence.
2. Better pricing decisions: It helps in overcoming the problem of overcosting and
undercosting as a result of which management is able to make more judicious
pricing decisions.
3. Realistic: The analysis of overhead costs with reference to activities is considered
to be more realistic because distribution of overhead based on activities is an
objective apporach. It may be recalled that traditional costing uses more arbitrary
bases for apportionment of overhead and is a subjective approach.
4. Control of cost: ABC produces more meaningful information regarding cost behaviour
and enables management to control many fixed overhead by exercising more control
over those activities which cause these fixed overhead.
5. Greater cost efficiency: ABC helps to identify unnecessary activities so that these
may be weeded out and thus achieving greater cost efficiency.
Limitations of Activity Based Costing
ABC is a very sophisticated and refined system which produces accurate costs.
However, it suffers from certain limitations given below:
1. All costs do not have unambiguous activity or resource consumption cost drivers
and thus certain costs have to be allocated to departments and products according
to traditional volume based measures. Examples of such costs are factory
manager’s salary, property taxes for factory building, insurance, etc.
2. ABC is a complex system and is not only time consuming but also comparatively
costly to maintain. For small organisation, ABC may not be suitable because
of its cost and complexity.
3. Implementation of ABC requires specialized trained professionals who are
available in limited number.
4. A lot of time and money is required to be invested to implement this system.
Overhead Cost
4.62
PROBLEMS AND SOLUTIONS
Problem 4.1 The following are the maintenance costs incurred in a machine shop for
six months with corresponding machine hours:
Machine
January
February
March
April
May
June
Hours
2,000
2,200
1,700
2,400
1,800
1,900
Total
12,000
Maintenance costs ( `)
300
320
270
340
280
290
1,800
Analyse the maintenance cost which is semi-variable into fixed and variable elements.
(CA Inter)
Solution
High and Low points method is used below to segregate semi-variable costs:
Machine hours
Maintenance costs
High point, April
2,400
`340
Low point, March
1,700
`270
700
`70
Difference
Rate of change of variable cost
= `70 ÷ 700 hrs
= `0.10 per machine hour
Total variable cost for 2,400 machine hours will be
2,400 × `0.10 = `240
Hence, fixed cost is (`340 – `240) = `100.
Statement of Analysis of Maintenance Cost into Fixed and Variable elements
Month
Maintenance cost
A
Fixed cost
B
Variable cost
A – B
January
February
March
April
May
June
300
320
270
340
280
290
100
100
100
100
100
100
200
220
170
240
180
190
Problem 4.2 A Company has five departments. P, N, R, S are producing departments
and T is a service department. The actual costs for a period are as follows:
`
`
Repairs
2,000
Insurance
1,500
Rent
2,500
Lighting
1,800
Depreciation
1,200
Employer’s liability insurance
600
Supervision
4,000
The following data are available in respect of the five departments:
4.63
Overhead Cost
Deptt. P
Deptt. N
Deptt. R
Deptt. S
Deptt. T
Area (sq. ft.)
No. of workers
Total wages
Value of plant
140
25
`10,000
`20,000
120
20
8,000
18,000
110
10
5,000
16,000
90
10
5,000
10,000
40
5
2,000
6,000
Value of stock
`15,000
10,000
5,000
2,000
—
Apportion the costs to various departments on equitable bases.
(B. Com. Madras)
Solution
Overheads Distribution Summary
Production departments
Service
deptt.
Expenses
Basis
Total
`
P
`
N
`
R
`
S
`
T
`
1. *Total wages
2. Repairs
3. Rent
4. Depreciation
5. Supervision
Actual
Plant value
Area
Plant value
No. of
workers
Stock value
Area
Total wages
2,000
2,000
2,500
1,200
—
571
700
343
—
514
600
309
—
457
550
274
—
286
450
171
2,000
172
200
103
4,000
1,500
1,800
1,430
703
504
1,143
469
432
571
234
396
571
94
324
285
—
144
600
200
160
100
100
40
Total
13,600
4,451
3,627
2,582
1,996
2,994
6. Insurance
7. Lighting
8. Employer's
liability
Insurance
*Note: Wages of production departments are direct wages and thus not included in overhead.
Problem 4.3 A factory has three production departments A, B and C and two service
departments P and Q. The overheads departmental distribution summary shows the
following:
A
`6,50,000
P
`1,20,000
B
`6,00,000
Q
`1,00,000
C
`5,00,000
The service department expenses are allotted on a percentage basis as follows:
Service Deptt P
Service Deptt Q
Production departments
Service departments
A
B
C
P
Q
30%
40%
40%
30%
15%
25%
—
5%
15%
—
Show how the expenses of the two service departments are to be charged to
production departments.
Overhead Cost
4.64
Solution
Secondary Overheads Distribution Summary (Repeated Distribution Method)
Production deptts.
Items
Service deptts.
A
`
B
`
C
`
Total as per primary
distribution
Service department P
Service department Q
Service department P
Service department Q
Service department P
Service department Q
6,50,000
36,000
47,200
1,770
354
13
3
6,00,000
48,000
35,400
2,360
266
18
2
5,00,000
18,000
29,500
885
221
7
1
Total
7,35,340
6,86,046
5,48,614
P
`
Q
`
1,20,000
1,00,000
(–) 1,20,000
18,000
5,900 (–) 1,18,000
(–) 5,900
885
44
(–) 885
(–) 44
6
—
(–) 6
—
—
Note: Fractions have been ignored as this method produces only approximate results.
Alternative Method: This problem may also be solved by an alternative method as given
below.
Simultaneous Equations Method
Let
X = Overheads of Service Deptt P
Y = Overheads of Service Deptt Q
or
X = 1,20,000 + 5% of Y
...(i)
Y = 1,00,000 + 15% of X
...(ii)
or
X = 1,20,000 + 0.05 Y
...(i)
Y = 1,00,000 + 0.15 X
...(ii)
or
X = 0.05 Y = 1,20,000
– 0.15 X +Y = 1,00,000
Multiplying equations (ii) by 0.05 and add
X – 0.05Y
= 1,20,000
–0.0075X + 0.05Y
=
0.9925X
= 1,25,000
X
=
5,000
1, 25, 000
 1, 25,944.58
0.9925
Substituting the value of X in equation (i)
1,25,944.58 – 0.05 Y
Y
...(i)
...(ii)
= 1,20,000
= 1,18,891.60
Thus, Overheads of Deptt P
= `1,25,944.58 or `1,25,945 (approx.)
Overheads of Deptt Q
= `1,18,891.60 or `1,18,892 (approx.)
...(i)
...(ii)
4.65
Overhead Cost
Secondary Overheads Distribution Summary
Production departments
Items
Total as per primary distribution
Overheads of deptt, P
(30%, 40% and 15% of `1,25,945)
Overheads of deptt, Q
(40%, 30% and 25% of `1,18,892)
Total
A
B
C
`
6,50,000
37,783
`
6,00,000
50,378
`
5,00,000
18.892
47,557
35,668
29,723
7,35,340
6,86,046
5,48,615
Problem 4.4 A company has three production departments and two service departments.
Distribution summary of overheads is as follows:
Production departments
A
`13,600
B
`14,700
C
`12,800
Service departments
X
`9,000
Y
`3,000
The expenses of service departments are charged on a percentage basis which is as follows:
X Deptt.
Y Deptt.
A
B
C
X
Y
40%
30%
30%
30%
20%
20%
—
20%
10%
—
Apportion the cost of service departments by using the Repeated Distribution Method.
(C.A. Inter)
Solution
Secondary Overhead Distribution Summary
(Repeated Distribution Method)
Production deptts.
A
`
Total as per primary distribution 13,600
Deptt. X
3,600
Deptt. Y
1,170
Deptt. X
312
Deptt. Y
23
Deptt. X
7
Total
18,712
Service deptts.
B
`
14,700
2,700
1,170
234
23
5
C
`
12,800
1,800
780
156
16
4
X
`
9,000
(–)9,000
780
(–)780
16
(–)16
Y
`
3,000
900
(–)3,900
78
(–)78
—
18,832
15,556
—
—
Problem 4.5 X Ltd has two production departments X and Y and three service
departments—time- keeping, stores and maintenance. The department summary showed
the following expenses for the month of October:
Overhead Cost
4.66
Production departments:
`
`
X
Y
16,000
10,000
26,000
Service departments:
Time keeping
Stores
Maintenance
4,000
5,000
3,000
12,000
38,000
The other information is:
Particulars
No. of employees
No. of Stores
requisitions
Machine hours
Prod. deptts.
Service deptts.
X
Y
Time
keeping
40
30
24
2,400
Stores
Maintenance
20
16
10
20
—
—
6
1,600
—
—
—
You are required to make departmental allocation of expenses.
(ICWA Inter, Adapted)
Solution
In this problem, service departments are providing services to production department as
well as other service department. The step ladder method of overheads distribution will
be followed. First of all, overhead of time keeping department will be apportioned, which
is providing its services to the largest number of departments, then stores department
expenses will be apportioned and lastly, the maintenance department expenses will be
distributed. This is shown below.
Secondary Overheads Distribution Summary
Production deptts.
Item
Basis
X
Y
`
Overhead as per
Primary summary —
16,000
Time keeping
No. of
deptt.
employees 1,667
Stores deptt.
No. of stores
requisitions 2,720
Maintenance
Machine
hours
2,458
Total
22,845
Service deptts.
Stores
`
Time
Keeping
`
`
Maintenance
`
10,000
4,000
5,000
3,000
1,250
(–)4,000
667
416
2,267
—
(–)5,667
680
1,638
—
—
(–)4,096
15,155
—
—
—
4.67
Overhead Cost
Problem 4.6 BB Ltd is a manufacturing company having three production departments, A,
B and C and two service departments X and Y. The following is the budget for December:
Total
`
Direct materials
Direct wages
Factory rent
Power
Depreciation
Other overheads
A
`
1,000
5,000
B
`
2,000
2,000
C
`
4,000
8,000
X
`
2,000
1,000
Y
`
1,000
2,000
500
20
1,000
50
250
40
2,000
40
500
20
4,000
20
250
10
1,000
15
500
10
1,000
25
4,000
2,500
1,000
9,000
Additional Information:
Area (sq. ft)
Capital value of assets (`lakh)
Machine hours
Horse power of machines
A technical assessment of the apportionment of expenses of service departments is
as under:
A
B
C
X
Y
Service deptt. X
45%
15%
30%
—
10%
Service deptt. Y
60%
35%
—
5%
—
Required:
(i) A statement showing distribution of overheads to various departments.
(ii) A statement showing re-distribution of service department’s expenses to production
departments.
(CA Inter)
Solution
(i)
Primary Distribution of Overheads
Expenses
Direct material*
Direct wages*
Factory rent
Power
Basis
Total
Production deptts.
Service deptts.
A
B
C
X
Y
Actual
Actual
Area
H.P. ×
machine hrs
Depreciation
Capital value×
machine hrs
Other overheads Direct wages
3,000
3,000
4,000
—
—
1,000
—
—
500
—
—
1,000
2,000
1,000
500
1,000
2,000
1,000
2,500
500
800
800
150
250
1,000
9,000
100
2,500
400
1,000
400
4,000
50
500
50
1,000
Total overheads
22,500
4,100
2,700
6,200
4,200
5,300
*Direct material and direct wages of service departments are indirect costs.
(ii) Re-distribution of Service Department Expenses
Total overheads of Service Deptts X and Y have been ascertained by means of
simultaneous equations.
Let the total overheads of Deptt X = x
Let the total overheads of Deptt Y = y
Overhead Cost
4.68
x = 4,200 + 5% of y
y = 5,300 + 10% x
...(i)
...(ii)
or
x – 0.05y = 4,200
– 0.10x + y = 5,300
On multiplying equation (ii) by 10 and adding it with equation (i)
x – 0.05y = 4,200
– x + 10y = 53,000
9.95 y = 57,200
or
y = `5,749
Substituting the value of y in equation (i), we get
...(i)
...(ii)
x = 4,200 + 5% of 5,749
or
x = 4,487
Secondary Distribution of Overheads
Production departments
Total overhead as per primary distribution
Service deptt. X (90% of `4,487)
Service deptt. Y (95% of `5,749)
Total
A
`
B
`
C
`
4,100
2,019
3,450
9,569
2,700
673
2,012
5,385
6,200
1,346
—
7,546
Note: Students should attempt re-distribution of service department overheads by Repeated Distribution
Method and see that results are approximately the same.
Problem 4.7 Anglo Co. Ltd has three production departments X, Y, Z and two departments
A and B. The following estimated figures for a certain period have been made available:
Rent and rates
Lighting and electricity
Indirect wages
Power
Depreciation of machinery
Other expenses and sundries
`10,000
`1,200
`3,000
`3,000
`20,000
`20,000
Following further details are also available:
Total
X
Y
Z
A
B
Floor space (sq. mts.)
10,000 2,000 2,500 3,000 2,000
500
Light points (Nos.)
120
20
30
40
20
10
Direct wages (`)
20,000 6,000 4,000 6,000 3,000 1,000
Horsepower of machines
300
120
60
100
20
—
Cost of machinery (`)
1,00,000 24,000 32,000 40,000 2,000 2,000
Working hours
—
4,670 3,020 3,050
—
—
The expenses of the service departments of A and B are to be allocated as follows:
X
Y
Z
A
B
A
20%
30%
40%
10%
B
40%
20%
30%
10%
4.69
Overhead Cost
You are required to calculate the overheads absorption rate per hour in respect of the
three production departments.
What will be the total cost of an article with material cost of `80 and direct labour
cost of `40 which passes through X, Y and Z departments for 2, 3 and 4 hours,
respectively?
(ICWA Inter)
Solution
Departmental Distribution Summary
Items
Basis of
apportionment
Total
Production deptts.
Service deptts.
X
Y
Z
A
B
`
2,000
200
`
2,500
300
`
3,000
400
`
2,000
200
`
500
100
900
1,200
600
600
900
1,000
450
200
150
—
4,800
6,000
6,400
4,000
8,000
6,000
400
3,000
400
1,000
—
—
—
3,000
1,000
15,100
14,400
19,300
9,250
3,150
1,850
1,630
82
16
2
18,680
2,775
815
122
8
—
18,120
3,700 (9,250)
925
1,222
408 (4,075)
163
(408)
41
13
4
(41)
2
(4)
—
24,400
Working hours (B)
4,670
3,020
3,050
` ) (A ÷ B)
Rate per hour (`
4.00
6.00
8.00
`
1. Rent & rates Floor area
10,000
2. Lighting and
Light points
1,200
electricity
3. Indirect wages Direct wages 3,000
4. Power
Machine H.P. 3,000
5. Depreciation
Value of
machine
20,000
6. Other expenses Direct wages 20,000
and sundries
7. Direct wages Actual
4,000
(only service
departments)
Primary total
61,200
Apportionment of service deptt.
Expenses to production deptts.
A
B
A
B
A
Total (`) (A)
Statement of Cost of an Article
`
80
40
120
Material cost
Labour cost
Prime Cost
Overhead
X – 2 hrs @ `4
Y – 3 hrs @ `6
Z – 4 hrs @ `8
8
18
32
Factory Cost
58
`178
Overhead Cost
4.70
Problem 4.8 A company has two production departments and two service departments.
The data relating to a period are as under:
Production deptt.
Direct materials
Direct wages
Overheads
Power requirement at normal
capacity operations
Actual power consumption
during the period
Service deptt.
PD 1
PD 2
SD 1
SD 2
(`)
(`)
(`)
80,000
95,000
80,000
40,000
50,000
50,000
10,000
20,000
30,000
20,000
10,000
20,000
(kWh)
20,000
35,000
12,500
17,500
(kWh)
13,000
23,000
10,250
10,000
The power requirement of these departments are met by a power generation plant.
The said plant incurred an expenditure, which in not included above, of `1,21,875, out of
which a sum of `84,375 was variable and the rest fixed.
After apportionment of power generation plant costs to the four departments, the
service department overheads are to be redistributed on the following bases:
SD 1
SD 2
PD 1
PD 2
SD 1
SD 2
50%
60%
40%
20%
—
20%
10%
—
You are required to:
(i) Apportion the power generation plant costs to the four departments;
(ii) Re-apportion service department cost to production departments;
(iii) Calculate the overhead rates per direct labour hour of production departments,
given the direct wage rates of PD1 and PD2 are `5 and `4 per hour, respectively.
(B Com Hons Delhi, CA Inter)
Solution
Primary Overheads Distribution Summary
Item
Total
Direct material
30,000
Direct wages
30,000
Overhead
1,80,000
Variable exp.
84,375
Fixed exp.
Total
37,500
Basis
of
apportionment
PD 1
PD 2
SD 1
SD 2
`
`
`
`
—
—
50,000
34,500
10,000
20,000
30,000
15,375
20,000
10,000
20,000
15,000
15,441
5,515
7,720
99,941
80,890
72,720
Given
—
Given
—
Given
80,000
Actual
19,500
consumption
Normal
8,824
capacity (kWh)
1,08,324
4.71
Overhead Cost
Secondary Overheads Distribution Summary
(Repeated Distribution Method)
PD 1
`
PD 2
`
SD 1
`
SD 2
`
Totals as per primary
distribution
SD 1 apportioned
SD 2 apportioned
SD 1 apportioned
SD 2 apportioned
SD 1 apportioned
SD 2 apportioned
SD 1 apportioned
1,08,324
40,445
48,485
8,081
970
162
19.20
3.55
(A) Total overhead
2,06,489.75
1,55,385.25
—
—
19,000
12,500
—
—
—
—
(B) Direct labour hours
(Direct wages ÷ Wage rate)
PD 1 = 95,000 ÷ 5 = 19,000
PD 2 = 50,000 ÷ 4 = 12,500
Overhead rate per hour (A ÷ B)
10.87
99,941
80,890
72,720
32,356
(–) 80,890
8,089
16,162
16,162
(–) 80,809
6,465
(–) 16,162
1,616
323
323
(–) 1,616
129
(–) 323
32
6.40
6.40
(–) 32
2.85
(–) 6.40
—
12.43
Problem 4.9 The production department of a factors furnishes the following information
for the month of October:
`
Material used
54,000
Direct wages
45,000
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
6,000
Direct wages
3,200
Labour hours worked
3,200
Hours of machine operation
2,400
Calculate the overheads chargeable to the job by the following methods: (i) Direct
material cost percentage rate; (ii) Labour hour rate; and (iii) Machine hour rate.
(B Com Hons Delhi, ICWA Inter)
Solution
1. Direct materials cost percentage rate:
36,000
2
Overheads
 100 = 66 %
 100 =
54,000
3
Direct materials
Overhead Cost
4.72
Materials used on the job cost `6,000.
Overheads chargeable to the job 66 23 % of 6,000  = `4,000
2. Labour hour rate:
Overheads
36,000
=
= `1
Labour hours 36,000
Overheads chargeable to the job [`1 for 3,200 hours] = `3,200
3. Machine hour rate:
Overheads
36,000

= `1.20
Machine hours 30,000
Overheads chargeable to the job [`1.20 for 2,400 hours] = `2,880
Problem 4.10 Work out the Machine Hour Rate for the following machine whose scrap
value is nil:
Details
Amounts ( ` )
Cost of machine
1,90,000
Freight and installation charges
10,000
Working life
Five years
Repairs and maintenance
40% of depreciation
Annual power expenses @ 25 paise per unit
6,000
Eight hourly day charges:
(1) Power
24
(2) Lubrication oil
20
(3) Consumable stores
28
(4) Wages
80
(B.Com., Hons., Delhi)
Solution
Computation of Machine Hour Rate
`)
Per hour (`
2.50
3.50
10.00
Standing Charges:
Lubricating oil (`20 ÷ 8 hrs)
Consumable stores (`28 ÷ 8 hrs)
Wages (`80 ÷ 8 hrs)
Total Standing Charges
16.00
Variable Charges:
 1,90, 000  10, 000 
Depreciation  5 year  2, 000 hrs.* 


20.00
Repairs and maintenance (40% of `20)
Power (`24 ÷ 8 hrs)
8.00
3.00
47.00
Machine Hour Rate
*Calculation of working hours per year:
Power bill per 8 hours
= `24
Power cost per hour
= `24 ÷ 8 = `3
No. of hours per year
= `6,000 ÷ 3 = 2,000 hrs
Problem 4.11 A machine was purchased for `5 lakh. The total cost of all machinery
inclusive of the new machine was `75 lakh. The following further particulars are available:
4.73
Overhead Cost
Expected life of the machine 10 years
Scrap value at the end of ten years `5,000
Repairs and maintenance for the machine during the year `2,000
Expected number of working hours of the machine per year 4,000 hours
Insurance premium annually for all the machines `4,500
Electricity consumption for the machine per hour (@ 75 paise per unit) 25 units
Area occupied by the machine 100 sq. ft
Area occupied by other machines 1500 sq. ft
Rent per month of the department `800
Lighting charges for 20 points for the whole department, out of which three points
are for the machine `120 per month
Compute the machine hour rate for the new machine on the basis of the data given above.
(B. Com. Hons., Delhi; CA Inter)
Solution
Computation of Machine Hour Rate
Per year
`
Standing Charges:
Insurance Premium (5,00,000 × 4,500) ÷ 75,00,000
Repair and Maintenance
Rent [(9,600 × 100) ÷ 1,600)
Lighting Charges (1,440 × 3) ÷ 20
Total Standing Charges
Hourly rate for Standing Charges (`3,116 ÷ 4,000 hrs)
Variable Charges:
Per hour
`
300
2,000
600
216
3,116
0.779
 5,00,000  5,000 
Depreciation 
 10  4,000 
12.375
Electricity (25 units @ 75 paise p.u.)
18.750
Machine Hour Rate
31.904
Problem 4.12 The cost of a machine is `66,000, and it has an estimated scrap value
of `6,000, at the end of its estimated effective life of 10 years. Annually the machine
works on all the 365 days at a rate of 8 hours every day of which 120 hours p.a. are
consumed by maintenance. About 1/7th of the total productive time is consumed in
setting the machines.
Various costs relating to the working of the machines are as follows:
(i) Two units of power are consumed every hour at the rate of `1.40 per unit.
(ii) Monthly cleaning and oiling expenses for the machines are `280.
(iii) Annual maintenance of machines amounts to `2,800.
(iv) Three operators combined together control operation of ten identical machines
and each of them gets a monthly salary of `2,100.
(v) Annual departmental overheads apportioned to the machines are:
fixed: `5,480; variable: `12,600
Overhead Cost
4.74
Compute machine hour rate in each of the following cases:
(i) Setting up time is regarded as productive but power is not consumed during
setting up time.
(ii) Setting up time is not regarded as productive but power is consumed during
setting up time.
(B.Com. Hons., Delhi)
Solution
(i) When setting up time is productive but power is not consumed during setting up
time.
Working hours per year (365 days × 8 hrs)
Less: Maintenance hours
= 2,920 hrs
120 hrs
Effective hours
2,800 hrs
Computation of Machine Hour Rate
Standing Charges:
Per annum
`
Salary of operators (`2,100 × 12 months ×
3
)
10
Per hour
`
7,560
Cleaning and oiling (`280 × 12 months)
Departmental overhead
3,360
5,480
 `66,000  600 

Depreciation 
 10 years 
Maintenance
6,000
2,800
Total
25,200
Standing charges per hour (`25,200  2,800 hrs)
Variable Overhead (`12,600  2,800 hrs)
9.00
4.50

2,400 hrs. 

Power  `1.40  2 units 
2,800 hrs. 

2.40
Machine Hour Rate
15.90
(ii) When setting up time is not productive but power is consumed during setting up
time. Set up time 2,800 × 1 7 = 400 hrs.
Effective hours = 2800 hrs – 400 hrs = 2400 hrs.
Computation of Machine Hour Rate
Standing charges (`25,200  2,400 hrs)
Variable overhead (`12,600  2,400 hrs)

2800 hrs.
Power  `1.40  2 units 
2400 hrs.

Machine Hour Rate
Per hour `
10.50
5.25
3.27
19. 02
4.75
Overhead Cost
Problem 4.13
From the data given below, calculate the machine hour rate:
Per annum
`
Rent of the department (space occupied by machine
is 1/5 of the department)
Lighting (number of men in the department, 12, two men
are engaged on this machine)
Insurance
Cotton waste, oil, etc.
Salary of foreman (one-fourth of the foreman’s time is occupied
by this machine)
780
288
36
60
6,000
The cost of the machine is `9,200 and it has an estimated scrap value of `200.
It is ascertained from past experience: (i) that the machine will work for 1,800 hours
per annum; (ii) that it will incur expenditure of `1,125 in respect of repairs and
maintenance; (iii) that it consumes 8 units of power per hour at the cost of `1 per unit;
and (iv) that the working life of the machine will be 10 years. (B. Com. Delhi, Mysore)
Solution
Computation of Machine Hour Rate
Per year
`
Standing Charges:
Rent
(780 × 1/5)
Lighting (288 × 2/12)
Foreman’s salary (6,000 × 1/4)
Insurance
Cotton waste, oil, etc.
Total
Hourly rate (`1,800 ÷ 1,800 hrs)
Variable Expenses:
Depreciation
 9,200  200 


 1,800 10 
*Repairs and maintenance
[1,125 ÷ (1,800 × 10)]
Power 8 units @ `1 per unit
Machine hour rate
Per hour
`
156
48
1,500
36
60
1,800
1.00
0.50
0.06
8.00
9.56
* It is assumed that expenditure of `1,125 on repairs and maintenance is for the whole life of 10 years of
the machine.
Problem 4.14 Calculate machine hour rate for recovery of overheads for a machine from
the following information:
Cost of machine is `25,00,000 and estimated salvage value is `1,00,000. Estimated
working life of the machine is 10 years. Annual working hours are 3,000 in the factory.
The machine is required 400 hours per annum for repairs and maintenance. Setting-up
time of the machine is 156 hours per annum to be treated as productive time. Cost of
repairs and maintenance for whole working life of the machine is `3,50,000. Power used
is 15 units per hour at a cost of `5 per unit. No power is consumed during maintenance
and setting-up time. A chemical required for operating the machine is `9,880 per annum.
Overhead Cost
4.76
Wages of an operator is `4,000 per month. The operator devoted one-third of his time
to the machine. Annual insurance charges 2 per cent of cost of machine.
Light charges for the department is `2,500 per month, having 48 points in all, out
of which only 8 points are used at this machine. Other indirect expenses are chargeable
to the machine are `6,500 per month.
(CA PE-II)
Solution
Computation of Machine Hour Rate
Per year
`
Standing Charges:
Insurance (2% of `25,00,000)
 ` 4,000  12 months 
Operator’s wages: 

3 machines

` 2,500  12  8
48
Other indirect expenses: `6,500 × 12 months
Light charges:
Total standing charges
Hourly rate for standing charges:
`1,49,000  2600 hrs*
Variable Expenses:
Per hour
`
50,000
16,000
5,000
78,000
1,49,000
57.31
` 25,00,000 – 1,00,000
Depreciation: 10 years  2,600 * hrs
92.31
`3,50,000
Repairs and maintenance: 10 yrs.  2,600 * hrs
13.46
Power:
`5  15  2, 444 * hrs
2,600 hrs *
70.50
`9,880
2, 600 hrs *
3.80
Chemical:
Machine Hour Rate (comprehensive)
237.38
Working Note:
1. Effective hours = 3,000 – 400 = 2,600 hrs.
2. Hours when power is used = 2,600 – 156 = 2,444 hrs.
Problem 4.15 The following annual charges are incurred in respect of a machine in a
shop where manual labour is almost nil and where work is done by means of five
machines of exactly similar type and specification:
`
1.
2.
3.
4.
5.
Rent and rates (proportional to the floor space occupied) for the shop 4,800
Depreciation on each machine
500
Repairs and maintenance for the five machines
1,000
Power consumed (as per meter) @ 5 paise per unit for the shop
3,000
Electric charges for lights in the shop
540
4.77
Overhead Cost
6.
Attendants: There are two attendants for the five machines and they
are each paid `60 per month.
7. Supervision: For the five machines in the shop there is one supervisor
whose emoluments are `250 p.m.
8. Sundry suppliers such as lubricants, cotton waste, etc., for the shop. 450
9. Hire-purchase instalment payable for the machine
1,200
The machine uses 10 units of power per hour.
Calculate the machine hour rate for machine for the year.
Solution
Computation of Machine Hour Rate
` (P.A.)
Fixed Charges per Machine:
Rent and rates 4800  5
960
Depreciation
Repairs and maintenance
Electric charges 540  5
500
200
108
(250  12)
5
Sundry supplies 450  5
Supervision
600
90
Total fixed charges
2,458
` Per hour
Fixed charges per hour (2,458 ÷ 1200 hrs*)
2.05
Variable Charges:
 60  2  12 
Attendants wages  5  1200 


0.24
Power (10 units @ 5 paise per unit)
0.50
Machine Hour Rate
2.79
*Working Notes:
1. Hire purchase instalment is a capital item and thus not included in machine hour rate computation.
2. Each machine runs for 1,200 hours per year. This is computed from the power cost as under.
10 units @ 5 paise = 50 paise per hour and total cost is `3,000
Total hours =
`3,000
= 6,000 hrs for 5 machines
50 paise
Hours per machine = 6,000 ÷ 5 = 1,200
Problem 4.16
below:
(a) Calculate the machine hour rate of a machine with information given
Operating data:
Total number of weeks per quarter
= 13
Total number of hours per week
= 48
Overhead Cost
4.78
Stoppage due to maintenance
= 8 hrs p.m.
Time taken for set-up
= 2 hrs/week
Cost details:
Cost of machine
= `2,00,000
Repair and maintenance
= `24,000 p.a.
Consumable stores
= `30,000 p.a.
Rent, rates and taxes
= `8,000 per quarter
Operator’s wages
= `3,000 p.m.
Supervisor’s salary
= `5,000 p.m.
Cost of power
= 15 units per hour at `3 per unit
Given:
(i) Life of the machine is 10 years. Depreciation is provided on straight line basis
and is treated as variable cost.
(ii) Repairs and maintenance and consumable stores are variable costs.
(iii) Power is consumed for production runs only and not for set-up or
maintenance. But cost of power is to be borne by the total time excluding
maintenance stoppages.
(iv) The supervisor is supervising work on five identical machines including the
one now being considered.
(b) The company hires out excess capacity in the machine shop for outside jobs.
Assuming that hire charges are fixed at variable cost plus 20%, what rate should be
quoted by the company?
(ICWA Inter)
Solution
Total hours per quarter = 48 hrs × 13 weeks
Less: Maintenance hours (8 hrs × 3 months)
Less: Set-up hrs (2 hrs × 13 weeks)
=
624
24
600
26
574
(a)
Computation of Machine Hour Rate
Per quarter
`
Fixed Costs:
Rent, rates and taxes
Operators’ wages (`3,000 × 3 months)
Supervisor’s salary (`5,000 × 3 months) ÷ 5
8,000
9,000
3,000
Total fixed cost
20,000
Variable Costs:
1 1

Depreciation  ` 2,00, 000 
 
10 4 

Repairs and maintenance (`24,000 ÷ 4)
5,000
6,000
(Contd...)
4.79
Overhead Cost
Consumable stores (`30,000 ÷ 4)
Power (15 units @ `3 per unit for 574 hrs)
7,500
25,830
Total variable cost
Total cost (Fixed + Variable)
Machine Hour Rate
44,330
64,330
= ` 107.22
= `64,330 ÷ 600 hrs
(b) Rate to be quoted for hiring out excess capacity
`
Variable cost per hour (`44,330 ÷ 600 hrs)
73.88
Add: 20% profit
14.78
Hire Rate
88.66
Problem 4.17 A Machine shop cost centre contains three machines of equal capacities.
Three operators are employed on all machines, payable `20 per hour each. The factory
works for 48 hours in a week which includes 4 hours set up time. The work is jointly
done by operators. The operators are paid fully for the 48 hours. In addition, they are
paid a bonus of 10 per cent of productive time. Costs are reported for this company on
the basis of thirteen four-weekly periods.
The company for the purpose of computing machine hour rate includes the direct
wages of the operator and also recoups the factory overheads allocated to the machines.
The following details of factory overheads applicable to the cost centre are available:
• Depreciation at 10% per annum on original cost of the machine. Original cost of
the each machine is `52,000.
• Maintenance and repairs per week per machine is `60.
• Consumable stores per week, per per machine are `75.
• Power: 20 units per hour per machine at the rate of 80 paise per unit.
• Apportionment to the cost centre: Rent per annum `5,400, heat and light per
annum `9,720, and foreman’s salary per annum `12,960.
Required:
(i) Calculate the cost of running one machine for a four week period.
(ii) Calculate machine hour rate.
(B.Com. Hons., Delhi, CA PE-II)
Solution
Computation of Machine Hour Rate
Standing Charges:
Rent
Heat and light
Foreman’s salary
Per annum `
5,400
9,720
12,960
28,080
Standing charges per machine for 4 weeks
 ` 28,080  4 weeks 


 3 machines  52 weeks 
Direct wages of operators
(48 hr × 4 weeks × `20)
Bonus (176* × `20 × 10%)
Total
720
3,840
352
4,912
Overhead Cost
4.80
Machine Expenses:
`
4 

Depreciation =  ` 52,000  10%  
52


Repairs and maintenance = `60 × 4 weeks
Consumable stores (`75 × 4 weeks)
Power (176 hrs × 20 units × 0.80)
240
300
2,816
Total machine expenses
3,756
Total cost (4,912 + 3,756)
Machine Hour Rate `8,668  176* hrs = ` 49.25
8,668
400
Working Note:
Productive time per 4 weeks = (48 hrs – 4 hrs) × 4 weeks = 176 hours.
Problem 4.18 PBR Enterprises undertake different jobs which require the use of a special
machine and also the use of a computer. The computer is hired and the hire charges work
out to `4,20,000 per annum. The expenses regarding the machine are estimated as follows:
`
Rent for quarter
17,500
Depreciation per annum
2,00,000
Indirect charges per annum
1,50,000
During the first month of operation, the following details were taken from the job register:
Jobs
A
B
C
(a) Without use of the computer
600
900
—
(b) With use of the computer
400
600
1,000
Number of hours the machine was used:
You are required to compute the machine hour rates for the firm as a whole for the
month: (a) when the computer was used, and (b) when the computer was not used.
(CA Inter, Adapted)
Solution
Computation of Machine Hour Rate
Rent (`17,500 ÷ 3)
Depreciation (`2,00,000 ÷ 12)
Indirect charges (`1,50,000 ÷ 12)
Total
(b) Machine Hour Rate (when the computer is not used)
`35,000  3,500 hrs*
 ` 4,20,000 
Computer hire charges  12  2,000 hrs 
(a) Machine Hour Rate (when computer is used)
Per month
`
5,833.33
16,666.67
12,500.00
Per hour
`
35,000.00
10.00
17.50
27.50
4.81
Overhead Cost
*Working Notes:
Total working hours when computer is used
Total working hours when computer is not used
Total hours of machine operation
= 400 + 600 + 1,000
= 600 + 900
= 2,000 + 1,500
= 2,000
= 1,500
= 3,500
Problem 4.19 A manufacturing company uses two large and four small identical machines.
Each large machine occupies one quarter of the workshop and fully employs three
workers, each small machine occupies half the space of a large machine and fully
employs two workers. The workers are paid by piece work.
Each of the six machines is estimated to work 1,440 hours per year, while the effective
working life is taken as 12,000 working hours for each large machine and 9,000 working
hours for each small machine Large machines cost `20,000 each and small machines `4,000
each. Scrap values are `4,000 and `100, respectively.
Repairs, maintenance and oil are estimated to cost for each large machine `4,000 and
each small machine `1,200 during its effective life.
Power consumption cost is 5 paise per unit and amounts for a large machine 20 units
per hour and for a small machine 2 units per hour.
The manager is paid `4,800 a year and workshop supervision occupies 1/2 of his time,
which is divided equally among the six machines.
Details of other expenses are:
Rent and rates to workshop: `6,400 a year.
Lighting (to be apportioned in the ratio of workers employed): `1,820 a year.
Taking a period of three months as a basis, calculate the Machine Hour Rate for a large
machine and a small machine, respectively.
(B Com Hons Delhi)
Solution
Computation of Machine Hour Rate
Standing Charges per 3 Months:
Rent and rates*
Lighting*
Manager’s salary*
Total
Per large
machine
`
Per small
machine
`
400.00
97.50
100.00
200.00
65.00
100.00
597.50
365.00
Large machine
per hour
`
Standing charges per hour
(Large `597.50 ÷ 360 hours)
(Small `365.00 ÷ 360 hours)
Variable Charges:
Depreciation*
Repairs and maintenance*
Power – Large (20 units @ `0.05)
Small (2 units @ `0.05)
Machine Hour Rate
Small machine
per hour
`
1.66
1.01
1.33
0.33
1.00
0.43
0.13
0.10
4.32
1.67
Overhead Cost
4.82
*Working Notes:
1. Working hours in the base period of 3 months = 1,440 × 3/12
= 360
2. Rent and rates – Per annum for the shop `6,400
for 3 months 6,400 × 3/12
= `1,600
Each large machine = 1,600 × 1/4
= `400
Each small machine = 1,600 × 1/8
3. Lighting - per annum for the shop
For three months = 1,820 × 3/12
= `200
= `1,820
= `455
No. of workers employed – Large machine = 3 × 2
= 6
– Small machine = 2 × 4
= 8
Thus lighting expenses of `455 have been distributed to large and small machines in the ratio
of 6 : 8
For two large machines = `455 × 6/14
= `195
For each large machine = `195 ÷ 2
= `97.50
Similar calculations can be made for small machine.
4. Manager’s salary – 4,800 × 1/2 = `2,400 for all the six machines
Per machine = `2,400 ÷ 6 machines
= `400
Per machine per three months = 400 × 3/12
= `100
20,000  4,000
5. Depreciation per hour: Large Machine –
12,000 hrs
Small Machine –
4,000  100
9,000 hrs
= `1.33
= `0.43
6. Repair and maintenance per hour
Large machine – `4,000 ÷ 12,000 hrs
= `0.33
Small machine – `1,200 ÷
= `0.13
9,000 hrs
Problem 4.20 X Ltd, having 15 different types of automatic machines, furnishes
information as under for the current year.
(i) Overhead expenses: Factory rent `96,000 (Floor area 80,000 sq. ft). Heat and gas
`45,000 and supervision `1,20,000.
(ii) Wages of the operator are `48 per day of 8 hours. He attends to one machine
when it is under set-up and two machines while they are under operation.
In respect of machine B (one of the above machines), the following particulars are
furnished:
(i) Cost of machine `45,000. Life of machine is 10 years and scrap value at the end
of its life `5,000.
(ii) Annual expenses on special equipment attached to the machine are estimated at
`3,000.
(iii) Estimated operation time of the machine is 3,600 hours while set up time is
400 hours per annum.
(iv) The machine occupies 5,000 sq. ft of floor area.
(v) Power costs `2 per hour while machine is in operation.
Find out the comprehensive machine hour rate of machine B. Also find out machine
costs to be absorbed in respect of use of machine B on the following two work-orders:
4.83
Overhead Cost
Work-order 31
10
90
Machine set-up time (hours)
Machine operation time (hours)
Work-order 32
20
180
(CA Inter)
Solution
Computation of Machine Hour Rate
Standing Charges per Machine per Annum:
`
 ` 96,000

× 5,000 sq. ft 
Factory rent 
80,000
sq.
ft


6,000
Heat and gas (`45,000 ÷ 15 machines)
Supervision (`1,20,000 ÷ 15 machines)
Expenses on special equipment
Depreciation (45,000 – 5,000) ÷ 10 years
3,000
8,000
3,000
4,000
Total
24,000
Standing charges per hour = `24,000 ÷ 4,000 hrs = `6.
Rate per
set-up hour
Rate per
operation hour
Fixed charges
Wages
Power
`
6
6
–
`
6
3
2
Machine Hour Rate (Comprehensive)
12
11
Statement of Cost
Rate
Setting up time cost
Operation time cost
Work order 31
per hour
Hours
`
Hours
12
11
10
90
120
990
20
180
Total
Problem 4.21
Work order 32
1,110
`
240
1,980
2,220
Following information of the three machines of a department of X Ltd.
Depreciation
Preliminary estimates of expenses (p.a.)
Total
Machines
A
B
C
`
`
`
`
20,000
7,500
7,500
5,000
Spare parts
10,000
Power
40,000
Consumable stores
8,000
Insurance of machines
8,000
Indirect labour
20,000
4,000
4,000
2,000
3,000
2,500
2,500
Overhead Cost
4.84
Building maintenance
20,000
Annual interest on capital outlay
50,000
Monthly charges for rent
10,000
Salary of foreman (per month)
20,000
Salary of attendant (per month)
5,000
The foreman and attendant control all the three machines and spend equal time on them.
The following additional information is also available:
Machines
A
B
C
Estimated direct labour hours
1,00,000
1,50,000
1,50,000
Ratio of kW rating
3
2
3
Floor space (sq. ft.)
40,000
40,000
20,000
There are 12 holidays besides Sundays in the year of which 2 were on Saturdays.
The manufacturing department works 8 hours in a day but Saturdays are half days. All
machines work at 90% capacity throughout the year and 2% is reasonable for break down.
Calculate the predetermined machine hour rates for the above machines after considering
the following factors:
• An increase of 15% in the prices of spare parts
• An increase of 25% in the consumption of spare parts of machines B and C only.
• 20% general increase in wage rates
(C.A. P.E.)
Solution
Computation of Machine Hour Rates
Particulars
Total
`
A
`
B
`
C
`
Floor space
Depreciation
Direct labour
Floor space
1,20,000
8,000
24,000
20,000
48,000
3,000
6,000
8,000
48,000
3,000
9,000
8,000
24,000
2,000
9,000
4,000
Foreman salary
Equal
2,40,000
80,000
80,000
80,000
Attendant salary
Equal
60,000
20,000
20,000
20,000
Standing Charges:
Rent
Insurance
Indirect labour*
Building maintenance
Basis
Total
4,72,000 1,65,000
*Standing charges per hr (A)
Variable Charges:
Depreciation
Direct
20,000
1,68,000 1,39,000
84.75
86.29
71.40
7,500
7,500
5,000
Spare parts*
Final estimates
13,225
4,600
5,750
2,875
Power
kW
40,000
15,000
10,000
15,000
Consumable stores
Direct
8,000
3,000
2,500
2,500
81,225
Total
30,100
25,750
25,375
*Variable charges per hour (B)
15.46
13.23
13.03
Machine Hour Rate (A + B)
100.21
99.52
84.43
4.85
Overhead Cost
*Working Notes:
1.
Calculation of effective working hours
No. of holidays 52 (Sundays) + 12 + 50 (Saturdays)
=
114
No. of full working days
= 365 – 114
=
251
Hrs for full working days
= 251 × 8
=
2,008
Saturday (half day)
50 × 4
=
200
2,208
Effective capacity (90% of 2,208 hrs)
1,987 hrs
Less: Normal breakdown time 2%
40 hrs
Effective running time (Rounded off)
2.
Cost of spare parts
Basic amounts
Add: 15% price increase
Add: 25% increase in consumption
Total
3.
1,947 hrs
A
B
`
`
C
`
4,000
4,000
2,000
600
600
300
4,600
4,600
2,300
—
1,150
575
4,600
5,750
2,875
Indirect labour = 20,000 + 20% increase = `24,000
Problem 4.22 Meerut Manufacturing Company makes several product lines which are
processed through three production departments—X, Y and Z. The relevant data for a
year is as follows:
Department X
Department Y
Department Z
Factory overhead
(including share of
service department)
`
1,24,000
2,30,000
5,46,000
Direct labour
hours
80,000
1,15,000
1,05,000
Direct labour
cost
`
1,60,000
2,41,500
1,99,500
Production records at the end of the year indicated the following for the product line
‘Krish’.
Units produced
20,000
Deptt. X
Deptt. Y
Deptt. Z
`
`
`
Prime cost
45,000
10,500
59,500
Direct labour hours
10,000
5,000
30,000
You are required to
(a) Calculate the departmental and plant-wide overhead rates based on direct labour
hours
(b) Compute the cost of ‘Krish’ line for the year by using:
(i) Plant wide rate, (ii) departmental rates
(c) Comment on the results
(B Com Hons Delhi)
Overhead Cost
4.86
Solution
(a) Calculation of Departmental Overhead Rates
Overhead rate per hour
=
Factory overhead
Direct labour hours
Department X
=
1,24,000
= `1.55
80,000
Department Y
=
2,30,000
= `2.00
1,15,000
Department Z
=
5,46,000
= `5.20
1,05,000
Single plant-wide rate
=
Total overheads of X, Y and Z deptts.
Total labour hours of X , Y and Z deptts.
=
1,24,000 + 2,30,000 + 5,46,000
9,00,000
=
= `3
80,000 + 1,15,000 + 1,05,000
3,00,000
(b)
Statement of Cost of ‘Krish’
Departmental
`
Prime cost – Deptt.
Y
Z
Factory overhead:
Deptt. X (10,000 hrs @ 1.55)
Y (5,000 hrs @ 2.00)
Z (30,000 hrs @ 5.20)
Plant-wide (45,000 hrs @ `3)
X
10,500
59,500
1,15,000
15,500
10,000
1,56,000
1,81,500
Factory Cost
2,96,500
Plant-wide
`
45,000
1,15,000
1,35,000
2,50,000
(c) Comments For accurate costing, departmental rates should be preferred over single
plant-wide rate for absorption of factory overheads. This is because a product
may not uniformly avail of the services of various departments. If this is so, the
use of a single plant-wide rate will distort the cost, resulting in under-costing or
over-costing of cost units. In the present problem, it can be seen that incidence
of factory overhead in different departments is different resulting in different
departmental overhead rates. Product ‘Krish’ has also not used various departmental
facilities in a uniform way. In this case, use of single plant-wide rate has resulted
in an overhead charge of `1,35,000, whereas use of departmental rates result in
an overhead charge of `1,81,500. Thus use of a plant-wide rate has resulted in
under-costing of Krish product because of inequitable absorption of factory
overheads. In this case, it is, therefore, better to use departmental overhead rates.
Problem 4.23
The following data relate to a manufacturing department for a period:
Budgeted data
Actual data
Direct material
`1,00,000
`1,40,000
Direct labour
`2,00,000
`2,50,000
4.87
Overhead Cost
`2,00,000
`2,30,000
Direct labour hours
50,000
62,500
Machine hours
40,000
50,000
Production overheads
Job ZX was one of the jobs worked on during the period. The actual data relating to
this job were: Direct material `6,000. Direct labour `3,000. Direct labour hours 750 and
machine hours 750.
Required:
(i) Calculate the production overhead absorption rate predetermined for the period
based on (1) percentage of direct material cost; and (2) machine hours.
(ii) Calculate the production overhead cost to be charged to Job ZX based on the rates
calculated in (i) above.
(iii) Assuming that a machine-hour rate of absorption is used, calculate the under/overabsorption of production overheads for the period and state the appropriate
treatment in the accounts.
(B. Com. Hons., Delhi)
Solution
(i) Calculation of Pre-determined Overhead Rates
1. Percentage of material cost
2. Machine hour rate
=
Production overhead
× 100
Direct material cost
=
2,00,000
× 100 = 200%
1,00,000
=
Production overhead
Machine hours
=
` 2,00,000
= `5
40,000 hrs
(ii) Overhead Chargeable to Job ZX
1. Percentage of direct material cost = Direct material cost × Rate
= `6,000 × 200% = `12,000
2. Machine hour rate method
= Machine hours × Rate
= 750 hrs × `5 = `3,750
(iii) Calculation of Under/Over-absorbed Overhead
Overhead absorbed
= Actual machine hrs × rate
= 50,000 × `5 = `2,50,000
Absorbed overhead – Actual overhead
= 2,50,000 – 2,30,000 = `20,000 over-absorbed overhead
Treatment in Cost Accounts There is over-absorption of production overhead to
the tune of `20,000. As this amount is significant, supplementary rate method should be
used. Supplementary rate is computed as under:
Over-absorbed overheads ÷ Actual machine hours
`20,000 ÷ 50,000 hrs = `0.40 per machine hour
The cost of goods sold, stock of finished goods and stock of work-in-progress should
be reduced by this supplementary rate as this is a minus rate.
Problem 4.24 The total overhead expenses of a factory are `4,46,380. Taking into
account the normal working of the factory, overhead cost was recovered in production
Overhead Cost
4.88
at `1.25 per hour. The actual hours worked were 2,93,104. How would you proceed to
close the books of accounts, assuming that besides 7,800 unit produced (of which 7,000
were sold), there were 200 equivalent units in work-in-progress.
On investigation, it was found that 50% of the unabsorbed overheads were on account
of increase in cost of indirect materials and indirect labour and the remaining 50% were
due to factory inefficiency. Also give the profit implication of the method suggested.
(CA Inter)
Solution
`
Less:
Actual overheads
Recovered overheads (2,93,104 hr × `1.25)
Unabsorbed overhead
4,46,380
3,66,380
80,000
Treatment
1. 50% of unabsorbed overheads, i.e., `40,000 due to factory inefficiency, should
be treated as abnormal loss and charged to Costing Profit and Loss Account.
2. Remaining 50% of unabsorbed overheads, i.e., `40,000, which is due to increase
in the cost of indirect material and labour, should be charged to units produced
by using supplementary rate.
Supplementary rate =
` 40,000
= `5 per unit
(7,800  200) units
Charge to cost of sales (7,000 units × `5)
`
35,000
Charge to finished good (800 units × `5)
4,000
Charge to work-in-progress (200 units × `5)
1,000
Total
40,000
The effect of this will be that it will increase cost of sales by 35,000. This will reduce
the profit by that amount. It will also increase the value of finished goods and work in
progress by 4,000 and `1,000, respectively, both being credit items, will increase profit
by `5,000. The net effect will be reduction in profit by `30,000 (i.e., `35,000 – 5,000).
Problem 4.25
The budgeted working conditions for a cost centre are as follows:
Normal working hours per week
Number of machines
Normal weekly loss of hours on
maintenance, etc.
No. of weeks worked per year
Estimated annual overheads
Estimated direct wage rate
42 hours
14
5 hours per machine
48
`1,24,320
`4 per hour
Actual results in respect of a 4 weeks period are:
Wages incurred
`9,000
Overheads incurred
`10,200
Machine hours produced
2,000
4.89
Overhead Cost
You are required to calculate:
(a) the overhead rate per machine hour, and
(b) the amount of under or over-absorption of wages and overheads.
(B. Com. Hons. Delhi, ICWA)
Solution
Normal working hours for the year
= 48 weeks × 42 hours × 14 machines
= 28,224 hours
Less: Loss of hours due to maintenance
= 48 weeks × 5 hours × 14 machines
= 3,360 hours
Effective working hours
= 24,864 hours
`1,24,320
Estimated overheads per year
(a) Machine Hour Rate (`1,24,320 ÷ 24,864 hrs)
Overheads absorbed 2,000 hrs @ `5
=
`5
=
`10,000
`10,200
Less: Overheads incurred
`200
(b) Under-absorbed Overheads
Wages absorbed (4 weeks × 42 hrs × 14 machines × `4) =
`9,408
`9,000
Less: Wages incurred
`408
Over-absorbed Wages
Problem 4.26 A manufacturing company has four production departments. Overhead
cost is absorbed to its production departments by means of departmental rates per direct
labour hour. In a particular year, there was a large difference between the overhead cost
incurred and the overheads absorbed. On analysis you get the following information:
Departments
Overheads incurred
Actual direct labour hours worked
Estimated departmental rate used
Total overheads absorbed
Direct labour hours contained in:
Work-in-progress
Finished goods
A
B
C
D
`
`
`
`
12,320
30,800
0,50
15,400
44,385
80,700
0,45
36,315
18,180
40,400
0,40
16,160
16,720
30,400
0,50
15,200
3,000
4,300
10,400
8,300
1,900
4,000
7,200
2,900
You are required to: (a) Calculate, for each deptt, the direct labour hour rates of
overheads incurred; (b) Calculate the extent to which the values of work-in-progress and
finished goods should be increased or decreased for each department for the year in view
of corrected rates; (c) What will be the impact on total profit of the company in view of
the correction in above?
(ICWA Inter)
Overhead Cost
4.90
Solution (a and b)
Computation of Overhead Rates and Under/Over-absorption
Departments
A
A. Overhead incurred
`
12,320
B. Actual hours worked
30,800
C. Actual rate per hr. (A ÷ B)
`
0.40
D. Estimated rate per hr.
`
0.50
E. Supplementary rate (C – D)
`
– 0.10
F. Direct labour hrs contained in
(i) Work in progress
3,000
(ii) Finished goods
4,300
Stock values to be adjusted (E × F):
(i) Work-in-progress
`
– 300
(ii) Finished goods
`
– 430
`
Total
– 730
B
C
D
44,385
80,700
0.55
0.45
+ 0.10
18,180
40,400
0.45
0.40
+ 0.05
16,720
30,400
0.55
0.50
+ 0.05
10,400
8,300
1,900
4,000
7,200
2,900
+ 1,040
+
830
+ 95
+ 200
+ 360
+ 145
+ 1870
+ 295
+ 505
Statement of Effect on Profit
`
Value of closing stock to be increased:
Deptt. B
Deptt. C
Deptt. D
1,870
295
505
Less: Value of closing stock to be decreased
Deptt. A
2,670
730
Net value of closing stock to be increased
1,940
Since the overhead cost was under-recovered to the extent of `1,940, increase in
value of closing stock will lead to an increase in profit by the same amount.
Problem 4.27 XYZ Co. uses a historical cost system and applies overheads on the
basis of predetermined rates. The following data are available from the records of the
company for the year ended 31 March 2018:
`
Manufacturing overheads incurred
8,50,000
Manufacturing overheads applied
7,50,000
Work-in-progress
2,40,000
Finished goods stock
4,80,000
Cost of goods sold
16,80,000
Apply two methods for disposal of under-absorbed overheads, showing the
implications of each method on the profit of the company.
(ICWA Inter)
Solution
Manufacturing overheads – Actual
Manufacturing overheads – Applied
`8,50,000
7,50,000
Under-absorbed overhead
1,00,000
4.91
Overhead Cost
Methods of Disposal
Method I Under-absorbed amount of overhead cost of `1,00,000 is added to cost of
sales, work-in-progress and finished stock in the ratio of 168 : 24 : 48 or 7 : 1 : 2 as under:
Amount
Cost of sales
Work-in-progress
Finished stock
Total
`
Under-absorbed
overheads added
`
16,80,000
2,40,000
4,80,000
70,000
10,000
20,000
17,50.000
2,50,000
5,00,000
24,00,000
1,00,000
25,00,000
`
Effect on Profit The profit will reduce by `70,000 because of increase in the cost
of sales which is debited to Profit and Loss Account. On the other hand, `30,000 will be
credited to Profit and Loss Account on account of increase in the value of closing stock
of work-in-progress and finished goods, i.e., `10,000 + 20,000. Thus, the net effect of
using this method is that the profit for the year will be reduced by `40,000, i.e., `70,000
– (10,000 + 20,000).
Method II The entire amount of under-absorbed manufacturing overheads may be
carried forward to the next year if it is presumed that such under-absorption has arisen
due to cyclical or seasonal fluctuations. In such a case, the profit of the current year will
then be based on predetermined overheads and remain unaffected.
Problem 4.28 In a factory, the expenses of factory are charged on a fixed percentage
basis on wages and office overhead expenses are calculated on the basis of percentage
of works cost. Following information is supplied to you:
Order I
Order II
Material
12,500
18,000
Wages
10,000
14,000
Selling price
44,850
61,880
Percentage of profit on cost
15%
12%
Find out the percentage for factory overheads and office overheads.
(CA Inter; ICWA Inter)
Solution
ORDER I:
Selling price = `44,850 including 15% profit on cost.
100 

\ Cost of production =  44,850 
 = `39,000

115 
ORDER II:
Selling price = `61,880 including 12% profit on cost.
100 

Cost of production =  61,880 
 = `55,250

112 
Cost of production = Materials + Wages + Factory overheads + Office overheads.
Factory overheads are charged as a fixed percentage of wages and office overheads
as fixed percentage of works cost. As factory overheads and office overheads are not
known, suppose
Overhead Cost
4.92
Factory overheads = X% of wages.
Office overheads
= Y% of works cost.
Substituting these values in equations
ORDER I:
X

 X
 Y 
 10,000  
 10,000
39,000 = 12,500 + 10,000 + 
 22,500 

100
 100
 100
Y
or 39,000 = 22,500 + 100X +
(22,500 + 100X)
100
or 16,500 = 100X + 225Y + XY
ORDER II:
Y 
X
 X


 14,000 
32,000 
 14,000
55,250 = 18,000 + 14,000 + 
 100 

100
100
or 23,250 = 140X + 320Y + 1.4XY
Solving equations (1) and (2) simultaneously by multiplying equation (1) by 14 and
equation (2) by 10, we get
(1) 2,31,000 = 1,400X + 3,150Y + 14XY
(2) 2,32,500 = 1,400X + 3,200Y + 14XY
By subtraction, we get
1,500 = 50Y
Y = 30
and pulling the value of Y in equation (1), we get
16,500 = 100X + 6,750 + 30X
or
9750 = 130X
or
X = 75
\ Factory overheads are 75% of wages and office overheads are 30% on works cost.
Verification
Order I
Order II
`
`
Materials
12,500
18,000
Wages
10,000
14,000
Factory overheads (75% on wages)
7,500
10,500
Works Cost
30,000
42,500
9,000
12,750
39,000
(15%) 5,850
55,250
(12%) 6,630
44,850
61,880
Office overheads (30% on works cost)
Cost of Production
Add: Profit
Selling Price
Problem 4.29 Aggarwal Manufacturing Company is producing three types of products—
A, B and C. The sales territory of the company is divided into three areas—North, South
and West. The estimated sales for the year are as under:
4.93
Overhead Cost
Products
A
B
C
North
`
Territories
South
`
West
`
5,000
3,000
—
2,000
—
7,000
—
8,000
4,000
Budgeted advertising cost is as under:
Products
Local cost
General
North
`
South
`
Territories
West
`
Total
`
320
—
450
—
420
—
1,190
580
Find out the advertising cost percent on sales for each product and territory showing
how you would present the statement to management.
(ICWA Inter)
Solution
General advertising cost of `580 is common to all territories and is apportioned on the
basis of sales value as under:
Territory
North
South
West
Product
Sales
General Advt.
Cost
`
`
`
`
A
B
5,000
3,000
8,000
100
60
160
A
C
2,000
7,000
9,000
40
140
180
B
C
8,000
4,000
12,000
160
80
Total
29,000
240
580
Local advertising costs allocated to territories are apportioned to products on the basis
of sales value and are as follows:
Territory
North
South
West
Product
Sales
General Advt.
Cost
`
`
`
`
A
B
5,000
3,000
8,000
200
120
320
A
C
2,000
7,000
9,000
100
350
450
B
C
8,000
4,000
12,000
280
140
420
Overhead Cost
4.94
Statement of Advertising Cost
Product
North
`
Territories
South
`
A
B
C
300
180
—
140
—
490
—
440
220
440
620
710
6.28%
5.64%
6.45%
Total
% on sales
480
6%
630
7%
660
5.5%
1770
6.10%
6.10%
West
`
Total
`
% of sales
Problem 4.30 Sistas & Co. manufacture product A, at the rate of 80 pieces per hour.
The company has been producing and selling 1,60,000 units annually, during the period
2007 to 2011. However, during the year 2012 the company was able to produce 1,46,000
units only. The company’s annual fixed overheads, for 2012 amounted to `5,84,000. The
company works on single shift only at 8 hours per day and 6 days a week. The company
had declared 13 holidays during the year 2012. The quarterly preventive maintenance and
repairs work involved 77 hours. You are required to:
(a) Calculate the maximum, practical, normal and actual capacities in 2012, in terms
of hours
(b) Compute the idle capacity and hourly rate for recovery of overhead rates for each
of the capacities computed at (a) above
(c) Prepare a statement showing the idle capacity cost assuming that the overhead
rates of recovery are based on the various capacities arrived at (a) above
(ICWA Inter)
Solution
(a) Calculation of Capacity Levels in Terms of Hours in the Year 2012
(i) Maximum capacity = 366 days × 8 hrs
= 2,928 hrs
(ii) Practical capacity = Max. capacity – [52 sundays + 13 holidays + (77 × 4 qtrs)]
= 2,928 – [(52 × 8) + (13 × 8) + 308)]
= 2,928 – (416 + 104 + 308)
= 2,928 – 828
= 2,100 hrs
(iii) Normal capacity = Normal production and sales ÷ Hourly production
1,60,000 ÷ 80
= 2,000 hrs
(iv) Actual capacity
= Actual production ÷ Hourly production
= 1,46,000 ÷ 80
= 1,825 hrs
(b)
Statement of Idle Capacity and Overhead Rate Per Hour
Type of
capacity
Base
capacity
hrs
(A)
Utilized
capacity
hrs
(B)
Idle
capacity
hrs
(A – B)
Overhead
rate (` )
(5,84,000 ÷
Base capacity)
Maximum
Practical
Normal
Actual
2,928
2,100
2,000
1,825
1,825
1,825
1,825
1,825
1,103
275
175
–
199.45
278.10
292.00
320.00
4.95
Overhead Cost
(c) Statement of Cost of Idle Capacity
Type of
capacity
Overhead
rate per hour (` )
(A)
Idle capacity
hrs
(B)
Idle capacity
cost (` )
(A × B)
Maximum
Practical
Normal
Actual
199.45
278.10
292.00
320.00
1,103
275
175
–
2,19,997
76,476
51,100
–
SUMMARY AND KEY TERMS












Overhead cost is the aggregate of all indirect costs, i.e., indirect materials,
indirect wages and indirect expenses. Overhead cost is also known as
oncost, supplementary cost, non-productive cost, burden.
Overhead costs may be classified according to function (production overheads,
administration overheads and selling & distribution overheads), according
to elements (indirect materials, indirect wages and indirect expenses) and
according to behaviour (fixed overheads and variable overheads).
Overheads are common costs and cannot be identified with individual cost
units and there are no accounting means of exact distribution. There-fore,
distribution of overhead costs to cost units is one of the most complex
problems of cost accounting.
The main steps in distribution of overheads are: 1. Collection and
classification of overheads; 2. Allocation and apportionment to production
departments and service departments; 3. Re-apportionment of total
overheads of each service department to production departments; and 4.
Absorption of overheads.
Allocation has been defined as ‘the allotment of whole items of cost to cost
centres or cost units.’
Apportionment is ‘the allotment of proportions of items of cost to cost centres or
cost units.’
Absorption of overheads is the process of charging to the product or
output all the overhead expenses which have been allocated and apportioned
to it. The purpose behind absorption is that overheads should be absorbed
in the cost of the output of the given period. Absorption is also known as
recovery or application of overheads.
There are six methods of absorption of factory overheads. Of these, Machine
Hour Rate method is considered a scientific and accurate method. It is
applicable where work is performed mainly on machines.
When overheads are absorbed on the basis of predetermined rates, there
may arise a problem of under- or over-absorption.
Under-absorption means that the amount of overheads absorbed is less
than the amount of overheads actually incurred.
Over-absorption is just opposite of under-absorption. It means that the
amount of overheads absorbed is more than the amount of actual overheads.
The under or over-absorbed overheads may be disposed of by using a
supplementary rate by adjusting the amount in the cost of: (i) Work-inprogress; (ii) Finished stock; and (iii) Cost of sales. This brings the cost to
actual level. When the amount of under/over-absorbed overheads is not
significant or when it is due to abnormal factors, it is written off to Costing
Profit and Loss Account.
Overhead Cost
4.96




In overheads, there are certain items which need special consideration.
These items include interest on capital, cash discount, bad debts, a charge
in lieu of rent, research and development cost, fringe benefits to labour
force, set-up costs, etc.
Activity based costing (ABC) is a new and scientific approach for assigning
overhead costs to end products. It calculates the costs of individual activities
and assigns costs to cost objects such as product and services on the basis
of activities undertaken to produce each product or service.
Activity is a particular task or unit of work with a specific purpose, for
example, placing of a purchase order, or setting up of a machine. Cost driver
is a factor that causes a change in the cost of an activity. Cost driver is of
two types—resource cost driver and activity cost driver. The procedure of
ABC begins by identifying the major activities of the organization. A cost
pool (total of individual cost items) is created for each activity. Then cost
driver rates are determined on the basis of which the overheads are absorbed.
ABC aims at rectifying the problem of under-costing and over-costing
resulting from traditional method of allocation and apportionment of
overhead on arbitrary basis.
EXAMINATION QUESTIONS
Objective Type Questions
I. True or False.
1. Fixed overhead cost per unit remains fixed when output level changes.
2. Re-apportionment of service department’s costs is known as secondary distribution
of overheads.
3. Overheads are also known as indirect expenses.
4. Increased mechanization results in greater amount of fixed costs.
5. When under or over-absorbed overhead cost is a significant amount, it should be
transferred to Costing Profit and Loss Account.
6. Apportionment of overheads on reciprocal basis is known as step ladder method.
7. Overheads absorption rates should be calculated on the basis of maximum capacity.
8. Machine hour rate method of absorption should be used in only those cost centres
in which work is dominantly done by machines.
9. When building is owned, rental value of the building should be included in cost.
10. Cost of after sales services is a part of selling and distribution overheads.
11. Traditional method of costing may result in undercosting and overcosting of products.
12. Machine hour rate is used in traditional method of overhead costing but not in
activity based costing.
13. Activity based costing is one of the best tools for refining a costing system.
14. ABC system helps companies to better price their products.
15. An activity is an item for which separate cost measurement is required.
16. Cost pool is like a cost centre.
17. Identifying less number of activities results is more accurate cost.
18. Purchasing of large quantity of materials is a cost driver.
I I . Filling the blanks.
1. Overhead cost is the aggregate of ............... and ............... and ...............
2. ............... is the allotment of whole items of overheads to cost units or cost centres.
4.97
Overhead Cost
3. ............... is the allotment of proportion of items of cost to cost centre or cost units.
4. Under/Over absorption of overheads arises only when overheads absorption is
based on ............... rates.
5. ............... is the cost of seeking to create and stimulate demand.
6. Under-absorption of overheads due to faulty management should be charged to ...............
7. Under-absorbed overhead is minimum when overhead rate is based on ............... capacity.
8. In ............... machine hour rate, wages of machine operator are included.
9. Factory rent should be apportioned to various departments on basis of ...............
10. When actual overheads are less than absorbed overheads, the difference between
the two is called ...............
III. Multiple Choice Questions.
1. Computation of overheads absorption rates should be based on
(a) Maximum capacity
(b) Practical capacity
(c) Normal capacity
(d) Idle capacity
2. Which of the following do you think is the most scientific method of absorption
of factory overheads?
(a) % on direct materials
(b) % on direct labour
(c) % on prime cost
(d) Machine hour rate
3. Warehousing cost is part of
(a) production overheads
(b) administration overheads
(c) selling overheads
(d) distribution overheads
4. Allotment of whole items of overheads to cost centres is known as:
(a) allocation
(b) apportionment
(c) classification
(d) absorption
5. Over-absorption of factory overheads, due to inefficiency of management, should
be disposed of by
(a) Supplementary rate
(c) Carry forward to next year
(b) transfer to costing P&L A/c
(d) any of these
6. Telephone bill falls in the category of
(a) fixed cost
(b) variable cost
(c) semi-variable cost
(d) stepped cost
7. The following balances appear in the books on 31 Dec. 2012:
Under-absorbed overheads –
`450
Cost of sales
– `9,40,000
Work-in-progress
Finished stock
–
–
`30,000
`25,000
The most appropriate method to treat under-absorbed overheads is to:
(a) Transfer it to costing P&L A/c
(b) Pro-rate it between work in progress and finished goods
(c) Pro-rate it in work in progress, finished goods and cost of sales
8. Idle plant capacity means
(a) Practical capacity minus normal capacity
(b) Maximum capacity minus normal capacity
(c) Practical capacity minus actual capacity
(d) Maximum capacity minus practical capacity
Overhead Cost
4.98
9. When absorbed overheads are `23,540 and actual overheads are `22,400, there is
(a) Under absorption of `1,140
(b) Over-absorption of `1,140
(c) Under absorption of `45,940
(d) Over-absorption of `45,940
10. Administration overheads are generally absorbed as a percentage of
(a) Direct materials
(c) Prime cost
(b) Direct wages
(d) Works cost
Theoretical Questions
1. Define overheads. Explain various classifications of overheads.
2. What is the advantage of classifying overheads into fixed and variable items?
3. Explain the various methods of segregating fixed and variable overhead costs.
4. What are the bases of apportionment of overhead expenses among departments?
Name the overheads for which each basis will be suitable.
5. Define a service department. Give illustrations of service departments.
6. Describe how service department costs are distributed to production departments.
7. Distinguish between allocation, apportionment and absorption of overheads.
8. What are the methods of distribution of service department overheads to production
departments?
9. What are the methods of secondary distribution of overheads. Explain these
methods for dealing with reciprocal services, giving an example.
10. Classify any eight of the following items of expenses by function and nature:
(a) Depreciation of plant; (b) Office telephone charges; (c) Salary paid to salesmen;
(d) Rent of finished goods warehouse; (e) Supervisory labour; (f) General
Manager ’s salary; (g) Consumable stores; (h) Commission on sales paid to
salesmen; (i) Factory power; (j) Delivery van expenses.
11. What do you mean by absorption of overheads? Discuss the different methods
for the absorption of factory overheads.
12. Describe ‘Direct Material Cost’ and ‘Direct Labour Cost’ methods of absorption
of factory overheads. Which one of these do you consider is better and why?
13. Discuss the procedure involved in the calculation of labour hour rate.
14. Discuss the importance of ‘Machine Hour’ as a basis for the absorption of factory
overheads.
15. Explain the computation of ‘Machine Hour Rate’ with an example.
16. What do you understand by under and over-applied costs? Explain how you would
dispose of under or over-applied costs.
17. What are office and administrative overheads? Give five examples.
18. What are the main differences between selling overheads and distribution
overheads? Give five examples of each.
19. What are the peculiar features of selling and distribution overheads as compared
to manufacturing overheads?
20. ‘While manufacturing costs are part of costs, the selling and distribution overheads
are the results of policy’. Discuss.
21. What are the arguments for and those against for inclusion of interest on capital
in cost accounts?
22. How will you treat research and development cost in cost account?
23. How will you deal with idle capacity costs in cost accounts?
24. What is notional rent of a factory building? Give one reason why it may be
included in cost accounts.
4.99
Overhead Cost
25. ‘The question whether or not interest on capital employed in manufacture (either
borrowed capital or proprietor’s capital) is rightly to be deemed an element of
cost, is a subject of considerable difference of opinion.’ Discuss.
26. How will you treat the following items in cost accounts?
(a) Fringe benefits
(b) Leave wages
(c) Inerest on capital
(d) Packing expenses
27. Explain the treatment of the following items:
(a) Reasearch cost
(b) Donation to National Defence Fund
( c ) Packing cost
(d) Cash discount
28. What is blanket overhead rate? In which situation blanket rate is used and why?
29. Briefly explain the meaning and purposes of activity based costing.
30. Describe the main features of activity based costing.
31. Do you agree that activity based costing is a more refined system of charging
of overhead cost to products than traditional method? Explain.
32. Explain the steps in activity based costing.
33. Explain the following in relation to ABC:
(a) Cost object, (b) Cost driver, (c) Cost pool.
34. Discuss the advantages of activity based costing.
Practical Questions
1. The following information is given:
Production (Nos.)
6,000
8,000
Labour cost (`)
15,000
19,000
Overhead cost (`)
1,17,000
1,47,000
Determine the fixed cost element in overhead cost and labour cost.
2. Following data has been extracted from the records of a manufacturing company
whose operations are varying from month-to-month.
Level of activity
Maximum
Minimum
Machine hours
8,00,000
3,00,000
Manufacturing overhead
`52 lakh
`32 lakh
Determine the fixed and variable components of manufacturing overheads and
then compute the total manufacturing cost for an activity level of 5,00,000 hours.
(ICWA Inter)
3. The following figures are extracted from the books of a manufacturing company.
Indirect materials:
`
—Production department A
950
—Production department B
1,200
—Production department C
200
—Maintenance department X
1,500
—Stores department Y
400
Indirect wages:
—Production department A
900
—Production department B
1,100
Overhead Cost
4.100
—Production department C
300
—Maintenance department X
1,000
—Stores department Y
650
Power and light
6,000
Rent and rates
2,800
Insurance on assets
1,000
Meal charges
3,000
Depreciation p.a.
6% on capital values
From the above prepare a Departmental Distribution Summary with following
departmental data:
Item
Production department
Area (sq. mt.)
Capital value
of assets `
kWh
No. of workers
Service department
A
400
1,00,000
B
400
1,20,000
C
300
80,000
X
200
60,000
Y
100
40,000
4,000
90
4,400
120
1,600
30
1,500
40
500
20
(B. Com)
4. In Bata Electronics, the following particulars have been collected for the three months
ending 31 Dec. You are required to prepare an overheads distribution summary.
Items
Direct wages
Direct materials
Staff
Electricity
Light points
Assets value
Area occupied
`
`
Nos.
kWh
Nos.
`
Sq. Yd
A
2,000
1,000
100
4,000
10
60,000
150
Production departments
B
C
3,000
4,000
2,000
2,000
150
150
3,000
2,000
16
4
40,000
30,000
250
50
Service departments
D
E
1,000
2,000
1,500
1,500
50
50
1,000
1,000
6
4
10,000
10,000
50
50
The expenses for the period were:
`
`
Motive power
550
Depreciation
15,000
Lighting
100
Repairs and maintenance
3,000
Stores overheads
400
General overheads
6,000
Amenities to staff
1,500
Rent and taxes
275
(a) Apportion the costs of service department E on the basis of direct wages and
that of department D in the ratio of 5 : 3 : 2 to production departments A, B
and C, respectively.
(b) Calculate the overhead absorption rates for each of the production departments
assuming that overheads are recovered as a percentage of wages. (ICWA Inter)
4.101
Overhead Cost
5. A factory has three production departments and two service departments. The
overheads departmental distribution summary shows the following:
Production deptts.
Service deptts.
A
B
C
D
E
Total overheads
20,000
15,500
14,800
8,500
10,500
The expenses of the service departments are to be charged on a percentage
basis as follows:
A
B
C
D
E
D
40%
30%
20%
—
10%
E
30%
40%
10%
20%
—
Show how the expenses of the two service departments are to be charged to
the production departments under ‘Repeated Distribution’ method.
(B. Com)
6. Mahindra Machinists Ltd have three production departments (A, B and C) and
two service departments (D and E). From the following figures extracted from
the records of the company, calculate the overhead rate per labour hour:
`
Indirect materials
15,000
Indirect wages
10,000
Depreciation of machinery
25,000
Depreciation of buildings
5,000
Rent, rates and taxes
10,000
Electric power for machinery
15,000
Electric power for lighting
500
General expenses
15,000
Total
95,500
Items
Total
A
B
C
D
E
Direct materials `
60,000
20,000
10,000
19,000
6,000
5,000
Direct wages
4,000
40,000
15,000
15,000
Value of machinery 2,50,000
60,000
1,00,000
Floor area (sq. ft)
50,000
15,000
H.P. of machines
150
No. of light points
50
15,000
Labour hours
2,000
4,000
40,000 25,000
25,000
10,000
10,000
5,000
10,000
50
60
30
5
5
15
10
10
5
10
5,000
5,000
2,000
1,000
2,000
The expenses of service departments D and E are to be apportioned as follows:
A
B
C
D
E
D
40%
20%
30%
—
10%
E
30%
30%
40%
—
—
(ICWA Inter)
Overhead Cost
4.102
7. You are supplied with the following information and are required to work out the
production hour rate of absorption of overheads, in departments A, B and C,
under simultaneous equations method of distributing service departments costs to
production departments.
Production
departments
Particulars
Total
A
B
Total overheads
46,000 11,310 13,050
No. of hours worked
— 5,000 4,000
Distribution % of service
P...
30%
40%
Deptt. costs to production Deptts. Q...
15%
25%
Service
departments
C
8,040
3,000
20%
40%
{
P
7,500
—
—
20%
Q
6,100
—
10%
—
8. A company has three production departments, A, B and C, and two service
departments X and Y. The following data are extracted from the records of the
company for a particular given period:
`
(i) Rent and rates
25,000
(ii) General lighting
3,000
(iii) Indirect wages
7,500
(iv) Power
7,500
(v) Depreciation on machinery
50,000
(vi) Sundries
50,000
Additional Data, department-wise:
Total
Departments
A
B
C
Direct wages (`)
50,000 15,000 10,000
15,000
H.P. of machines used
150
60
30
50
Cost of machinery
(`)
12,50,000 3,00,000 4,00,000 5,00,000
Production hours
worked
—
6,226
4,028
4,066
Floor space used
(sq. mtr.)
10,000
2,000
2,500
3,000
Lighting points (No.)
60
10
15
20
X
Y
7,500
10
2,500
—
25,000
25,000
—
—
2,000
10
500
5
Service departments’ expenses allocation:
A
B
C
X
Y
X
20%
30%
40%
—
10%
Y
40%
20%
30%
10%
—
You are required to:
(a) Compute the overhead rate of production departments using the repeated
distribution method; and
(b) Hence, determine the total cost of a product whose direct material cost and direct
labour cost are `250 and `150, respectively and which would consume 4 hours, 5
hours and 3 hours in department A, B and C, respectively. (B Com, ICWA Inter)
9. Atlas Engineering Ltd accepts a variety of jobs which require both manual and
machine operations. The budgeted Profit and Loss Account for the period 2017–
18 is as follows:
4.103
Overhead Cost
(In lakh of rupees)
75
Sales
Cost:
Direct materials
Direct labour
10
5
Prime Cost
Production overheads
Production Cost
Administrative, selling and
Distribution overheads
15
30
45
15
Profit
60
15
Other budgeted data:
Labour hours for the period
25,000
Machine hours for the period
15,000
No. of jobs for the period
300
An enquiry has been received recently from a customer and the production
department has prepared the following estimate of the prime cost required for the
job:
`
Direct material
2,500
Direct labour
2,000
Prime Cost
4,500
Labour hours required
= 80
Machine hours for the period = 50
You are required to:
(a) Calculate by different methods, six overhead absorption rates for absorption
of overheads and comment on the suitability of each.
(b) Calculate the production overhead cost of the order based on each of the
above rates.
(c) Give your recommendation to the company. (B Com(H) Delhi, ICWA Inter)
10. Compute a machine hour rate so as to cover the overhead expenses given below:
Per hour
Per annum
Electric power
75 Paise
Steam
20 Paise
Water
5 Paise
Repairs
`680
Rent
`350
Other information available:
`
1. Original cost of the machine
15,000
2. Present book value
3,000
3. Replacement value
10,000
4. Rate of depreciation (per annum)
10%
5. Running hours of the machine
2,400 p.a.
4.104
Overhead Cost
11. Calculate the machine hour rate from the following details:
1. Cost of machinery `45,000
2. Installation charges `5,000
3. Life of machine 5 years
4. Working hours per year 2,500
5. Repair charges 75% of depreciation
6. Electric power consumed: 10 units per hour @ 15 paise per unit
7. Lubricant oil `4 per day of 8 hours
8. Consumable stores @ `10 per day of 8 hours.
9. Wages of machine operator @ `8 per day of 8 hours
12. From the following data of textile factory machine room, compute an hourly
machine rate, assuming that the machine room will work on 90% capacity
throughout the year and that a breakdown of 10% is reasonable. There are 3
days’s holiday at Deepawali, 2 days at Holi and 2 days at Christmas, exclusive of
Sunday. The factory work 8 hours a day and 4 hours on Saturday.
Number of machines – 40 (each of the same type)
Expenses per annum
`
Power
3,12,000
Light
64,000
Salaries to foreman
1,20,000
Lubricating oil
6,600
Repairs to machine
1,44,600
Depreciation
78,560
13. In a factory department, a machine costs `11,500. It is expected that it will work
for about 20,000 hours and its scrap value is estimated at `1,500.
The rent for the department is `400 p.m. and 25% of the area of the department
is utilized for conducting the operation of the machine.
One foreman and an operator are employed on a salary of `800 and `400 p.m.,
respectively, to work on one more machine of a similar type.
The other expenses for the month in the department are as follows:
Light charges for the department are `80, having 16 light points in all, out of which
only 4 points are used by this machine. Total power consumption for two machines of
equal H.P. is `320. Indirect labour for the machine is `50 and repairs `40.
You are required to compute the machine hour rate for the month when it is
expected to work for 160 hours a month.
14. The following data pertains to the machine shop of an engineering company, relating
to one year. The machine shop has 3 cost centres—A, B and C—each having 3
distinct set of machines.
A
B
C
Total
1. No. of workers
400
400
800
1,600
2. No. of machine-hours
50,000
50,000
60,000
1,60,000
3. Percentage of H.P.
40
25
35
100
4. Value of assets (` in lakh)
20
35
30
85.00
5. Direct wages (` in lakh)
16
20
24
60.00
6. Indirect wages (` in lakh)
18.00
7.00
7. Supervisory salaries (` in lakh)
8. Depreciation (` in lakh)
8.50
9. Insurance (` in lakh)
4.25
10. Electricity charges (` in lakh)
12.00
11. Welfare expenses (` in lakh)
9.00
12. Office and other expenses (` in lakh)
16.00
Overhead Cost
4.105
Work out a composite machine-hour rate for each of the cost centres, showing
the basis of apportionment of expenses amongst the cost centres. (ICWA Inter)
15. In a factory department, there are three machines, to which the following expenses
have been allocated:
`
Machine
A
639
B
607
C
951
In addition, there is an overhead crane to bring materials to the machines as
necessary. The expenses allocated to this machine are `570.
During the period of expenditure, the machines were used as follows:
Machine A
Machine B
Machine C
Hr
Hr
Hr
With use of crane
160
130
480
Without use of crane
428
577
—
Total
588
707
480
Calculate machine hour rate for each machine distinguishing between the hours in
which the crane is used and those in which it is not. (B Com, ICWA Inter, Adapted)
16. In a manufacturing concern ABC Ltd, the machine shop has 8 identical machines,
manned by 6 operators. The machines cannot be worked without an operator
wholly engaged on them. The total cost of the machines is `8,00,000.
Following information relates to a six monthly period ended 30 June 2018:
Normal available hours per month
208
Absenteeism (without pay) hours per month
18
Leave (with pay) hours per month
20
Normal idle time (unavoidable) hours per month
10
Average rate of wages per day of 8 hours
`20
Production bonus
15% on wages
Power and fuel consumption
`9,000
Supervision and indirect labour
`3,300
Electricity
`1,200
The following particulars are on a yearly basis:
Repairs and maintenance
3% of value of machines
Insurance
`42,000
Depreciation
10% of original cost
Other factory expenses
`12,000
Allocated general management expenses
`63,670
You are required to work out a comprehensive machine hour rate for the machine
shop.
(ICWA Inter)
17. A manufacturing unit has added a new machine to its fleet of five existing
machines. The total cost of purchase and installation of the machine is `7,50,000.
The machine has an estimated life of 15 years and is expected to realize `30,000
as scrap at the end of its working life.
Other relevent data are as under:
(i) Budgeted working hours are 2,400 based on 8 hours per day for 300 days.
This includes 400 hours for plant maintenance.
(ii) Electricity used by the machine is 15 units per hour at a cost of `2 per unit.
No current is drawn during maintenance.
Overhead Cost
4.106
(iii) The machine requires special oil for heating which is replaced once every
month at a cost of `2,500 on each occasion.
(iv) Estimated cost of machine maintenance is `500 per week of 6 working days.
(v) Three operators control the operations of the entire battery of six machines
and the average wages per person are `450 per week plus 40% fringe benefits.
(vi) Departmental and general works overheads allocated to the operation during
the last year were `60,000. During the current year, it is estimated that
there will be an increase of 12.5% of this amount. No incremental overhead
cost is envisaged for the installation of the new machine.
You are required to compute the machine hour rate of recovery of the running
cost of the machine.
(B Com Hons Delhi, ICWA Inter)
18. Compute the machine hour rate from the following data:
Cost of machine
Installation charges
Estimated scrap value (after the expiry of its life of 15 years)
Rent and rates for the shop per month
General lighting for the shop per month
Insurance premium for the machine per annum
Repairs and maintenance expenses per annum
Power consumption—10 units per hour
Rate of power per 100 units
Estimated working hours per annum
This includes setting up time of 200 hours
Shop supervisor’s salary per month
`
1,00,000
10,000
5,000
200
300
960
1,000
—
20
2,200
—
600
The machine occupies 1/4th of the total area of the shop. The supervisor is expected
to devote 1/5th of his time for supervising the machine.
(B Com Hons Delhi)
19. A cost centre in a factory furnishes the following working conditions:
Normal working week
40 hrs
Number of machines
15
Normal weekly loss of hours on maintenance, etc. 4 hrs per machine
Estimated annual overheads
`1,55,520
Estimated direct wage rate
`3 per hour
Number of weeks worked per year
48
Actual results of a 4 week period are:
Overheads incurred
`15,000
Wages incurred
` 7,000
Machine-hours produced
2,200
You are required to:
(a) Calculate the overhead rate per machine-hour, and
(b) Calculate the amount of under or over-absorption of both wages and overheads.
((B. Com., Delhi, ICWA Inter)
20. Separate department overheads application rates based on direct labour hours are
being used by a manufacturing company. At the end of the year, following
information is supplied to you:
4.107
Overhead Cost
Deptt. I
`
4.00
81,900
72,800
Deptt. II
`
3.00
1,20,960
1,00,800
Deptt. III
`
7.00
79,360
86,800
Overheads absorption rates used
Actual overheads incurred
Overheads absorbed
Direct labour hours recorded against:
Work-in-progress
2,800
4,930
820
Finished goods stock
5,400
3,700
1,210
(a) Calculate the revised overheads application rate in rupee per direct labour hour
(to the nearest paisa) in the light of actual figures supplied to you for the year.
(b) Calculate also the total amounts by which the work-in-progress and finished
goods stock in each department will have to be increased or decreased in the
light of the revision of the overhead application rate.
(c) What is the impact on profit of the company in view of revision of rates?
(ICWA Inter)
21. Baban Industries absorbs factory overhead costs at `2.50 per direct labour hour.
Both opening and closing balances of work-in-progress and finished goods
inventories are zero. The following data are available for a year and the fact that
all goods produced have been sold:
Direct labour hours used
50,000
Direct labour cost
`1,00,000
Indirect labour cost
`25,000
Indirect materials cost
`10,000
Depreciation of plant and equipment
`50,000
Miscellaneous factory overheads
`50,000
You are required to
(i) calculate factory overheads incurred and factory overheads absorbed; and
(ii) pass journal entry for disposing of over-absorbed or under-absorbed factory
overheads.
(B Com Hons Delhi)
22. (a) B & Co. has recorded the following data in the two most recent periods:
Total cost of production
Volume of production
`
(units)
14,600
800
19,400
1,200
What is the best estimate of the firm’s fixed costs per period? (CA Inter)
(b) In a manufacturing unit, overhead cost was recovered at a predetermined
rate of `20 per labour-hour. The total factory overheads incurred and the
labour-hours actually worked were `45,00,000 and 2,00,000 labour-hours,
respectively. During this period 30,000 units were sold. At the end of the
period 5,000 units were held in stock while there was no opening stock of
finished goods. Similarly though there was no stock of uncompleted units
at the beginning of the period, at the end of the period there were 10,000
uncompleted units which may by reckoned at 50% complete.
On analysing the reasons, it was found that 60% of the unabsorbed
overheads were due to defective planning and the rest were attributable to
increase in overhead costs. How would unabsorbed overheads be treated in
cost accounts?
(B Com Hons Delhi, CA Inter)
Overhead Cost
4.108
23. A factory has three production departments. The policy of the factory is to recover
the production overheads of the entire factory by adopting a single blanket rate,
based on the percentage of total factory overheads to total factory wages. The
relevant data for a month are given below:
Departments
Budget:
Machining
Assembly
Packing
Actuals:
Machining
Assembly
Packing
Direct
materials
`
Direct
wages
`
Factory
overheads
`
Direct
labour
hours
Machine
hours
6,50,000
1,70,000
1,00,000
80,000
3,50,000
70,000
3,60,000
1,40,000
1,25,000
20,000
1,00,000
50,000
80,000
10,000
—
7,80,000
1,36,000
1,20,000
96,000
2,70,000
90,000
3,90,000
84,000
1,35,000
24,000
90,000
60,000
96,000
11,000
—
The details of one of the representative jobs produced during the month are as under:
Job No. CW 7083
Department
Direct
materials
`
Direct
wages
`
Direct
labour
hours
Machine
hours
Machining
Assembly
Packing
1,200
600
300
240
360
60
60
120
40
180
30
—
The factory adds 30% on the factory cost to cover administration and selling
overheads and profit.
Required:
(i) Calculate the overheads absorption rate as per the current policy of the
company and determine the selling price of the job no. CW 7083.
(ii) Suggest any suitable alternative method(s) of absorption of the factory
overheads and calculate the overheads recovery rates based on the method(s)
so recommended by you.
(iii) Determine the selling price of job no. CW 7083 based on the overheads
application rates calculated in (ii) above.
(iv) Calculate the department-wise and total under or over-recovery of overheads,
based on the company’s current policy and the method(s) recommended by
you.
(B.Com. Hons., Delhi, CA Inter)
24. The factory overhead costs of four production departments of a company engaged
in executing job orders, for an accounting year, are as follows:
`
A
19,300
B
4,200
C
4,000
D
2,000
Overhead Cost
25.
26.
27.
28.
4.109
Overheads have been applied as under:
Deptt. A
`1.50 per machine hour for 14,000 hours
B
`1.30 per direct labour hour for 3,000 hours
C
80% of direct labour cost of `6,000
D
`2 per piece, for 950 pieces
Find out the amount of departmentwise under or over-absorbed overheads.
What are the methods that could be considered for disposal of the resultant under
or over-absorbed factory overheads?
(ICWA Inter)
X Ltd recovers overhead at a pre determined rate of `50 per man day. The total
factory overheads incurred and the man days worked were `79 lakhs and 1.50
lakh days respectively. During the period, 30,000 units were sold. At the end of
the period, 5,000 completed units were in stock. 10,000 incomplete units (50%
complete) were in stock at the end of the period. There was no opening stock of
finished goods or incomplete units.
On analysing the reasons, it was found that 60% of the unabsorbed overhead were due
to defective planning and the balance were attributable to increase in overhead cost.
How would unabsorbed overhead be treated in cost accounts?
(CA-CPE)
In a certain factory, there are three departments about which the following
information is available:
Overheads
Direct wages
`
`
Department 1
10,000
5,000
Department 2
5,000
10,000
Department 3
15,000
15,000
Total
30,000
30,000
Overhead rate = 100% of direct wages.
For each job, overhead cost is charged @ 100% on direct wages. Assuming
that direct wages are a good measure for charging the overheads, can you see
any objection?
(ICWA Inter)
The following data is available in respect of a machine:
Cost of machine
`10,000
Estimated scrap value
`1,000
Working life
6 years
The machine is discarded because of obsolescence, after 4 years of service
and was sold for `2,000. What is the resultant loss and how would you treat the
same in cost accounts.
(CS Inter)
Late in 2016, a company set up a factory overheads absorption rate of 84 per
cent of direct labour cost based on the following budget:
Factory overhead costs
`75,600
Direct labour hours
60,000
Labour rate per hour
`1.50
Direct labour cost
`90,000
Early in 2017, the method of operation was changed. The new operations require
labour that will be paid at `1.75 per hour, the operating time would be reduced by
20 per cent.
What steps should be taken by the company’s cost accountant to meet the
situation? Give the necessary calculations also. (B Com Hons Delhi, Adapted)
Overhead Cost
4.110
ANSWERS
Objective Type Questions
I. True or False.
True — 2, 4, 8, 9, 10, 11, 13, 14, 15, 16
False — 1, 3, 5, 6, 7, 12, 17, 18
I I . Filling the blanks.
1. Indirect material, indirect wages and indirect expenses; 2. Allocation; 3.
Apportionment; 4. Predetermined; 5. Selling overhead; 6. Costing P&L A/c; 7.
Normal; 8. Comprehensive; 9. Area occupied; 10. Over-absorption
III. Multiple Choice Questions.
1. (c), 2. (d), 3. (d), 4. (a), 5. (b), 6. (c), 7. (a), 8. (c), 9. (b), 10. (d)
Practical Questions
1. Overheads—fixed `27,000, variable `15 per unit.
Labour cost—fixed `3,000, variable `2 per unit
2. Fixed overheads `20,00,000, Variable overheads per hour `4;
Manufacturing overheads for 5,00,000 hours – `40 lakh
3. A–`11,800; B–`14,000; C–`7,200; X–`7,800; Y–`4,200
4. (a) A–12,443; B–10,523; C–9,859; (b) A–622.15%; B–350.77%; C–246.47%
5. A–`27,801, B–`23,377, C–`18,122
6. Labour hour rate A–`8.38; B–`7.95; C–`15.44
7. Production hour rate–A `3.005; B–`4.589; C–`4.205
8.
A
B
C
D
E
Primary totals `
37,750
36,000
48,250
23,125
7,875
Secondary totals `
46,697
45,304
60,999
—
—
Rate per hour `
7.50
11.25
15.00
—
—
Total cost for the product = `531.25
9.
% of
% of
% of
MHR
DLHR
Rate
material
labour
prime cost
per unit
Rate
300%
600%
200%
`200
`120
`10,000
Overheads (`)
7,500
12,000
9,000
10,000
9,600
10,000
10. `2.05
11. `11.25
12. `10 (Total effective hours = 72,576.)
13. `6.56
14. MHR – A `75.20, B `86.50, C `89.33
15. Without crane `1.09, `0.86, ` 1.98, with crane `1.83, `1.60, `2.72
(Hint: This is similar to Problem and Solution No. 4.18)
16. `25
(Hint:
1. Calculation of wages
Hours paid for
= Normal hours – Absenteeism hours without pay
= 208 – 18 = 190 hrs per month
4.111
Overhead Cost
Hourly wage rate
= `20 ÷ 8 = `2.50
Total wages for six months = 190 × 6 operators × 6 months × `2.50 = `17,100
2. Calculation of machine hours worked
Normal hours – (Absenteeism + Leave + Idle hours)
= 208 – (18 + 20 + 10) = 160 hrs per month
Total hours for six months for six operators = 160 × 6 × 6 = 5,760 hrs
Since the machines could not work without an operator, total hours for all the
machines worked were also 5,760 hours.)
17. `95
(Hint: 1. Effective machine hours = 2,400 – 400
=
2,000
2. Wages of 3 operators @ `450 for 50 weeks
= `67,500
Add: Fringe benefits (40%)
= 27,000
94,500
Wages per machine = 94,500 ÷ 6 machines
Wages per hour = `15,750 ÷ 2,000 hours
3. Depart. and general overheads = 60,000 + 12.50%
Per machine per hour = 67,500 ×
1
1
×
6 2,000
= `15,750
= `7.875
= `67,500
=
`5.625
18. `7.95
(Hint: It is assumed that 200 hrs of setting-up time is unproductive. Thus effective
working hrs are 2,200 – 200 = 2,000.)
19. Under-absorbed overheads `1,800, over-absorbed wages `200.
20. Revised Rates–(I) 4.50, (II) 3.60, (III) 6.40; Profit will increase by `8,060.
21. Supplementary Rate = `0.20 per labour hour
22. (a) Fixed cost `5,000
(b) Unabsorbed overheads `5 lakh, Supplementary Rate–`2,00,000  40,000
units = `5 per unit, Transfer to costing P&L A/c `3,00,000
23. (i) 125%; Selling price `4,660.50;
(ii) Machining deptt—Machine hour rate `4.50, Assembly deptt—Direct labour
hour rate `1.40; Packing deptt Direct labour hour rate `2.50;
(iii) `4,989.40;
(iv) Over/under (–) recovery; Current Method—Machining `2,70,000 (–);
Assembly `2,53,500; Packing `22,500 (–) As per recommended method—
Machining `42,000; Assembly `42,000; Packing `15,000
Note: The answer will vary in accordance with the method of absorption of factory overhead
used.
24. Over-absorption A–`1,700; C–`800
Under-absorption B–`300; D–`100
25. Under-absorbed overhead `4 lakh.
Tr. to P & L A/c `2,40,000.
26. Instead of blanket (single) rate, multiple rates should be used
27. Resultant loss of `2,000 charged to costing P&L A/c
28. Overhead rate should be 90% of direct labour cost
4.112
Overhead Cost
CHAPTER
5
OUTPUT OR UNIT COSTING
(Cost Sheet)
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of output costing and the type of industries in which
this method of costing is used
• Understand the costing procedure used to ascertain the cost of products
• Know the meaning of cost sheet and the method of its preparation
• Understand the method of determining the prices to be quoted
Output costing (or unit costing or single costing) is a method of cost ascertainment which is
used in those industries which have the following features:
(i) Production consists of a single product or a few varieties of the same product with
variations in size, shape, quality, etc., and
(ii) Production is uniform and on continuous basis.
COSTING PROCEDURE
In order to ascertain the cost of products, a cost
sheet is prepared periodically. As the production
is uniform and cost units are identical, the cost
per unit is the average cost. It is ascertained by
dividing the total cost by the number of units
produced. Cost unit may be 1,000 bricks, a barrel
of beer, a gallon of milk, a tonne of steel/cement/
sugar, etc. The cost sheet is designed to show the
total cost as well as cost per unit of output for
the given period.
Output Costing may be used in:
• Brick works
• Cement industry
• Quarries
• Breweries
• Dairies
• Steel mills
• Paper mills
• Sugar mills, etc.
Cost Sheet
Cost sheet is defined as ‘a document which provides for the assembly of the detailed
cost of a cost centre or cost unit.’1
Thus cost sheet is a periodical statement of cost, designed to show in detail the various
elements of cost of goods produced, like prime cost, factory cost, cost of production and
*CIMA London Terminology.
5.2
Output or Unit Costing (Cost Sheet)
total cost. A simple form of Cost Sheet is given in Chapter 1 (page 1.30). It is prepared
at regular intervals, e.g., weekly, monthly, quarterly, yearly, etc. Comparative figures of the
previous period may also be shown in the cost sheet so that assessment can be made about
the progress of the business.
Though the term Production Statement is used interchangeably with Cost Sheet, the
former is an expanded form of the latter. In addition to cost elements, a production statement
includes items of sales, stocks and profits. When the details of cost sheet or production
statement are shown in a T-shape account, it is known as Production Account. Other terms
used are Cost Statement and Statement of Cost and Profit.
Purposes Cost sheet serves the following purposes:
1. It reveals the total cost and cost per unit of goods produced.
2. It discloses the break-up of total cost into different elements of cost.
3. It provides a comparative study of the cost of current period with that of the
corresponding previous period.
4. It acts as a guide to management in fixation of selling prices and quotation of tenders.
Treatment of Stocks
Stocks may be of the following three types:
(a) Stocks of raw materials
(b) Stocks of work-in-progress
(c) Stocks of finished goods
Stocks of Raw Materials In order to calculate the value of raw materials consumed
during the period, opening stock of raw materials is added to the raw materials purchased
and closing stock is subtracted. This is shown below with assumed figures:
`
Opening stock of raw materials
12,000
Add: Purchases
42,000
54,000
Less: Closing stock of raw materials
9,000
Cost of materials consumed
45,000
Stocks of Work-in-progress This is the stock of semi-finished goods. In cost sheet,
opening stock of work-in-progress is added in prime cost along with factory overhead and closing
stock of work-in-progress in subtracted therefrom. Thus opening and closing stocks of workin-progress are adjusted in works or factory cost as shown below (with assumed figures):
`
Prime Cost
62,000
Add: Factory overheads
27,000
Current manufacturing cost
89,000
Add: Opening stock of work-in-progress
13,000
Total goods processed during the period
1,02,000
Less: Closing stock of work-in-progress
11,000
Works or factory cost
91,000
Stock of Finished Goods In cost sheet, finished goods are adjusted after calculating
cost of production. Opening stock of finished goods is added to cost of production and closing
stock of finished goods is subtracted therefrom. The resultant figure is called cost of goods
sold. This is illustrated below (with assumed figures):
Output or Unit Costing (Cost Sheet)
5.3
`
Cost of Production
1,15,000
Add: Opening stock of finished goods
17,000
Cost of goods available for sale
1,32,000
Less: Closing stock of finished goods
12,000
Cost of Goods Sold
1,20,000
The treatment of the above three types of stocks is illustrated in the following proforma
cost sheet.
Treatment of Administrative Overheads
As per Cost Accounting Standards, the Administrative Overheads need to be analysed
into those related to production activities and those not relating to production activities
i.e., other activities. The administrative overhead in relation to production activities
shall be included in the Cost of Production. Administrative overhead in relation to
activities other than manufacturing activities e.g., marketing, corporate office expenses,
project management, etc. shall be excluded from the cost of production. This means
that administrative overhead relating to production activities are added in Works Cost
to arrive at Cost of Production. If administrative overheads are general in nature i.e.,
not relating to production activities, this is taken after cost of production along with
selling and distribution overhead to arrive at total cost or cost of sales.
In questions, the nature of administrative overhead is given. If it is not, then administrative
overhead may be assumed to be related to production activities or it may be assumed that
these are general in nature i.e., not related to production activities or alternatively these may
be assumed to be partly related to production activities and partly general in nature. In Cost
Sheet, these are treated accordingly. Treatment of administrative overhead is shown in the
proforma Cost Sheet given below.
Proforma Cost Sheet
for the period..........
Production............units.
Particulars
Add:
Add:
Less:
Add:
Add:
Less:
Add:
Add:
Less:
Opening stock of raw materials
Purchases
Expenses on purchases
Closing stock of raw materials
Cost of material consumed
Direct wages
Direct expenses
Total cost
`
XXX
XXX
XXX
XXX
XXX
Prime Cost
Factory overheads
Opening stock of work-in-progress
Closing stock of work-in-progress
Factory or Works Cost
Administrative overheads (Relating to production)
Cost of Production
Opening stock of finished goods
Closing stock of finished goods
Cost per unit
`
Output or Unit Costing (Cost Sheet)
5.4
Add:
Add:
Cost of Production of Goods Sold
Selling and distribution overheads
Administration overhead (General)
Cost of Sales
Profit (or Loss)
Sales
Items Excluded from Cost
The following items are of financial nature and are thus not included in cost sheet:
1. Cash discount
2. Interest paid
3. Preliminery expenses written off
4. Goodwill written off
5. Provision for taxation
6. Provision for bad debts
7. Transfer to reserves
8. Donations
9. Income tax paid
10. Dividend paid
11. Profit/loss on sale of fixed assets
12. Damages payable at law, etc.
13. Pension and gratuity
14. Discount on issue of shares
15. Appropriation to sinking fund
Treatment of Scrap
Scrap may be defined as an unavoidable residue material arising in certain types of
manufacturing processes. Examples of scrap are trimmings, turnings or boring from metals
or timber, on which operations are performed. Scrap usually has a small realizable value.
Such realizable value of scrap is deducted from either factory overheads or factory cost
while preparing a cost sheet.
Exhaustive Cost Sheet (Detailed)
Units produced............
Particulars
Add:
Add:
Add:
Add:
Less:
Opening stock of raw materials
Purchases
Carriage inward
Octroi and customs duty
Other expenses on purchases
Closing stock of raw materials
Cost of Direct Materials Consumed
Direct or Productive Wages
Direct (or Chargeable) Expenses
Prime Cost
Add:
Works or Factory Overheads:
Indirect Materials
Indirect or Unproductive wages
Leave Wages
Overtime Premium
Fuel and Power
Rent and Taxes
Total cost
`
Cost per unit
`
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
Output or Unit Costing (Cost Sheet)
Less:
Insurance
Factory Lighting
Supervision
Works Stationery
Canteen and Welfare Expenses
Repairs
Grease and Oil
Works Salaries
Depreciation— Plant & Machinery
— Factory Building
— Factory Furniture
Works Expenses
Gas and Water
Drawing Office Salaries
Technical Director’s Fees
Laboratory Expenses
Packing cost
Quality Control Cost
Research and Development Cost
Works Telephone Expenses
Internal Transport Expenses
Sale of Scrap
Add:
Opening Stock of Work-in-progress
Less:
Closing Stock of Work-in-progress
Add:
Works Cost
Office and Administrative Overheads:
(Relating to production activities)
Office Salaries
Director’s Fees
Office Rent and Rates
Office Stationery and Printing
Sundry Office Expenses
Depreciation of Office Furniture
Subscription to Trade Journals
Office Lighting
Office Airconditioning
Establishment Charges
Director’s Travelling Expenses
Postage
Legal Charges
Audit Fees
Depreciation and Repair of Office Equipment
5.5
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
Output or Unit Costing (Cost Sheet)
5.6
Add:
Less:
Add:
Cost of Production
Opening Stock of Finished Goods
Cost of Goods Available for Sale
Closing Stock of Finished Goods
Cost of Goods Sold
Selling and Distribution Overheads:
Advertising
Showroom Expenses
Bad Debts
Salesmen’s Salaries and Expenses
Packing Expenses
Carriage Outward
Commission of Sales Agents
Counting House Salaries
Cost of Catalogues
Expenses of Delivery Vans
Collection Charges
Travelling Expenses
Cost of Tenders
Warehouse Expenses
Cost of Mailing Literature
Sales Manager’s Salaries
Sales Director’s Fees
Showroom Expenses
Sales Office Expenses
Depreciation and Repairs of Delivery Vans
Expenses of Sales Branches
Adm. overhead (general)
Cost of Sales (or Total Cost)
PROFIT
Sales
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
Illustration 5.1 The following particulars have been extracted from the books of J K
Production Co. Ltd, for the year ended 31 March 2022.
`
Stock of materials as on 1 April 2021
47,000
Stock of materials as on 31 March 2022
45,000
Materials purchased
2,08,000
Drawing office salaries
9,600
Counting house salaries
14,000
Carriage inwards
8,200
Output or Unit Costing (Cost Sheet)
5.7
Carriage outwards
5,100
Donations to relief fund
4,300
Sales
4,87,000
Bad debts written off
4,700
Repairs of plant, machinery and tools
8,600
Rent, rates, taxes and insurance (factory)
3,000
Rent, rates, taxes and insurance (office)
1,000
Travelling expenses
3,700
Travelling salaries and commission
7,800
Production wages
1,45,000
Depreciation written off on machinery, plant and tools
9,100
Depreciation written off on office furniture
600
Director’s fees
6,000
Gas and water charges (factory)
1,000
Gas and water charges (office)
1050
General charges
11,000
Factory manager’s salary
11,250
Administrative overheads relate to production activities. Prepare a cost sheet showing
different elements of cost.
Solution
Cost Sheet
for the year ending 31 March 2022
Add:
Opening stock of raw materials
Purchases
Add:
Carriage inwards
`
47,000
2,08,000
`
8,200
2,63,200
Less: Closing stock
45,000
Cost of materials consumed
2,18,200
Production wages
1,45,000
Prime Cost
3,63,200
Factory Overheads:
Rent and rates
3,000
Drawing office salaries
9,600
Depreciation of plant
9,100
Repairs of plant
8,600
Output or Unit Costing (Cost Sheet)
5.8
Factory gas and water
1,000
Factory manager’s salary
11,250
Factory Cost
Administration Overheads:
Office rent and rates
42,550
4,05,750
1,000
Depreciation on furniture
600
Director’s fees
6,000
Gas and water
1050
General charges
11,000
19,650
Cost of Production
Selling and Distribution Overheads:
Counting house salaries
Carriage outwards
Bad debts
Travelling expenses
Travelling salaries
Cost of Sales
Profit
Sales
4,25,400
14,000
5,100
4,700
3,700
7,800
35,300
4,60,700
26,300
4,87,000
Note: Donation to relief fund is not included in cost.
Production Account
When information shown in a cost sheet is presented in the form of a T-shape account, it is
known as Production Account. In this account, debit side shows the various item of cost
while credit side shows the sales of finished goods. Opening stock may be written on the
debit side while closing stock may be written on the credit side.
Alternatively, closing stock may be shown as a deduction from the items in debit side.
In this way this account shows the total cost. The balance in this account shows profit or
loss, as the case may be.
Illustration 5.2 Prepare a Production Account from the information extrated from the books
of J K Production Co. Ltd as given in Illustration 5.1.
Solution
Production Account
for the year ending 31 March 2022
`
To Opening stock of raw materials 47,000
Add: Purchases
2,08,000
Add: Carriage inwards
8,200
2,63,200
Less: Closing stock
45,000
By Prime cost c/d
`
3,63,200
Output or Unit Costing (Cost Sheet)
Cost of materials consumed
To Production wages
To Prime Cost b/d
To Factory overheads:
Rent and rates
Drawing office salaries
Depreciation of plant
Repairs of plant
Factory gas and water
Factory manager’s salary
5.9
2,18,200
1,45,000
3,63,200
3,63,200
By Factory cost c/d
3,000
9,600
9,100
8,600
1,000
11,250
4,05,750
To Factory Cost b/d
To Administration overheads:
Office rent and rates
Depreciation on furniture
Director’s fees
Gas and water
General charges
4,05,750
4,05,750
By Cost of production c/d
To Cost of Sales b/d
To Profit
4,25,400
1,000
600
6,000
1,050
11,000
4,25,400
To Cost of Production b/d
To Selling and dist. overheads:
Counting house salaries
Carriage outwards
Bad debts
Travelling expenses
Travelling salaries, etc.
3,63,200
4,05,750
4,25,400
4,25,400
By Cost of sales c/d
14,000
5,100
4,700
3,700
7,800
4,60,700
4,60,700
26,300
4,87,000
4,60,700
4,60,700
By Sales
4,87,000
4,87,000
Price Quotations and Estimated Cost Sheet
Quite often the management has to quote prices of its products in advance or has to submit
tenders for goods to be supplied. For this purpose an estimated cost sheet has to be prepared.
Such an estimated cost sheet is prepared to show the estimated cost of products to be
manufactured. In this cost sheet, cost of direct materials, direct wages and various types of
overheads are predetermined on the basis of past costs after taking into account the present
conditions and also the anticipated changes in the future price level. Overheads are absorbed
on the basis of a suitable method of absorption like percentage of direct materials, or wages
or machine hour rate, etc. These methods were discussed in the overhead chapter.
Calculation of profit After the total cost has been estimated, a desired percentage
of profit is added to arrive at the price to be quoted. Such profit may be given as a percentage
of cost or percentage of selling price. In order to calculate the amount of profit, it is easy to
assume that figure as 100 on which profit percentage is given and then calculate the amount
of profit.
Output or Unit Costing (Cost Sheet)
5.10
Example 1
Total cost = `50,000
Profit = 20% of cost
Suppose cost = `100
Profit = 100 × 20% = `20
\ When cost is `50,000:
Given:
Profit = 50,000 ×
20
= `10,000
100
Example 2
Given: Total cost = `50,000
Profit = 20% of selling price
Suppose selling price = `100
Profit = 100 × 20% = `20
Cost = Selling price – Profit
= 100 – 20 = `80
So when profit is 20% or 1/5 of selling price, it is 20/80 = 1/4 or 25% of cost. When
total cost is `50,000, the profit will be calculated as follows:
Profit = 50,000 × 25% = `12,500
Example 3
Given: Selling price = `50,000
Profit = 20% of cost
Suppose cost = `100
Profit = 100 × 20% = `20
Selling price = Cost + Profit
100 + 20 = `120
So profit of 20% of cost is equal to 20/120 or 1/6 of selling price. Thus, the profit will be
calculated as follows:
Profit = `50,000 × 1/6 = `8,333.33
PROBLEMS AND SOLUTIONS
Problem 5.1 Mr Gopal furnishes the following data relating to the manufacture of a
standard product during the month of April 2021:
Raw materials consumed
Direct labour charges
Machine hours worked
Machine hour rate
Administration overheads
Selling overheads
Units produced
Units sold
`15,000
`9,000
900
`5
`5,700
`0.50 per unit
17,100
16,000 at `4 per unit
Output or Unit Costing (Cost Sheet)
5.11
You are required to prepare a cost sheet from the above, showing:
(i) the cost per unit,
(ii) cost per unit sold and profit for the period.
Cost sheet is to be prepared when:
(a) Administration oveheads are related to production
(b) Administration overheads are not related to production
(c) Administration overhead `3,420 are related to production and balance is not related
to production activities
(B.Com. Bangalore)
Solution (a)
Cost Sheet
for the month of April 2021
Direct materials
Direct labour
Prime Cost
Production overheads (900 machine hrs @ `5 per hour)
Works Cost
Administration overheads
Cost of Production
Less: Closing Stock on 30 April 2021
(1,100 units @ `2 per unit)
Cost of Goods Sold
Selling Overheads (@ `0.50 per unit for 16,000)
Cost of Sales
Profit
Sales (16,000 units)
Total
Per unit
`
15,000
9,000
24,000
4,500
28,500
5,700
34,200
`
0.877
0.526
1.403
0.263
1.666
0.334
2.000
2,200
32,000
8,000
40,000
24,000
64,000
2.000
0.500
2.500
1.500
4.000
Solution (b)
Cost Sheet for the month of April 2021
Direct materials
Direct labour
Prime cost
Production overhead (900 hrs @ `5 per hr)
Cost of Production
Less: Closing stock of finished goods
(1,100 units @ `1.666)
Selling and dist. overhead
(16,000 units @ `0.50 per unit)
Adm. overhead (General)
Cost of sales (Total cost)
PROFIT
Sales (16,000 units @ `4 per unit)
Total
`
Per unit
`
15,000
9,000
24,000
4,500
28,500
1,833
0.877
0.526
1.403
0.263
1.666
–
26,667
8,000
1.666
0.500
5,700
40,367
23,633
64,000
0.356
2.522
1.478
4.000
Output or Unit Costing (Cost Sheet)
5.12
Solution (c)
Cost Sheet for the Month of April 2021
Direct materials
Direct labour
Prime cost
Production overhead (900 hrs @ `5 per hr)
Work Cost
Adm. overhead (related to production)
Cost of Production
Less: Closing stock of finished goods
(1,100 units @ `1.866)
Cost of Goods Sold
Selling overhead
Adm. overhead (General)
Cost of sales
PROFIT
Sales (16,000 units @ `4 per unit)
Total
`
Per unit
`
15,000
9,000
24,000
4,500
28,500
3420
31920
2,053
0.877
0.526
1.403
0.263
1.666
0.2000
1.866
–
29,867
8,000
2,280
40,147
23,853
64,000
1.866
0.500
0.143
2.509
1.491
4.000
Problem 5.2 The following extract of costing information relates to commodity A for
the year ending 31 December 2021:
`
Purchases of raw materials
60,000
Direct wages
50,000
Rent, rates, insurance and works oncost
20,000
Carriage inward
1,000
Stock–1 January 2021:
Raw materials
10,000
Finished products – 2,000 tonnes
8,000
Stock–31 December 2021:
Raw materials
11,000
Finished products—4,000 Tonnes
—
Work-in-progress—1 January 2021
2,400
Work-in-progress—31 December 2021
8,000
Cost of factory supervision
4,000
Sales of finished products
1,50,000
Advertising, discount allowed and selling costs were `0.40 per tonne sold. 32,000 tonnes
of the commodity were produced during the period. Prepare a Production Statement to ascertain:
(a) the cost of the output of the period and the cost per tonne of production;
(b) the net profit.
(B. Com., Delhi, Adapted)
Output or Unit Costing (Cost Sheet)
5.13
Solution
Production Statement
for the year ending 31 December 2021
Particulars
Add:
Less:
Per tonne
`
Opening stock of raw materials
Purchases
10,000
60,000
70,000
11,000
59,000
50,000
1,09,000
Closing stock
Materials consumed
Direct wages
Prime Cost
Factory Overheads:
Rent, rates, insurance and works on cost
Carriage inward
Factory supervision
20,000
1,000
4,000
Add:
Work-in-progress (1 January 2021)
Less:
Work-in-progress (31 December 2021)
Cost of Production
Stock (finished)—1 January 2021
Add:
Less:
Stock (finished)—31 December 2021
(4,000 tonnes @ `4.0125)*
Cost of Goods Sold (30,000 tonnes)*
Selling and distribution overheads
(@ 40 paise for 30,000 units)
Cost of Sales
Profit
Selling price
*Notes: Quantity sold = 2,000 tonnes + 32,000 tonnes – 4,000 tonnes
Cost of production per tonne = `1,28,400 ÷ 32,000 tonnes
Total
`
4.01*
25,000
1,34,000
2,400
1,36,400
8,000
1,28,400
8000
1,36,400
16,050
0.40
1,20,350
12,000
4.41
0.59
5.00
1,32,350
17,650
1,50,000
= 30,000 tonnes
= `4.0125
Problem 5.3 From the books of account of M/s ZYX Enterprises, the following details
have been extracted for the year ending 31 March 2021:
`
Stock of materials—Opening
1,88,000
Closing
2,00,000
Materials purchased during the year
8,32,000
Direct wages paid
2,38,400
Indirect wages
25,600
Salaries to administrative staff
78,400
Freight—Inward
32,000
Outward
20,000
Sales
15,79,800
Output or Unit Costing (Cost Sheet)
5.14
Cash discount allowed
14,000
Bad debts written off
18,800
Repairs of plant and machinery
42,400
Rent, rates and taxes—Factory
12,000
Office
6,400
Travelling expenses
12,400
Salesmen’s salaries and commissions
33,600
Depreciation written off—Plant and Machinery
28,900
Furniture
2,400
Director’s fees
24,000
Electricity charges (factory)
48,000
Fuel (for boiler)
64,000
Sale of scrap
500
General charges
24,800
Administration overhead relate to production activities.
From the above details you are required to prepare a cost sheet to show:
(a) Prime Cost; (b) Factory Cost; (c) Cost of Production; (d) Total Cost; (e) Profit.
(ICWA Inter, Adapted)
Solution
Cost Sheet
for the year ending 31 March 2021
`
Add:
Opening stock of materials
Purchases
Freight inwards
1,88,000
8,32,000
32,000
Less:
Closing stock of materials
10,52,000
2,00,000
Materials consumed
Direct wages
8,52,000
2,38,400
Prime Cost
Factory Overheads:
Indirect wages
Repairs of plant and machinery
Factory, rent rates and taxes
Depreciation of plant and machinery
Electricity charges
Fuel
Less:
10,90,400
25,600
42,400
12,000
28,900
48,000
64,000
2,20,900
500
Sale of scrap
Factory Cost
Administration Overheads:
Salaries to administrative staff
Office rent, rates and taxes
2,20,400
13,10,800
78,400
6,400
(Contd...)
Output or Unit Costing (Cost Sheet)
5.15
Depreciation of furniture
Director’s fees
General charges
2,400
24,000
24,800
Cost of Production
Selling and Distribution Overheads:
Freight outwards
Travelling expenses
Salesmen’s salaries and commission
Bad debts
Cost of Sales (Total Cost)
Profit
1,36,000
14,46,800
20,000
12,400
33,600
18,800
Sales
84,800
15,31,600
48,200
15,79,800
Note: Cash discount has not been included.
Problem 5.4
records:
The PET Chemicals Co. supplies you the following details from its cost
`
75,000
91,500
52,500
2,750
2,00,000
28,000
35,000
66,000
15,000
3,500
1,500
1,000
5,000
2,500
6,500
54,000
31,000
Stock of raw materials on 1 September 2021
Stock of raw materials on 30 September 2021
Direct wages
Indirect wages
Sales
Work-in-progress on 1 September 2021
Work-in-progress on 30 September 2021
Purchases of raw materials
Factory rent, rates and power
Depreciation of plant and machinery
Expenses on purchases
Carriage outward
Advertising
Administrative overhead related to production
Travellers wages and commission
Stock of finished goods on 1 September 2021
Stock of finished goods on 30 September 2021
Prepare a cost sheet giving the maximum possible break-up of cost and profit.
(B. Com. Delhi)
Solution
Cost Sheet
for the year ending 30 September 2021
Add:
Stock of raw materials (1 September 2021)
Purchases
Expenses on purchases
Less:
Stock of raw material (30 September 2021)
`
75,000
66,000
1,500
1,42,500
91,500
`
(Contd...)
Output or Unit Costing (Cost Sheet)
5.16
Materials consumed
Direct wages
Prime Cost
Add: Work in-progress (1 September 2021)
Factory overheads:
Indirect wages
Factory, rent rates and power
Depreciation of plant and machinery
51,000
52,500
1,03,500
28,000
2,750
15,000
3,500
Less:
Work-in-progress (30 September 2021)
Works Cost
Administrative overheads:
Cost of Production
Add: Stock of finished goods (1 September 2021)
Less:
Stock of finished goods (30 September 2021)
Cost of Goods Sold
Selling and distribution overheads:
Carriage outward
Advertising
Travellers wagers and commission
Cost of Sales
Profit
Sales
1,000
5,000
6,500
21,250
1,52,750
35,000
1,17,750
2,500
1,20,250
54,000
1,74,250
31,000
1,43,250
12,500
1,55,750
44,250
2,00,000
Problem 5.5 The following data are available from the Cost Ledger of Acme Industries
for the year 2021:
`
Plant Maintenance
25,000
Lighting
6,300
Depreciation on Plant
8,100
Rates and Taxes for the Works
3,900
Staff Salaries
32,000
Adm. Salaries (general)
22,000
Power (for this Plant)
10,600
Rental for Leasehold Equipments
9,600
Indirect Wages
37,100
Rectification Cost of Defectives (Normal)
8,400
Consumable Stores
17,600
Selling Expenses
30,000
General Charges
15,600
Sale Proceeds from Scrap
4,200
During the year total production was 1,20,000 units. The break-up of prime cost per unit
was: materials `2.20 and wages `1.80. The average selling price was `6.75 per unit and entire
quantity produced during the year was sold out.
Output or Unit Costing (Cost Sheet)
5.17
With effect from 1 January 2022, the selling price was reduced to `6.40 per unit. It was
envisaged that production could be enhanced during 2022 by 33 1 3 per cent without incurring
any overtime or extra-shift work, or additional selling expenses.
You are required to prepare statements showing:
(i) Actual cost and profit for the year 2021.
(ii) Estimated cost and profit for 2022 assuming that the entire production will be sold during
the year.
Assumptions, if any, required to be made in the above exercise, should be clearly stated.
(B Com Adapted, ICWA, Inter)
Solution
Statement of Cost and Profit
for the year 2021
Output 1,20,000 units
Particulars
Per unit
`
Materials
Materials
Wages
Prime Cost
Variable Charges:
Power
Rectification cost
Consumable stores
Less: Sale of scrap
Total Variable Cost
Fixed Charges:
Indirect wages
Plant maintenance
Lighting
Depreciation for plant
Rates and taxes for works
Rental for leasehold equipments
Cost of Production
Adm. and Selling Charges
Staff salaries
Management salaries
General charges
Selling expenses
Cost of Sales
Profit
Sales
0.088
0.070
0.147
0.305
0.035
Total
`
`
2.20
2.20
1.80
2,64,000
2,64,000
2,16,000
4.00
4,80,000
0.27
10,600
8,400
17,600
36,600
4,200
4.27
0.309
0.208
0.053
0.067
0.033
0.080
0.267
0.183
0.130
`
0.75
5.02
0.58
0.25
5.85
0.90
6.75
32,400
5,12,400
37,100
25,000
6,300
8,100
3,900
9,600
32,000
22,000
15,600
90,000
6,02,400
69,600
30,000
7,02,000
1,08,000
8,10,000
Output or Unit Costing (Cost Sheet)
5.18
Statement of Estimated Cost and Profit
for the year 2022
Estimated output = 1,60,000 units
Particulars
Per unit
`
Prime Cost @ `4.00 per unit
Variable Charges: Less: Scrap value
Variable Cost
Fixed Charges:
Works
Administrative
Selling
Working Notes:
0.5625
0.4350
0.1875
Total
`
`
`
4.000
0.270
6,40,000
43,200
4.270
6,83,200
1.185
90,000
69,600
30,000
1,89,600
Cost of Sales
Profit
5.455
0.945
8,72,800
1,51,200
Sales
6.400
10,24,000
1. Estimated output is 1,20,000 ×
4
= 1,60,000 units.
3
2. Variable charges have been assumed to increase in proportion to the volume of output
whereas fixed charges have been assumed to remain constant.
3. Adm. charges are not related to production.
Problem 5.6 Usha Engineering Works Ltd manufactured and sold 1,000 sewing machines
in 2021. Following are the particulars obtained from the records of the company.
`
Cost of materials
Wages paid
80,000
1,20,000
Manufacturing expenses
50,000
Salaries of managerial staff
60,000
Rent, rates and insurance
10,000
Selling expenses
30,000
General expenses
Sales
20,000
4,00,000
The company plans to manufacture 1,200 sewing machines in 2022. You are required to
submit a statement showing the price at which machines would be sold so as to show a profit
of 10 per cent on the selling price. The following additional information is supplied to you:
(a) The price of materials will rise by 20 per cent over the previous year’s level.
(b) Wages rates will rise by 5 per cent.
(c) Manufacturing expenses per unit will rise in proportion to the combined cost of materials
and wages.
(d) Selling expenses per unit will remain unchanged.
(e) Other expenses will remain unaffected by the rise in output.
(f) Adm. overhead relate to production activities.
(B.Com. Hons. Adapted)
Output or Unit Costing (Cost Sheet)
5.19
Solution
Statements showing the Quotation of Price
for the year 2022
Total (1,200
machines)
`
Per
machine
`
1,15,200
1,51,200
96.00
126.00
Prime Cost
2,66,400
66,600
222.00
55.50
Works Cost
3,33,000
277.50
10,000
60,000
20,000
8.33
50.00
16.67
Cost of Production
4,23,000
36,000
352.50
30.00
Cost of Sales
Profit (10% on Selling price)*
4,59,000
51,000
382.50
42.50
Selling Price
5,10,000
425.00
Particulars
Materials (`80 + 20% = `96 per machine)
Direct wages (`120 + 5% = `126 per machine)
Manufacturing expenses*
Admn. overhead:
Rent, rates and insurance
Management and staff salaries
General expenses
Selling expenses
*Working Notes:
1. Mfg. expenses in 2022
2. Profit of 10% or
=
Materials + Labour in 2022 × Mfg. exp. in 2021
Materials + Labour in 2021
=
222
× 50 = `55.50 per unit
200
1
on selling price is equal to 1/9 of total cost = 382.50 × 1/9
10
= `42.50 per machine.
Problem 5.7 A company makes two distinct types of vehicles, A and B. The total
expenses during a period as shown by the books for the assembly of 600 of the type
A and 800 of the type B vehicles are as under:
`
Materials
1,98,000
Direct wages
12,000
Stores overheads
19,800
Running expenses of machines
4,400
Depreciation
2,200
Labour amenities
1,500
Works general overheads
30,000
Administration and selling overheads
26,800
Output or Unit Costing (Cost Sheet)
5.20
The other data available to you is:
A : B
Material cost ratio per unit
1:2
Direct labour ratio per unit
2:3
Machine utilization ratio per unit
1:2
Calculate the cost of each vehicle per unit giving reasons for the bases of apportionment
adopted by you.
(ICWA Inter)
Solution
Cost Statement
for the period..........
Vehicle A
`
Materials
Direct wages
Vehicle B
`
Total
`
54,000
4,000
1,44,000
8,000
1,98,000
12,000
Prime Cost
Works Overhead:
Stores overhead (10% of materials)
Running expenses of machines
Depreciation
Labour amenities
Works general overhead
58,000
1,52,000
2,10,000
5,400
1,200
600
500
10,000
14,400
3,200
1,600
1,000
20,000
19,800
4,400
2,200
1,500
30,000
Cost of Production
Administration and selling overhead
75,700
7,573
1,92,200
19,227
2,67,900
26,800
Total Cost
83,273
2,11,427
2,94,700
Cost Per Unit
138.78
264.28
Working Notes:
1. Material cost has been apportioned on the basis of cost ratio per unit multiplied by the units produced:
A:B
600 × 1 : 800 × 2
or
600 : 1,600
or
3:8
2. Direct wages have been apportioned in a similar manner:
A: B
600 × 2 : 800 × 3
or
1,200 : 2,400
or
1: 2
3. The stores overheads have been apportioned as a percentage of material cost as follows:
19,800
1,98,000 × 100 = 10%
4. Running expenses and depreciation have been apportioned on the basis of machine utilization ratio
multiplied by units produced, i.e., 600 : 1,600 or 3 : 8.
Output or Unit Costing (Cost Sheet)
5.21
5. Works overheads and labour amenities have been apportioned as a percentage of wages as follows:
Works overheads
Labour amenities
30,000
× 100 = 250%
12,000
1,500
=
× 100 = 12.5%
12,000
=
6. Administrative overheads have been apportioned as a percentage of works cost as calculated below:
26,800
× 100 = 10.003%
2,67,900
Problem 5.8 Jolly Shoes Co. manufactures two types of shoes A and B. Production
costs for the year ended 31 March 2021 were:
`
Direct materials
Direct wages
Production overheads
15,00,000
8,40,000
3,60,000
27,00,000
There was no work-in-progress at the beginning or at the end of the year. It is ascertained
that: (a) Direct material in type A shoes consists twice as much as that in type B shoes; (b)
The direct wages for type B shoes were 60% of those of type A shoes; (c) Production overhead
cost was the same per pair of A and B type; (d) Administrative overhead for each type was
150% of direct wages; (e) Selling cost was `1.50 per pair; (f) Production during the year were:
Type A 40,000 pairs of which 36,000 were sold; Type B 1,20,000 pairs of which 1,00,000
were sold; (g) Selling price was `44 for type A and `28 for type B per pair. Prepare a statement
showing cost and profit assuming administrative overhead related to production.
(B Com Hons Delhi Adapted, CA Inter; ICWA, Inter)
Solution
Statement of Cost and Profit
for the year ending 31 March 2021
Type A
Per pair
`
Type B
Total
Per pair
`
`
Particulars
Total
`
Direct materials
Direct wages
6,00,000
3,00,000
15.00
7.50
9,00,000
5,40,000
7.50
4.50
Prime Cost
Production overhead
9,00,000
90,000
22.50
2.25
14,40,000
2,70,000
12.00
2.25
Works Cost
Administrative overhead
9,90,000
4,50,000
24.75
11.25
17,10,000
8,10,000
14.25
6.75
Cost of Production
Less: Closing stock
14,40,000
1,44,000
36.00
—
25,20,000
4,20,000
21,00
—
Cost of Goods Sold
Selling overhead
12,96,000
54,000
36.00
1.50
21,00,000
1,50,000
21.00
1.50
Cost of Sales
13,50,000
2,34,000
37.50
6.50
22,50,000
5,50,000
22.50
5.50
Sales
15,84,000
44.00
28,00,000
28.00
Profit
Output or Unit Costing (Cost Sheet)
5.22
Working Notes:
1. Materials cost has been allocated as follows:
Suppose Type B’s material cost is =
Then Type A’s materials =
1,20,000x + 80,000x =
2,00,000x =
x=
Type B material cost =
A material cost =
x
2x
`15,00,000
`15,00,000
`7.50
`7.50 per pair
`15.00 per pair
2. Wages
Let labour charges for A be = x
Then labour charges for B =
\ 40,000x + (1,20,000 × 0.6x) =
\ 1,12,000x =
x=
\ A’s labour charges =
B’s labour charges =
60x or 0.6x
100
`8,40,000
`8,40,000
`7.50
`7.50 per pair
7.50 × 60% = `4.50 per pair.
Problem 5.9 On 30 June 2021, a flash flood damaged the warehouse and factory of
ABC Corporation completely destroying the work-in-progress inventory. There was no
damage to either the raw materials or finished goods inventories. A physical verification
taken after the flood revealed the following valuations.
`
Raw materials
62,000
Work-in-progress
0
Finished Goods
1,19,000
The inventory on 1 January 2021, consisted of the following :
Raw materials
30,000
Work-in-progress
1,00,000
Finished goods
1,40,000
2,70,000
A review of the books and records disclosed that the gross profit margin historically
approximated 25% of sales. The sales for the first six months of 2021 were `3,40,000. Raw
material purchases were `1,15,000. Direct labour costs for this period were `80,000 and
manufacturing overhead has historically been 50% of direct labour.
Compute the cost of work-in-progress inventory lost at 30 June 2021 by preparing a
statement of cost and profit.
(B. Com. Hons., Delhi)
Solution
ABC Corporation
Statement of Cost and Profit
`
Opening stock of raw materials
Add : Purchases
30,000
1,15,000
Less : Closing stock
1,45,000
62,000
(Contd...)
Output or Unit Costing (Cost Sheet)
5.23
Raw materials consumed
83,000
Direct labour
80,000
Prime Cost
1,63,000
Factory overhead
40,000
2,03,000
Add : Opening work-in-progress:
1,00,000
Total goods in process during the period
3,03,000
Less : Closing work-in-progress (balance figure)
69,000*
Cost of Production
2,34,000
Add : Opening stock of finished goods
1,40,000
Cost of goods available for sale
3,74,000
Less : Closing stock of finished stock
1,19,000
Cost of Goods Sold
2,55,000
Profit (25% of sales)
85,000
Sales
*Note:
3,40,000
Closing stock of work-in-progress is calculated by working backward from sales and reaching at workin-progress, which is the difference between cost of production and total goods in process during the
period.
Problem 5.10 The manager of a small manufacturing company consults you as to the
minimum price at which he can sell the output of one of the depeartments of the
company, which is intended for mass production in future. The Company’s records
show the following particulars for this department for the preceding year.
`
Production and Sale (100 units)
80,000
Materials
26,000
Direct Labour
14,000
Direct charges
4,000
Production Overheads
16,000
Administrative Overheads related to production activities
5,600
Selling Overheads
6,400
Profit
8,000
It is ascertained that 45% of the Production Overheads fluctuate directly with Production
and 60% of the Selling Overheads fluctuate with sales. It is anticipated that the department
would produce 6,000 units per annum and that direct labour charges per unit will be
reduced by 20%, while the fixed production overheads will increase by `8,000.
Administrative overheads and fixed selling overheads are expected to show an increase
of 25% but otherwise no changes are expected. Compute the minimum price.
(B.Com. Hons. Delhi)
Solution
Cost Sheet
Particualrs
Materials*
Direct Labour*
Direct Charges
`
6,000 units ` Per unit (`)
15,60,000
6,72,000
4,000
(Contd...)
Output or Unit Costing (Cost Sheet)
5.24
Prime cost
Production overheads*
Fixed (`8,800 + `8,000)
Variable
Factory cost
Administrative overheads (`5,600 + 25%)
Cost of Production
Selling overheads*
Fixed
Variable
Total cost
Profit
Sales*
16,800
4,32,000
3,200
2,30,400
22,36,000
372.66
4,48,800
26,84,800
7,000
26,91,800
74.80
447.46
1.17
448.63
2,33,600
29,25,400
3,25,045
32,50,445
39.93
487.57
54.17
541.74
*Working Notes:
1. Material cost =
` 26,000
 6,000 units = `15,60,000
100
2. Labour cost =
`14,000
= `140 less 20% = ` 112 per unit
100
Total labour cost = ` 112 × 6,000 units = ` 6,72,000
3. Production overheads: Variable = [16,000 × 45%]  100 = `72 per unit
Total variable overheads = ` 72 × 6,000 units = `4,32,000
Fixed = 16,000 × 55% = `8,800
4. Selling overheads:
Variable = (` 6,400 × 60%)  100 = `38.40
Total variable overheads = `38.40 × 6,000 units = ` 2,30,400
Fixed = `6,000 – (38.40 × 100) × 125% = ` 3200
5. Current profit =
6. Sales =
`8,000
 100 = 10% of sales.
`80,000
29, 25,400
= ` 32,50,445 (Approx.)
90%
Problem 5.11 In a manufacturing company, a product passes through 5 operations.
The output of the 5th operation becomes the finished product. The input, rejection,
output and labour and overheads of each operation for a period are as under:
Operation
Input
(units)
Rejection
(units)
Output
(units)
Labour and Overhead
(`)
1
21,600
5,400
16,200
1,94,400
2
20,250
1,350
18,900
1,41,750
3
18,900
1,350
17,550
2,45,700
4
23,400
1,800
21,600
1,40,400
5
17,280
2,880
14,400
86,400
You are required to:
(i) Determine the input required in each operation for one unit of final output.
Output or Unit Costing (Cost Sheet)
5.25
(ii) Calculate the labour and overhead cost at each operation for one unit of final output
and the total labour and overhead cost of all operations for one unit of final output.
(CA Inter)
Solution
Calculation of Rejection as a percentage of Output
Operation
Input
(units)
Rejection
(units)
Output
(units)
Rejection
as % of output
1
21,600
5,400
16,200
33.33
2
20,250
1,350
18,900
7.14
3
18,900
1,350
17,550
7.69
4
23,400
1,800
21,600
8.33
5
17,280
2,880
14,400
20.00
Input Required for Each Operation
Operation
Output
Rejection %
(units)
5
1.00
20
4
1.20
8.33
3
1.30
7.69
2
1.40
7.14
1
1.50
33.33
Input required
120
= 1.20
100
108.33
1.20 ×
= 1.30
100
107.69
1.30 ×
= 1.40
100
107.14
1.40 ×
= 1.50
100
133.33
1.50 ×
= 2.00
100
1 ×
Thus input required in operation 1 for one unit of final output = 2 units
Statement of Labour and Overhead Cost
Operation
Input
(units)
Labour and
overhead
Labour and
overhead per
unit of input
`
`
Input units Labour and
required overhead cost
per unit of
per unit of
output
output
`
(a)
(b)
(c)
d = c ÷ b
e
f = d × e
1
2
3
4
5
21,600
20,250
18,900
23,400
17,280
1,94,400
1,41,750
2,45,700
1,40,400
86,400
9
7
13
6
5
2.00
1.50
1.40
1.30
1.20
18.00
10.50
18.20
7.80
6.00
Total
60.50
Output or Unit Costing (Cost Sheet)
5.26
Thus labour and overhead cost for all the operations for one unit of output is `60.50.
Problem 5.12
The following inventory data relate to XYZ Ltd:
Inventories
Finished goods
Work-in-progress
Raw materials
Beginning
Ending
`1,10,000
`70,000
`90,000
95,000
80,000
95,000
Additional information:
Cost of goods available for sale
Total goods processed during the period
Factory overheads
Direct materials used
`6,84,000
`6,54,000
`1,67,000
`1,93,000
Requirements:
(i) Determine raw materials purchases
(ii) Determine the direct labour cost incurred
(iii) Determine the cost of goods sold
(B. Com. Hons., Delhi)
Solution
Statement of Cost
`
Operating stock of raw materials
Add: Purchases of raw material (i) (Bal. Fig.)
90,000 (given)
1,98,000
Less: Closing stock
2,88,000
95,000 (given)
Raw material used
Direct labour cost incurred (ii) (Bal. Fig.)
1,93,000 (given)
2,24,000
Prime Cost
Factory overheads
4,17,000
1,67,000 (given)
Current manufacturing cost
Add: Opening stock of work-in-progress
5,84,000
70,000 (given)
Goods processed during the period
Less: Closing stock of work-in-progress
6,54,000 (given)
80,000 (given)
Cost of Goods Manufactured
Add: Opening stock of finished goods
5,74,000
1,10,000 (given)
Cost of goods available for sale
Less: Closing stock of finished goods
6,84,000
95,000 (given)
Cost of Goods Sold (iii)
5,89,000
Problem 5.13 The Triputi Electrical Ltd, manufactures one product. A summary of its
activities for 2021 is as follows:
Output or Unit Costing (Cost Sheet)
Sales
Material inventory:
Work-in-progress inventory:
Finished goods:
5.27
`
8,00,000
40,000
32,000
55,000
72,000
64,000
—
1,52,000
1,45,000
1,08,000
50,000
40,000
Units
80,000
1.1.2021
31.12.2021
1.1.2021
31.12.2021
1.1.2021
31.12.2021
16,000
24,000
Material purchases
Direct labour
Manufacturing overheads
Selling expenses
General and administration expenses related to production
Calculate:
(i) The current manufacturing cost for 2021.
(ii) The total cost of goods manufactured (finished), the number of units manufactured
(finished) and the cost per unit.
(iii) The cost of goods sold for the year presuming the company uses the LIFO inventory
costing method for its finished goods inventory.
(B. Com. Hons., Delhi)
Solution
Cost Sheet
for the Year 2021
Output: 88,000 units*
`
Add:
Less:
Direct materials:
Opening stock
Purchases
40,000
1,52,000
1,92,000
32,000
Closing stock
Materials consumed
Direct labour
Prime Cost
Add:
Factory overheads
Opening work-in-progress
Less:
Closing work-in-progress
Add:
Factory cost (cost of goods manufactured)
General and admn. expenses
Cost of Production
Opening stock of finished goods
Less:
Closing stock of finished goods
Cost of Goods Sold
Selling and distribution expenses
Net Profit
Sales
1,60,000
1,45,000
3,05,000
1,08,000
4,13,000
55,000
4,68,000
72,000
3,96,000
40,000
4,36,000
64,000
5,00,000
1,04,000*
3,96,000
50,000
4,46,000
3,54,000
8,00,000
Output or Unit Costing (Cost Sheet)
5.28
*Working Notes:
1. No. of units manufactured during the year
Sales + Closing stock – Opening stock
80,000 + 24,000 – 16,000 = 88,000 units.
= 4,36,000 ÷ 88,000 = `5 Approx.
2.
Cost per unit finished
3.
Valuation of closing finished stock on LIFO basis
16,000 units @ `4
8,000 units @ `5
=
=
`64,000
`40,000
Total
=
`1,04,000
Problem 5.14 With respect to a factory, the following particulars have been extracted
for the year 2021:
`
6,00,000
5,00,000
3,00,000
3,36,000
2,24,000
1,40,000
4,20,000
Cost of materials
Wages
Factory overheads
Administration charges related to production
Selling charges
Distribution charges
Profit
A work order has to be executed in 2022 and the estimated expenses are:
Materials `8,000, Wages `5,000.
Assuming that in 2022 the rate of factory overheads has gone up by 20%, distribution
charges have gone down by 10% and selling and administration charges have each gone up by
15%, at what price should the product be sold so as to earn the same rate of profit as in 2021?
Factory overheads are based on wages and administration, selling and distribution overheads
on factory cost.
(B. Com. Delhi, Bangalore)
Solution
Cost Statement
for the year 2021
`
6,00,000
5,00,000
Direct materials
Wages
Prime Cost
Factory overheads (60% of wages)
11,00,000
3,00,000
Factory or Works Cost
Administration charges (24% of factory cost)
14,00,000
3,36,000
Cost of Production
17,36,000
2,24,000
1,40,000
Total Cost or Cost of Sales
21,00,000
4,20,000
25,20,000
Selling charges (16% of factory cost)
Distribution charges (10% of factory cost)
Profit (20% on total cost)
Sales
Output or Unit Costing (Cost Sheet)
5.29
Statement of Estimated Cost and Profit
on Work Order in 2022
Materials
Wages
`
8,000
5,000
Prime Cost
Factory overheads (60% of wages, increased by 20%, i.e., 72%)
13,000
3,600
Factory Cost
16,600
Administration charges
(24% of cost, increased by 15%, i.e., 27.6%)
4,581
Cost of Production
Selling charges (16% of factory cost, increased by 15%, i.e., 18.4%)
Distribution charges
(10% of factory cost, decreased by 10%, i.e., 9%)
21,181
3,054
24,235
1,494
Cost of Sales
25,729
5,146
Price to be Quoted
30,875
Profit (20% on cost of sales)
Problem 5.15 Metal Products Company produces a sewing machine that sells for `300.
An increase of 15% in cost of materials and of 10% in cost of labour is anticipated.
If the only figures available are those given below, what must be the selling price to give
the same percentage of gross profit as before?
(a) Material costs have been 45% of cost of sales (b) Labour costs have been 40% of
cost of sales (c) Overhead costs have been 15% of cost of sales. (d) The anticipated increased
costs in relation to the present sales price would cause 35% decrease in the present gross profit.
(B Com Hons Delhi Adapted, CA Inter)
Solution
Statement Showing Cost of Sales
(Suppose Cost of Sales = `100)
Assumed present
cost of sales
Increase
Anticipated
cost of sales
Materials
Labour costs
Overhead costs
`45
`40
`15
15%
10%
—
`51.75
`44.00
`15.00
Cost of sales
`100
Selling price = 300 ×
`110.75
110.75
= `332.25
100
Increase in cost in relation to the assumed present cost of sales
= `110.75 – `100 = `10.75
Increase in cost = 35% decrease in the amount of gross profit
Gross profit = `10.75 ×
100
= 30.72
35
Gross profit as a percentage of sales =
30.72  100
300
Actual present cost of sales = `300 – `30.72
= `10.24%
= `269.28
Output or Unit Costing (Cost Sheet)
5.30
Taking the anticipated increase:
Material
Labour
Overheads
Percentage
Present cost
`
Increase
`
Anticipated cost
`
45%
40%
15%
100%
121.18
107.72
40.38
269.28
18.18
10.78
—
139.36
118.50
40.38
298.24
\ Anticipated cost of sales with the increase
Same percentage of gross profit (10.24% of sales)
\ Selling price
298.24
34.01
332.25
Problem 5.16 A company manufactures radios, which are sold at `1,600 per unit. The
total cost is composed of 30% for direct materials, 40% for direct wages and 30% for
overheads. An increase in material price by 30% and in wage rates by 10% is expected
in the forthcoming year, as a result of which the profit at current selling price may
decrease by 40% of the present profit per unit. You are required to prepare a statement
showing current and future profit at present selling price.
How much should selling price be increased to maintain the present rate of profit?
(B Com Hons Delhi)
Solution
Suppose cost = x; Profit = y
Statement of Cost
Present
`
Incrcase
`
New cost
`
Direct material
Direct labour
Overheads
0.3x
0.4x
0.3x
0.09x
0.04x
—
0.39x
0.44x
0.30x
Total
x
0.13x
1.13x
x + y = 1,600
1.13x + 0.6y = 1,600
On solving equation (i) and (ii)
x =
1,207.55 i.e., Cost
y =
392.45 i.e., Profit
Total
....(i)
....(ii)
1,600.00 i.e., Selling price
Revised Statement of Cost and Profit
Direct materials (1,207.55 × 0.39)
Direct labour (1,207.55 × 0.44)
Overhead (1,207.55 × 0.30)
Total cost
Profit (32.50% on cost) *
Revised selling price
`
470.94
531.32
362.27
1364.53
443.47
1808.00
Output or Unit Costing (Cost Sheet)
* Profit percentage on cost =
5.31
392.45
100  32.50%
1207.55
Thus the selling price should be increased by `208, i.e., form `1,600 to `1,808 to maintain
the present rate of profit.
Problem 5.17
Philips India Ltd has just completed operations for the year 2021.
Company’s assistant accountant (who is very inexperienced) prepared the following
Profit and Loss Account for the year’s activities:
`
Sales
Operating expenses:
Insurance
Gas, electricity and water
Direct labour cost
Indirect labour cost
Depreciation of factory equipment
Raw materials purchased during the year
Rent
Selling and admn. overheads
Net profit
`
32,00,000
40,000
1,00,000
6,00,000
1,20,000
1,60,000
12,00,000
4,00,000
3,20,000
29,40,000
2,60,000
You have been asked to assist the company in preparing a correct Profit and Loss Account
for the year 2021. The following additional information is available.
1. The company is a manufacturing firm that produces a product for sale to outside customers.
2. 80 per cent of the rent paid applies to factory operations and the remainder to selling
and administrative activities.
3. No raw materials were on hand on 1 January. However, raw materials of the value of
`1,50,000, purchased during 2021, were still on hand on 31 December. The remainder
was used in production during the year.
4. 70 per cent of the insurance and 90% of the gas, electricity and water paid apply to
factory operations; the remainder apply to selling and administration activities.
5. Work-in-progress and finished goods inventories were:
1 January
31 December
Work-in-progress
4,20,000
4,80,000
Finished goods
5,40,000
4,00,000
You are required to prepare—
(i) Statement of Cost of Goods Manufactured in 2021.
(ii) Corrected Profit and Loss Account for the year ended 31 December 2021.
(ICWA Adapted)
Solution
(a)
Statement of Cost of Goods Manufactured in 2021
Direct marterials purchased
Less: Closing stock
Direct materials consumed
`
12,00,000
1,50,000
`
10,50,000
(Contd...)
Output or Unit Costing (Cost Sheet)
5.32
Direct labour
Prime Cost
Manufacturing Overheads:
Indirect labour
Gas, electricity and water (90% of `1,00,000)
Insurance (70% of `40,000)
Depreciation
Rent (80% of `4,00,000)
6.00.000
16,50,000
1,20,000
90,000
28,000
1,60,000
3,20,000
Add: Opening work-in-progress
Less: Closing work-in-progress
Cost of Goods Manufactured
(b)
7,18.000
23,68,000
4,20,000
27,88,000
4,80,000
23,08,000
Corrected Profit and Loss Account for the year ended 31-12-2021
`
Cost of goods manaufactured (as per statement above)
Add: Opening stock of finished goods
Less: Closing stock of finished goods
Cost of Goods Sold
Administration and selling expenses:
Selling & admn. overheads
Rent (20% of `4,00,000)
Insurance (30% of `40,000)
Gas, electricity and water (10% of `1,00,000)
`
23,08,000
5,40,000
28,48,000
4,00,000
24,48,000
3,20,000
80,000
12,000
10,000
Cost of Sales
Net Profit
4,22,000
28,70,000
3,30,000
Sales
32,00,000
Problem 5.18 M K Works can produce 60,000 units per annum at its optimum (100%)
capacity. The estimated costs of production are as under:
Direct material
Direct labour
Indirect expenses:
Fixed:
Variable:
Semi-variable:
`3 per unit
`2 per unit
`1,50,000 per annum
`5 per unit
`50,000 p.a. up to 50% capacity and an extra expenses of
`10,000 for every 25% increase in capacity on part thereof
The factory produced only against orders and not for own stock. If the production
programme of the factory is as indicated below, and the management desires to ensure a profit
of `1,00,000 for the year, work out the average selling price at which each unit should be quoted.
First 3 months of the year
50% of capacity
Remaining 9 months
80% of capacity
Ignore selling, distribution and administration overheads.
(CA, Adapted; B. Com. Hons., Delhi)
Output or Unit Costing (Cost Sheet)
5.33
Solution
Production Statement
(Output: 43,500* units)
`
1,30,500
87,000
Direct materials (43,500 units @ `3 per unit)
Direct labour (43,500 @ `2 per unit)
Prime Cost
Indirect expenses:
Fixed
Variable (43,500 units @ `5 per unit)
Semi-variable:
For first 3 months at 50% capacity
= 50,000 × 3/12
For 9 months at 80% capacity
= 70,000 × 9/12
2,17,500
1,50,000
2,17,500
12,500
52,500
Cost of Production
4,32,500
6,50,000
1,00,000
Estimated profit
Estimated sales revenue for 43,500 units
Selling price per unit = `7,50,000 ÷ 43,500 units = ` 17.24
7,50,000
*Working Note:
Output: First 3 months at 50% capacity
For next 9 months 80% capacity
Total units produced
50
3

100 12
80
9

= 60,000 ×
100 12
= 60,000 ×
= 7,500 + 36,000
= 7,500 units
= 36,000
= 43,500.
Problem 5.19
Electrovision Co. can produce 1,00,000 units at 100% capacity. Its
works cost at varying levels of output are as under:
Capacity level
Works cost per unit (`)
30%
380
100%
310
Its fixed administration expenses related to production activities amount to `1,50,000 and
fixed marketing expenses amount to `2,50,000 per month respectively. The variable distribution
cost amounts to `30 per unit.
It can market 100% of its output at `500 per unit provided it incurs the following further
expenditure:
(a) It gives gift items costing `30 per unit of sale;
(b) It has lucky draws every month giving the first prize of `50,000; 2nd prize of `25,000,
3rd prize of `10,000 and three consolation prizes of `5,000 each to customers buying
the product.
(c) It spends `1,00,000 on refreshments served every month to its customers;
(d) It sponsors a television programme every week at a cost of `20,00,000 per month.
It can market 30% of its output at `550 per unit without incurring any of the expenses
referred to in (a) to (d) above.
Prepare a cost sheet at 30% and 100% capacity levels showing per unit and total cost and
profit.
(CA Inter, Adapted)
Output or Unit Costing (Cost Sheet)
5.34
Solution
Cost Sheet
Capacity level
Output units
30%
30,000
100%
1,00,000
Per unit
`
Total
`
Per unit
`
Total
`
Works cost
Add: Adm. exp. (fixed)
Cost of Production
Add: Marketing exp. (fixed)
Distribution exp. (variable)
Add: Further special exp:
Gift items
Lucky draw price
TV Programme
Refreshments
380.00
5.00
385.00
8.33
30.00
1,14,00,000
1,50,000
1,15,50,000
2,50,000
9,00,000
310.00
1.50
311.50
2.50
30.00
3,10,00,000
1,50,000
3,11,50,000
2,50,000
30,00,000
–
–
–
–
–
–
–
–
30.00
1.00
20.00
1.00
30,00,000
1,00,000
20,00,000
1,00,000
Total Cost
Profit
423.33
126.67
1,27,00,000
38,00,000
396.00
104.00
3,96,00,000
1,04,00,000
Sales
550.00
1,65,00,000
500.00
5,00,00,000
Problem 5.20 Maximum production capacity of JK Ltd. is 5,20,000 units per annum.
Details of estimated cost of production are as follow:
Direct material `15 per unit.
Direct wages `9 per unit (subject to a minimum of `2,50,000 per month).
Fixed overheads `9,60,000 per annum.
Variable overheads `8 per unit.
Semi-variable overheads are `5,60,000 per annum, up to 50 per cent capacity and additional
`1,50,000 per annum for every 25 per cent increase in capacity or a part of it.
JK Ltd. worked at 60 per cent capacity for the first three months during the year 2021,
but it is expected to work at 90 per cent capacity for the remaining nine months.
The selling price per unit was `44 during the first three months.
What selling price per unit should be fixed for the remaining nine months to yield a total
profit of `15,62,500 for the whole year?
(CA PE-II)
Solution
Statement of Cost and Profit
for the year 2021
Maximum capacity = 5,20,000 units per annum
First 3
months 60%
78,000 units
`
Next 9
months 90%
3,51,000 units
`
Total
4,29,000
units
`
Direct materials @ `15 p.u.
Direct wages @ 9 p.u.
11,70,000
7,50,000
52,65,000
31,59,000
64,35,000
39,09,000
A. Prime Cost
19,20,000
84,24,000
1,03,44,000
Overheads:
Fixed
Variable @ `8 p.u.
Semi Variable*
2,40,000
6,24,000
1,77,500
7,20,000
28,08,000
6,45,000
9,60,000
34,32,000
8,22,500
Capacity used
Production units*
(Contd...)
Output or Unit Costing (Cost Sheet)
5.35
B. Total Overheads
10,41,500
41,73,000
52,14,500
C. Total Cost (A + B)
Profit in first 3 months
29,61,500
4,70,500
1,25,97,000
1,55,58,500
Sales @ `44 p.u.
34,32,000
Add: Desired profit in next 9 months
(`15,62,500 – `4,70,500)
10,92,000
Sales required for next 9 monts
1,36,89,000
Total profit
15,62,500
Total Sales
(34,32,000 + 1,36,89,000)
1,71,21,000
Selling price to be fixed for the remaining 9 months
Total sales in 9 months
= Output in units in 9 months
`1,36,89,000
= 3,51,000 units = `39 per unit
*Working Notes:
1. Production units
First 3 months =
5, 20, 000 units  3 months  60%
12 months
9 months
Next 9 months = 5,20,000 units × 12 months  90%
2. Semi-variable overheads:
(a) First 3 months at 60% capacity
(b) Remaining 9 months at 90% capacity
= 78,000 units
= 3,51,000 units
= (`5,60,000 + 1,50,000) × 3/12
= `1,77,500.
= (`5,60,000 + 3,00,000) × 9/12
= `6,45,000.
SUMMARY AND KEY TERMS




Output costing, also known as single costing, is a method of cost
ascertainment, which is used in those industries in which production consists
of a single product or a few varieties of the same product, like cement
industry, steel mills, paper mills and sugar mills.
For ascertainment of the cost of products, a cost sheet is prepared. Cost
sheet is a periodical statement of cost, designed to show in detail, the
various elements of cost of goods produced like prime cost, factory cost,
cost of production and total cost.
Cost sheet reveals the total cost and cost per unit of goods produced.
Cost sheet is also prepared to determine the price to be quoted. In
such a situation, an estimated cost sheet is prepared in which a fixed
percentage of profit is added in the estimated total cost to arrive at
the selling price to be quoted.
Output or Unit Costing (Cost Sheet)
5.36
EXAMINATION QUESTIONS
Theoretical Questions
1. What is unit or output costing? In what industries is it used?
2. What is a cost sheet? Explain the purposes served by it.
Practical Questions
1. The following data relate to the manufacturing of a standard product during the four
weeks ending on 31 March 2021:
Raw materials consumed
`20,000
Direct wages
`12,000
Machine-hours worked
1,000 hours
Machine-hour rate
`2 per hour
Adm. overhead related to production
20% on works cost
Selling overheads
`0.40 per unit
Units produced
20,000 units
Units sold at `3 each
18,000 unitsa
Prepare a Cost Sheet and show the profit.
(B. Com., Bangalore)
2. A factory produces a standard product. The following information is given to you from
which you are required to prepare a ‘Cost Sheet’ for the period ended 31 July 2021:
Consumable materials:
`
Opening stock
10,000
Purchases
85,000
Closing stock
4,000
Direct wages
20,000
Other direct expenses
10,000
Factory overheads
100% of direct labour
Office overheads
10% of works cost
Selling and distribution expenses
`2 per unit sold
Units of finished product:
In hand at the beginning of the period
Units 1,000 (value `16,000)
Produced during the period
10,000 units
In hand at the end of the period
2,000 units
Also, find out the selling price per unit on the basis that profit mark-up is uniformly
made to yield a profit of 20% of the selling price. There was no work-in-progress
either at the beginning or at the end of the period.
(B. Com., Delhi)
3. Z company is manufacturing transistor sets and the following details are furnished
with respect to its factory operations for the year ended 31 December 2021.
Raw materials:
`
Purchases
40,000
Opening stock
8,000
Closing stock
6,000
Direct labour
28,000
Manufacturing expenses
8,500
Administration expenses related to production
5,300
Output or Unit Costing (Cost Sheet)
Work-in-progress:
Materials
Labour
Manufacturing expenses
Total
5.37
Opening
`1,000
`1,200
`600
Closing
`1,500
`1,400
`700
`2,800
`3,600
During the year, 600 sets are produced. Prepare a Statement of Cost of Production.
4. Calculate the prime cost from the following:
`
Opening stock of raw materials
3,000
Purchases
60,000
Closing stock of raw materials
5,000
Wages
42,000
Carriage inwards
6,000
Carriage outwards
12,000
Direct expenses
4,000
Indirect expenses
6,000
Salaries
12,000
5. Pee Co. manufactures two types of pens P and Q. The cost date for the year ended 30
September 2021 is as follows:
`
Direct materials
4,00,000
Direct wages
2,24,000
Production overheads
96,000
7,20,000
It is further ascertained that:
(a) Direct materials in type P cost twice as much direct materials in type Q.
(b) Direct wages for type Q were 60% of those for type P.
(c) Production overhead cost was same for both types.
(d) Administration overheads related to production for each were 200% of direct labour.
(e) Selling costs were 50 paise per pen sold for both types.
(f) Production during the year:
Type P
40,000
Type Q
1,20,000
(g) Sales during the year:
Type P
36,000
Type Q
1,00,000
(h) Selling prices were `14 per pen for the type P and `10 per for the type Q.
Prepare a statement showing per unit Cost of Production, Total Cost, Profit and
also the Total Sales Value separately, for two types of pens P and Q.
(ICWA Inter Adapted)
6. The following date relate to the manufacture of a product for the month of Jan 2022.
Direct materials
`1,60,000
Direct employee cost
`1,10,000
Machine hours worked
10,000 hrs.
5.38
Output or Unit Costing (Cost Sheet)
Machine hour rate
`8
Administrative overheads (general)
`35,000
Selling overhead per unit
`5
Units produced
4000
Units sold
3600
Selling price per unit
`125
Prepare a cost sheet showing
(i) Total and per unit cost
(ii) Profit for the month
(Adapted)
7. The accounts of J K Enterprises Ltd disclose the following information for the six
months ending 31 December 2021:
`
Materials used
1,50,000
Production wages
1,20,000
Factory overhead expenses
24,000
Establishment and general expenses related to production
17,640
Prepare a Cost Sheet of the machines and calculate the price which the company
should quote for the manufacture of a machine requiring materials valued at `1,250
and expenditure on productive wages of `750, so that the price may yield a profit of
20% on the selling price.
8. A firm has purchased a plant to manufacture a new product, the cost data for which
is given below:
Estimated annual sales
24,000 units
Estimated costs:
Materials
`4 per unit
Direct labour
`0.60 per unit
Overheads
`24,000 per unit
Adm. expenses related to production
`28,800 per year
Selling expenses
15% of sales
Calculate the selling price if profit per unit is `1.02
(ICWA Inter)
9. The following information relates to a commodity for the half year ended 30 June 2021:
`
Purchase of raw materials
1,32,000
Direct wages
1,10,000
Rent, rates, insurance and works oncost
44,000
Carriage inward
1,584
Stock on 1 January 2021
Raw materials
22,000
Finished products (1,600 Tonnes)
17,600
Stock on 30 June 2021
Raw materials
24,464
Finished products (3,200 Tonnes)
—
Work-in-progress 1 January 2021
5,280
Work-in-progress 30 June 2021
17,600
Cost of factory supervision
8,800
Sales of finished products
3,30,000
Output or Unit Costing (Cost Sheet)
5.39
Advertising, discounts allowed and selling cost 75 paise per tonne sold. 25,600 Tonnes
of commodity was produced during the period.
You are required to prepare a cost statement showing the cost and profit.
(B Com Delhi Adapted)
10. Modern Manufacturing Company submits the following information on 31 March 2021.
Sales for the year
`2,75,000
Inventories at the beginning of the year:
Finished goods
`7,000
Work-in-progress
`4,000
Purchases of materials:
`1,10,000
Materials inventory at the beginning of the year
`3,000
End of the year inventory
`4,000
Direct labour
`65,000
Factory overheads were 60% of the direct labour cost.
Inventories at the end of the year were :
Work-in-progress
`6,000
Finished goods
`8,000
Other expenses for the year were:
Selling expenses 10% of sales
Administrative expenses 5% of sales.
Prepare statement of cost.
(B Com Adapted)
11. The books and records of Acme Manufacturers present the following data for the
month of January 2021.
Direct labour cost
`16,000 (160% of factory overheads)
Cost of goods sold
`56,000
Inventory accounts showed the following opening and closing balances:
1 January
31 January
`
`
Raw materials
8,000
8,600
Work-in-progress
8,000
12,000
Finished goods
14,000
18,000
Selling expenses
3,400
Administration expenses related to production
2,600
Sales for the months
75,000
You are required to prepare a cost sheet showing cost of goods manufactured and
sold and profit earned.
(B Com. CA, CS Inter, Adapted)
12. XY Engineering Works has a Machine Shop in which it manufactures two Auto Parts
“X” and “Y”. For the quarter ending December 2021, the following cost data are
available.
`
Consumption of raw material- X
1,50,000
Consumption of raw material- Y
2,00,000
Direct Wages-X
36,000
Direct Wages-Y
32,000
Salaries (Factory)
85,000
(Contd...)
5.40
Output or Unit Costing (Cost Sheet)
Stores and spares
Repairs and Maintenance
Power
Insurance
Depreciation
Other factory overheads
Administration overheads related to production
Selling and distribution overheads
Total Cost
12,000
15,000
16,000
8,000
50,000
68,000
64,400
75,000
8,11,400
You are given the following further information:
(i) Production, sales and machine hours utilized for “X” and “Y” were as under:
Production
X
Y
Production (Units)
6,000
4,000
Sales of above units (`)
4,80,000
5,20,000
Machine hours utilized
550
450
(ii) Direct wages paid for each product is used for apportioning salaries and other
factory overheads.
(iii) Factory overhead items like stores and spares, repairs and maintenance, power,
insurance and depreciation are charged to cost of both the products on the basis
of machne hours used.
(iv) Administration overheads are apportioned on the basis of respective conversion
costs (Wages and all factory overhead items) while selling and distribution overheads
on the basis of their sales realizations.
(v) All the production was sold out.
Required: Prepare cost sheet of both the products and work out profits earned on
each of them.
(B.Com. Hons. Delhi)
13. The cost of manufacturing 5,000 units of a commodity comprises:
`
Materials
20,000
Wages
25,000
Chargeable expenses
400
Fixed overheads
16,000
Variable overheads
4,000
For manufacturing every 1,000 extra units of the commodity, the cost of production
increases as follows:
Materials: Proportionately
Wages: 10% less than proportionately
Chargeable expenses: No extra cost
Fixed overheads: `200 extra
Variable overheads: 25% less than proportionately
Output or Unit Costing (Cost Sheet)
5.41
You are required to:
(a) Calculate the estimated cost of producing 8,000 units of the commodity
(b) Show by how much it would differ if a flat rate of factory overhead based on
wages were charged.
14. The cost structure of an article the selling price of which is `45,000 is as follows :
Direct materials
50%
Direct labour
20%
Overheads
30%
An increase of 15% in the cost of materials and of 25% in the cost of labour is
anticipated. These increased costs in relation to the present selling price would cause a
25% decrease in the amount of present profit per article.
You are required:
(1) To prepare a statement of profit per article at present, and
(2) To compute the revised selling price to produce the same percentage of profit to
sales as before.
(CA Inter)
15. Bajaj Enterprises is a manufacturer of scooters. It finds that in 2021, it cost `7,20,060
to manufacture 175 scooters which it sold for `5,400 each. The cost was made up of:
`
Materials
2,82,000
Direct wages
3,24,000
Factory overheads
48,600
Office overheads
65,460
For the year 2022, it is estimated that:
(a) Each scooter will require materials of `1,600 and labour of `1,800.
(b) Factory overheads will bear the same relation to wages as in the previous year.
(c) Office overheads percentage on factory cost will be the same as in the past.
You are required to prepare a statement showing the profit it would make per
scooter if the price of the scooter is increased by `200.
16. Television Enterprises supply you the following information for 10,000 TV valves
manufactured during the year ending 31.12.2021:
`
Direct materials
90,000
Direct wages
60,000
Power and consumable stores
12,000
Factory indirect wages
15,000
Lighting of factory
5,500
Defective work (cost of rectification)
3,000
Clerical salaries and management expenses
33,500
Selling expenses
5,500
Sale proceeds of scrap
2,000
Plant repairs and maintenance and depreciation
11,500
The net selling price was `31.60 per unit sold and all units were sold.
As from 1 January 2022, the selling price was reduced to `31 per unit. It was
estimated that production could be increased in 2022, by 50% due to spare capacity.
Rates for materials and direct wages will increase by 10%.
You are required to prepare:
(a) Cost sheet for the year 2021 showing various elements of cost per unit; and
5.42
Output or Unit Costing (Cost Sheet)
(b) Estimated cost and profit statement for 2022 assuming that 15,000 units will be
produced and sold during the year and factory overheads will be recovered as a
percentage of direct wages and office and selling expenses as a percentage of
works cost.
(B Com Hons, Delhi)
17. A Timber Merchant purchased 10,000 c.ft of timber logs on 1 October 2021 at `10
per c.ft and stored them in his timber yard for six months for seasoning. In the timber
yard, the following items of expenses were incurred during seasoning period:
(i) Rent of the yard (area 2,000 sq. ft) `250 p.m.
(ii) Salaries of watch and ward for 5 persons at `100 p.m. each
(iii) Incidental expenses for maintenance, lighting, etc., at `150 p.m.
(iv) Annual share of general overheads of the business `2,000
(v) Insurance charged of the logs to be seasoned at 1% p.a. on the value of the
unseasoned logs for the period of seasoning.
50% of the floor area of the yard has been set apart for seasoning of the timber
and the remaining area for storing seasoned timber.
Loss in volume of logs due to seasoning is 10%.
Calculate the selling rate of the seasoned logs as on 1 April 2022 so that 10%
profit on the cost may be earned.
(ICWA Inter)
18. (a) The particulars obtained from the records of M/s. Jeevan Industries for the year
2021 are given below:
`
Opening Stock
Raw materials
1,40,000
Finished goods (1,000 units)
20,000
Purchases
2,10,000
Factory wages
3,80,000
Factory overheads
70,000
Office overheads
40,000
Selling overheads
9,600
Sales (3,200 units)
9,28,000
Closing Stock—
Raw Materials
19,600
Finished goods (900 units)
1,64,080
(b) Prepare a cost sheet showing prime cost, factory cost, cost of production, total
cost and sales per unit.
During 2022 the industry expects to receive an order for 5,000 units. It is estimated that
(i) the prices of raw materials and factory wages will rise by 15% and 10% respectively.
(ii) there will be no change in the total factory overheads and office overheads.
(iii) Selling overheads per unit will remain the same.
Prepare an estimated cost sheet. The factory intends to earn the same rate of profit
on cost.
(B. Com.)
Output or Unit Costing (Cost Sheet)
5.43
19. The summarized Trading and Profit and Loss Account of a Company for the year
ending on 31-3-2021 is as under:
To Cost of Materials
To Direct Wages
To Manufacturing Expenses
To Gross Profit
`
1,00,000
1,50,000
80,000
2,50,000
By Sales
5,80,000
To Staff Salaries
To Rent and Rates
To Selling Expenses
To General Expenses
To Net Profit
`
5,80,000
5,80,000
60,000
10,000
50,000
40,000
90,000
By Gross Profit
2,50,000
2,50,000
2,50,000
During the year the company manufactured 2,000 motors.
For the year ending 31-3-2022 is estimated that:
(a) Output and sales will be 2,100 mini motors.
(b) Price of materials will rise by 30% on the previours year’s strend.
(c) Wage rates will rise by 33 1 3 %
(d) Manufacturing cost will rise by 25%.
(e) A bonus of 1/6 of salary is expected to be paid to office staff.
(f) Selling cost and other expenses will rise in proportion to the cost of materials.
You are required to submit a statement for the directors showing the price at which
the motors should be marketed so as to show a profit of 10% on the selling price.
(Adapted, M. Com., Kerala)
20. From the following information prepare a cost sheet for the year ending 31-3-2021:
Raw Materials Used:
Direct Labour:
M1: 200 tonnes @ `100 per tonne
L1– 6 skilled workers @ `20 per day for
300 days
M2: 800 tonnes @ `50 per tonne
L2–8 Unskilled workers @ `10 per day for
300 days.
M3: 1,000 tonnes @ `30 per tonne
Direct expenses `15,000
Factory overheads 75% of direct wages
Office overhead–10% of works cost
Selling overheads `2 per unit sold
Units produced and sold during the month are 15,000 units. The company earns a
profit of 20% on selling price.
(I.C.W.A. Inter, Adapted)
ANSWERS
Practical Questions
1. Profit `10,080
2. Selling price `21.96 per unit
Output or Unit Costing (Cost Sheet)
5.44
3. Cost of production per set `138.33
[Hint: Total amount of opening and closing stocks of work-in-progress
may be adjusted in factory cost]
4. `1,10,000
5. Profit per unit P `2.90; Q `3.30
6. Cost of production (total) `3,50,000 per unit `87.50
Total cost `3,68,000 per unit cost `102.22
Total Profit `82,000
7. Quotation price `2,848.75
[Hint: Absorb factory overheads as a % of wages and establishment and
general expenses as a % of works cost.]
8. Selling price `9.20 per unit, Cost of production `1,63,200
[Hint: Assume sales as ‘x’]
9. Cost of production `2,81,600; Value of finished stock `35,200; Profit `48,000
10. Profit `23,750
11. Profit `15,600; Purchases `36,000
[Hint: Purchases are calculated by working backward from the cost of goods sold.]
12. Total cost: X `393060
Y `418340
13.
14.
15.
16.
17.
18.
19.
20.
3(a) `93,300; (b) `1,01,700
Profit `15,000; Revised profit `16,875; Revised selling price `50,625
Profit `1,563 per scooter
Prime cost
`1,50,000,
Works cost `1,95,000
Cost of sales
`2,34,000,
Profit
`82,000
Estimated profit for 2016 `78,900.
Total cost `1,06,150; Sales value of 9,000 c.ft `1,16,765; Profit `10,615; Selling price
`12.97 per c.ft
[Hint: Loss in volume of logs @ 10% of 10,000, i.e., 1,000 c.ft
has been treated as normal loss. Thus quantity for sale is 9,000 c.ft]
Profit in 2021 `2,42,080; Profit in 2022 `4,98,350; Rate of proift 35.29% on total
cost.
Selling price `348.14 per motor, total sales `7,31,111.
Sales `3,26,250.
CHAPTER
6
JOB COSTING
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of job costing and the type of industries in which this
method is used
• Understand the costing procedure used to ascertain the cost of jobs
• Know the method of preparation of job cost sheet
Introduction
All methods of costing i.e., methods of cost ascertainment were briefly described in
Chapter 1. Job costing or job order costing is a method of cost ascertainment used in
job order industries. Special features of such industries are as follows:
(a) Production is against customer’s orders as per specifications.
(b) Each job has its own characteristics and
Job Costing is used in:
requires special attention.
• Printing press
(c) The flow of production from one
• Automobile repair shop
department to another is not uniform. It
• Interior decoration
is the nature of job which determines the
• General engineering
department through which it is to be
•
Machine tools, etc.
processed.
• Hospitals use job costing to
determine the cost of each
Objectives of Job Costing
patient’s treatment
The following are the main objectives of job
costing:
1. Cost of each job/order is ascertained separately. This helps in finding out the
profit or loss on each individual job.
2. It enables the management to know those jobs which are more profitable and
those which are unprofitable.
3. It provides a basis for determining the cost of similar jobs undertaken in future.
It thus helps in future production planning.
4. It helps the management in controlling costs by comparing the actual costs with
the estimated costs.
Job Costing
6.2
Job Costing Procedure
The following steps are taken in job costing:
1. Job number When an order has been accepted, an individual job number must
be assigned to each job so that separate jobs are identifiable at all stages of
production. Assignment of job numbers also facilitates reference for costing purposes
in the ledger and is conveniently short for use on various forms and documents.
2. Production order The production control department then makes out a
Production Order, thereby authorizing to start work on the job. Several copies of the
production order are prepared, the copies often being in different colours to distinguish
between them more easily. These copies are passed on to the following:
(i) All departmental foremen concerned with the job
(ii) Storekeeper for issuance of materials
(iii) Tool room for an advance notification of tools required
PRODUCTION ORDER
Name of the Customer..................................
Date of Commencement..................................
Date of Completion..................................
Special Instructions..................................
Quantity
Description
Job No. ...................................
Date. ........................................
Bill of Material No. .............
Drawing attached Yes/No. ...
Machines
to be used
Tools
required
(Sign).................
Production authorised by :
Head of Production Control Dept.
Fig. 6.1
Production order for job.
The columns provided in the production order differ widely, depending largely upon
the nature of production. Sometimes orders are accompanied by the blue prints and
contain a bill of materials and detailed instructions as to which tools and machinery
are to be used.
3. Job cost sheet The unique accounting document under job costing is the
job cost sheet. Receipt of production order is the signal for the cost accountant to prepare
a job cost sheet on which he will record the cost of materials used and the labour and
machine time taken. Each concern has to design a job cost sheet to suit its needs. A
simple pro forma of job cost sheet is given in Fig. 6.2.
Job Costing
6.3
Job Cost Sheet
Customer.................................. ...
Date of Commencement..................................
Material Cost
Date
Material
Req. No.
Labour Cost
Amount
`
Total
Date
Hours
Profit or Loss
Rate
`
Factory Overhead
(Absorbed)
Amt.
`
Total
Profit/Loss
Price Quoted
Less: Cost
Job No. ...................................
Date of Completion ..............
Dept
Hours
Rate
`
Amt.
`
Total
Cost Summary
`
.......
.......
.......
.......
.......
`
Material
Labour
Prime Cost
Factory overhead
Works Cost
Adm. overhead
Cost of Production
Selling and dist overhead
Total Cost
Fig. 6.2
Job cost sheet.
Job cost sheets are not prepared for specified periods but they are made out for
each job regardless of the time taken for its completion. However, material, labour
and overhead costs are posted periodically to the relevant cost sheet.
The material, labour and overheads to be absorbed into jobs are collected and
recorded in the following way:
(a) Direct materials The method of recording receipts and issues of materials
on materials requisitions or bill of materials was explained in detail in the chapter on
materials. It may be recalled that material requisitions or bills on materials show the
quantities of materials issued to jobs from store. When copies of these documents
reach the cost office, they are priced and entered in the stores ledger account in the
‘issues’ column. Each requisition shows the job number to which the material is to be
charged. Summaries of material requisitions are prepared at regular intervals on Materials
Abstract or Materials Issue Analysis Sheet (a pro forma of which was also given in
the chapter on materials). These summaries facilitate debiting the job with total cost of
Job Costing
6.4
materials rather than charging with many small items. These totals are also used for
entries in stores ledger control account and work-in-progress control account.
(b) Direct wages As explained earlier in the chapter on labour cost, the wages
payable to workers are calculated on clock cards, job cards, time sheets, etc. The
summaries of job cards are made on Wages Abstract or Wages Analysis Sheets, which
show the direct wages chargeable to each job. The total of wages chargeable to various
jobs is debited to work-in-progress control account.
(c) Direct expenses Direct expenses which can be identified with specific jobs
are directly charged to these jobs, the total being debited to work-in-progress control
account.
(d) Overheads Indirect materials, indirect wages and indirect expenses which
cannot be identified with specific jobs are apportioned to cost centres in the manner
described earlier in the chapter on overhead cost. Absorption of overheads by the
jobs passing through the cost centres is based upon percentage of direct wages or
direct material cost, direct labour hours or machine hours, etc. These methods of
absorption have also been discussed in detail in the chapter on overheads.
The direct materials, wages and expenses and the overheads absorbed are totalled
to give the total cost.
Completion of Jobs
When jobs are completed, the cost is transferred to cost of sales account. The total
cost of jobs completed during each period is set against the sales to determine the
profit or loss for the, period.
Illustration 6.1 A factory uses job costing. The following data are obtained from its books
for the year ended 31 December 2021:
`
`
Direct materials
90,000
Selling and distribution overheads
52,500
Direct wages
75,000
Administration overheads
42,000
Profit
60,900
Factory Overheads
45,000
(a) Prepare a Job Cost Sheet indicating the Prime cost, Works cost, Production cost,
Cost of sales and the Sales value.
(b) In 2022, the factory received an order for a number of jobs. It is estimated
that direct materials required will be `1,20,000 and direct labour will cost
`75,000. What should be the price for these jobs if factory intends to earn
the same rate of profit on sales assuming that the selling and distribution
overheads have gone up by 15%? The factory recovers factory overheads as
a percentage of direct wages and administration and selling and distribution
overheads as a percentage of works cost, based on cost rates prevailing in
the previous year.
(CA Inter)
Job Costing
6.5
Solution
Production Statement
for the year ended 31 December 2021
`
90,000
75,000
Direct materials
Direct wages
Prime Cost
1,65,000
45,000
Works Cost
2,10,000
42,000
Cost of Production
2,52,000
52,500
Cost of Sales
Profit
3,04,500
60,900
Sales Value
3,65,400
Factory overheads
Administration overheads
Selling and distribution overheads
Calculation of Rates
1. % of factory overheads to direct wages
=
45,000
× 100 = 60%
75,000
2. % of administration overheads to works cost
=
42,000
× 100 = 20%
2,10,000
3. Selling and distribution overheads
`52,500
Add 15% increase
7,875
60,375
Selling and distribution overhead % to works cost =
4. % of profit to sales =
60,375
× 100 = 28.75%
2,10,000
60,900
1
1

× 100 = 16.67%  6 of sales or 5 of total cost 
3,65,400


Job Cost Sheet
(Statement showing Estimated Cost and Price of Jobs in 2022)
`
1,20,000
75,000
Direct materials
Direct wages
Prime Cost
1,95,000
45,000
Works Cost
(Administration overheads (20% of works cost)
2,40,000
48,000
Cost of Production
Selling and distribution overheads (28.75% of works cost)
2,88,000
69,000
Total Cost
3,57,000
71,400
Selling Price
4,28,400
Factory overheads (60% of direct labour)
Profit (1/5 of cost)
Job Costing
6.6
PROBLEMS AND SOLUTIONS
Problem 6.1. The following direct costs were incurred on Job No. 415 of Standard
Radio Company:
Materials
Wages:
Deptt.
`6,010
A—60 hours @ `30 per hr
B—40 hours @ `20 per hr
C—20 hours @ `50 per hr
Overheads for these three departments were estimated as follows:
Variable overheads:
Deptt
A `15,000 for 1,500 labour hours
B `4,000 for 200 labour hours
C `12,000 for 300 labour hours
Fixed overheads:
Estimated at `40,000 for 2,000 normal working hours.
You are required to calculate the cost of Job 415 and calculate the price to give profit
of 25% on selling price.
(B. Com. Delhi)
Solution
Job Cost Sheet
Job No. 415
Amount
`
Direct materials
Wages–Dept.
A—60 hr × `30
B—40 hr × `20
C—20 hr × `50
*Variable Overheads
Dept.
A—60 hr @ `10
B—40 hr @ `20
C—20 hr @ `40
*Fixed Overheads : 120 hr @ `20 per hour
1800
800
1,000
600
800
800
Amount
`
6010
3,600
2,200
2,400
Total Cost
14,210
4,737
Selling Price
18,947
Profit (25% of sales or 1/3 of total cost)
*Working Notes: Overhead rates per hour are calculated as under:
Variable Overheads:
Deptt.
A ` 15,000 ÷ 1,500 hr = `10 per hour
B
` 4,000 ÷
200 hr = `20 per hour
C ` 12,000 ÷
300 hr = `40 per hour
Fixed Overheads:
` 40,000 ÷ 2,000 hr = `20 per hour
Total hours worked on the job = 60 + 40 + 20 = 120 hours
Problem 6.2. Mayur Engineering, engaged in job work, has completed all jobs in hand on
30 December 2021, except Job No. 447. The cost sheet on 30 December showed direct
materials and direct labour costs of `40,000 and `30,000, respectively, as having been
incurred on Job No. 447.
The costs incurred by the business on 31 December 2021 the last day of the accounting
year, were as follows:
Job Costing
6.7
Direct materials (Job 447)
`2,000
Direct labour (Job 447)
`8,000
Indirect labour
`2,000
Miscellaneous factory overheads
`3,000
It is the practice of the business to make the jobs absorb factory overheads on the basis
of 120% of direct labour cost.
Calculate the cost of work-in-progress of Job No. 447 on 31 December 2021.
(B. Com. Hons., Delhi)
Solution
Cost of Work-in-progress of Job No. 447
as on 31 December 2021
`
42,000
38,000
Direct materials (40,000 + 2,000)
Direct labour (30,000 + 8,000)
Prime Cost
80,000
45,600
Works Cost
1,25,600
Add :Factory overhead (38,000 × 120%)
Problem 6.3. A shop floor supervisor of a small factory presented the following cost for
Job No. 303 to determine the selling price.
Per unit `
Materials
70
Direct wages 18 hr @ `2.50
45
(Deptt. X 8 hr, Deptt. Y 6 hr, Deptt. Z 4 hr)
Chargeable expenses (Special stores items)
5
120
40
Add: 331/3% for expenses
Total Cost
160
Analysis of the Profit/Loss Account for 2021 shows the following:
Material used
Direct wages:
Deptt. X
Deptt. Y
Deptt. Z
Special stores items
Works overheads:
Deptt. X
Deptt. Y
Deptt. Z
Works cost
Gross profit c/d
`
1,50,000
10,000
12,000
8,000
Sales less returns
30,000
4,000
5,000
9,000
2,000
16,000
2,00,000
50,000
2,50,000
Selling expenses
Net profit
`
2,50,000
20,000
30,000
50,000
2,50,000
Gross profit b/d
50,000
50,000
Job Costing
6.8
It is also noted that average hourly rates for the 3 departments, X, Y, Z are similar.
You are required to:
1. Draw up a job cost sheet
2. Calculate the entire revised cost using 2021 actual figures as basis
3. Add 20% to total cost to determine the selling price
(ICWA Inter)
Solution
Job Cost Sheet
Job No. 303
Particulars
Rate
`
Materials
Direct wages:
Amount
`
70.00
Dept. X
Y
Z
Chargeable expenses
8 hr
6 hr
4 hr
2.50
2.50
2.50
Prime Cost
*Works overhead:
Dept. X
Y
Z
20.00
15.00
10.00
5.00
120.00
8 hr
6 hr
4 hr
1.250
1.875
0.625
10.00
11.25
2.50
Works Cost
143.75
14.38
Total Cost
158.13
31.63
Selling Price
189.76
Selling overhead (10% on works cost)
Profit 20% on total cost
* Working Notes:
1. Works overheads have been charged on direct labour hour rate basis. Number of hours
works in each department have been ascertained by dividing the direct wages in each
department by the labour hour rate as shown below:
Deptt X ` 10,000 ÷ ` 2.50 = 4,000 hours
Y `12,000 ÷ `2.50 = 4,800 hours
Z
` 8000 ÷ ` 2.50 = 3,200 hours
2. Overhead rates are calculated as follows:
Dept. X
Dept. Y
Dept. Z
=
Overhead
No. of hours
5,000
= `1.25 per hour
4,000
9,000
=
= `1.875 per hour
4,800
2,000
=
= `0.625 per hour
3,200
=
3. Selling overheads are charged at 10% on works cost as calculated below :
` 20,000
Selling overhead
=
× 100 = 10%.
2,00,000
Works cost
Problem 6.4. A manufacturing unit has predetermined the overheads recovery rates as
400% on direct wages, 20% on works cost and 25% on cost of production for works
expenses, management expenses and commercial expenses, respectively.
Job Costing
6.9
At the end of the year, it has been found that the works overheads stand underabsorbed to the extent of 30% of the total productive wages, management overheads show
under-recovery of one-eight of the absorbed amount, and the recovery of commercial
expenses result in an over-absorption of one-third of the total amount absorbed.
If the prime costs of three jobs are as under, find the profit/loss on the respective selling
prices (both on the basis of standard cost and on the basis of full absorption of overheads):
Direct materials
Direct wages
Job A
`
45.50
15.20
Job B
`
32.60
8.60
Job C
`
26.80
7.20
60.70
41.20
34.00
Selling price
200.00
130.00
90.00
(ICWA Inter)
Solution
Statement of Cost and Profit
Job A
`
Job B
`
Job C
`
Direct materials
Direct wages
45.50
15.20
32.60
8.60
26.80
7.20
Prime Cost
Works overheads (400% on direct wages)
60.70
60.80
41.20
34.40
34.00
28.80
Work Cost
Management expenses (20% on works cost)
121.50
24.30
75.60
15.12
62.80
12.56
Cost of Production
Commercial expenses (25% on cost of production)
145.80
36.45
90.72
22.68
75.36
18.84
(A) Cost of Sales (at Standard rates)
Add:
Under-absorption of works overheads
(30% on direct wages)
Add:
Under absorption of management expenses
(1/8 of absorbed amount)
182.25
113.40
94.20
4.56
2.58
2.16
Less:
Over-absorption of commercial expenses
(1/3 of absorbed amount)
3.04
1.89
1.57
189.85
117.87
97.93
12.15
7.56
6.28
(B) Cost of Sales (on Actual cost)
(C) Selling Price
177.70
200.00
110.31
130.00
91.65
90.00
Profit/Loss(–)
— At standard cost (C – A)
— At actual cost (C – B)
17.75
22.30
16.60
19.69
(–) 4.20
(–) 1.65
Problem 6.5. A machine tool manufacturing unit was asked to manufacture a grinding
machine by a customer, Finish Co. The price quoted by the manufacturing unit was `50,000
with the intention of making a profit of 20% on cost. Finish Co. accepted the price and the
machine was to be delivered within 2 months. The job was taken in hand and completed in
two months, October and November and duly delivered to Finish Co. The following details
are given:
Job Costing
6.10
October
November
Material used:
Machine shop (`)
3,000
800
Assembly shop (`)
1,000
3,000
Machine shop
250
50
Assembly shop
100
500
400
100
Direct labour hours
Machine hours in machine shop
Direct wages rate per hour for Machine shop is `4 per hour and for Assembly shop
is `5 per hour. Production overheads are absorbed at the following pre-determined rates:
Assembly shop
—`10 per direct labour hour
Machine shop
—`15 per machine hour
The following additional costs were incurred:
Technical drawings
—`2,500
Trial cost of the machine
—`500
Selling and general administration costs are charged to jobs at the rate of 25% of
production cost.
You are required to prepare a job order cost sheet with the above information and
comment on actual profit earned as compared to profit forecast.
(ICWA Inter)
Solution
Job Cost Sheet
`
Machine shop
3,000
Assembly shop
1,000
Nov. —
Machine shop
800
Assembly shop
3,000
Direct wages — Oct. Machine shop
1,000
Assembly shop
500
Nov. —
Machine shop
200
Assembly shop
2,500
Production Overheads —
Oct.
Machine shop
6,000
Assembly shop
1,000
Nov. —
Machine shop
1,500
Assembly shop
5,000
Other direct costs –
Technical drawings
Trial Cost
Cost of Production
Selling and Adm. Cost
Total Cost
Estimated Profit (20% of Cost) 7,125
Actual Profit
Sales
`
`
Materials — Oct.
4,000
3,800
7,800
1,500
2,700
4,200
7,000
6,500
2,500
500
13,500
3,000
28,500
7,125
35,625
14,375
50,000
Job Costing
6.11
Comments: Actual profit from the job has more than doubled from the profit forecast.
The management should analyse the reasons for such a vast difference.
Problem 6.6. The following information for the year ended 31 December 2021, is
obtained from the books and records of a factory:
Raw materials supplied from stores
Wages
Chargeable expenses
Materials transferred to work-in-progress
Materials returned to stores
Completed jobs
`90,000
`1,00,000
`10,000
`2,000
`1,000
Work-in-progress
`30,000
`40,000
`4,000
`2,000
Factory overhead cost is 80% of wages and office overhead cost is 25% of factory cost.
The price of the executed contracts during 2021 was `4,10,000.
Prepare (i) Consolidated Completed Jobs Account showing the profit made or loss
incurred, and also (ii) Consolidated Work-in-progress Account.
(B. Com. Hons., Delhi, Adapted)
Solution
Consolidated Completed Jobs Account
`
To Materials
Less: Transfer
Less: Return
To Wages
To Chargeable expenses
90,000
2,000
1,000
By Sales
87,000
1,00,000
10,000
Prime Cost
1,97,000
Works Cost
2,77,000
To Factory overhead
(80% of wages)
`
4,10,000
80,000
To Office overheads
(25% of works cost)
To Net Profit
69,250
63,750
4,10,000
4,10,000
Consolidated Work-in-progress Account
`
To Materials
Add: Transfer
To Wages
To Chargeable expenses
30,000
2,000
Prime Cost
To Factory overhead
(80% of wages)
Works Cost
To Office overhead
(25% of works cost)
By Balance c/d
32,000
40,000
4,000
76,000
32,000
1,08,000
27,000
1,35,000
To Balance b/d
`
1,35,000
1,35,000
1,35,000
Job Costing
6.12
Problem 6.7. From the records of a manufacturing company, the following budgeted
details are available:
`
`
1,99,000
Direct materials
Direct Wages:
Machine shop (12,000 hours)
Assembly shop (10,000 hours)
63,000
48,000
1,11,000
Works Overheads:
Machine shop
Assembly shop
88,200
51,800
1,40,000
Administrative overheads
90,000
Selling overheads
81,000
Distribution overheads
62,100
Assuming that the company follows absorption method of costing, you are
required to:
(a) Prepare a Schedule of Overhead Rates from the figures available stating the basis of
overheads recovery rates used under the given circumstances.
(b) Work out a Cost Estimate for the following job based on overhead so computed.
Direct material:
25 kg @ `16.80/kg
15 kg @ `20.00/kg
Direct labour: (On the basis of hourly rate
Machine shop 30 hours
for machine shop and assembly shop)
Assembly shop 42 hours
(ICWA Inter)
Solution
(a)
Cost Sheet
for the period......
`
Direct materials
Direct Wages:
Machine shop
Assembly shop
63,000
48,000
Prime Cost
`
1,99,000
1,11,000
3,10,000
Works Overheads:
Machine shop
Assembly shop
88,200
51,800
1,40,000
Works Cost
4,50,000
90,000
Cost of Production
5,40,000
81,000
62,100
Total Cost
6,83,100
Administration overheads
Selling overheads
Distribution overheads
Schedule of Overhead Rates
(i) Work Overheads: Hourly rate
Machine shop
Assembly shop
= (Overhead ` ÷ Hours)
= (88,200 ÷ 12,000) = `7.35 per hour
= (51,800 ÷ 10,000) = `5.18 per hour
Job Costing
6.13
(ii) Administrative Overheads as a % of works costs:
=
90,000
× 100
4,50,000
= 20%
(iii) Selling and distribution Overheads as % of works costs:
=
81,000 + 62,100
× 100
4,50,000
= 31.80%
Labour hour rates are calculated as under:
Machine shop
= `63,000 ÷ 12,000 hr
= `5.25
Assembly shop
= `48,000 ÷ 10,000 hr
= `4.80
(b)
Cost Estimate for Job
`
Direct Materials:
`
(i) 25 kg @ `16.80 per kg
(ii) 15 kg @ `20 per kg
420
300
720.00
Direct Labour:
Machine shop (30 hr @ `5.25)
Assembly shop (42 hr @ 4.80)
157.50
201.60
359.10
Prime Cost
Works Overheads:
Machine shop (30 hr @ `7.35)
Assembly shop (42 hr @ 5.18)
1,079.10
220.50
217.56
438.06
Works Cost
Administration overheads (20% of works cost)
1,517.16
303.43
Cost of Production
Selling and distribution cost (31.8% of works cost)
1,820.59
482.46
Total Cost
2,303.05
SUMMARY AND KEY TERMS





Job costing is a method of cost ascertainment which is used in job order
industries, where production is against orders from customers as per their
specifications.
Examples of job order industries are printing press, interior decoration,
general engineering, etc.
For ascertainment of the cost of jobs, a job cost sheet is prepared.
For this purpose, a job number is allotted to each job so that separate jobs
are identifiable at all stages of production.
After this a Production Order is made out, thereby authorizing to start
work on the job.
Job Costing
6.14
EXAMINATION QUESTIONS
Objective Type Questions
State whether the following statements are True or False.
1.
2.
3.
4.
5.
6.
A production order is an order received from a customer for a particular job.
In job costing, cost of each job is separately ascertained.
In toy manufacture, job costing should be used.
In a car repair shop, job costing is used.
Job costing can be used only in small companies.
When profit is 25% of the selling price of a job, it is equal to 20% of its cost.
Theoretical Questions
1. Write a note on job costing and the industries which adopt job costing.
2. What are the main features of job costing? Give a pro forma cost sheet under such a
system.
3. What are the main features of job costing? Describe briefly the procedure of recording
costs under job order costing.
4. What is a job order number? Explain how costs are booked against job order numbers.
Practical Questions
1. Job No. 2198 was commenced on 10 October 2021 and completed on 1 November
2021. Materials used were `600 and labour cost charged directly to the jobs was
`400. Other information was as follows:
Machine No. 215 used for 40 hours; the machine hour rate is `3.50.
Machine No. 160 used for 30 hours; the machine hour rate is `4.00.
6 welders worked on the job for 5 days of 8 hours each; the direct labour hour rate for
welders is 20 paise.
Other expenditure of the concern not apportioned for calculating the machine hour or
the direct labour hour rates amounted to `20,000, total direct wages for the period being
`20,000.
Ascertain the works cost of Job No. 2198.
2. The estimated material cost of a job is `5,000 and direct labour cost is likely to be `1,000.
In a machine shop it will require machining by Machine No. 8 for 20 hrs and by Machine
No. 11 for 6 hours. Machine hour rates for Machine No. 8 and Machine No. 11 are
respectively `10 and 15. Considering only machine shop cost, the direct wages in all
other shops last year amounted to `80,000 as against `48,000 factory overhead. Last
year factory cost of all jobs amounted to `2,50,000 as against `37,500 office expenses.
Prepare a quotation which guarantees 20% profit on selling price.
3. The following expenses were incurred for a job during the year ended 31 December 2021:
`
Direct materials
3,000
Direct wages
4,000
Chargeable expenses
1,000
Factory overheads
2,000
Selling and distribution overheads
2,000
Administration overheads
3,000
Job Costing
6.15
Selling price for the above job was `18,000. You are required to prepare a
statement showing the profit earned for the year 2021 from the job and an estimated
price of a job which is to be executed in the year 2022. Materials, wages and
chargeable expenses required will be of `5,000, `7,000 and `2,000, respectively,
for the job. The various overheads should be recovered on the following basis
while calculating the estimated price:
(a) Factory overheads as a percentage of direct wages.
(b) Administration and selling and distribution overhead as a percentage of
factory cost.
4. In respect of a factory, the following particulars have been extracted for the year 2021:
`
Cost of materials
6,00,000
Wages
5,00,000
Factory overheads
3,00,000
Administration charges
3,36,000
Selling charges
2,24,000
Distribution charges
1,40,000
Profit
4,20,000
A work order has to be executed in 2022 and the estimated costs are:
Materials `8,000, wages `5,000
Assuming that in 2022, the rate of factory overheads has gone up by 20%,
distribution charges have gone down by 10% and selling administration charges
have each gone up by 15%, at what price should the product be sold so as to
earn the same rate of profit on the selling price as in 2021?
Factory overheads are based on wages and administration, selling and distribution
overheads on factory cost.
5. R K Ltd has to quote a price for Job No. 450. The cost estimator has produced the
following data:
Direct materials:
34 units @ `2 per unit
Direct labour:
Deptt. A – 12 hours @ `2 per hour
Deptt. B – 20 hours @ `1.80 per hour
The following additional information is extracted from the company’s budgets:
Deptt. A variable overheads
`18,000
Hours to be worked
18,000
Deptt. B variable overheads
`18,000
Hours to be worked
10,000
Fixed overheads for the company
`1,00,000
Total hours to be worked
50,000
Profit is taken at 20% of the selling price.
You are required to prepare a Job Cost Sheet.
6. From the following information, prepare Job No. 314 and Job No. 425 accounts in the
Job Cost Ledger:
Job no. 314
Job no. 425
`
`
Direct materials
2,400
1,200
Materials received from stores
16,800
14,400
6.16
Job Costing
Direct wages
9,600
5,000
Other direct expenses
1,000
500
The production overheads are to be taken at 100% of wages and administration
overheads at 20% of the production cost. The contract price of Job No. 314, which is
completed, is fixed at `55,000. Job No. 425 is under progress.
7. Prepare Work-in-progress Account and Completed Jobs Account from the following
information:
Completed jobs
Incomplete jobs
`
`
Materials consumed
48,000
3,000
Direct labour
36,000
4,000
Materials transferred from
completed jobs to incomplete jobs
4,000
4,000
Works expenses are charged at 60% of direct labour and office expenses are recovered
at 10% of works cost.
8. The following expenses were incurred on Job No. 664.
(1) Materials: `9,720
(2) Wages paid:
Deptt A
40 hours at `8 per hour
Deptt B
50 hours at `9 per hour
Deptt C
60 hours at `5 per hour
(3) Works overhead expenses of these departments were estimated as under:
Deptt. A
`9,000 for 6,000 working hours
Deptt. B
`10,000 for 5,000 working hours
Deptt. C
`12,000 for 3,000 working hours
(4) Office expenses were `75,000 when total direct wages paid in all three departments
came to `2,50,000. It is the practice to recover office overheads as percentage of
direct wages.
You are required to calculate the cost of Job No. 664 and its price to be quoted
which would include 20% profit on selling price.
9. X Co. Ltd had absorbed overheads by means of a blanket rate based on direct labour
hours. As from 1 January 2021, it decides to adopt separate rates for the three
main activities—storekeeping and material handling, machining and assembly. The
estimates of costs and absorption rates for selling and distribution cost remain
unchanged.
Overheads absorption rates are:
Prior to 1 January 2021:
Production overheads—`0.50 per direct labour hour
Selling and distribution overheads—25% of production cost
From 1 January 2021:
Production overheads:
Storekeeping and material handling—10% of direct material cost
Machining—`0.75 per machine hour
Assemble—`0.30 per labour hour
Selling and distribution overheads—25% of production cost.
Job Costing
6.17
`
90
Direct costs of Job 204 have been:
Direct material cost
Direct wages:
Machining 200 hours @ `0.60
Assembly 100 hours @ `0.40
120
40
250
Contract price of the job is `525 and it requires 180 machine hours to complete.
Show the Cost Sheet for Job 204 as it would appear:
(a) If the job had been completed prior to 1 January 2021.
(b) If the job were completed in January 2021.
(ICWA Inter)
10. In an engineering company, the factory overheads are recovered on a fixed
percentage basis on direct wages and the administration overheads are absorbed
on a fixed percentage basis on factory cost. The company has furnished the
following data relating to two jobs undertaken by it in a period:
Direct materials
Direct wages
Selling price
Profit percentage on total cost
Job 101
`
Job 102
`
54,000
42,000
1,66,650
10%
37,500
30,000
1,28,250
20%
Required:
(i) Computation of percentage recovery rates of factory overheads and administration
overheads.
(ii) Calculation of the amount of factory overheads, administration overheads and profit for
each of the two jobs.
(iii) Using the above recovery rates, fix the selling price of Job 103. The additional data
being:
Direct materials
`24,000
Direct wages
`20,000
Profit percentage on selling price
12.5%
(CA Inter)
ANSWERS
Objective Type Questions
State whether the following statements are True or False.
True — 2, 4;
False — 1, 3, 5, 6
Practical Questions
1. `1,708
(Hint: Overheads have been absorbed at 100% of direct wages)
2. Price Quotation `9,905
(Hints: 1. Factory overheads are charged at 60% of wages. These are in addition to
machining cost; 2. Office overheads are charged at 15% of factory cost.)
6.18
Job Costing
3. Profit `3,000; Factory overheads 50% on direct wages, Adm. overheads 30% on
factory cost, Selling and dist. overheads 20% on factory cost, Profit 20% on
total cost; Estimated selling price of job `31,500
4. Selling price of the work order `30,875
5. `300
6. Job No. 314 profit `7,720; Job No. 425 W.I.P. `31,320
7. Completed jobs `1,11,760; Incomplete jobs `14,740
8. Total cost `11,511; Profit `2,877.75; Price `14,388.75
9. (a) Profit `25; (b) Loss `5
10. (i) 60% and 25%, (ii) Profit Job 101 `15,150; Job 102 `21,375, (iii) `80,000
(Hint: This is similar to solved Problem no. 4.28 in Chapter 4 on overhead cost.)
CHAPTER
7
CONTRACT COSTING
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of a contract and the type of industries in which
contract costing method is used
• Know the special features of contract costing
• Understand the method of preparing a contract account
• Understand the rules of transferring the amount of profit to Profit and Loss
Account on incomplete contracts at the end of each year
• Explain the meaning and purpose of escalation clause and cost-plus contracts
Contract costing is a form of job costing. In this method of costing, each contract is a
cost unit and an account is opened for each contract in the books of the contractor to
ascertain profit/loss thereon. Contract costing is also known as terminal costing because
the work is terminated once it is completed and contract account is closed.
Contract Costing and Job Costing—Distinction
Main points of distinction between contract and job costing are as follows:
1. Contract costing is a specialised type of job costing which is applied to large
and long term contracts as distinct from small and short term jobs.
2. The number of jobs undertaken at a time are usually large as compared to number
of contracts because contracts are
generally much bigger in size.
Contract Costing is used in:
3. In contract costing, most of the costs
• Building construction
are chargeable direct to contract
• Road construction
accounts. Under job costing, direct
• Bridge construction
allocation to such an extent is not
• Other civil engineering works
possible.
• Ship building, etc.
4. Allocation and apportionment of
overhead costs is simpler in contract costing as compared to job costing.
5. Contract is generally big while job is small. It is well said, ‘a job is a small
contract and a contract is a big job.’
6. Jobs are usually carried out in factory premises while contract work is done at
site.
7.2
Contract Costing
Features of Contract Costing
Contract costing usually shows the following features:
1. Contracts are generally of large size and, therefore, a contractor usually carries
out a small number of contracts in the course of one year.
2. A contract generally takes more than one year to complete.
3. Work on contracts is carried out at the site of contracts and not in factory
premises.
4. Each contract undertaken is treated as a cost unit.
5. A separate contract account is prepared for each contract in the books of the
contractor to ascertain profit or loss on each contract.
6. Most of the materials are specially purchased for each contract. These will,
therefore, be charged direct from the supplier’s invoices. Any materials drawn
from the store is charged to contract on the basis of material requisition notes.
7. Nearly all labour is direct.
8. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.
9. Specialist sub-contractors may be employed for say, electrical fittings, welding
work, glass work, etc.
10. Plant and equipment may be purchased for the contract or may be hired for
the duration of the contract.
11. Payments by the customer (contractee) are made at various stages of completion
of the contract based on architect’s certificate for the completed stage. An
amount, known as retention money, is withheld by the contractee as per agreed
terms.
12. Penalties may be incurred by the contractor for failing to complete the work
within the agreed period.
Contract Costing Procedure
The basic procedure for costing of contracts is as follows:
1. Contract account Each contract is allotted a distinct number and a separate
account is opened for each contract.
2. Direct costs Most of the costs of a contract can be allocated direct by to
the contract. All such direct costs are debited to the contract account. Direct
costs for contracts include: (i) Materials; (ii) Labour and supervision; (iii)
Direct expenses; (iv) Depreciation of plant and machinery; (v) Sub-contract
costs, etc.
3. Indirect costs Contract account is also debited with overheads which tend
to be small in relation to direct costs. Such costs are often absorbed on some
arbitrary basis as a percentage on prime cost, or materials, or wages, etc.
Overheads are normally restricted to head office and storage costs.
4. Transfer of materials or plant When materials, plant or other items are
transferred from the contract, the contract account is credited by that amount.
5. Contract price The contract account is also credited with the contract price.
However, when a contract is not complete at the end of the financial year, the
contract account is credited with the value of work-in-progress as on that date.
6. Profit or loss on contract The balance of contract account represents profit
or loss which is transferred to Profit and Loss Account. However, when contract
Contract Costing
7.3
is not completed within the financial year, only a part of the profit arrived is
taken into account and the remaining profit is kept as reserve to meet any
contingent loss on the incomplete portion of the contract. This is discussed in
detail later in this chapter.
SPECIAL POINTS IN CONTRACT COSTING
Some of the important points to be considered in contract costing are now discussed:
Cost of Materials
Materials include: (i) materials specifically purchased for the contract; (ii) materials
issued from store against material requisition notes. The cost of both these types of
materials is debited to the contract account.
Materials Returned to Store Whenever materials are issued in excess of
requirements, for instance, cement, sand, pipes and bricks, these are later returned to
the store accompanied by a Material Return Note which gives the details of the materials
returned. Such returned materials are credited to contract account.
Materials at Site At the end of each accounting period, value of materials lying
unused at site is credited to contract account and is carried forward for charging against
the next period.
Cost of Labour
All wages of workers engaged on a particular contract are charged direct to the
contract, irrespective of the type of work they perform. When several contracts
are running at different locations, payroll is normally sectionalized so as to have
separate payroll for each contract. Difficulties in costing may be encountered when
some workers may have to move from one site to another if a number of small
contracts are undertaken. In such situations, it becomes necessary to provide time
sheets from which allocations can be made. In order to control labour utilization
and prevent fraud in the payment of wages, surprise visits by head-office personnel
will be necessary.
Plant
There are two different methods of dealing with depreciation of plant in contract
account:
(a) Contract account is debited with the cost of the plant installed. When the
contract is completed or the plant is no longer required, the plant is revalued and contract
account is credited with this revalued or depreciated figure. In case plant is sold on the
completion of the contract, the contract account is credited with its sale proceeds. The
net effect of the above debit and credit will be that the contract account will stand
debited with the amount of depreciation, which is the difference between the value of
plant debited and value of plant credited. The method is generally used on long contracts
which extend over more than one year because depreciated value of the plant is credited
to the contract account and brought down as an opening balance in the next period.
(b) Alternatively, contract account is simply debited with the amount of depreciation.
It is usual to use this method when plant is sent to contract only for a short period. For
example, mobile crane or bulldozer used in a contract may be charged on this basis.
7.4
Contract Costing
However, when a plant is hired for a contract, a charge for the hire of the plant is
debited to the contract as a direct expense.
Sub-contracts
Work of specialized character, for which facilities are not internally available, is offered
to a sub-contractor. For example, steel work, glass work, painting, etc., is usually carried
out by the sub-contractors who are accountable to the main contractor. The cost of
such work is charged to the contract account.
Payment based on Architect’s Certificate
In case the contract is small, full payment is usually made on the completion of the
contract. But in case of large contracts, it may take more than one year to complete.
In such a case, if no payment is received until the completion of the contract, the
financial resources of the contractor could surely become strained. Therefore, a system
of progress payments is followed. In this system, part payments of the contract amount
are paid from time to time on the basis of certificate issued by the architects (acting
for the contractee), certifying the value of the work satisfactorily completed. Such
payments received by the contractor are usually credited to the personal account of
the contractee. It should be noted that such payments are not entered in the Contract
Account.
Work Certified and Work Uncertified
When the contract is not completed till the end of the accounting year, the architect is
required to value the work-in-progress. Such work-in-progress is classified into work
certified and work uncertified.
Work Certified This is that part of the work-in-progress which has been
approved by the contractee’s architect or engineer for payment. Work certified is valued
at contract price (i.e., selling price), and includes an element of profit.
Work Uncertified This is that part of the work-in-progress which is not approved
by the architect or engineer. This is valued at cost and thus does not include an element
of profit.
Both work certified and uncertified appear on the credit side of the contract account
and also on the assets side of the balance sheet.
Retention Money and Cash Ratio
It is a usual practice not to pay the full amount of work certified. The contractee may
pay a fixed percentage, say 80% or 90% of the work certified, depending upon the
terms of the contract. This is known as Cash Ratio. The balance amount not paid is
known as Retention Money. For example, if cash ratio is 75%, the retention money
will be the remaining 25%. This retention money is a type of security for any defective
work which may be found in the contract later on. This also works as a deterrent for
the contractor to leave the contract incomplete, if he finds the contract unprofitable.
The retention money may also be adjusted against penalties that become due if the
contract is not completed within the stipulated time as per the terms of the agreement.
Contract Costing
7.5
Extra Work
Sometimes the contractor is required to do some extra work like additions or alterations
in the work originally done as per agreement. The contractor will charge extra money
for such extra work. The cost of such extra work is debited to the contract account
and extra price realized is credited to the contract account.
Profit on Uncompleted Contracts
Contracts which are started and finished during the same financial year create no
accounting problems. But in case of those contracts which take more than one year to
complete, a problem arises whether profit on such contracts should be worked out only
on the completion of the contract or at the end of each financial year on the partly
completed work. If profit is computed only on the completion of the contract, profit
will be high in the year of completion of the contract, whereas in other years of working
on contract, profit will be nil. This would result not only in distorted profit pattern but
also higher tax liability because income tax at higher rates may have to be paid.
Therefore, when contracts extend beyond a year, it becomes necessary to take into
account the profit earned (or loss incurred) on the work performed during each year.
This helps in avoiding distortion of the year-to-year profit trend of the business.
There are two aspects of profit computation:
(a) Computation of notional profit or estimated profit.
(b) Computation of the portion of such profit that is to be transferred to Profit and
Loss Account.
Notional Profit
Notional profit is the difference between the value of work-in-progress certified and
the cost of work-in-progress certified. It is computed as follows (Figures are assumed):
`
Value of work certified
20,00,000
Add: Cost of work not yet certified
1,50,000
21,50,000
Less: Cost of work to date
19,00,000
Notional Profit
2,50,000
If in any year, cost of work done exceeds the value of work certified and uncertified,
the result will be a notional loss.
Estimated Profit
Estimated profit represents the excess of the contract price over the estimated total
cost of the contract. It is computed as follows (Figures are assumed):
`
Contract price
30,00,000
Less: Total cost already incurred
21,00,000
9,00,000
Less: Estimated additional costs to complete the contract
3,50,000
Estimated Profit 5,50,000
Contract Costing
7.6
Portion of Notional Profit or Estimated Profit to be Transferred to
Profit and Loss Account
The portion of the notional or estimated profit to be transferred to P&L Account depends
upon the stage of completion of the contract, i.e., ratio of work-in-progress certified to
total contract work. For this purpose work-in-progress uncertified is not considered.
Prudence requires that the total notional profit should not be transferred to P&L Account
but a portion of it should be withheld as a reserve to meet any unforeseen future expenses
or contingencies.
Rules There are no hard and fast rules in this regard. However, the following
general rules may be followed in this context.
1. When work certified is less than 1/4 of the contract price, no profit is transferred
to Profit and Loss Account. This is based on the principle that no profit should be taken
into account unless the contract has advanced reasonably.
2. When work-in-progress certified is 1/4 or more but less than 1/2 of the contract
price, then generally 1/3 of the profit is transferred to Profit and Loss Account. The
balance amount is treated as reserve. Thus, profit to be transferred to Profit and Loss
Account is computed by the following formula:
1
Transfer to P&L A/c = Notional profit ×
3
Alternatively, a more common practice is to further reduce this amount by the cash
ratio.
Cash received
1
Thus: Transfer to P&L A/c = Notional profit × ×
Work certified
3
3. When work certified is 1/2 or more but less than 9/10 of the contract price, (i.e.
50% to 90%), then the profit to be transferred to P & L Account is computed as follows:
2
Transfer to P&L A/c = Notional profit ×
3
Here also a more common practice is to further reduce this amount by cash ratio.
This is shown below:
2
Cash received
×
3
Work certified
4. When contract is near completion, then the estimated profit should be calculated
on the whole contract. The proportion of estimated profit to be transferred to Profit
and Loss Account is computed by any one of the following formulas:
Transfer to P&L A/c = Notional profit ×
(a) Estimated profit ×
Work certified
Contract price
(b) Estimated profit ×
Work certified
Cash received
×
Contract price
Work certified
(c) Estimated profit ×
Cost of work to date
Estimated total cost of work
(d) Estimated profit ×
Cost of work to date
Cash received
×
.
Estimated total cost of work
Work certified
Contract Costing
7.7
5. Loss on Uncompleted Contracts In the event of a loss on uncompleted contracts,
this should be transferred in full to the Profit and Loss Account, whatever be the stage
of completion of the contract.
It was stated earlier also that these are not hard and fast rules. The practice may
vary from firm-to-firm depending upon the nature of work involved, degree of risk in
the business, extent of work completed, etc. But whatever method is adopted, it should
be applied consistently from year-to-year so as not to disturb the trend of profits.
Proforma Contract Account
Contract No............Account
Particulars
To Materials purchased
To Materials from store
To Materials transferred
from other contract
To Wages paid
To Wages outstanding
To Plant purchased
OR
To Plant depreciation
To Direct expenses
To other expenses paid +
outstanding
To Cost of sub-contracts
To Profit and Loss A/c (profit)
(if contract is complete)
OR
To Notional profit
(if contract incomplete)
Amount
Particulars
Amount
By Materials returned to supplier
By Materials returned to store
By Materials tr. to other contracts
By Materials at site
By Materials stolen or lost or
damaged
By Plant at site (if purchased)
By Plant returned or sold
By Plant Lost/destroyed
By Contractee’s A/c
(if contract completed)
OR
By Work in progress
Work certified
Work uncertified
(if contract incomplete)
By P&L A/c
(when there is a loss)
Illustration 7.1 The following was the expenditure on a contract for `12,00,000
commenced in January 2021.
Materials
Wages
Plant
Overheads
Work uncertified
2,40,000
3,28,000
40,000
17,200
8,000
Cash received on account of the contract on 31 December 2021 was `4,80,000, being
80% of the work certified. The value of materials in hand was `12,000. The plant had
undergone 20% depreciation.
Prepare Contract Account.
Contract Costing
7.8
Solution
Contract Account
for the year ending 31 December 2021
To Materials
To Wages
To Plant
To Overheads
To Notional profit c/d
`
2,40,000
3,28,000
40,000
17,200
26,800
By Materials in hand
By Plant in hand
(40,000 less 20%)
By Work-in-progress:
Work certified
100 

 4,80,000 

80 

Work uncertified
6,52,000
To Profit & Loss A/c
14,293
2
80 


 26,800 

3
100 

To Reserve
12,507
`
12,000
32,000
6,00,000
8,000
6,52,000
By Notional profit b/d
26,800
26,800
26,800
Note: Work certified is 50% of the contract price. Thus, transfer to P&L A/c is done by the following
formula:
Notional profit × 2/3 × Cash ratio
Alternatively, the amount of notional profit to be transferred to P&L A/c may be calculated by the
following formula:
Notional profit × 2/3
Illustration 7.2 Raja Construction Ltd took a contract in 2021 for road construction.
The contract price was `10,00,000 and its estimated cost of completion would be `9,20,000.
At the end of 2021, the company has received `3,60,000, representing 90% of the work
certified. Work not yet certified had a cost of `10,000.
Expenditure incurred on the contract during 2021 was as follows:
Materials `50,000, Labour `3,00,000, Plant `20,000.
Materials costing `5,000 were damaged and had to be disposed of for `1,000. Plant
is considered as having depreciated by 25 per cent.
(i) Prepare Contract Account for 2021 in the books of Raja Construction Ltd.
(ii) Show all possible figures that can be reasonably credited to Profit and Loss
Account in respect of the contract.
Solution
(i)
To Materials
To Labour
To Plant
To Profit (Notional)
Contract A/c
for the year 2021
`
50,000
3,00,000
20,000
60,000
By Materials damaged
By Plant at site
By Work-in-progress:
Work certified
Work uncertified
4,30,000
* Working Note: Work certified = `3,60,000 ÷ 90% = `4,00,000.
`
5,000
15,000
4,00,000*
10,000
4,30,000
Contract Costing
(ii)
7.9
Amount of profit that may be taken to Profit and Loss Account:
The contract price is `10,00,000
The work certified is `4,00,000, i.e., 40% of contract price.
Method I —
1/3 of the notional profit may be transferred to Profit and Loss
Account
= 60,000 × 1/3
= ` 20,000
Method II —
The amount calculated, as above, may be reduced on cash basis:
i.e., Notional profit × 1/3 × cash ratio
= 60,000 × 1/3 × 90%
= ` 18,000
Method III — The estimated profit is `80,000, i.e., `10,00,000 – 9,20,000
Profit to be transferred to Profit and Loss Account may be
calculated on the basis of estimated profit which is:
= Estimated profit ×
= 80,000 ×
Work certified
Contract price
4,00,000
10,00,000
= ` 32,000
Method IV — Profit calculated in method III may be further reduced by cash
ratio as follows:
80,000 ×
4,00,000
90
×
100
10,00,000
= ` 28,800
Escalation Clause
This clause is often provided in contracts to cover any likely changes in the price or
utilization of materials and labour. Thus, a contractor is entitled to suitably enhance the
contract price if the cost rises beyond a given percentage. The object of this clause is
to safeguard the interest of the contractor against unfavourable changes in cost. The
escalation clause is of particular importance where prices of material and labour are
anticipated to increase or where quantity of material and/or labour time cannot be
accurately estimated.
Just as an escalation clause safeguards the interest of the contractor by upward
revision of the contract price, a de-escalation clause may be inserted to look after the
interest of the contractee by providing for downward revision of the contract price in
the event of cost going down beyond an agreed level.
Cost-plus Contracts
Cost-plus contract is a contract in which the price is not fixed at the time of entering
into the contract. The contract price is determinded by adding a specified amount or
percentage of profit to the costs allowed in the contract. The contractee compensates
the contractor for all allowable costs actually incurred by him. Over and above these
costs the contractor is paid a fixed amount or a fixed percentage of cost as profit. The
items of cost to be included for the purpose of determining contract price are broadly
Contract Costing
7.10
agreed upon in advance. The accounts of the contractor are usually subject to audit by
the contractee.
Cost-plus contracts are usually entered into for executing special types of work,
like construction of dam, power house, newly designed ship, etc., where accurate cost
estimation is difficult. Government often prefers to give contracts on ‘cost-plus’ terms.
Advantages:
Cost-plus contracts offer the following advantages:
To the Contractor:
1. There is no risk of loss being incurred on such contracts.
2. It protects him from the risk of fluctuations in market prices of material, labour,
etc.
3. It simplifies the work of preparing tenders and quotations.
To the Contractee:
The contractee can ensure a fair price of the contract by being entitled to audit
the accounts of the contractor.
Disadvantages:
The disadvantages of cost-plus contracts are:
To the Contractor:
1. The contractor is deprived of the advantages which would have accrued due to
favourable market prices.
2. The contractor has to suffer for his own efficiency. This is because profit is
usually based as a percentage of cost and efficient working resulting in lower
cost also leads to lower profits.
To the Contractee:
1. The contractee has to pay more for the inefficiency of the contactor as the
contractor has no incentive to reduce costs.
2. The price the contractee has to pay is unknown until after the completion of
work.
PROBLEMS AND SOLUTIONS
Problem 7.1 The following are the particulars relating to a contract which has begun
on 1 January 2021:
Contract price
`
5,00,000
Machinery
30,000
Materials
1,70,600
Wages
1,48,750
Direct expenses
6,330
Contract Costing
7.11
Outstanding wages
5,380
Uncertified work
9,000
Overheads
8,240
Materials returned
1,600
Materials on hand 31 December 2021
3,700
Machinery on hand 31 December 2021
22,000
Value of work certified
3,90,000
Cash received
3,51,000
Prepare the Contract Account for the year 2021 showing the amount of profit that
may be taken to the credit of Profit and Loss A/c of the year. Also show the amount of
the work-in-progress as it would appear in the balance sheet of the year.
Solution
Contract Account
for the year ending 31 December 2021
`
To Materials
To Wages
Add: Outstanding
1,48,750
5,380
To Direct expenses
To Overheads
1,70,600
By Materials returned
1,600
By Materials on hand
By Work-in-progress:
3,700
1,54,130
6,330
8,240
To Depreciation on machinery
To Notional Profit c/d
Certified
Uncertified
3,90,000
9,000
8,000
57,000
4,04,300
To P&L A/c*
3,99,000
4,04,300
By Notional Profit b/d
57,000
34,200
2 3,51,000 

 57,000  

3 3,90,000 

To Balance c/d (Reserve)
22,800
57,000
57,000
*Notes: Work certified is `3,90,000 which is 78% of contract price of `5,00,000. Thus transfer to P&L
A/c is by the following formula:
Notional profit ×
Cash received
2
×
Work certified
3
Contract Costing
7.12
Balance Sheet
as on 31 December 2021
Liabilities
`
Outstanding wages
5,380
`
Assets
Materials on hand
Machinery on hand
Work-in-progress:
Work certified
3,90,000
Work uncertified
9,000
3,700
22,000
3,99,000
Less: Cash received 3,51,000
48,000
Less: Profit in reserve 22,800
25,200
Problem 7.2 Modern contractors have undertaken the following two contracts on 1
January 2021.
Contract A
`
Contract B
`
Materials sent to sites
85,349
73,267
Labour engaged on sites
74,375
68,523
Plants installed at sites at cost
15,000
12,500
Direct expenditures
3,167
2,859
Establishment charges
4,126
3,852
549
632
1,95,000
1,45,000
Cost of work not certified
4,500
3,000
Materials in hand on 31 December 2021
1,883
1,736
Wages accrued on 31 December 2021
2,400
2,100
240
180
11,000
9,500
Materials returned to store
Work certified
Direct expenditure accrued on 31 December 2021
Value of plant on 31 December 2021
The contract prices have been agreed at `2,50,000 for contract A and `2,00,000 for
contract B. Cash has been received from the contractees as follows:
Contract A `1,80,000 and contract B `1,40,000.
Prepare Contract Accounts, Contractee’s Accounts and show how the work-inprogress shall appear in the Balance Sheet of the contractor.
Contract Costing
7.13
Solution
Contract A Account
for the year ending 31 December 2021
To Materials sent to site
To Labour
To Plant
To Direct expenditure
To Establishment charges
To Wages accrued
To Direct expenses accrued
To Notional profit c/d
`
85,349
74,375
15,000
3,167
4,126
2,400
240
28,275
`
By Materials (returned to
stores)
By Materials in hand
By Plant in hand
By Work-in-progress:
Work certified 1,95,000
Work uncertified 4,500
2,12,932
To Profit & Loss A/c*
To Balance c/d (Reserve)
17,400
10,875
1,99,500
2,12,932
By Notional profit b/d
28,275
*Note.
549
1,883
11,000
28,275
28,275
Profit transferred to Profit and Loss Account has been calculated as follow:
Profit (notional) ×
= 28,275 
2
Cash received

3
Work certified
2 1,80,000

= `17,400
3 1,95,000
Contractee’s Account
`
By Cash
31st Dec. 2021
To Balance c/d
`
1,80,000
1,80,000
1,80,000
1,80,000
1 Jan. 2019
By Balance b/d
1,80,000
Contract B Account
for the year ending 31 December 2021
To Materials
To Labour
To Plant
To Direct expenditure
To Establishment charges
To Wages accrued
To Direct expenditure accrued
`
73,267
68,523
12,500
2,859
3,852
2,100
180
`
By Materials returned to store
632
By Materials in hand
1,736
By Plant in hand
9,500
By Work-in-progress:
Work certified
1,45,000
Work uncertified
3,000 1,48,000
By Notional loss transferred to
P&L A/c
3,413
1,63,281
1,63,281
Contract Costing
7.14
Contractee’s Account
`
`
1,40,000
By Cash
31 December 2021
To Balance c/d
1,40,000
1,40,000
1,40,000
1 January 2022
By Balance b/d
1,40,000
Balance Sheet
as on 31 December 2021
Liabilities
Wages accrued (2,400 + 2,100)
Direct expenses accrued
(240 + 180)
Profit on contract A
17,400
Less: Loss on contract B
3,413
`
4,500
420
13,987
`
Assets
Plant less Dep.(27,500 – 7,000)
Materials in hand
Work-in-progress:
Contract A
Work certified
1,95,000
Work uncertified
4,500
Less: Profit in reserve
Less: Cash received
Contract B
Work certified
Work uncertified
Less: Cash received
20,500
3,619
1,99,500
10,875
1,88,625
1,80,000
8,625
1,45,000
3,000
1,48,000
1,40,000
8,000
Problem 7.3 The following information relates to a building contract for `10,00,000
for two years, i.e., 2020 and 2021:
Materials issued
Direct wages
Direct expenses
Indirect expenses
Work certified
Work uncertified
Materials at site
Plant issued
Cash received from contractee
2020
`
3,00,000
2,30,000
22,000
6,000
7,50,000
8,000
5,000
14,000
6,00,000
2021
`
84,000
1,05,000
10,000
1,400
10,00,000
—
7,000
2,000
10,00,000
The value of plant at the end of 2020 and 2021 was `7,000 and `5,000, respectively.
Prepare (i) Contract Account, and (ii) Contractee’s Account for two years 2020 and
2021 taking into consideration such profit for transfer to Profit and Loss Accounts as
you think proper.
Contract Costing
7.15
Solution
Contract Account
for the year 2020 and 2021
2020
`
To Materials
3,00,000
To Direct wages
2,30,000
To Direct expenses
22,000
To Indirect expenses
6,000
To Depreciation on plant
(14,000 – 7,000)
7,000
To Balance c/d (Notional profit) 1,98,000
`
By Work-in-progress:
Work certified 7 , 5 0 , 0 0 0
Work uncertified
8,000
By Materials at site
7,63,000
To P&L A/c
1,05,600
2 6,00,000 

 1,98,000  

3 7,50,000 

To Work-in-progress A/c
(Reserve)
7,58,000
5,000
7,63,000
By Balance b/d
1,98,000
92,400
1,98,000
2021
To Work-in-progress:
Certified
Uncertified
7,50,000
8,000
Less: Profit in reserve
7,58,000
92,400 6,65,600
1,98,000
By Contractee A/c
By Materials at site
10,00,000
7,000
To Materials at site b/d
5,000
To Materials issued
84,000
To Direct wages
1,05,000
To Direct expenses
10,000
To Indirect expenses
1,400
To Depreciation on plant
4,000
(14,000 + 2,000 – 7,000 – 5,000)
To P&L A/c
1,32,000
10,07,000
10,07,000
Contractee’s Account
2020
To Balance c/d
`
6,00,000
By Cash
6,00,000
2021
To Contract A/c
10,00,000
10,00,000
`
6,00,000
6,00,000
By Balance b/d
By Cash (balance)
6,00,000
4,00,000
10,00,000
Problem 7.4 Compute a conservative estimate of profit on a contract (which has been
80% complete) from the following particulars. Illustrate at least 4 methods of computing
the profit:
Contract Costing
7.16
`
Total expenditure to date
85,000
Estimated further expenditure to complete the contract
(including contingencies)
17,000
Contract price
1,53,000
Work certified
1,00,000
Work not certified
8,500
Cash received
81,600
(ICWA Inter; CA Inter, Adapted)
Solution
Calculation of Notional Profit
`
1,00,000
8,500
Work certified
Uncertified
1,08,500
85,000
Less: Total expenditure
Notional profit
23,500
Calculation of Estimated Profit
Contract price
Less: Expenditure incurred
Estimated further expenditure
`
1,53,000
85,000
17,000
1,02,000
Estimated profit
1. Notional profit ×
51,000
81,600
2
2
× Cash ratio = 23,500 × ×
3
3 1,00,000
=
` 12,784
(Approx.)
Work certified
1,00,000
2. Notional profit × Contract price = 23,500 ×
1,53,000
Work certified
3. Estimated profit × Contract price × Cash ratio
1,00,000
81,600
= 51,000 ×
×
1,53,000
1,00,000
4. Estimated orofit ×
= ` 15,359 (Approx.)
= ` 27,200
Total cost to date
× Cash ratio
Estimated total cost
= 51,000 ×
85,000
81,600
×
1,02,000
1,00,000
= ` 34,680.
Problem 7.5 Alcon Construction Company Ltd commenced its business of construction
on 1-1-2018. The trial balance as on 31-12-2021 showed the following balances:
Paid up share capital
Cash received on account of contract
(80% of work certified)
Land and buildings
Machinery at cost (75% at site)
Bank
Materials at site
Direct labour
Dr. ( ` )
–
Cr. ( ` )
1,00,000
–
30,000
40,000
4,000
40,000
55,000
1,20,000
–
–
–
–
–
Contract Costing
7.17
Expenses at site
Lorries and vehicles
Furniture
Office equipment
Postage and telegrams
Office expenses
Rates and taxes
Fuel and power
2,000
30,000
1,000
10,000
500
2,000
3,000
2,500
–
–
–
–
–
–
–
–
2,20,000
2,20,000
The contract price is `3,00,000 and work certified is `1,50,000. The work completed
since certification is estimated at `1,000 (at cost). Machinery costing `2,000 was returned
to stores at the end of the year. Stock of material at site on 31-12-2021 was of the value of
`5,000. Wages outstanding were `200. Depreciation on machinery was at 10%.
You are required to calculate the profit from the contract and show how the workin-progress will appear in the Balance Sheet as on 31-12-2021. (B.Com. Hons., Delhi)
Solution
Contract Account
for the your ending 31-12-2021
To Materials
To Direct labour
To Expenses at site
`
40,000
55,000
2,000
To Wages outstanding
To Fuel and Power
To Machinery at site
To Notional Profit c/d
200
2,500
30,000
53,300
`
By Work-in-progress:
Certified
1,50,000
Uncertified
1,000
By Materials at site
By Machinery at site
By Machinery returned
1,83,000
To P&L A/c
(53,300 × 2/3 × 80%)
To Reserve
1,51,000
5,000
25,200
1,800
1,83,000
By Notional Profit b/d
53,300
28,427
24,873
53,300
53,300
Note: Postage and telegrams, office expenses and rent and rates have been assumed to be general expenses
of business and thus not charged to Contract Account. These are to be debited to P&L A/c of the
company.
Balance Sheet
as on 31 December 2021
Liabilities
`
Assets
`
Work-in-progress
—Certified
—Uncertified
1,50,000
1,000
Less: Cash received
1,51,000
1,20,000
Less: Reserve
31,000
24,873
6,127
Contract Costing
7.18
Problem 7.6 Engineers Ltd undertook serveral contract during the year 2021. The
following information relate of Contract No. 107:
`
20,250
15,500
10,500
2,400
Direct materials
Direct wages
Stores issued
Loose tools
Tractor Expenses:
Running material
Wages of driver
2,300
3,000
Other direct charges
5,300
2,650
The contract took 13 weeks to complete. The value of loose tools and stores returned
at the end of the period were `200 and `3,000, respectively. The plant was also returned
at a value of `16,000 after charging depreciation at 20%. The value of tractor was `20,000
and the depreciation to be charged to the tractor was at 15% per annum. The administration
and office expenses are to be provided at 10% on works cost. Profit is to be charged at
20% of the total cost.
Prepare the aforesaid Contract Account, assuming the balance of the contract was
duly received from the contractee.
(B.Com. Hons., Delhi)
Solution
Contract Account
for the year ending 2021
Particulars
To Direct materials
To Direct wages
To Stores (10,500 – 3,000)
To Loose tools (2,400 – 200)
To Tractor expenses
(`2,300 + 3,000)
To Depreciation of tractor*
To Depreciation on plant
(`20,000 – 16,000)
To Other direct charges
Works Cost
To Administrative and office
expenses (10% of works cost)
Total Cost
To Profit & Loss A/c
(20% of total cost)
`
20,250
15,500
7,500
2,200
Particulars
`
By Contractee’s account
(Balancing figure)
76,758
5,300
750
4,000
2,650
58,150
5,815
63,965
12,793
76,758
*Note: Depreciation of tractor for 13 weeks: `20,000 ×
76,758
15 13

= `750.
100 52
Contract Costing
7.19
Problem 7.7 The following is the trial balance of M/s K K Construction Co., engaged
in the execution of Contract No. 1247, for the year ending 31 December 2021.
Contractee’s Account (amount received)
Building
Creditors
Bank Balance
Capital Account
Materials
Wages
Expenses
Plant
`
—
1,60,000
—
35,000
—
2,00,000
1,80,000
47,000
2,50,000
`
3,00,000
8,72,000
8,72,000
72,000
5,00,000
—
—
—
—
The work on Contract No. 1247 was commenced on 1 January 2021. Materials costing
`1,70,000 were sent to the site of the contract but those worth `6,000 were destroyed in
an accident. The wages of `1,80,000 were paid during the year. A plant costing `50,000
was used on the contract all through the year. Another plant with a cost of `2,00,000
was used from 1 January to 30 September and was then returned to the store. Materials
of the cost of `4,000 were at site on 31 December 2021.
The contract was for `6,00,000 and the contractee pays 75% of the work certified.
The work certified was 80% of the total contract work at the end of 2021. Uncertified
work was estimated at `15,000 on 31 December 2021. Expenses are charged to contract
at 25% of wages. The plant is to be depreciated at 10% for the entire year.
Prepare Contract No. 1247 Account for the year 2021 and make out the Balance Sheet
as on 31 December 2021 in the books of K K Construction Co. (B.Com. Hons., Delhi)
Solution
Contract No. 1247 Account
for the year ending 31-12-2021
To Materials
To Wages
To Expenses
To Depreciation on plant
(5,000 + 15,000)
To Balance c/d (Notional Profit)
`
1,70,000
1,80,000
45,000
20,000
90,000
`
By Work certified
4,80,000
By Work uncertified
15,000
By P&L A/c (Loss by accident)
6,000
By Materials at site
5,05,000
To P&L A/c
(90,000 × 2/3 × 5/8*)
To Balance (Reserve)
4,000
5,05,000
By Balance b/d
90,000
37,500
52,500
90,000
90,000
Contract Costing
7.20
Balance Sheet
as on 31 December 2021
Capital
P&L A/c
37,500
Less: Loss of materials 6,000
`
5,00,000
31,500
Work-in-progress:
Less: Unabsorbed exp. 2,000*
Less: Dep. on plant
29,500
5,000*
Creditors
`
1,60,000
1,80,000
30,000
Building
Plant in stores
Materials in store
Certified
Uncertified
24,500
72,000
4,80,000
15,000
4,95,000
Less: Reserve
52,500
4,42,500
Less: Cash received 3,00,000
Materials at site
Plant at site
Bank
5,96,500
1,42,500
4,000
45,000
35,000
5,96,500
*Notes: 1. The cash ratio for computing the amount to be transferred to P&L A/c has been taken as
5/8, i.e.,
3,00,000  Cash received 

 . It may also be taken as 75% as given in the
4,80,000  Work certified 
question.
2. The unabsorbed expenses shown in the balance sheet is
= `47,000 – 45,000 = `2,000.
3. Depreciation on plant of `2,00,000 has been charged to contract only for 9 months. For
remaining 3 months it has been charged to profit in the balance sheet.
Problem 7.8 A contractor, who prepares his accounts on 31 December each year,
commenced a contract on 1 April 2021. The costing records concerning the said contract
reveal the following information on 31 December 2021:
Materials charged to site
Labour engaged
Foremen’s salary
`2,58,100
`5,60,500
`79,300
Plants costing `2,60,000 had been on site for 146 days. Their working life is estimated
at 7 years and their final scrap value at `15,000. A supervisor, who is paid `4,000 p.m.,
has devoted approximately three-fourth of his time to this contract. The administrative
and other expenses amount to `1,40,000. Materials in hand at site on 31 December 2021
cost `25,400. Some of the material costing `4,500 was found unsuitable and was sold
for `4,000 and part of the plant costing `5,500 (on 31.12.2021) unsuited to the contract
was sold at a profit of `1,000.
The contract price was ` 22,00,000 but it was accepted by the contractor for
`20,00,000. On 31 December 2021, two-third of the contract was completed. Architect’s
certificate had been issued covering 50% of the contract price and `7,50,000 has so far
been paid on account. Prepare Contract Account and state how much profit or loss should
be included in the financial accounts to 31 December 2021. Workings should be clearly
given. Depreciation is charged on time basis.
Contract Costing
7.21
Also prepare the Contractee’s Account and show how these accounts would appear
in the Balance Sheet as on 31 December 2021.
(B.Com. Hons., Delhi, CA Inter)
Solution
Contract Account
for the year ending 31 December 2021
To Materials
To Labour
To Foreman’s salary
To Supervisor’s salary
`
2,58,100
5,60,500
79,300
27,000
3


× 9 months 
 4,000 ×

4
To Plant depreciation
146 

 (2,60,000 – 15,000) × 7 × 365 


`
25,400
4,000
500
By Materials at site
By Materials sold
By Loss on sale of materials
By Work in porgress:
Certified
10,00,000
Uncertified
2,62,250*
14,000
To Admn. and other exp.
1,40,000
To Balance c/d (Notional Profit) 2,13,250
12,92,150
To Profit and Loss A/c
1,06,625
12,92,150
By Balance b/d
2,13,250
2 7, 50,000 

 2,13, 250 × 3 × 10, 00,000 
To Balance (Reserve)
1,06,625
2,13,250
2,13,250
*Calculation of cost of work uncertified:
Contract completed
= 2/3
Work certified
= 50% or 1/2
\ Work uncertifed
= 2/3 – 1/2 = 1/6
Total cost incurred
= 2,58,100 + 5,60,500 + 79,300 + 27,000 + 14,000
+ 1,40,000 – (25,400 + 4,000 + 500) = `10,49,000
Cost of 2/3 of the contract
= 10,49,000
\ Cost of the complete contract
= 10,49,000 ×
3
= `15,73,500
2
Cost of work uncertified
= 15,73,500 ×
1
= `2,62,250
6
Contractee’s Account
To Balance c/d
`
7,50,000
31-12-2021
By Cash
`
7,50,000
Contract Costing
7.22
Balance Sheet as on 31 December 2021
`
Liabilities
Profit and Loss A/c:
Profit on contract 1,06,625
Add: Profit on sale
1,000
of plant
1,07,625
Less: Loss on sale
of materials
500
`
Assets
Materials at site
Plant at site
Work-in-progress:
Work certified
10,00,000
Work uncertified
2,62,250
1,07,125
25,400
2,40,500
12,62,250
Less: Reserve
1,06,625
Less: Cash
7,50,000
11,55,625
4,05,625
Problem 7.9 Prabhu Builders Ltd commenced work on 1 April 2021 on a contract, of
which the agreed price was `5 lakh. The following expenditure was incurred during the
year up to 31 March 2022:
`
Wages
1,40,000
Plant
35,000
Materials
Head office expenses
1,05,000
12,500
Materials costing `10,000 proved unsuitable and were sold for `11,500 and a part of
the plant was scrapped and sold for `1,700.
Of the contract price, `2,40,000 representing 80% of work certified had been received
by 31 March 2022 and on that date, the value of the plant on the job was `8,000 and the
value of materials was `3,000. The cost of work done but not certified was `25,000.
It was decided to: (a) estimate what further expenditure would be incurred in
completing the contract; (b) compute from the estimate and the expenditure already
incurred, the total profit that would be made on the contract; and (c) ascertain the amount
of profit to be taken to the credit of Profit and Loss Account for the year ending 31 March
2022. While taking profit to the credit of Profit and Loss Account, the portion of the
total profit should be taken which the value of work certified bears to the contract price.
Details of the estimates were as follows:
(i) That the contract would be completed by 30 September 2022
(ii) The wages to complete would amount to `84,750
(iii) That materials in addition to those in stock on 31 March 2022 would cost `50,000
(iv) That further `15,000 would have to be spent on plant and the residual value of
the plant on 31 September 2022 would be `6,000
(v) The head-office expenses to the contract would be at the same annual rate as in
2021–22
(vi) That claims, temporary maintenance and contingencies would require `9,000
Prepare contract account for the year ended 31 March 2022 and show your calculations
of the sum to be credited to Profit and Loss Account for the year.
(CS Inter)
Contract Costing
7.23
Solution
Contract Account
for the year ending 31 March 2022
`
To Materials
1,05,000
To Wages
1,40,000
To Plant
35,000
To Head office expenses
12,500
To P&L A/c (Profit on materials)
1,500
To Notional profit c/d
55,200
`
By Work-in-progress:
Certified  2, 40,000  80% 
Uncertified
By Plant at site
By Plant sold
By Materials at site
By Materials sold
3,49,200
To P&L A/c*
To Balance (Reserve)
36,120
19,080
3,00,000
25,000
8,000
1,700
3,000
11,500
3,49,200
By Notioanl profit b/d
55,200
55,200
55,200
*Calculation of profit transferred to P&L Account:
Transfer of profit to Profit and Loss Account is on the basis of extimated profit as shown below:
Total expenditure (up to 31.3.2022)
`
Materials (1,05,000 – 10,000 – 3,000)
92,000
Wages
1,40,000
Head office expenses
12,500
Plant (35,000 – 8,000 – 1,700)
25,300
Total
2,69,800
Add: Further expenditure estimate to completion:
Materials (50,000 + 3,000)
53,000
Wages
84,750
Plant (8,000 + 15,000 – 6,000)
17,000
Head office expenses (12,500 ÷ 2)
6,250
Contingencies
9,000
Total estimated cost
4,39,800
Contract price
Total estimated profit
5,00,000
(5,00,000 – 4,39,800) = `60,200
Profit transferred to P&L A/c = Estimated profit ×
= 60,200 ×
Work in progress certified
Contract price
3, 00, 000
= `36,120
5,00, 000
Problem 7.10 Surya Construction Ltd, with a paid-up share capital of `50 lakh, undertook
a contract to construct MIG apartments. The work commenced on the contract on 1 April
2021. The contract price was `60 lakh. Cash received on account of the contract up to
31 March 2022 was `18 lakh (being 90% of the work certified). Work completed but not
certified was estimated at `1,00,000. As on 31 March 2022, material at site was estimated
Contract Costing
7.24
at `30,000, machinery at site costing `2,00,000 was returned to stores and wages outstanding
were `5,000. Plant and machinery at site is to be depreciated at 5%.
The following were the ledger balances (Dr.), as per trial balance, as on 31 March 2022:
`
Land and Building
23,00,000
Plant and Machinery (60% at site)
25,00,000
Furniture
60,000
Materials
14,00,000
Fuel and Power
1,25,000
Site expenses
5,000
Office expenses
12,000
Rates and taxes
15,000
Cash at Bank
1,33,000
Wages
2,50,000
Prepare the Contract Account and Balance Sheet.
Solution
Contract Account
for the year ending 31 March 2022
Particulars
To Materials
To Wages
To Wages outstanding
To Plant and machinery
To Fuel and power
To Office expenses
To Site expenses
To Rates and taxes
To Notional profit c/d
To Profit & loss A/c
1


 90% 
 2,43,000 
3


To Reserve (Balance)
`
Particulars
`
14,00,000
2,50,000
5,000
15,00,000
1,25,000
12,000
5,000
15,000
2,43,000
By Plant returned
2,00,000
Less: Depreciation
10,000 1,90,000
By Plant at site
13,00,000
Less: Depreciation
65,000 12,35,000
By Materials at site
30,000
By Work-in-progress:
Certified
20,00,000
Uncertified
1,00,000
33,55,000
35,55,000
72,900
By Notional profit b/d
2,43,000
1,70,100
2,43,000
2,43,000
Note: Fuel and power, office expenses and rates and taxes are assumed to be specifically incurred on
this contract.
Balance Sheet as on 31-3-2022
Liabilities
Share capital
Wages outstanding
To Profit & loss account
`
50,00,000
5,000
72,900
Assets
Land and building
Pant and machinery
(`10,00,000 + 1,90,000)
`
23,00,000
11,90,000
(Contd.)
Contract Costing
7.25
Plant at site
Cash at Bank
Materials at site
Furniture
Work-in-progress:
Certified
Uncertified
12,35,000
1,33,000
30,000
60,000
20,00,000
1,00,000
Less: Cash
21,00,000
18,00,000
Less: Reserve
3,00,000
1,70,100
50,77,900
1,29,900
50,77,900
Problem 7.11 The following figures are extracted from the books of a contractor, for
the year ending 31 December 2021:
`
Work-in-progress on 31 December 2020
Less: Advances from contractees
17,00,000
11,00,000
Materials supplied to contract direct
Materials issued from store
Wages
Working expenses
Materials returned to store
Contracts finished
Work certified
Profit taken to profit and loss account upon contract completed
Administrative expenses (out of which `5,000 is chargeable to
profit and loss account)
Plant issued
Materials returned from contract to suppliers
Advances from contractees
Plant at site
6,00,000
1,20,000
2,10,000
1,70,000
30,000
11,000
4,50,000
3,00,000
2,30,000
25,000
50,000
9000
8,00,000
40,000
Prepare the Contract Ledger Control Account as in General Ledger and Total
Contractees’ Account. Show also how the work-in-progress would appear in the balance
sheet as on 31 December 2021.
Solution
Contract Account Ledger Control Account
(In general ledger)
To Work-in-progress b/d
To Materials issued
To Wages
To Working expenses
`
17,00,000
2,10,000
1,70,000
`
By Materials returned:
To Store
11,000
To Suppliers
9,000
20,000
30,000
(Contd.)
Contract Costing
7.26
To Materials supplied direct
To Administrative expenses
To Plant
To Profit
1,20,000
20,000
50,000
2,30,000
By Contractees a/c
(contract finished)
4,50,000
By Plant at site
40,000
By Work-in-progress:
Work certified
3,00,000
Work Uncertified (Bal. Fig.) 17,20,000
25,30,000
25,30,000
Total Contractee’s Account
To Contract Ledger Control a/c
(contracts finished)
4,50,000
To Balance c/d
14,50,000
`
11,00,000
8,00,000
By Balance b/d
By Bank
19,00,000
19,00,000
By Balance b/d
14,50,000
Balance Sheet as on 31 December 2021
Liabilities
`
`
Assets
Work-in-progress:
Work certified
Work uncertified
3,00,000
17,20,000
Less: Advance received
20,20,000
14,50,000
5,70,000
Problem 7.12 A construction company undertaking a number of contracts, furnished
the following data relating to its incompleted contracts as on 31 March 2022:
( ` in lakh)
723
Contract numbers
726
729
731
Contract price
23.20
14.40
10.08
28.80
Estimated costs on completion of contract
20.50
11.52
12.60
21.60
Direct materials
5.22
1.80
1.98
0.80
Direct wages
2.32
4.32
3.90
2.16
Overheads (excluding depreciation)
Expenses for the year ended 31.3.2022:
1.06
2.60
2.62
1.05
Profit reserve as on 1.4.2021
1.50
—
—
—
Plant issued at cost
5.00
3.50
2.75
3.00
Materials at site on 1.4.2021
0.75
—
—
—
Materials at site on 31.3.2022
0.45
0.20
0.08
0.05
Work certified till 31.3.2021
4.65
Work certified during the year 2021–22
12.76
13.26
7.56
4.32
Work uncertified as on 31.3.2022
0.84
0.24
0.14
0.18
Progress payments received during the year
9.57
9.00
5.75
3.60
Contract Costing
7.27
Depreciation @ 20% per annum is to be charged on plant issued. While the Contract
No. 723 was carried over from last year, the remaining contracts were started in the 1st
week of April 2021. Required:
(i) Determine the profit/loss in respect of each contract for the year ended 31 March
2022
(ii) State the profit/loss to be carried to Profit & Loss Account for the year ended
31 March 2022
(CA Inter)
Solution
Contract Accounts
for the year ending 31-3-2022
(Figures in ` Lakh)
Contract numbers
723
726
729
Contract numbers
731
723
To WIP
certified
Material at site
4.65
0.75
By WIP:
certified
Uncertified
Less: Reserve
5.40
1.50
By Material at
site
To D. materials
To D. wages
To Overheads
To Depreciation
To Notional profit
3.90
5.22
2.32
1.06
1.00
5.20
1.80
4.32
2.60
0.70
4.28
2.60
2.60
1.80
2.48
5.20
4.28
729
731
17.41 13.26
0.84 0.24
7.56
0.14
4.32
0.18
0.45
0.20
0.08
0.05
—
—
1.27
0.06
18.70 13.70
9.05
4.61
—
—
1.98 0.80
3.90 2.16 Loss: Tr. to
2.62 1.05
P&L A/c
0.55 0.60
—
18.70 13.70 9.05 4.61
*To P&L A/c
To Reserve
726
By Notional
profit
5.20
4.28
5.20
4.28
*Notes : Contract no. 723—This contract is 75% certified.
Tr. to P & L A/c
= Notional profit ×
= 5.20 ×
2
Cash received
×
3
Work certified
2 9.57

= `2.60
3 12.76
Contract No. 726—This contract is 92% (i.e., 13.26 ÷ 14.40) complete.
Tr. to P & L A/c
= Estimated profit ×
Work certified Cash received

Contract price Work certified
= (14.40 – 11.52) ×
13.26 9.00

= `1.80.
14.40 13.26
Problem 7.13 Flex Limited commenced a contract on 1-7-2017. The total contract
price was `5,00,000 but Flex Limited accepted the same for `4,50,000. It was decided
to estimate the total profit and to take to the credit of Profit & Loss Account that
proportion of estimated profit on cash basis which the work completed bore to the total
contract. Actual expenditure till 31.12.2021 and estimated expenditure in 2022 are given
below:
Contract Costing
7.28
Expenses
Actuals
Estimate
Till 31.12.2021 For 2022
`
`
Materials
75,000
1,30,000
Labour
55,000
60,000
Plant purchased (original cost)
40,000
—
Misc. expenses
20,000
35,500
Plant returned to stores on 31.12.2021 at original cost 10,000
25,000
As on 30.9.2022
Materials at site
5,000
Nil
Work certified
2,00,000
Full
Work uncertified
7500
Nil
Cash received
1,80,000
Full
The plant is subject to annual depreciation @ 20% of original cost. The contract is
likely to be completed on 30-9-2022.
You are required to prepare the contract account for the year ended 31-12-2021.
Workings should be clearly given. It is the policy of the company to charge depreciation
on time basis.
(B.Com. Hons., Delhi Adapted, CA Inter)
Solution
Contract Account
(for the year ending 31-12-2021)
`
To Materials
To Labour
To Plant
To Misc. expenses
To Balance c/d
`
75,000
55,000
40,000
20,000
58,500
By Plant returned to
Stores
By Plant at site
By Material at site
By WIP:
Work certified
Work uncertified
2,48,500
To P&L A/c
To Reserve
9,000*
27,000*
5,000
2,00,000
7,500
2,48,500
26,400*
32,100
By Balance b/d
58,500
58,500
58,500
*Working Notes:
1. Estimated profit has been ascertained by preparing Memorandum Contract Account as
follows:
Memorandum Contract Account
(1-7-2015 to 30-9-2022)
`
To Material
To Labour
To Plant
To Misc. expenses
To Estimated profit
2,05,000
1,15,000
40,000
55,500
66,000
4,81,500
`
By Plant returned to stores
*(18,750 + 9,000)
By Plant at site
By Contractee’s A/c
27,750
3,750*
4,50,000
4,81,500
Contract Costing
2.
7.29
Profit to be transferred to P&L A/c for the year ending on 31.12.2021
Cash received Work certified
Estimated profit × Work certified  Contract price
= `66,000 ×
3.
`1,80,000 ` 2,00,000

= `26,400
` 2,00,000 ` 4,50,000
(i) Calculation of plant returned to stores on 31-12-2021
Original cost
Less: Depreciation @ 20% for 6 months
`10,000
`1,000
`9,000
(ii) Plant at site on 31-12-2021
= (Original cost of plant – Plant returned – Depreciation)
= `40,000 – `10,000 – `3,000 = `27,000.
(iii) Plant returned to stores on 30-9-2022
Original cost
Less: Depreciation for 15 months
`25,000
6,250
18,750
(iv) Plant at site on 30-9-2022:
Original cost
Less: Depreciation for 15 months
`5,000
1,250
3,750
Problem 7.14 A contractor undertook a contract for `5,00,000 on 1-7-2020 for the
construction of a library building. On 30-6-2021, when the accounts were closed, the
following details about the contract were gathered:
Materials purchased
Wages paid
General expenses
Plant purchased
Materials in hand on 30-6-2021
Wages accrued 30-6-2021
Work certified
Work uncertified
Cash received
Plant depreciation
`
1,00,000
45,000
9,000
60,000
25,000
5,000
2,00,000
15,000
1,50,000
6,000
The above contract contains an escalation clause which reads as follows. ‘In the event
of prices of materials and rates of wages increase by more than 5%, the contract price
would be increased accordingly by 25% of the rise in the cost of materials and wages
beyond 5% in each case.’
It was found that since the date of signing the agreement, the prices of materials and
wage rates increased by 25%. The value of work certified does not take into account the
effect of the above clause.
Prepare the Contract Account. Working should form part of the answer.
(ICWA Inter; CA Inter)
Contract Costing
7.30
Solution
Calculation of Escalation
1. Materials consumed
= 1,00,000 – 25,000 = `75,000
25
125
Increase in material cost
= 75,000 ×
Wages
= 45,000 + 5,000
Increase in wages
= 50,000 ×
= `15,000
= 50,000
25
125
= `10,000
`25,000
Total increase
Since the increase in materials and wages is more than 5%, the escalation will apply.
Escalation is 25% of the increase in the cost of material and wages beyond 5%.
`25,000
5,000
25% increase
Less: 5% increase
Increase beyond 5%
20,000
Escalation = 20,000 × 25% = `5,000
This contract escalation of `5,000 will be credited to contract account.
Contract Account
for the year ending 30 June 2021
To Material
To Wages paid
Add: Accrued
`
1,00,000
45,000
5,000
To General expenses
To Depreciation
To Balance c/d
(Notional profit)
`
50,000
By WIP:
Certified
Uncertified
9,000
6,000
By Materials in hand
By Contract escalation
2,00,000
15,000
25,000
5,000
80,000
2,45,000
To P&L A/c
20,000
2,45,000
By Balance b/d
80,000
*
1
1,50,000 


 80,000 

3
2,00,000 

To Balance c/d (Reserve)
60,000
80,000
80,000
*Note: As the contract is only 40% certified, only 1/3 of the profit in cash ratio has been transferred to
P&L Account.
Problem 7.15 The following relates to a contract for `4,00,000. Work commenced on
1 Januray 2021 with the following expenditure:
Stores and materials `72,000, wages `65,000. Plant and tools `20,000, Sundry
expenses `5,300 and Establishment charges `11,700. The value of plant and tools on site
on 31 December 2021 was `6,200. The value of stores and materials was `3,400 and the
cost of uncertified work was `21,900. It was later certified for `25,000. `1,40,000 cash
received being 80% of work certified.
Certain materials costing `12,000 were unsuited to the contract and were sold for
`14,500. A portion of the plant was scrapped and sold for `2,300.
Contract Costing
7.31
The contractor wished to take profit on this contract on estimation basis and the
following estimates were made:
1. That the contract would be completed by 30 September 2022.
2. That further wages required would be `71,500.
3. That further stores and materials required in addition to those in stock on
31 December 2021 would be `68,600 and that of sundry expenses would be `6,000.
4. That further plant and tools required would be `25,000 which would have residual
value of `3,000 on completion of contract.
5. That establishment expenses would cost the same per month as in 2021.
6. That 2½% of total cost of the contract would be charged as a provision for
contingencies.
Prepare Contract Account and the Statement of Estimation of Profit on Contract.
(CS Inter)
Solution
Contract Account
for the year ending 31 December 2021
To Stores and materials
To Wages
To Plant and tools
To Sundry expenses
To Extablishment charge
To Profit & Loss A/c: Profit
on sale of materials
Total
To Notional Profit c/d
`
72,000
65,000
20,000
5,300
11,700
2,500
`
By Sale of materials
`14,500
(Cost `12,000)
By Sale of plant
2,300
By Plant on hand at the end
6,200
By Stores and materials on hand 3,400
By Work certified
1,75,000
By Work uncertified
21,900
1,76,500
46,800
2,23,300
To P&L A/c
To Balance (Reserve)
19,178
27,622
2,23,300
By Notional Profit b/d
46,800
46,800
46,800
Profit Estimation for Complete Contract:
`
Total Expenditure on contract
1,76,500
Less: Plant and store on hand and sold (14,500 + 2,300 + 6,200 + 3,400) 26,400
Cost incurred till 31 December 2021
Add: Estimated further expenses:
Wages
Stores and materials (3,400 + 68,600)
Sundry expenses
Further plant and tools
(6,200 + 25,000 – 3,000)
Establishment expenses:
For 9 months @
11, 700
= `975 p.m.
12
1,50,100
71,500
72,000
6,000
28,200
8,775
1,86,475
3,36,575
Contract Costing
7.32
Add: Provision for contingency: 2½% on total cost =
 3,36,575 × 2.5 


97.5
Estimated Total Cost
8,630
3,45,205
Contract price
Less: Estimated total cost
4,00,000
3,45,205
Estimated Total Profit
54,795
Tr. of profit to P&L A/c = Estimated total profit ×
Work certified Cash received
×
Contract price Work certified
= 54,795 ×
1,75,000 80
= ` 19,178
×
4,00,000 100
SUMMARY AND KEY TERMS

Contract costing is a variation of job costing. The main difference between
the two is that contract is generally big while job is small. It is well said, ‘a
contract is a big job and a job is a small contract.’

Contract costing is used in building construction, road construction, ship
building, etc. A contract is generally big enough and takes more than one
year to complete.

Each contract is allotted a distinct number and a separate contract account
is prepared in the books of the contractor under each contract number for
the ascertainment of the cost and profit/loss on each contract.

When a contract extends beyond a year, it becomes necessary to take into
account the profit earned (or loss incurred) on the work performed during
the year.

Architect is required to value the work-in-progress so that payment is
made for the work certified by him. Work certified is that part of the
work-in-progress which is approved by the architect for payment. Work
uncertified is that part of the work-in-progress which is not approved by
the architect. Both work certified and uncertified appear on the credit of
the contract account and also on the assets side of the balance sheet.

It is a usual practice not to pay the full amount of work certified. The
contractee pays a fixed percentage, say 80% or 90% of the work certified,
depending upon the terms of the contract. This is known as Cash Ratio.
The balance amount not paid is known as Retention Money.

At the end of the year, it becomes necessary, to take into account the profit
earned (or loss incurred) on the completed part of the contract. A portion
of notional profit or estimated profit on the work in progress is transferred
to Profit and Loss Account. Certain general rules have been framed for
this purpose.

Escalation clause in contracts entitles a contractor to suitably enhance the
contract price if the cost rises beyond a given percentage.
Contract Costing

7.33
In cost-plus contracts, the contract price is not fixed at the time of entering
into the contract but is determined by adding a specified amount or
percentage of profit on the costs allowed in the contract. This type of
contracts are useful where accurate cost estimation is difficult. Government
often prefers to give contracts on ‘cost plus’ terms.
EXAMINATION QUESTIONS
Objective Type Questions
State whether the following statements are True or False.
1. A job is a small contract and a contract is a big job.
2. Profit on each contract is computed every year on complete portion of the contract.
3. When a contract is 50% complete, 50% of its profit on cash basis is generally
transferred to P&L A/c at the end of the year.
4. There is no difference between notional profit and estimated profit in relation to
contracts.
5. When there is a notional loss on an incomplete contract, transfer to P&L A/c
depends upon the degree of completion of the contract.
6. Escalation clauses in contracts are often provided as safeguards against any likely
changes in price of materials and labour rates.
7. Most of the costs in a contract are direct costs.
8. Work certified is shown in contract account at cost.
9. Work certified in a subsequent year is greater than that in the preceding year.
10. Work uncertified in a subsequent year is always higher than in the preceding year.
Theoretical Questions
1. Distinguish between job costing and contract costing. State the special features
of contract costing.
2. What are the different methods of calculating profit on incomplete contracts?
Give illustrations.
3. Explain how the profits are determined in the case of uncompleted contracts.
4. What is a cost-plus contract? Discuss this from the point of view of (a) the
manufacturer, (b) the buyer.
5. What is the relevance of escalation clause provided in contracts?
6. Discuss the methods of ascertaining profit on the following contracts:
(a) When contract is completed
(b) When contract is not completed
(c) When the contract is nearing completion
7. The Builders Association is an organization of people engaged in the construction
industry. You are retained as cost accountant by the Association to answer the
following questions:
(a) What are the problems of costing for a construction industry? How would
you deal with them?
(b) Discuss in your answer the apportionment of the cost of plant and machinery
and ascertainment of profit on contracts which are not completed at the end
of the accounting year.
Contract Costing
7.34
Practical Questions
1. Thekedar accepted a contract for the construction of a building for `10,00,000;
the contractee agreeing to pay 90% of work certified as complete by the architect.
During the first year, the amounts spent were:
Material
`1,20,000
Machinery
`30,000
Labour
1,50,000
Other expenses
90,000
At the end of the year, the machinery was considered to be of `20,000, and
materials at site were of the value of `5000. Work certified during the year totalled
`4,00,000. In addition, work-in-progress but not certified at the end of year had
cost `15,000. Prepare Contract Account in the books of Thekedar. Also show the
various figures of profit that can be transferred reasonably to the Profit and Loss
Account.
2. The Indian Construction Company undertakes large contracts. The following particulars
to contract No. 125 carried out during the year ended on 31 March 2021.
`
Work certified by architect
1,43,000
Cost of work not certified
3,400
Plant installed at site
11,300
Value of plant on 31 March 2021
8,200
Material sent to site
64,500
Labour
54,800
Establishment charges
3,250
Wages accrued on 31 March 2021
1,800
Direct expenditure
2,400
Materials on hand on 31 March 2021
1,400
Materials returned to store
400
Direct expenditure accrued on 31 March 2021
200
Contract price
2,00,000
Cash received from contractee
1,30,000
Prepare a Contract Account for the period ending 31 March 2021 and find out
the profit. It was decided to transfer 2/3 of the profit on cash basis to Profit and
Loss Account.
3. The Hindustan Construction Co. Ltd has undertaken the construction of a bridge
over River Yamuna for a Municipal Corporation. The value of the contract is
`12,50,000, subject to a retention of 20% until one year after the certified
completion of the contract, and final approval of the Corporation’s engineer. The
following are the details as shown in the books on 30 June 2021:
`
Labour on site
4,05,000
Materials direct to site less returns
4,20,000
Materials from stores
81,200
Hire and use of plant (plant upkeep account)
12,100
Direct expenses
23,000
General overheads allocated to the contract
37,100
Materials on hand 30 June 2021
6,300
Wages accrued on 30 June 2021
7,800
Direct expenses accrued on 30 June 2021
1,600
Works not yet certified—at cost
16,500
Amount certified by the Corporation’s Engineer
11,00,000
Cash received on account
8,80,000
Contract Costing
7.35
Prepare (a) Contract Account, (b) Contractee’s Account and (c) show how it
would appear in the Balance Sheet.
4. Tata Construction Ltd is engaged on two contracts A and B during the year. The
following particulars are obtained at year ending 31 December.
Contract A
Contract B
Date of Commencement
1 April
1 September
`
`
Contract price
6,00,000
5,00,000
Materials issued
1,60,000
60,000
Materials returned
4,000
2,000
Materials on site (31 December)
22,000
8,000
Direct labour
1,50,000
42,000
Direct expenses
66,000
35,000
Establishment expenses
25,000
7,000
Plant installed at cost
80,000
70,000
Value of plant (31 December)
65,000
64,000
Cost of contract not yet certified
23,000
10,000
Value of contract certified
4,20,000
1,35,000
Cash received from contractees
3,78,000
1,25,000
Architects fees
2,000
1,000
During the period, materials amounting to `9,000 have been transferred from
contract A to contract B. You are required to show: (a) Contract accounts, (b)
Contractee’s accounts and (c) Extracts from Balance Sheet as on 31 December,
clearly showing the calculation of work-in-progress.
5. A firm of contractors undertook three contracts on 1 April 2020, 1 October 2020
and 1 January 2021. On 31 March 2021, when their accounts were made up, the
position was as follows:
I
II
III
`
`
`
Contract price
4,00,000
1,35,000
1,50,000
Materials
72,000
29,000
10,000
Wages
1,10,000
56,200
7,000
General expenses
4,000
1,400
500
Plant
20,000
8,000
6,000
Materials on hand
Wages outstanding
4,000
2,000
1,000
3,400
1,800
800
Work certified
2,00,000
80,000
18,000
Cash received
1,50,000
60,000
13,500
6,000
4,000
1,050
Work uncertified
General expenses outstanding
600
200
100
The plants were installed on the respective dates of the contract and depreciation
is taken at 10% p.a. Prepare contract accounts.
6. M/s Sewers Ltd undertook a contract for erecting a sewerage treatment plant for
the municipality for a total value of `24 lakh. It was expected that the contract
would be completed by 31 January 2022. You are required to prepare a contract
account for the year ending 31 January 2021 from the following particulars:
Contract Costing
7.36
(i) Wages
`6,00,000
(ii) Special Plant
`2,00,000
(iii) Materials
`3,00,000
(iv) Overheads
`1,20,000
(v) Depreciation @ 10% to be provided on plant
(vi) Materials lying at the site on 31 January 2021 `40,000
(vii) Work certified was to the extent of `16,00,000 and 80% of same was
received in cash
(viii) 5 per cent of the value of material issued and 6 per cent of wages may be
taken to have been incurred for the portion of work completed but not yet
certified
(ix) Overheads are charged as percentage of direct wages
(x) Ignore depreciation on plant for use on uncertified portion of the work
(xi) Ascertain the amount to be transferred to Profit and Loss account on the
basis of realized profit.
(B. Com, Delhi, ICWA Inter)
7. Y & Co. undertook a contract for `15,00,000 on an arrangement that 80% of the
value of work done as certified by the architects of the contractee, should be
paid immediately and the remaining 20% be retained until the contract is completed.
In 2016 the amounts expended were: Materials `1,80,000; Wages `1,70,000;
Carriage `6,000; Cartage `1,000, Sundry expenses `3,000. The work was certified
for `3,75,000 and 80% of this was paid as agreed.
In 2017, the amounts expended were: Materials `2,20,000, Wages `2,30,000, Carriage
`23,000. Cartage `2,000, and Sundry expenses `4,000. Three-fourths of the contract
was certified as done by 31 December and 80% of this received accordingly. The
value of unused stock and work-in-progress was ascertained at `20,000.
In 2018, the amounts expended were: Materials `1,26,000; Wages `1,70,000; Cartage
`6,000; S. expenses `3,000, and on 30 June the whole contract was completed.
Show how the Contract Account as also the Contractee’s Accounts would appear
for each of these years in the books of the contractor, assuming that balance due
to him was received on completion of the contract.
8. MG Construction Company is engaged in two contracts, contract number 501 and
601 during the year 2020. The following particulars are obtained at the end of the
year 31st December, 2020:
Contract price
Materials issued
Materials returned
Materials on site
Direct labour
Direct expenses
Establishment expenses
Plants installed at cost
Value of plant (December 31)
Cost of work not yet certified
Value of work certified
Cash received from contractees
Architect’s fees
Contract 501 (`)
3,00,000
80,000
2,000
11,000
75,000
33,000
12,500
50,000
42,500
11,500
2,10,000
1,89,000
1,000
Contract 601 (`)
2,50,000
30,000
1,000
4,000
21,000
17,500
3,500
45,000
42,000
5,000
67,500
62,500
500
Contract Costing
7.37
During the period, materials amounting to `4,500 have been transferred from
contract 501 to contract 601. The date of commencement of contract number
501 is 1st April and contract number 601 is 1st Sep. You are required to show:
(i) Contract accounts, and
(ii) Extract from balance sheet as on 31st December, clearly showing the calculation
of WIP.
9. Modern Construction Ltd has taken two contracts on 1 October 2020. The position
of the contracts on 30 September 2021 is as follows:
Contact I
Contract II
`
`
Contract price
27,00,000
60,00,000
Materials
5,80,000
10,80,000
Wages paid
11,24,000
16,50,000
Other expenses
28,000
60,000
Plant at site
1,60,000
3,00,000
Unused materials at site
40,000
60,000
Wages payable
36,000
54,000
Other expenses due
4,000
9,000
Work certified
16,00,000
30,00,000
Cash received
12,00,000
22,50,000
Work completed but not yet certified
80,000
90,000
The plant at site is to be depreciated at 10%. Prepare the contract account in
respect of each work showing the notional profit and also the profit to be
transferred to Profit and Loss Account.
(CS Inter)
10. The following was the expenditure on a contract for `6,00,000 that commenced
in February 2021:
Materials `1,20,000; Wages `1,64,400; Plant `20,000; Business charges `8,600;
Cash received on account to 31-12-2021 amounted to `2,40,000 being 80% of
work certified; the value of materials on hand at 31-12-2021 was `10,000. Prepare
the Contract Account for 2021 showing the profit to be credited to the year’s
P&L A/c. Plant is to be depreciated at 10%.
11. The following is a summary of the expenditure on a contract up to 31 December 2021:
`
Direct wages
6,900
Direct materials
34,000
Stores issued
3,800
Stores returned
500
Sub-contractor costs
6,300
Plant
12,300
The following additional information is supplied to you:
(a) The contract began in 2021 and the contract price is `60,000.
(b) The architect had certified that 4/5th of the contract had been completed on
15 December 2021.
(c) Depreciation on plant upto 15 December 2021 is `4,800.
(d) The summary set out below includes items relating to the period since 15
December 2021.
Contract Costing
7.38
Wages
` 700
Materials
`1,620
(e) Materials on site on 31 December 2021 had cost `5,000 and stores on site
had cost `400.
(f ) Establishment charges are 40% on direct wages.
(g) A fine of `1,000 is likely to be imposed for late completion.
You are required to prepare:
(i) a contract account,
(ii) to show what profit or loss has arisen in the work certified, and
(iii) to suggest what figures should be taken to the profit and loss account for
the year ended 31 December 2021.
12. Bharat Construction Co. has obtained a contract for construction of a building.
The price of the contract is `12 lakh and the work commenced on 1 October
2020. The following details are shown in their books for the year ending 30
September 2021.
`
Plant purchased
60,000
Wages paid
3,40,000
Materials issued to site
3,36,000
Direct expenses
8,000
General overheads apportioned
32,000
Wages accrued (30 September 2021)
2,800
Materials at site (30 September 2021)
4,000
Cost of work not certified
14,000
Direct expenses accrued (30 September 2021)
1,200
Cash received (80% of work certified)
6,00,000
Life of plant is 5 years and scrap value nil
(a) Prepare a contract account for the year ending 30 September 2021.
(b) Show the amount which you consider might be fairly taken as profit on the
contract and how you have calculated it.
(CA Inter)
13. Swastik building company engaged in contract work has the following trial balance
on 31 December 2021.
Dr.
Cr.
`
`
Share capital—Shares of `10 each
—
35,180
Profit and Loss A/c as on 1 January 2021
—
2,500
Provision for depreciation on plant and tools
—
6,300
Contractee’s A/c—Contract no. 902
—
1,28,000
Creditors
—
8,120
Land and building (at cost)
7,400
—
Plant and tools (at cost)
5,200
—
Bank balance
4,500
—
Contract no. 902:
—
Materials issued
60,000
—
Direct labour
83,000
—
Expenses
4,000
—
Plant and tools at site (at cost)
16,000
—
1,80,100
1,80,100
Contract Costing
7.39
Contract No. 902, having a contract price of 2,40,000 was begun on 1 January
2021 and contractee pays 80% of the work completed and certified. The cost of
work done since certification is estimated to be `1,600. After the above Trial Balance
was extracted on 31 December 2021, plant costing `3,200 was returned to the
stores and materials at site on that date were valued at `3,000. Provision is to be
made for sub-contract costs amounting to `600 incurred on Contract No. 902 and
for depreciation of all plants and tools @ 12½% on cost.
Prepare Contract No. 902 Account showing the computation of profit, if any,
for which credit may properly be taken in 2021 and prepare the Balance Sheet of
the construction company on 31 December 2021.
(B.Com. Hons., Delhi)
14. A firm of building contractors began to trade on 1 January 2021. During the year,
the company was engaged on only one contract. The contract price was `5,00,000.
Of the plant and materials charged to the contract, the plant which cost `5,000
and materials which cost `4,000 were lost in an accident.
On 31 December 2021, the plant which cost `5,000 was returned to the stores;
the cost of work done but uncertified was `2,000 and the materials costing `4,000
were in hand on site.
Charge 10% depreciation of the plant and compile the Contract Account and
the Balance Sheet from the following Trial Balance on 31 December 2021:
`
`
Share capital
—
1,20,000
Creditors
—
10,000
Cash received on contract (80% of work certified)
—
2,00,000
Land, buildings, etc.
43,000
—
Bank balance
25,000
—
Charged to contract
Materials
90,000
—
Plant
25,000
—
Wages
1,40,000
—
Expenses
7,000
—
3,30,000
3,30,000
15. Compute a conservative estimate of profit on a contract (which has been 80% complete)
from the following particulars. Illustrate four methods of computing the profit:
Total expenditure to date
Estimated further expenditure to complete
the contract (including contingencies)
Contract price
Work certified
Work not certified
Cash received
`
1,70,000
34,000
3,06,000
2,00,000
17,000
1,63,200
(CA Inter)
16. Work out, in a suitable Cost Accounts form, the financial result in respect of a
contract for construction of temporary buildings undertaken by a firm in River
Valley project. Your answer should be based on the following figures extracted
from the financial books of the firm. The term of the contract is `10 per sq.ft,
of the covered floor area as accepted and certified to be correct by the competent
engineering authorities of the project.
7.40
Contract Costing
(a) Material: Building materials in stock at the commencement of the work
`10,000, purchases during the currency of the contract: (i) Cement 9,000
bags @`5 per bag; (ii) Bricks 1,00,000 @ `50 per thousand; (iii) Sand 10,000
c.ft @ `10 per 100 c.ft and (iv) Wood work 900 c.ft @ `10 per c.ft Value of
balance of various materials in hand after completion of the work `10,000.
(b) Labour: 100 masons @ `2.50 per day for 40 days; 500 coolies @ `1.00 per
day 40 days.
(c) Tools and Plants: 2 new concrete mixers were purchased @ `10,000 each
at the commencement of the contract. Residual value as assessed after
completion of the contract @ `3,500 for each concrete mixer.
(d) Supervision: 50% of 4 Engineer's pay @ `500 per month for each engineer
for 2 months. 50% of ten Overseers’ pay at `200 per month for each Overseer
for 4 months.
(e) Administration overheads: 20% of the head office expenses for the period
of the contract. The total head office expenses amount to `5,000.
(f ) Quantity of work done: Quantity of work certified and accepted by the
engineering authority of the Project is 12,000 sq. ft of covered floor area.
17. Modern construction company with a paid up share capital of `50 lakh undertook a
contract to construct LIG houses. The contract work commenced on 1.1.2021 and
the Contract price was `50 lakh. Cash received on account of contract on 31.12.2021
was `18 lakh (90% of the work certified). Work completed but not certified was
estimated at `1,00,000. As on 31.12.2021, material at site was estimated at `30,000
and machinery at site costing `2,00,000 was returned to stores. Plant and machinery
at site is to be depreciated at 5%. Wages outstanding on 31.12.2021 were `5000.
The following were ledger balances (Dr.), as per Trial Balance, as on 31.12.2021:
`
Land and buildings
15,00,000
Plant and Machinery at cost (60% at site)
25,00,000
8,00,000
Lorries and other vehicles
Furniture
50,000
Office equipment
10,000
Materials sent to site
14,00,000
Fuel & power
1,25,000
Site expenses
5,000
Postage & telegrams
4,000
Office expenses
8,000
Rates & taxes
15,000
Cash at bank
1,33,000
Wages
2,50,000
Prepare the Contract Account to ascertain the profit from the contract and
show the WIP in the balance sheet.
(ICWA Inter)
18. An expenditure of `3,88,000 has been incurred on a contract upto the end of
31 December 2021. The value of work certified is `4,40,000. The cost of work
uncertified is `12,000. It is estimated that the contract will be completed by 31
March 2022 and an additional expenditure of `80,000 will have to be incurred to
complete the contract. The total estimated expenditure on the contract is to include
a provision of 2.5 per cent for contingencies. The contract price is `5,60,000
and `4,00,000 has been realized in cash upto 31 December 2021. Calculate the
proportion of profit to be taken to Profit and Loss Account as on 31 December
2021 under different methods.
(ICWA Inter)
Contract Costing
7.41
19. A company undertook a contract for construction of a large building complex.
The construction work commenced on 1 April 2020 and the following data are
available for the year ended 31 March 2021.
` ’000
Contract Price
35,000
Work Certified
20,000
Progress Payments Received
15,000
Materials Issued to Site
7,500
Planning & Estimating Costs
1,000
Direct Wages Paid
4,000
Materials Returned from Site
250
Plant Hire Charges
1,750
Wage Related Costs
500
Site Office Costs
678
Heads Office Expenses Apportioned
375
Direct Expenses Incurred
902
Work Not Certified
149
The contractors own a plant, which originally costed `20 lakh and has been
continuously in use in this contract throughout the year. The residual value of the
plant after 5 years of life is expected to be `5 lakh. Straight line method of
depreciation is in use.
As on 31 March 2021, the direct wages due and payable amounted to `2,70,000
and the materials at site were estimated at `2,00,000.
Required:
(i) Prepare the contract account for the year ended 31 March 2021.
(ii) Show the calculation of profit to be taken to the profit and loss account of
the year.
(iii) Show the relevant balance sheet entries.
(CA Inter)
20. R K Builders obtained a contract to construct a building for `3 crore. Building work
commenced on 1 October 2020 and at the close of financial year as on 31 March
2021, the construction was still in progress. The following information is available:
(a) Party paid `1.20 crore, being 80% of the amount as per Surveyor’s Certificate
of work completed as on 31 March 2021.
(b) Total cost as per Contract Account after adjustment of closing work-inprogress was `1.35 crore.
As a prudent accountant, determine the amount of profit R K Builders are
justified in taking to the credit of their Profit and Loss Account.
(CS inter)
21. X Ltd undertook a contract for the construction of a building for `15,00,000.
During the first year, the following amounts were spent against which a sum of
`5,62,500 (representing 90% of the work certified) was received by the contractor.
`
Materials used
2,62,500
Wages paid
1,50,000
Overhead expense
37,500
During the second year, the contrator spent the following expenses.
Materials used
3,75,000
Wages paid
3,00,000
Overheads
75,000
Contract Costing
7.42
In the second year, the contract was completed and a sum of `8,75,000 was
received by the contractor.
You are required to prepare the Contract Account and the Contractee’s Accounts
for both the years and determine the profit.
(Note: Only 40% of the notional profit is to be taken to the credit of P&L A/c in
the first year as the work done was less than 50% of the contract).
(ICWA
Inter)
22. Kunal Construction signed a contract for the construction of a building at a
contract price of `30 lakhs. During the first year, the following amounts were
spent against which `11,25,000 (which is equal to 90% of the work certified)
was received by the contractor:
Material used
`5,25,000
Wages paid
3,00,000
Overhead expenses
75,000
The following expenses were incurred during the second year:
Material
`7,50,000
Wages
6,00,000
Overheads
1,50,000
During the second year, the contract was completed. In the second year,
`17,50,000 was received by the contractor.
Prepare the contract account and the contractee’s account for both the years and
determine the profits.
(CS Inter)
ANSWERS
Objective Type Questions
State whether the following statements are True or False.
True — 1, 2, 6, 7, 9;
False — 3, 4, 5, 8, 10
Practical Questions
1. Transfer to P&L A/c `15,000; Reserve `35,000.
(Hint: Work certified is less than half the price of the contract. Hence 1/3 of the
profit on cash basis has been transferred to P&L A/c).
2. Transfer to P&L A/c, `11,000 Reserve `7150.
3. Transfer to P&L A/c 72,000; Reserve `63,000.
4. Contract A–Transfer to P&L A/c `36,000: Reserve `24,000; Contract B–Loss
`5,000.
5. Contract I—Transfer to P&L A/c `9,000; Reserve `9,000; Contract II—Loss
`3,000; Contract III—Reserve `1,500. No. transfer to P&L A/c.
6. Transfer to P&L A/c 3,51,040, Reserve 3,07,160.
(Hint: Work uncertified is calculated as under:
`
Material (5% of ` 3,00,000)
15,000
Labour (6% of ` 6,00,000)
36,000
Overhead (20% of ` 36,000)
7,200
Cost of work not certified
58,200)
7. Reserve 2016—` 11,000; 2017—`1,40,933; Tr. to P&L A/c 2016—`4,000;
2017—`1,61,067; 2021—`1,90,933.
Contract Costing
7.43
8. Contract 501 Notional profit `30,000, Tr. to P & L A/c `18,000.
Contract 601 Loss Tr. to P & L A/c `2,500.
9. Loss on Contract I—`68,000; Contract II—Profit to be credited to P&L A/c
`1,33,500. Reserve on WIP `1,33,500.
10. Transfer to P&L A/c `8,000; Reserve `7,000.
11. Loss `2,060. (Fine of `1,000 likely to be imposed for late completion of the
contract has not been charged in the year 2021. A provision for this contingent
loss may be made).
(Hint: Work uncertified = Material + Wages + Establishment Charges.)
12. Transfer to P&L A/c `19,200; Reserve `16,800.
13. Transfer to P&L A/c `8,000; Reserve 7,000; Balance Sheet total `69,700.
14. Transfer to P&L A/c `11,200; Reserve `9800; Balance Sheet total `1,32,200.
15. Estimated profit `1,02,000; Notional profit `47,000.
16. Profit `10,000.
17. Notional profit `2,43,000; Tr. to P&L A/c `72,900.
18. Notional profit `64,000; Estimated profit `80,000.
(Hint: Provision for contingencies is calculated as under:
(`3,88,000 + 80,000) ×
2.5
= `12,000)
97.5
19. Notional profit `33,24,000; Transfer to P&L A/c `16,62,000.
20. Notional profit `15 lakh. Tr. to P&L A/c `8 lakh.
21. First year notional profit `1,75,000; Transfer to P&L A/c `70,000; Second year
profit `2,30,000.
22. First year-Notional profit `3,50,000, Tr. to P& L A/c `1,05,000; Second year
profit `4,95,000.
CHAPTER
8
PROCESS COSTING
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of process costing and the type of industries in which
this method of costing is used
• Know the problems peculiar to process costing
• Understand the method of preparing process accounts
• Understand the accounting adjustments relating to normal and abnormal process
losses
• Understand the valuation of work-in-progress in terms of equivalent production
• Understand the meaning of joint products and by-products and the difference
between the two
• Explain and understand the methods of apportionment of joint cost
• Understand the method of accounting for by-products
Process costing is probably the most widely used method of cost ascertainment. It is used in
mass production industries producing standard products, like steel, sugar and chemicals. In
all such industries, goods produced are identical and all factory processes are standardized.
Goods are produced without waiting for any
Process Costing is applicable in:
instructions or orders from customers and are
• Textiles mills
put into warehouse for sale. Raw materials
• Chemical works
move down the production line through a
• Oil refining
number of processes in a particular sequence
• Cement mills
and costs are compiled for each process or
• Paper mills
department by preparing a separate account for
• Food processing
each process.
• Steel mills
• Paint industry
Essential Characteristics of
• Soap making
Process Costing
• Sugar works
1. The production is continuous and the
• Confectionaries
final product is the result of a sequence
• Plastic manufacture, etc.
of processes.
Process Costing
8.2
2. Costs are accumulated process-wise.
3. The products are standardized and homogeneous.
4. The cost per unit produced is the average cost which is calculated by dividing the
total process cost by the number of units produced.
5. The finished product of each but last process becomes the raw material for the next
process in sequence and that of the last process is transferred to the finished goods
stock.
6. The sequence of operations or processes is specific and predetermined.
7. Some loss of materials in processes (due to chemical action, evaporation, etc.) is
unavoidable.
8. Processing of a raw materials may give rise to the production of several products.
These several products produced from the same raw material may be termed as
joint products or by-products.
Process Costing and Job Costing—A Comparison
A comparison of process and job costing methods will help in the better understanding of
process costing system.
Process costing
Job costing
1. Costs are compiled process-wise and
cost per unit is the average cost, i.e.,
the total cost of the process divided
by the number of units produced.
Costs are separately ascertained for each
job, which is cost unit.
2. Production is of standardized
products and cost units are identical.
Production is of non-standard items with
specifications and instructions from the
customers.
3. Production is for stocks.
Production is against orders from customers.
4. Costs are computed at the end of a
specific period.
Costs are calculated when a job is completed.
5. The cost of one process is transferred
to the next process in the sequence.
Cost of a job is not transferred to another
job but to finished stock account.
6. On account of continuous nature of
production, work-in-progress in the
beginning and end of the accounting
period is a regular feature.
There may or may not be work-in-progress
in the beginning and end of the accounting
period.
7. Cost control is comparatively easier.
This is because factory processes
and products are standardized.
Cost control is comparatively more
difficult because each cost unit or job
needs individual attention.
Process Costing Procedure
The essential stages in process costing procedure are:
1. The factory is divided into a number of processes and an account is maintained for
each process.
2. Each process account is debited with material cost, labour cost, direct expenses and
overheads allocated or apportioned to the process.
Process Costing
8.3
3. The output of a process is transferred to the next process in the sequence. In other
words, finished output of one process becomes input of the next process.
4. The finished output of the last process (i.e., the final product) is transferred to the
Finished Goods Account.
Process A A/c
Process B A/c
Process C A/c
Dr.
Cr.
Dr.
Cr.
Dr.
Cr.
Input
Output
Input
Output
Input
Output
Finished Goods A/c
Dr.
Cr.
Fig. 8.1 Process costing procedure.
Illustration 8.1 A product passes through three distinct processes to completion. These
processes are numbered respectively, 1, 2 and 3. During the week ended 31 January, 1,000
units are produced. The following information is obtained:
Process 1
Process 2
Process 3
`
`
`
Materials
6,000
3,000
2,000
Labour
5,000
4,000
5,000
Direct expenses
1,000
200
1,000
The indirect expenses for the period were `2,800, apportioned to the processes on the
basis of labour cost.
Prepare process accounts showing total cost and cost per unit.
Solution
Process 1 Account
Output: 1,000 units
Particulars
To Materials
To Labour
To Direct expenses
To Indirect expenses*
Per unit
`
Total
`
Particulars
6
5
1
1
6,000
5,000
1,000
1,000
By Output transferred
to Process 2
13
13,000
*Indirect expenses as a % of labour
Per unit
`
Total
`
13
13,000
13
13,000
2,800
= 5, 000  4,000 + 5,000  100
=
2,800
 100 = 20%
14, 000
Process Costing
8.4
Process 2 Account
Output: 1,000 units
Particulars
Per unit
`
Total
`
Particulars
To Process I (Transfer) 13.00
To Materials
3.00
To Labour
4.00
To Direct expenses
0.20
To Indirect expenses
0.80
13,000
3,000
4,000
200
800
By Output transferred
to Process 3
21.00
21,000
Per unit
`
Total
`
21.00
21,000
21.00
21,000
Process 3 Account
Output: 1,000 units
Particulars
To Process 2
To Materials
To Labour
To Direct expenses
To Indirect expenses
Per unit
`
Total
`
Particulars
21
2
5
1
1
21,000
2,000
5,000
1,000
1,000
By Output transferred
to finished stock
30
30,000
Per unit
`
Total
`
30
30,000
30
30,000
Finished Stock Account
Units
To Process 3
1,000
`
30,000
Sections in this Chapter
There are certain accounting adjustments which are peculiar to process costing and
accordingly, this chapter is broadly divided into three sections:
(i) Process losses and wastages
(ii) Valuation of work-in-progress—Equivalent Production
(iii) Joint products and by-products
PROCESS LOSSES AND WASTAGES
In industries which employ process costing, a certain amount of loss occurs at various stages
of production. Such a loss may arise due to chemical reaction, evaporation, inefficiency, etc.
It is, therefore, necessary to keep accurate records of both input and output. Where loss
occurs at a late stage in manufacture, it is apparent that financial loss is greater. This is
because more and more costs are incurred in processes as products move towards completion
stage.
Process losses may by classified into (a) normal, and (b) abnormal.
Process Costing
8.5
Normal Process Loss
That amount of loss which cannot be avoided because of the nature of material or process
is normal process loss. Such a loss is quite expected under normal conditions. It is caused by
factors, like chemical change, evaporation, withdrawals for tests or sampling and unavoidable
spoiled quantities.
Abnormal Process Loss
This type of loss consists of loss due to carelessness, machine breakdown, accident, use of
defective materials, etc. Thus, it arises due to abnormal factors and represents a loss which
is over and above the normal loss.
Accounting procedure for normal and abnormal loss differs.
Accounting Treatment of Normal Loss
It is a fundamental costing principle that the cost of normal losses should be borne by the
good production. Normal loss is generally determined as a percentage of input. Sometimes
such a loss is due to loss of weight, say, due to evaporation or chemical action. Since such
a wastage is not physically present, obviously it cannot have any value.
However, when normal loss is physically present in the form of scrap, it may have some
value, i.e., it may be sold at some price. Whenever scrapped material has any value, it is
credited to the Process Account. This is illustrated below.
Illustration 8.2
The following information is given in respect of process A.
1,000 kg @ `6 per kg
`5,000
`1,000
Material
Labour
Direct expenses
Indirect expenses allocated to Process A `1,000
Normal wastage 10% of input
Prepare Process A Account when:
(a) Scrap value of normal loss is nil
(b) Scrap arising out of normal has a sale value of `1 per unit
Solution
(a) When scrap value of normal loss is nil:
Process A Account
Particulars
To Material
To Labour
To Direct exp.
To Indirect exp.
Cost per unit
kg
`
1,000
6,000
5,000
1,000
1,000
1,000
13,000
= `13,000 ÷ 900 units
= ` 14.44
Particulars
kg
`
By Normal loss
By Transfer to
Process 2
100
900
—
13,000
1,000
13,000
Process Costing
8.6
The normal loss is absorbed by good production and as a result the cost per unit of good
production inflates. When there is no loss, the cost per unit produced is `13
(i.e., 13,000 ÷ 1,000 units). But when there is a normal loss, the cost per unit is higher at `14.44.
(b) When scrap of normal loss has a sale value of `1 per unit.
Process A Account
Particulars
To Material
To Labour
To Direct exp.
To Indirect exp.
Cost per unit
kg
`
1,000
6,000
5,000
1,000
1,000
1,000
13,000
Particulars
kg
`
By Normal loss
By Transfer to
Process 2
100
900
100
12,900
1,000
13,000
= `12,900 ÷ 900 units
= ` 14.33
Whenever any value is realized from the sale of normal wastage, it reduces the cost to that
extent.
Accounting Treatment of Abnormal Process Loss
It has been stated earlier that abnormal loss is due to carelessness, accidents, machine
breakdown and other abnormal reasons. Unlike normal loss, abnormal loss is not absorbed
by good production, rather it is transferred to Costing Profit and Loss Account. This is because
if the cost of abnormal loss were to fall upon the good production, the cost thereof will fluctuate
and the information provided would be misleading. In order to overcome this and also to
disclose the cost of abnormal loss, the following procedure may be adopted:
(a) Allow for normal loss in the manner described earlier.
(b) After considering normal loss, find out the cost per unit in that process. This is done
by the following formula:
Cost per unit =
Total cost – Value of normal loss
Units introduced – Normal loss units
(c) Multiply the cost per unit (calculated as above) by the number of units of abnormal
loss. This gives the total value of abnormal loss.
(d) Credit the relevant Process Account with the quantity and value of abnormal loss.
(e) The balance figure in the Process Account is the cost of good units produced in the
process. This can also be found by multiplying cost per unit with the number of good
units produced.
(f) Open ‘Abnormal Loss Account’ and debit it with the quantity and value of abnormal
loss shown in the Process Account. Sale proceeds from abnormal loss are credited
to Abnormal Loss Account. Any balance left in this account is net loss and transferred
to Costing Profit and Loss Account.
Illustration 8.3 Fifty units are introduced into a process at a cost of rupee one each. The
total additional expenditure incurred by the Process is `30. Of the units introduced, 10% are
normally spoiled in the course of manufacture, these possess a scrap value of `0.25 each. Owing
to an accident, only 40 units are produced. You are required to prepare (i) Process Account,
and (ii) Abnormal Loss Account.
Process Costing
8.7
Solution
Process Account
Particulars
Units
`
To Materials
To Expenses
50
—
50.00
30.00
50
80.00
Particulars
By Normal loss
By Abnormal loss
By Transfer to next
process (B/F)
Units
`
5
5
1.25
8.75*
40
50
70.00
80.00
*Cost of abnormal loss is calculated as follows:
Total cost–Value of normal loss
`80 – 1.25
78.75
=
= `1.75
=
Input–Normal loss (in units)
Units 50 – 5
45
Cost per unit
=
Cost of abnormal loss
= Abnormal loss units × Cost per unit
= 5 × `1.75 = `8.75
Abnormal Loss Account
Particulars
To Process A/c
Units
`
Particulars
5
8.75
By Sales
By Profit and Loss A/c
(Balanced figure)
5
8.75
Units
`
5
1.25
7.50
5
8.75
Abnormal Gain or Effectiveness
The normal process loss represents the loss that would be expected under normal conditions.
It is an estimated figure. The actual loss may be greater or less than the normal loss. If the
actual loss is greater than normal loss, it is known as abnormal loss. But if actual loss is less
than normal loss, a gain is obtained which is termed as abnormal gain or effectiveness. The
value of abnormal gain is calculated in a manner similar to abnormal loss. It is shown on the
debit side of the Process Account and credit side of the Abnormal Gain Account. Like abnormal
loss, it is ultimately transferred to Costing Profit and Loss Account. This is illustrated below.
Example:
Using the figures of Illustration 8.3, except that output is 47 units, show how the process
account will be prepared. Also prepare Abnormal Gain Account.
Solution
When normal output is 45 units and actual output is 47 units, there is an abnormal gain of 2
units. This is shown in the following account.
Process Account
Particulars
Units
`
To Material
To Expenses
To Abnormal gain*
50
2
50
30
3.50
52
83.50
Particulars
By Normal loss
By Transfer to next
process
*The value of abnormal gain is calculated as follows:
Units
`
5
1.25
47
82.25
52
83.50
Process Costing
8.8
`80 – 1.25
× 2 units = `3.50
50 – 5 units
It should be noted that the method of valuation of abnormal gain is the same as that of
abnormal loss.
Abnormal Gain Account
Particulars
To Normal loss A/c (Shortfall
in the sale of normal loss)
To Profit & Loss A/c (B.F.)
Units
`
2
0.50
3.00
2
3.50
Particulars
Units
`
By Process A/c
2
3.50
2
3.50
Illustration 8.4 A product passes through three processes A, B and C. The normal wastage
of each process is as follows: Process A – 3 per cent, Process B – 5 per cent, and Process C
– 8 per cent. Wastage of Process A was sold at 25 p. per unit, that of Process B at 50 p. per
unit and that of Process C at `1 per unit.
10,000 units were issued to Process A in the beginning of October 2012 at a cost of
`1 per unit. The other expenses were as follows:
Process A
Process B
Process C
Sundry materials
`1,000
`1,500
`500
Labour
5,000
8,000
6,500
Direct expenses
1,050
1,188
2,009
Actual output
9,500 units
9,100 units
8,100 units
Prepare the Process Accounts, assuming that there were no opening or closing stocks.
Also give the Abnormal Wastage and Abnormal Gain Accounts.
Solution
Process A Account
Particulars
Units
`
To Units introduced
To Sundry materials
To Labour
To Direct expenses
10,000
10,000
1,000
5,000
1,050
10,000
*Value of abnormal wastage =
Particulars
By Normal wastage
(3% of 10,000)
By Abnormal wastage
By Process B (transfer)
17,050
`17,050 ` 75
10,000 300 units × 200 units = `350
Units
`
300
75
200
9,500
350*
16,625
10,000
17,050
Process Costing
8.9
Process B Account
Particulars
Units
`
To Process A
To Sundry materials
To Labour
To Direct exp.
To Abnormal gain
9,500
By Normal wastage
475
(5% or 9,500)
By Process C (transfer) 9,100
27,300
75
16,625
1,500
8,000
1188
225*
9,575
27,538
9,575
27,538
Particulars
Units
`
By Normal wastage
(8% of 9,100)
By Abnormal wastage
By Finished goods
(transfer)
728
728
272
1156*
8,100
34,425
9,100
36,309
Units
`
200
272
50
272
*Abnormal gain =
Particulars
Units
`
238
` 27,313 ` 238
9,500 475 units = `225
Process C Account
Particulars
Units
`
To Process B
(transfer)
To Sundry materials
To Labour
To Direct expenses
9,100
27,300
500
6,500
2,009
9,100
*Abnormal wastage =
36,309
`36,309 – `728
× 272 units = `1,156
9,100 – 728 units
Abnormal Wastage Account
Particulars
Units
`
To Process A
To Process B
200
272
350
1,156
472
1,506
Particulars
By Sales of scrap in
Process A @ `0.25
Process C @ `1
By Profit and Loss
A/c (B/F)
1,184
472
1,506
Particulars
Units
`
By Process B
75
225
75
225
Abnormal Gain Account
Particulars
Units
To Normal wastage A/c
(shortfall in the sale of
normal wastage @
`0.50 per unit)
To Profit & Loss A/c (B.F.)
75
`
38
187
75
225
Process Costing
8.10
When the Output of a Process is Partly Sold and Partly Transferred
to the Next Process
Sometimes the output of a process may be partly sold and partly transferred to the next
process for further processing. For example, in a textile mill, part of the output of a spinning
process may be sold and the remaining output is passed on to the weaving process for further
processing. A part of the output so sold will contain an element of profit or loss which will be
revealed in the Process Account. But when a part of the output is sent to warehouse for
sale, it is at cost and does not contain an element of profit or loss.
Illustration 8.5 XYZ Ltd manufactures and sells three chemicals produced by consecutive
processes known as X, Y and Z. In each process 2% of the total weight put in is lost and 10%
is scrap, which from processes X and Y realized `100 a tonne and from Z `200 a tonne. The
products of the three processes are dealt with as follows:
X
Sent to warehouse for sale
25%
Passed on the next process
75%
The following particulars relate to the month of May:
Materials used (tonnes)
1,000
Cost per tonne of materials (`)
120
Mfg. expenses (`)
30,800
Y
50%
50%
Z
100%
—
140
200
25,760
1,348
80
18,100
Prepare an account for each process, showing the cost per tonne of each product.
Solution
Process X Account
Particulars
Tonnes
To Materials
(@ `120)
To Mfg. exp.
1,000
`
1,20,000
30,800
1,000
Particulars
Tonnes
`
By Loss in weight
(2% of 1,000)
20
By Scrap (10% of 1000) 100
By Warehouse
(25% of 880)
220
By Process Y (transfer) 660
35,200
1,05,600
1,000
1,50,800
1,50,800
—
10,000
Working Notes:
`1,50,800 – `10,000
220 tonnes = `35,200.
880 tonnes
Similar calculation has been made in Process Y.
2. As the question is silent about the nature of loss, it is presumed that both weight loss and scrap are
normal.
1. Transfer to warehouse =
Process Y Account
Particulars
Tonnes
`
To Process X (transfer)
660
1,05,600
To Materials
To Mfg. exp.
140
__
28,000
25,760
800
1,59,360
Particulars
By Loss in weight
(2% of 800)
By Scrap
By Warehouse
By Process Z (transfer)
Tonnes
`
16
80
352
352
—
8,000
75,680
75,680
800
1,59,360
Process Costing
8.11
Process Z Account
Particulars
Tonnes
To Process Y
(transfer)
To Materials
To Mfg. exp.
352
1,348
—
1,700
`
75,680
1,07,840
18,100
Particulars
By Loss in Weight
(2% of 1,700)
By Scrap
By Warehouse
(transfer)
2,01,620
Tonnes
`
34
170
—
34,000
1,496
1,67,620
1,700
2,01,620
Illustration 8.6 Chemicals Ltd processes a patent material used in buildings. The material is
produced in three consecutive grades—soft, medium and hard.
Raw materials used
Cost per tonne
Manufacturing wages and exp.
Weight lost (% of input of the process)
Scrap (sale price `50 per tonne)
Sale price per tonne
Process I
1,000 tonnes
`200
`87,500
5%
50 tonnes
`350
Process II
—
—
`39,500
10%
30 tonnes
`500
Process III
—
—
`10,710
20%
51 tonnes
`800
Management expenses were `17,500 and selling expenses `10,000. Two-thirds of the output
of Process I and one-half of the output of Process II are passed on to the next process and the
balances are sold. The entire output of Process III is sold. Prepare the three process accounts
and a statement of profit. Make approximations, where necessary.
(B. Com. Hons. Delhi)
Solution
Process I Account
Particulars
Tonnes
To Raw materials
To Mfg. wages
and expenses
To Profit (B.F.)
1,000
—
—
1,000
`
Particulars
—
2,500
1,05,000
1,90,000
2,97,500
2,97,500
Total cost – Scrap value 2,85, 000

Units produced
900
Cost of 600 tonnes =
`
2,00,000 By Weight lost
50
By Scrap
50
87,500 By Sales
300
10,000 By Process II (transfer)* 600
*Cost of 600 tonnes transferred to Process II is calculated below:
Cost per tonne =
Tonnes
2,85, 000
× 600 = `1,90,000
900
Similar procedure has been followed in other processes.
1000
Process Costing
8.12
Process II Account
Particulars
To Process I transfer
To Mfg. wages and
expenses
To Profit (B/F)
Tonnes
`
600
1,90,000
—
—
39,500
13,500
600
Particulars
By Weight loss
By Scrap
By Sales
By Process III
(transfer)
2,43,000
`
Tonnes
60
—
30
1,500
255 1,27,500
255 1,14,000*
600 2,43,000
*Cost of 255 tonnes transferred to Process III
=
` 2,28,000
× 255 tonnes = `1,14,000
510 tonnes
Process III Account
Particulars
Tonnes
`
To Process II (transfer) 255
To Manufacturing
wages and expenses
—
To Profit (B.F.)
—
1,14,000
255
1,24,950
10,710
240
Particulars
Tonnes
`
By Weight loss
By Scrap
By Sales
51
51
153
—
2,550
1,22,400
255
1,24,950
Notes:
1. Profit in each process is a balancing figure.
2. It is assumed that weight loss and scrap are normal.
Statement of Profit/Loss
`
10,000
13,500
240
Profit as per Process I
Profit as per Process II
Profit as per Process III
Total profit
Less:
Management expenses*
Selling expenses
23,740
17,500
10,000
Net Loss
27,500
3,760
*Note: It is assumed that management expenses and selling expenses are not allocable to processes.
Therefore, these have been charged in Profit/Loss Statement.
Solution by Alternative Method (Illustration 8.6)
Process I Account
Particulars
Tonnes
To Raw materials
1,000
To Mfg. exp. and wages —
`
Particulars
Tonnes
`
2,00,000
87,500
By Weight lost
By Scrap
50
50
—
2,500
(Contd...)
Process Costing
8.13
By Cost of goods sold
transfer to P&L A/c*
By Process II A/c (BF)
1,000
2,87,500
300
95,000
600 1,90,000
1,000 2,87,500
*Total cost = `2,87,500 – 2,500 = `2,85,000; Cost of goods sold `2,85,000 × 1/3 = `95,000.
Process II Account
Particulars
To Process I A/c
To Mfg. exp. wages
Tonnes
`
600
—
1,90,000
39,500
600
Particulars
By Weight loss
By Scrap
By Cost of goods sold
transfer to P&L A/c
By Process III A/c
2,29,500
Tonnes
`
60
30
—
1,500
255 1,14,000
255 1,14,000
600 2,29,500
Process III Account
Particulars
Tonnes
`
To Process II A/c
To Mfg. exp. and wages
255
—
1,14,000
10,710
255
1,24,710
Particulars
By Weight loss
By Scrap
By Cost of goods sold
transfer to P&L A/c
Tonnes
`
51
51
—
2,550
153 1,22,160
255 1,24,710
Profit and Loss Account
To Cost of goods sold
Process I
II
III
Tonnes
`
300
255
153
95,000
1,14,000
1,22,160
708
17,500
10,000
3,58,660
Tonnes
By Sales – Process I
II
III
300 1,05,000
255 1,27,500
153 1,22,400
By Net Loss
To Management exp.
To Selling exp.
`
3,760
708 3,58,660
WORK-IN-PROGRESS (EQUIVALENT PRODUCTION)
Process costing mainly deals with continuous type of production. At the end of the accounting
period, there may be some work-in-progress, i.e., semi-finished goods may be in the pipeline.
The valuation of such work-in-progress is done in terms of equivalent or effective production.
Equivalent Production
Equivalent production represents the production of a process in terms of completed units.
Work-in-progress at the end of an accounting period are converted into equivalent completed
units. This is done by the following formula:
Equivalent Completed
No. of units of
Degree of
=
+
×
production
units
work in progress
completion in %
Process Costing
8.14
For example, if there are 50 units in work-in-progress and these are estimated to be
60% complete, then their equivalent production is 50 units × 60% = 30 units.
In each process, an estimate is made of the degree of completion of work-in-progress
in terms of percentage. Such an estimate must be accurate because any error in such
estimation will lead to erroneous valuation of work-in-progress stock which enters into final
accounts.
Evaluation of Equivalent Production
After work-in-progress has been converted into equivalent completed units, the following steps
are taken to evaluate it:
(i) Find out the total cost (net) for each element of cost, i.e., material, labour and
overheads. Scrap value of normal loss is deducted from the material cost.
(ii) Ascertain the cost per unit of equivalent production separately for each element of
cost. This is done by dividing the total cost of each element by the respective number
of equivalent units.
(iii) At this rate of cost per unit, ascertain the value of finished production and work-inprogress.
For the purpose of computation of equivalent production and its evaluation, the following
three statements are generally prepared:
(a) Statement of equivalent production
(b) Statement of cost (per unit)
(c) Statement of evaluation
These three statements may also be combined in one comprehensive statement called
‘Statement of Production, Cost and Evaluation.’
For clear understanding, illustrations on equivalent production are classified into the
following two categories.
(a) When there is no opening stock, i.e., when there is only closing stock of work-inprogress. In such a situation there may or may not be process losses.
(b) When there is opening as well as closing stock—Here also, there may or may
not be process losses.
When there is no opening stock and no process loss
In such a case, valuation of work-in-progress in terms of equivalent production is comparatively
simple. Procedure followed in this type of situation is shown in the following illustration.
Illustration 8.7 In process A, on 1 March, there was no work-in-progress. During the month
of March, 2,000 units of material were issued at a cost of `18,000. Labour and overheads totalled
`9,000 and `6,600 respectively. On 31 March, 1,500 units were completed and transferred to
the next process. On the remaining 500 units, which were incomplete, degree of completion
was as follows:
Materials
Labour
Overheads
100%
60%
30%
Process Costing
8.15
Prepare:
(a) Statement of Equivalent Production
(b) Statement of Cost
(c) Statement of Evaluation
(d) Process Account
Solution
(a)
Statement of Equivalent Production
Input
Units
Items
Output
Units
Equivalent units
Material
Labour
Qty.
%
Qty.
%
Overhead
Qty.
%
2,000
Finished output
Work-in-progress
1,500
500
1,500
500
100
100
1,500
300
100
60
1,500
150
100
30
2,000
Total
2,000
2,000
—
1,800
—
1,650
—
(b)
Statement of Cost
Element of cost
Material
Labour
Overhead
Cost
`
(A)
Equivalent
units
(B)
Cost per units
`
(A ÷ B)
18,000
9,000
6,600
2,000
1,800
1,650
9
5
4
18
Total
(c)
Statement of Evaluation
Finished goods
(1,500 × `18)
Value of work-in-progress:
Materials
500 units @ `9 per unit
Labour
300 units @ `5 per unit
Overhead
150 units @ `4 per unit
(d)
`
27,000
`
4,500
1,500
600
6,600
Process A Account
Particulars
Units
`
Tot Materials
To Labour
To Overhead
2,000
18,000
9,000
6,600
2,000
33,600
Particulars
Units
`
By Next process A/c
By Work-in-progress c/d
1,500
500
27,000
6,600
2,000
33,600
When there is no opening stock of work-in-progress but there are process losses—as
discussed earlier, losses are inherent in process operations. Normal and abnormal process
losses are treated differently in the calculation of equivalent production.
Normal Loss—Equivalent units of normal loss are taken as nil. In other words, normal loss
is not added in the equivalent production. However, realizable value of normal scrap is
deducted from the cost of material so as to calculate the net material cost. This net material
cost becomes the basis of calculating the material cost per unit in the statement of cost.
Process Costing
8.16
Abnormal Loss—This is treated as if this were good production lost. Abnormal loss, thus,
is added to equivalent production with due consideration to its degree of completion. Unless
the degree of completion is specified, it may be assumed that abnormal loss units are 100%
complete in respect of all elements of cost.
Abnormal Gain—Units of abnormal gain are represented by good finished production. It is
therefore, always taken as 100% complete in respect of all elements of cost, i.e., material,
labour and overheads. Abnormal gain is deducted to obtain equivalent production.
Illustration 8.8 During a month, 2,000 units were introduced into Process I. The normal
loss was estimated at 5% on input. At the end of the month 1,400 units had been produced and
transferred to next process, 460 units were uncompleted and 140 units had been scrapped. It
was estimated that uncompleted units had reached a stage in production as follows:
Material
Labour
Overheads
75% completed
50% completed
50% completed
The cost of 2,000 units introduced was `5,800.
Direct materials introduced during the process amounted to `1,440.
Production overheads incurreds were `1,670. Direct labour `3,340.
Units scrapped realized `1 each.
The units scrapped have passed through the process, so were 100% completed as regards
material, labour and overheads.
You are required to: (a) prepare a Statement of Equivalent Production; (b) evaluate the cost
of abnormal loss, finished goods and closing stock; and (c) prepare the Process I Account and
Abnormal Loss Account.
(ICWA Inter, Adapted)
Solution
Statement of Equivalent Production
Input
Output
Units
Equivalent units
Units
Overhead
2,000 Normal loss
Abnormal loss
Finished production
Work-in-progress
100
40
1,400
460
2,000 Total
2,000
Equivalent Production
Material
Labour
Qty.
%
Qty.
%
Qty.
%
—
40
1,400
345
—
100
100
75
—
40
1,400
230
—
100
100
50
—
40
1,400
230
—
100
100
50
1,785
1,670
1,670
Statements of Cost
Element of cost
Materials:
Units introduced
Direct materials
Cost
`
(A)
Equivalent
production (units)
(B)
Cost per
unit `
(A ÷ B)
5,800
1,440
7,240
(Contd...)
Process Costing
8.17
Less: Scrap value of loss (normal)
100
Material cost
Direct labour
Overhead
7,140
3,340
1,670
Total
12,150
1,785
1,670
1,670
4
2
1
7
Statement of Evaluation
Particulars
Element of
cost
Equivalent
production
Cost per
unit `
Cost
`
Total cost
`
Abnormal Loss:
Material
Labour
Overhead
40
40
40
4
2
1
160
80
40
280
Material
Labour
Overhead
1,400
1,400
1,400
4
2
1
5,600
2,800
1,400
9,800
Material
Labour
Overhead
345
230
230
4
2
1
1,380
460
230
Finished
Production:
Work-in-progress:
2,070
12,150
Process I Account
Particulars
Units
To Units introduced
2,000
To Direct material
To Direct wages
To Production overheads
`
Particulars
`
Units
5,800
1,440
3,340
1,670
By Normal loss
100
By Abnormal loss
40
By Finished production
transferred to Process II1,400
By Balance c/d
(work-in-progress)
460
100
280
2,000 12,250
2,000
12,250
Units
`
40
40
240
40
280
9,800
2,070
Abnormal Loss Account
Particulars
Units
`
Particulars
To Process I
40
280
By Sale of scrap
By Costing P&L A/c
40
280
When there is opening as well as closing stock of work-in-progress
In such a case there are two methods of calculating equivalent production:
(i) FIFO Method, and (ii) Average Cost Method.
These methods have been discussed in detail, further.
Process Costing
8.18
FIFO (First-in, First out) Method
This method is based on the assumption that work-in-progress moves on a first-in-first out
basis. This means that unfinished work on the opening stock is completed first, before work
on any new units is taken up. Thus no units from opening work-in-progress will be left
incomplete and none of these find a place in the closing work-in-progress. In other words,
closing stock will be calculated out of the materials introduced during the current period and
will be valued at the current cost. The costs incurred during the current period will be
distributed over opening stock of work-in-progress (for its completion), units introduced and
completed during the period and closing stock of work-in-progress. This is done by dividing
the costs incurred by the relevant equivalent production so as to arrive at the per unit cost of
equivalent production.
FIFO method gives satisfactory results when prices of materials, rates of wages and
overheads are relatively stable.
Computation of Equivalent Production under FIFO Method. The following steps
are taken in the computation of equivalent production:
(i) State the opening stock of work-in-progress in equivalent completed units. This is
done by applying the percentage of work needed to complete the unfinished
work of the previous period. For example, if there are 200 units of opening
work-in-progress which are 70% complete, then the equivalent units of this will be
200 × 30% (work required to complete the incomplete portion) = 60 units.
(ii) Ascertain the number of units introduced into the process and deduct the number of
units of closing work-in-progress. This gives the number of units started and completed
during the period. Add these units to the opening stock of work-in-progress calculated
in (i) above.
(iii) Add to the above the equivalent completed unit of closing work-in-progress. This
can be determined by applying the percentage of work done on the finished units at
the end of the period.
Illustration 8.9
Opening work-in-progress (30% complete)
Put into the process during the month
Transferred to next process
Closing work-in-progress (40% complete)
Calculate equivalent production.
—
—
—
—
2,000 units
20,000 units
18,000 units
4,000 units
Solution
Equivalent units
Opening work-in-progress (70% unfinished work × 2,000 units)
1,400
Add: No. of units introduced and completed during the month:
Units put into process
20,000
Less: Units not completed
4,000
16,000
Add: Closing stock-work done [4,000 units × 40%]
1,600
Equivalent production
The above calculation may be made by the following alternative method:
Units completed during the month
Add: Closing stock—work done [4,000 × 40%]
Less: Opening stock—work already done [2,000 × 30%]
Equivalent production
19,000
18,000
1,600
19,600
600
19,000
Process Costing
Illustration 8.10
8.19
The following information pertains to Process A:
Units
200
1,000
1,100
100
`8,400
Opening work-in-progress (40% complete) valued at `560
Units introduced during current period
Finished output during the period transferred to Process B
Closing work-in-progress (30% complete)
Costs incurred during the period
Make the necessary calculations and prepare Process A Account.
Solution
Statement of Equivalent Production
Input
Output
Equivalent Production
Items
Units
Items
Units
Units
%
Opening WIP
Introduced
200
1,000
Opening WIP
Introduced and
completed
Closing stock
200
120
*60%
900
100
900
30
100%
30%
1,200
1,050
1,200
Total
*Opening WIP requires 60% to complete the work because 40% was completed in the previous period.
Calculation of cost per unit
Cost incurred during the period = `8,400
Equivalent production during the period = 1,050 units
Cost per unit = `8,400 ÷ 1,050 units = `8
Statement of Evaluation
Particulars
Equivalent
units
Opening stock of WIP
Introduced and completed
Closing stock of WIP
Cost
per unit
`
Total
cost
`
120
900
30
8
8
8
960
7,200
240
1,050
8
8,400
Process A Account
Particulars
To Opening WIP
To Costs incurred
during the period
Units
`
Particulars
200
560
1,000
8,400
By Finished Production
transfer to Process B 1,100
By Closing WIP
100
8,720*
240
1,200
8,960
1,200
8,960
Units
*Cost of finished production transferred to Process B is calculated as follows:
Opening WIP
(200 units) = Old cost `560 + Current cost `960
Cost of units introduced and completed during the period (900 units)
= `1,520
= `7,200
Cost of 1,100 units completed
= `8,720
`
Process Costing
8.20
Illustration 8.11 A company follows process costing and manufactures a product in one
process. The work-in-progress at the end of each month is valued according to FIFO method.
At the beginning of the month of January, the inventory of work-in-progress showed the
400 units, 40% completed, valued as follows:
`
Materials
3,600
Labour
3,400
Overheads
1,000
8,000
In the month of January, materials were purchased for `75,000. Wages and overheads in
the month amounted to `79,800 and `21,280, respectively. Actual issue of materials to production
was `68,500. Finished production taken into stock in the month was 2,500 units. There was
no loss in the process.
At the end of the month, the work-in-progress inventory was 500 units, 80% complete as
regards materials and 60% complete, as regards labour and overheads.
You are required to compute equivalent production and prepare process account.
(ICWA Inter)
Solution
Statement of Production
Input
units
Particulars
Output
units
Opening stock of WIP 400
Completely processed
2,600
during the period
2,100
Closing stock of WIP
500
Equivalent production
Material
Overhead
%
Qty.
%
Qty.
%
240
60*
240
60*
240
60*
2,100
400
100
80
2,100
300
100
60
2,100
300
100
60
400
3,000
Labour
Qty.
3,000
Equivalent units
2,740
2,640
2,640
*Opening stock is only 40% complete, it requires the remaining 60% material, labour and
overhead for completion.
Statement of Cost
Materials
Labour
Overhead
Total cost
(A) `
Equivalent
units (B)
68,500
79,800
21,280
2,740
2,640
2,640
Per unit (a ÷ b)
`
25.00
30.23
8.06
Total
63.29
Statement of Evaluation
Items
Cost
element
Equivalent
units
Rate
`
Amount
`
Opening WIP
Material
Labour
Overhead
240
240
240
25.00
30.23
8.06
6,000
7,252
1,934
15,186
(Contd...)
Process Costing
8.21
Introduced and
completed
Material
Labour
Overhead
2,100
2,100
2,100
25.00
30.23
8.06
52,500
63,483
16,926
1,32,909
Closing WIP
Materials
Labour
Overhead
400
300
300
25.00
30.23
8.06
10,000
9,068
2,417
21,485
Process Account
Particulars
Units
To Opening WIP
To Material
To Labour
To Overhead
`
400
2,600
8,000
68,500
79,800
21,280
3,000
1,77,580
`
Particulars
Units
By Finished stock
By Closing WIP
2,500 1,56,095*
500 21,485
3,000 1,77,580
* Note: Cost of finished goods of 2,500 units comprises as follows:
Opening stock (400 units) `8,000 + 15,186
Introduced and completed (2,100 units)
`23,186
1,32,909
Total
1,56,095
Average Cost Method
In this method, the cost of opening work-in-progress is not kept separately but is averaged
with the additional costs incurred during the period. This method thus combines the cost of
opening work-in-progress and new production. Information relating to degree of completion
of opening WIP is not required.
In order to find out the cost per unit of equivalent production, the cost of each element
(material, labour and overheads) applicable to the opening work-in-progress is added to the
cost incurred in the current period for that element. A single cumulative total and unit cost is
obtained. Units completed and transferred as well as closing work-in-progress will be valued
at this average unit cost. The use of average method is illustrated below.
Illustration 8.12
The following figures related to single industrial process:
`
Opening stock (10,000 units):
Material
2,250
Wages
650
Overheads
400
3,300
`
Units introduced (40,000 units):
Material
9,250
Labour
4,600
Overheads
3,100
During the period 30,000 units were completed and 20,000 units remained in process.
The degree of completion of closing stock or WIP was as under:
Materials
100%
Labour
25%
Overheads
25%
Make the necessary computations and prepare Process Account by using average method.
Process Costing
8.22
Solution
Statement of Equivalent Production
Input
units
10,000
40,000
Particulars
Output
units
Opening work-in-progress
Units started and finished
(40,000 – 20,000)
Closing work-in-progress
(Material 100% complete,
labour and overhead 25%)
50,000
Equivalent production
Material
Labour & overhead
10,000
10,000
10,000
20,000
20,000
20,000
20,000
20,000
5,000
50,000
35,000
50,000
Equivalent Units
Statement of Cost
Cost element
Materials
Wages
Overhead
(A)
Opening
cost
`
(B)
Cost
put in
`
(C)
Total cost
(A + B)
`
(D)
Equivalent
production
units
(C ÷ D)
Cost
per unit
`
2,250
650
400
9,250
4,600
3,100
11,500
5,250
3,500
50,000
35,000
35,000
0.23
0.15
0.10
Total
0.48
Statement of Evaluation
Cost of finished goods
30,000 units @ `0.48
Closing work-in-progress:
Materials (100% complete)
20,000 × `0.23
Labour
(25% complete)
5,000 × `0.15
Overheads (25% complete)
5,000 × ` 0.10
=
`14,400
=
=
=
`4,600
`750
`500
Cost of closing WIP
=
`5,850
Process Account
Particulars
Units
`
To Opening WIP
To Material
To Wages
To Overhead
10,000
40,000
—
—
3,300
9,250
4,600
3,100
50,000
20,250
Particulars
By Completed
and transferred
By Closing
work-in-process
Units
`
30,000
14,400
20,000
5,850
50,000
20,250
Process Costing
8.23
FIFO Method vs Average Cost Method
Both FIFO and average methods have certain advantages and it cannot be said that one
method is either simpler or more accurate than the other. The main difference between these
two methods is regarding the treatment of the opening stock-in-progress.
In FIFO method, opening stock of work-in-progress is kept as a separate figure. Costs
incurred to complete this opening work-in-progress are added to the opening work-in-progress
cost and the sum of these two costs is the total cost of completed units of opening work-inprogress at which it is transferred to the next process. The units which are introduced in the
process and finished during the same period have their own cost per unit which may be
different from the completed cost per unit of opening work-in-progress.
In average cost method, on the other hand, the cost of opening work-in-progress is added
to material, labour and overhead costs incurred during the period. The cost per unit is computed
by dividing the total of these costs by equivalent units.
How to choose between FIFO and Average Method
Both FIFO and Average methods have advantages and disadvantages. If one were to choose
between these methods in an examination question, the following rules may be followed:
1. Use FIFO – If the cost of the opening work-in-progress in one lump sum figure
and the stage of completion is given. For Example:
Given:
Opening work-in-progress
Cost
Stage of completion:
1,000 units
`18,000
Materials
100%
Labour
60%
Overheads
60%
2. Use Average – If the cost of opening work-in-progress is given in terms of materials,
labour and overhead but the stage of completion is not given. For example:
Given:
Opening work-in-progress
1,000 units
Cost— Materials
`10,000
Labour
`4,000
Overheads
`4,000
3. FIFO or Average—Your Choice – If the degree of completion and the cost in
terms of materials, labour and overheads of the opening work-in-progress are given,
then one has a choice between FIFO and Average methods. For example:
Given:
Opening work-in-progress
1,000 units
Degree of completion and cost:
Material
(100% Complete)
`10,000
Labour
(60% Complete)
`4,000
Overhead
(60% Complete)
`4,000
4. Where the question specifies a method to be followed, then that method must be
followed.
Illustration 8.13
The following information relates to Process X for May 2017:
Opening work-in-progress
Introduced during the month
200 units
1,600 units
Process Costing
8.24
Completed during the month
Closing work-in-progress
1,480 units
320 units
Degree of Completion
Opening work-in-progress
Closing work-in-progress
Costs:
Opening work-in-progress
Costs incurred during the period
Material
100%
100%
`
2,400
19,200
Labour
50%
25%
`
320
6,368
Overheads
50%
25%
`
3,210
6,368
Assuming materials were introduced in the beginning of the process and labour and overhead
were incurred uniformly throughout the process, prepare process account using:
(a) FIFO Method (b) Average Method.
Solution
(a) FIFO Method
(i)
Input
Statement of Production
Particulars
Equivalent units
Output
units
units
Material
Labour
Overhead
Units
%
Units
%
Units
%
—
—
100
100
100
—
1,280
80
50
—
100
25
100
—
1,280
80
50
200
1,600
—
—
Opening WIP
Units introduced
Finished output
Closing WIP
200
—
1,280*
320
—
—
1,280
320
1,800
Total
1,800
1,600
1,460
100
25
1,460
* Units introduced and completed during the month
= Units completed – Units of opening W.I.P
= 1,480 – 200 = 1,280 units.
(ii)
Cost element
Material
Labour
Overhead
Statement of Cost
`
(A)
Equivalent units
(B)
Cost per unit ( ` )
(A ÷ B)
19,200
6,368
6,368
1,600
1,460
1,460
12.00
4.36
4.36
Total
20.72
(iii)
Statement of Evaluation
Particulars
Elements of
cost
Equivalent
units
Per unit
`
Cost
`
Total
cost
Opening WIP
Material
Labour
Overhead
—
100
100
—
4.36
4.36
—
436
436
—
872
(Contd...)
Process Costing
8.25
Finished Production
Closing WIP
Material
Labour
Overhead
1,280
1,280
1,280
12.00
4.36
4.36
15,360
5,583
5,583
26,526
Material
Labour
Overhead
320
80
80
12.00
4.36
4.36
3,840
349
349
4,538
Process A Account
Particulars
Units
`
To Opening WIP
200
(2,400 + 320 + 320)
To Material
1,600
To Labour
To Overhead
19,200
6,368
6,368
1,800
34,976
(b) Average Method
(i)
Input
Particulars
3,040
Units
By Completed production
(3,040 + 872 + 26,526) 1,480
By Closing WIP
320
30,438
4,538
1,800
34,976
Statement of Production
Output
Particulars
Equivalent Units
Labour
Overhead
Materials
200
1,600
Indentity is
lost
1,480
320
1,800
`
Opening WIP
Finished Production
Closing WIP (Labour
and overhead 25%)
1,800
(ii)
—
—
—
1,480
1,480
1,480
320
80
80
1,800
1,560
1,560
Equivalent
units
Cost per
unit
`
1,800
1,560
1,560
= 12.00
= 4.29
= 4.29
Statement of Cost
Opening W.I.P. + Cost incurred =
`
`
Material
Labour
Overhead
2,400
320
320
+
+
+
19,200
6,368
6,368
=
=
=
Total
`
21,600
6,688
6,688
÷
÷
÷
Total
20.58
(iii)
Statement of Evaluation
Particulars
Element of
cost
Equivalent
units
Per unit
`
Cost
`
Total
cost `
Finished units
Material
Labour
Overhead
1,480
1,480
1,480
12.00
4.29
4.29
17,760
6,345
6,345
30,450
Material
Labour
Overhead
320
80
80
12.00
4.29
4.29
3,840
343
343
4,526
Closing WIP
Process Costing
8.26
Process Account
Units
To Opening WIP
To Material
To Labour
To Overhead
`
200
1,600
—
—
3,040
19,200
6,368
6,368
1,800
34,976
Units
`
By Finished output
1,480
30,450
By Closing WIP
320
4,526
1,800
34,976
JOINT PRODUCTS AND BY-PRODUCTS
In most of the industries in which process costing is used, two or more products are
unavoidably produced from the same process and same raw materials. These products
are produced in natural proportions which cannot be changed at the will of the
management. For example, in an oil refinery, when crude oil is processed, many products
are simultaneously produced from the same set of inputs. Examples of these products
are petrol, kerosene oil, diesel, grease and lubricating oils. Such products are known as
joint products or by-products.
Joint Products
The term joint products is used for two or more products of almost equal economic
value, which are simultaneously produced from the same manufacturing process and
the same raw material. Joint products thus represent two or more products separated
in the course of processing, each product being in such proportion and of such economic
significance that no single one of them can be regarded as the main product.
Characteristics Characteristics of joint products are:
(a) Joint products are produced from the same raw material in natural proportions
(b) They are produced simultaneously by a common process
(c) They are comparatively of almost equal value
(d) Joint products may be saleable after separation or may be further processed
by incurring additional costs to make them saleable or an improved product
A classic example of joint products, as given above, is found in oil refining, where
items like petrol, diesel, naptha and kerosene are produced from the crude oil. Other
examples are in flour mill, where joint products are white flour, brown flour, animal
feeding stuff; in meat canning where joint products are hides, canned meat, fertilizers,
etc. The term joint product is also used to describe various qualities of the same product,
as for example, many grades of coal which may be produced in coal mining.
Joint Products and Co-products
Joint products should be distinguished from co-products. Co-products refer to more than
one product being manufactured by a company but need not necessarily arise from the
same raw material and manufacturing process and the quantity of each co-product can
be changed by the management. For example, in a bakery the various co-products are
bread, cake, biscuits, etc. and the quantity of each such product may be changed by
the management as per needs. On the other hand, in joint products like meat and hides
produced in meat industry, the quantity of any of these products cannot be changed at
will without changing the quantity of other products.
Process Costing
8.27
Examples of Joint Products
Industry
Joint Products
1. Oil refining
Petrol, diesel, kerosene, grease, lubricating oils, etc.
2. Dairy
Skimmed milk, butter
3. Meat processing Meat, hides
4. Mining
Several metals from the same ore, e.g., copper, silver, zinc, etc.
Several grades of coal produced from coal mining
Joint Costs and Subsequent Costs
Joint costs are those costs which are incurred before that stage in manufacture at which
the products get separated. It comprises raw material, labour and overheads.
Subsequent (or attributable) costs, on the other hand, are those costs which are
incurred after the separation or split-off point. These are separately incurred for individual
joint or by-products and thus are identifiable with each product. Subsequent costs are
also knows as ‘after separation costs’ or ‘after split-off costs’.
The distinction between joint costs and subsequent costs is important because when
accounting for products, the joint costs are the main problem. This is because joint costs
cannot be traced to individual products and the cost accountant is faced with the problem
of apportioning the joint costs incurred to various joint products produced.
Subsequent costs, on the other hand, pose no accounting problem because such
costs relate to individual products. These are, therefore, charged to the appropriate
product and not regarded as joint. It should be noted and remembered that selling and
distribution costs are virtually always subsequent costs.
Accounting for Joint Products
Accounting for joint products means the apportionment of joint cost to each of the joint
product. Such apportionment serves the following objectives:
(a) To determine the cost per unit of products
(b) To help in inventory valuation
(c) To determine the profit or loss on each line of product
(d) To determine the price of each product
The various methods of apportionment of joint costs (discussed below) are based
mainly on individual opinion and tend to produce only approximate results. This is
because no perfectly logical basis exists for the apportionment of joint costs to
products and most of the methods are arbitrary. Therefore, while selecting a
particular methods it should be kept in mind that the method should be logical,
appropriate and reliable and should be
consistently followed. Following are the
Methods of Apportionment
main methods of apportionment of joint
of Joint Cost
costs over joint products:
1. Sales Value Method
2. Reverse Cost Method
1. Sales Value Method Under this method,
3. Physical Units Method
joint costs are apportioned to various joint
products on the basis of sales value of each
4. Average Unit Cost Method
such product. The sale value method has the
5. Survey Method
following variants:
Process Costing
8.28
(a) On the basis of unit prices In this method, the selling prices per unit of
various joint products is taken as the basis for apportionment of joint costs. In other
words, joint cost is apportioned to various joint products in the ratio of selling prices of
individual joint products without any regard to the quantities. It is thus suitable when
the number of units of production of all the products are equal. It is illustrated below
with assumed figures.
Example:
Joint Cost `9,000
Products
A
B
C
Selling price
per unit
`
Apportioned cost
(Ratio 12 : 8 : 4)
`
12
8
4
4,500
3,000
1,500
`9,000
(b) On the basis of sales value In this method, the apportionment is done on
the basis of weighted sales value, i.e., number of units produced and sold × selling
price per unit. This method thus gives due consideration to the quantities of various
joint products produced. The difference between the method based on unit selling
prices discussed earlier and this method is that while the former gives no consideration
to the quantities of joint products produced, the latter gives due importance to the
quantities. This method will give satisfactory results even when number of units of
different joint products are widely different. The method is illustrated below with
assumed figures:
Example:
Products
A
B
C
Joint cost `9,000
Selling price
per unit
Production quantities
units
Sales value
(a) × (b)
(a) `
(b)
(c) `
Apportioned
joint cost
(24 : 48 : 28)
(d) `
12
8
4
200
600
700
2,400
4,800
2,800
2,160
4,320
2,520
10,000
9,000
Total
2. Reverse Cost Method or Net Realisable Value Method In this method, the joint
cost is apportioned on the basis of net value of each product. The net realisable value
is calculated by deducting the following from the sales value.
(a) Estimated profit margin
(b) Selling and distribution costs, if any
(c) After split off processing costs
The net realisable values of individual products so obtained are taken as the basis
for apportioning joint costs. This is known as reverse cost method because net realisable
values are calculated by working backwards from sales values. This method is
particularly used when products are not sold at their stage at split off point but require
further processing. Operation of this method is illustrated below.
Process Costing
8.29
Illustration 8.14 In processing a basic raw material, three joint products ‘X’, ‘Y’ and
‘Z’ are produced. The joint expenses of manufacturing are: Materials `10,000; Labour
`8,000; Overheads `9,000 (Total `27,000). Subsequent expenses are as follows:
Material
Labour
Overheads
Total
X
`
2,000
2,500
2,500
7,000
Y
`
1,600
1,400
1,000
4,000
Z
`
1,800
1,700
1,500
5,000
Sales Value
42,000
20,000
18,000
Estimated profit on sales
50%
50%
33 1/3 %
Show how you would apportion the joint costs of manufacture by Reverse Cost Method.
Solution:
Statement of Apportionment of Joint Costs
X
`
Y
`
Z
`
Sales value
Less: Estimated profit on sales
42,000
21,000
20,000
10,000
18,000
6,000
Estimate total cost
21,000
10,000
12,000
Less: Subsequent costs (total)
7,000
4,000
5,000
14,000
6,000
7,000
Joint costs (`27,000) apportioned
3. Physical Units Method Under this method, the joint cost is apportioned on the
basis of relative weight, volume or quantity, etc., of each product, obtained at the point
where the split-off occurs. For the method to be suitable, the unit of measurement should
be applicable for all products, e.g., usually gases, liquids and solids cannot be taken
together. However, where joint products cannot be measured by the same measurement
unit, the joint products must be converted to a denominator common to all the units
produced. For instance in the manufacture of coke, products such as coke, coal tar,
benzol, sulphate of ammonia, gas, etc., are measured in different units. The yield of
these recovered units is measured on the basis of quantity of product extracted per
tonne of coal. This is illustrated below.
Illustration 8.15
The following data have been extracted from the books of Coke Co. Ltd:
Joint products
Coke
Coal tar
Benzol
Sulphate of ammonia
Gas
Yield (in lbs) of recovered
products per tonne of coal
1,420
120
22
26
412
2,000
The price of coal is `80 per tonne. The direct labour and overhead costs to the point
of split-off are `40 and `60, respectively, per tonne of coal.
Calculate the material, labour and total cost of each product on the basis of weight.
Process Costing
8.30
Solution
Statement of Apportionment of Joint Cost
Yield
in lbs
`
% of
total
`
Apportionment of cost
Coal
Direct
Overhead
labour
`
`
`
Coke
Coal tar
Benzol
Sulphate of ammonia
Gas
1420
120
22
26
412
71.0
6.0
1.1
1.3
20.6
56.80
4.80
0.88
1.04
16.48
28.40
2.40
0.44
0.52
8.24
42.60
3.60
0.66
0.78
12.36
127.80
10.80
1.98
2.34
37.08
Total
2,000
100
80.00
40.00
60.00
180.00
Total
`
4. Average Unit Cost Method In this method, the joint cost is apportioned by using
the average unit cost which is obtained by dividing the total joint cost by the total number
of units produced of all the products. The average cost per unit of each product is the
same. The procedure is illustrated as follows.
Illustration 8.16 From the following particulars, find out the cost of joint products A,
B and C under the average unit cost method.
(a) Pre-separation point cost `30,000
(b) Other production data:
Product
X
Y
Z
Units produced
1,000
400
600
2,000
Solution
Average unit cost
=
`30,000
Joint cost
= 2,000 units  `15 per unit
Total no. of units produced
Statement of Apportionment of Joint Cost
Product
Units produced
(A)
Average cost
` (B)
Apportioned cost
( `) A × B = C
X
Y
Z
1,000
400
600
15
15
15
15,000
6,000
9,000
Total
2,000
30,000
5. Survey Method This method apportions the joint cost to various products, on the
basis of the results of a survey or technical evaluation. In this survey, various factors,
like volume, selling price, marketing process, etc., are studied and points or weights are
assigned to each product. Costs are apportioned on the basis of such weights or points.
Process Costing
8.31
Illustration 8.17 X, Y and Z are the three joint products in a factory. Their joint cost
is `30,000. Quantities produced are as follows:
X
Y
Z
1,000
400
600
On the basis of technical evaluation, points allotted to X, Y and Z products are 3.2,
5 and 8 per unit, respectively. Apportion the joint cost.
Solution
Statement of Apportionment of Joint Cost
Product
X
Y
Z
Units
produced
Points
assigned
Weighted
units
(a)
(b)
(c) = (a) × (b)
1,000
400
600
3.2
5.0
8.0
Total
3,200
2,000
4,800
*Cost per
weighted
unit
(d)
`
3.00
3.00
3.00
Apportioned
cost
(32 : 20 : 48)
(e)
`
9,600
6,000
14,400
10,000
3.00
30,000
Joint cost
`30,000
* Total number of weighted units  10,000 = `3 per unit.
By-Products
By-products are products of relatively small value which are incidentally and unavoidably
produced in the course of manufacturing the main product. For example, in sugar mills,
the main product is sugar. But baggasse and molasses of comparatively smaller value
are incidentally produced and thus are by-products. Other examples of by-products are
oil cake produced in the extraction of edible oil; cotton seed produced in cotton textile
industry, etc. These by-products are unavoidably produced and are of secondary value.
The sales value of these by-products is much less as compared to the main product.
For example, sales value of by-products bagasse and molasses is much less than that
of the main product sugar.
By-products may be:
(a) Those sold in their original form without further processing
(b) Those which require further processing in order to be saleable
Examples of By-products
Industry
1. Sugar
2. Cotton textile
3. Edible oil
4. Meat
5. Rice mills
By-products
Bagasse, Molasses
Cotton seed
Oil cake
Bones
Husk
Distinction between Joint Products and By-products
There are no hard and fast rules to distinguish between joint products and by-products.
A product may be treated as a joint product in one business and the same product may
be treated as a by-product in another business. However, the following factors should
Process Costing
8.32
be considered to determine if a product is a joint product or aby-product.
(a) Relative sales value If the sales value of all the products are more or less
equal, they are treated as joint products. If, however, there are wide differences
in the relative sales values of products, the product with the greater sales value
is treated as the main product and the products of lower value are treated as
by-products.
(b) Objective of manufacture If the objective of manufacturing is product A,
then unwanted products B and C be treated as by-products.
(c) Policy of management The management may decide to treat a particular
product as the main product and the other products as by-products.
Alternatively, it may choose to treat all products as joint products.
By-products, Scrap and Waste
By-products should not be confused with waste or scrap. Waste is used to describe a
material which has no value or even negative value, if it has to be disposed of at some
cost. Examples of waste are gases, smoke and other unsaleable residues from the
manufacturing process.
Scrap is also different from by-products in the sense that it is the leftover part of
the raw materials whereas by-products are different from the material which went into
the production process. Small pieces of wood left in furniture manufacture or metal
sheet pieces left in utensil manufacture are examples of scrap, whereas minor chemicals,
having some value, emerging from a chemical process are classified as by-products.
Sale value of scrap is relatively less than that of by-products. However accounting
treatment for scrap and by-products is quite similar.
Accounting for By-products
Various methods of accounting for by-products are as follows:
1. Where by-products are of small total value In such a case it is not considered
practicable to apportion any part of the joint cost to by-products. The net income realized
by the sale of by-products may be treated in any one of the following two ways:
(i) It may be treated as ‘miscellaneous income’ and credited to the Costing Profit
and Loss Account.
(ii) It may be credited to the process account in which the by-product has arisen.
In determining the net income from by-products, the following should be deducted
from the sales value of by-products: (i) any selling and distribution expenses incurred
in the sale of by-products; and (ii) any costs incurred in further processing of byproducts to make them saleable.
2. Where by-products are of considerable total value Where by-products are
of considerable sales value, it is proper to apportion a part of the joint cost to by-products.
Such apportioned cost of by-products is debited to by-product account and credited to
the main product account or the relevant process account. Any cost incurred in further
processing of the by-product is debited to by-product account. The by-product account
is credited with its sales value and any profit/loss arising out of this account is
transferred to costing Profit and Loss Account.
Process Costing
8.33
The apportionment of joint cost to by-products can be done by any of the four
methods discussed earlier in costing of joint products. These methods are: (i) Sales value
method; (ii) Physical units method; (iii) Average cost method; and (iv) Points value or
survey method.
3. Where by-products require further processing In such situations, the share
of by-product in joint-cost at the split-off point may be arrived at by subtracting the
profit and the further processing cost from the realizable value of the products, i.e., by
using Reverse Cost Method. In case the cost of the by-products at the split-off point is
small or negligible, it may be treated as per the method (a) discussed above. On the
contrary, if it is of considerable amount, it is treated as per method (b) discussed above,
i.e., joint cost is apportioned to by-products.
Illustration 8.18 Product Z yields two by-products A and B. The joint cost of
manufacture is `65,800. From the following information, show how would you apportion
the joint cost of manufacture:
Z
A
(i) Sales `
1,00,000
40,000
(ii) Manufacturing costs after separation `
5,000
(iii) Estimated selling expenses on sales
20%
(iv) Estimated profit on sales
25%
Solution
Statement of Cost of By-products—A and B
Sales
Less: Profit
Less: After separation costs
Selling expenses
Share in joint cost
B
25,000
4,000
20%
30%
A (` )
B (` )
40,000
10,000
25,000
7,500
30,000
17,500
5,000
8,000
4,000
5,000
17,000
8,500
Statement of Cost of Product Z
`
Total joint cost
Less: Joint cost apportioned to A
B
Cost of Product Z
17,000
8,500
`
65,800
25,500
40,300
4. Where by-product is utilized in the undertaking itself In those cases where
by-products are used by the company itself as a raw material for some other process,
such by-products may be priced at the opportunity cost. The opportunity cost is that
cost which would have been incurred had the by-product been purchased from an outside
firm. For example, a company is running a sugar plant as well as a paper plant. The
bagasse, a by-product of sugar plant, may be utilized in manufacture of paper as raw
material. So credit for the cost of the bagasse would be given to the sugar cost at the
price which the company would have otherwise paid to buy it from an outside firm for
the manufacture of paper.
Process Costing
8.34
Decision regarding Further Processing of Joint and By-products
Apportionment of joint costs is not relevant in decision making regarding further
processing of joint or by-products. Whenever management has to take a decision
whether or not to further process a joint product or by-product after split-off, decision
will be taken by comparing the incremental revenue after split-off point with the
incremental cost after split-off point. So long as the incremental revenue is more than
the incremental cost on further processing of a joint or a by-product, it is profitable to
further process the product, not otherwise.
Illustration 8.19 A company produces two joint products P and Q, their cost upto
separation point being `47,000. These products can be sold at the split-off point at `150
and `350 per unit, respectively. Alternatively, the two products can be further processed at
a cost of `15,000 and `12,000, respectively. After further processing these can be sold at
`320 and ` 500 per unit, respectively. The output of P is 150 units and of Q is 60 units.
Advise whether these products should be sold at split-off point or these should be
processed further.
Solution
Statement Showing Incremental Profit/Loss
Output
Incremental revenue from further processing
P (`320 – 150) × 150 units
Q (`500 – 350) × 60 units
Less: Incremental cost
Incremental Profit/loss (–)
Product P
150 units
`25,500
Product Q
60 units
15,000
`9,000
12,000
10,500
(–) 3,000
Conclusion Product P should be processed further because it gives an incremental
profit of `10,500 whereas product Q should be sold at split-off point because it results
in incremental loss of `3,000.
Limitations of Joint Cost Analysis
Analysis of joint cost over joint products and by-products suffers from the following
limitations.
1. Apportionment of joint cost over various products is mainly arbitrary and the
true costs of various individual products cannot be known.
2. Apportionment of joint cost is based on certain assumptions which may be
unrealistic or even misleading.
3. Arbitrary apportionment of joint costs makes inter-firm comparison difficult.
4. There is no clear cut distinction between joint products and by-products. Different
firms may treat them differently.
5. Where by-products are of very small value, no worthwhile purpose is served
by joint cost analysis.
6. When management has to take a decision as to whether sell the products at
the split off point or to further process the products, joint cost analysis is not
very relevant for such decision making.
Process Costing
8.35
PROBLEMS AND SOLUTIONS
Problem 8.1 In a manufacturing unit, the raw material passes through four processes
I, II, III and IV and the output of each process is the input of the subsequent process.
The loss in the four processes I, II, III and IV are respectively 25%, 20%, 20% and
16 2 3 % of the input. If the end product at the end of process IV is 40,000 kg, what is
the quantity of raw materials required along with its cost to be fed at the beginning of
Process I when the cost of the same is `5 per kg.
Solution
Output in a process is input minus loss in process. Suppose input in Process I = 100 kg
Output in Process I = 100 – 25%
= 75 kg
Output in Process II = 75 kg – 20%
= 60 kg
Output in Process III = 60 kg – 20%
= 48 kg
Output in Process IV = 400 kg – 16 2 3 %
= 40 kg
When output in Process IV is 40,000 kg, then input in Process I will be
100
= 1,00,000 kg
= 40,000 kg ¥
40
Thus cost of materials introduced in Process I = 1,00,000 kg at `5 = `5,00,000.
Problem 8.2 From the following particulars, prepare Process X account showing the
cost per tonne of output:
Materials in tonnes
1,000
Manufacturing expenses
`10,000
Cost of material per tonne
`125
Wages
`26,000
Output in tonnes
830
It is ascertained that in the process normally 5% of the total weight is lost and 10% is
scrap which realizes `80 per tonne. There was no stock or work-in-progress.
Solution
Process X Account
Particulars
Tonnes
`
1,000 1,25,000 By Weight
26,000 By Scrap @ `80
10,000 By Abnormal Loss @ `180*
By Output @ `180
per tonne*
50
100
20
830
—
8,000
3,600
1,49,400
1,000 1,61,000
1,000 1,61,000
Tonnes
To Materials
To Wages
To Mfg. expenses
1, 61, 000 – 8,000
`
Particulars
1,53,000
*Cost per unit = 1000 – (50 + 100) = 850 = `180
Problem 8.3 A product passes through two processes. The output of Process I becomes
the input of Process II and the output of Process II is transferred to warehouse. The
quantity of raw materials introduced into Process I is 20,000 kg at `10 per kg. The cost
and output data for the month under review are as under:
Direct materials
Direct labour
Production overheads
Normal loss
Process I
`60,000
`40,000
`39,000
8%
Process II
`40,000
`30,000
`40,250
5%
Process Costing
8.36
Output
`18,000
`17,400
Loss realization of `/unit
2.00
3.00
The company’s policy is to fix the selling price of the end product in such a way as to
yield a profit of 20% on selling price.
Required:
(i) Prepare the Process Accounts
(ii) Determine the selling price per unit of the end product.
(CA PE II)
Solution
(i)
Process I Account
Particulars
`
kg
Particulars
kg
`
1,600
400
3,200
7,300
To Raw materials
20,000 2,00,000 By Normal loss
To Direct materials
60,000 By Abnormal loss
To Direct labour
40,000
To Production overhead
39,000 By Transfer to Process II
18,000 3,28,500
20,000 3,39,000
20,000 3,39,000
`3,39,000 – 3,200
3,35,800
=
= `18.25
` 20,000 – 1,600 kg 18, 400 kg
Cost per kg of output
=
Cost of abnormal loss
= 400 kg @ `18.25 = `7,300
Process II Account
Particulars
`
kg
Particulars
kg
`
To Process I account 18,000 3,28,500 By Normal loss
To Direct materials
40,000 By Transfer warehouse
To Direct labour
30,000
To Production overhead
40,250
To Abnormal gain
300
7,650
900
2,700
17,400 4,43,700
18,300 4,46,400
18,300 4,46,400
Cost per kg of output
Cost of abnormal gain
(ii) Selling price per kg
` 4,38,750 – 2,700 ` 4,36,050
=
= ` 25.50
18,000 – 900 kg
17,100 kg
= 300 kg @ `25.50
= `7,650
100
= `25.50 ×
= ` 31.875
80
=
Problem 8.4 Product B is obtained after it passes through three distinct process. The
following information is obtained from the accounts for the week ending 31 October 2021:
Items
Direct materials
Direct wages
Production overhead
Total
`
7,542
9,000
9,000
I
`
2,600
2,000
Process
II
`
1,980
3,000
III
`
2,962
4,000
1,000 units at `3 each were introduced to Process I. There was no stock of material or
work-in-progress at the beginning or at the end of the period. The output of each process passes
direct to the next process and finally to finished stock. Production overhead cost is recovered
Process Costing
8.37
on 100% of direct wages. The following additional data are obtained:
Process
Output during the
Percentage of norValue of scrap
week
mal loss to input
per unit `
Process I
950 units
5%
2
Process II
840
10%
4
Process III
750
15%
5
Prepare process cost accounts and abnormal gain or loss accounts.
(B.Com., Hons. Delhi)
Solution
Process I Account
Particulars
Units
`
To Units introduced
To Direct materials
To Direct wages
To Production
Overhead (100%
of direct wages)
1,000
3,000
2,600
2,000
Particulars
Units
`
By Normal loss
By Process II
(Balance figure)
50
950
100
9,500
1,000
9,600
Units
`
95
15
380
300*
840
16,800
950
17,480
Units
`
126
750
630
28,500
876
29,130
Units
`
15
60
15
300
2,000
1,000
9,600
Process II Account
Particulars
Units
`
To Process I (transfer) 950
To Direct materials
To Direct wages
To Production overhead
9,500
1,980
3,000
3,000
950
17,480
*Abnormal loss =
Particulars
By Normal loss
By Abnormals loss
By Process III
(transfer)
`17, 480 `380
× 15 units = `300.
950 95 units
Process III Account
Particulars
Units
`
To Process II (transfer) 840
To Direct materials
To Direct wages
To Production overheads
To Abnormal gain
36
16,800
2,962
4,000
4,000
1,368*
876
29,130
*Abnormal gain =
Particulars
By Normal loss
By Finished stock
`27, 762 ` 630
× 36 units = `1,368.
840 126 units
Abnormal Loss Account
Particulars
Units
`
Particulars
To Process II
15
300
By Sale of scrap
(@ `4 per unit)
By Costing P&L A/c
15
300
240
Process Costing
8.38
Abnormal Gain Account
Particulars
Units
`
Particulars
Units
`
36
180
By Process III
36
1,368
36
1,368
36
1,368
To Normal Loss A/c
(shortfall in the sale
of normal loss @
`5 per unit)
To Costing P&L A/c
1,118
Normal Loss Account
Particulars
Units
`
Particulars
Units
`
To Process I
To Process II
To Process III
50
95
126
100
380
630
By Cash (sales)
By Abnormal gain A/c
235
36
930
180
271
1,110
271
1,110
Problem 8.5 A product manufactured by the Standard Chemicals Ltd passes through
three processes—I, II and III. The following costs have been incurred for the month of
September 2021:
1. Materials Consumed
2. Direct Wages
3. Direct Expenses
Process I
(` )
40,000
22,500
20,500
Total ` 83,000
Process II
(`)
7,500
10,000
2,250
Process III
(` )
5,000
10,000
2,505
19,750
Units
3,900
Units
3,850
Units
3,200
600
500
550
800
800
Nil
24.50
2
31.00
5
37.00
10
13.50
16.25
21.00
17,505
4. Output
5. Finished Process Stock:
(i) 01-9-2021
(ii) 30-9-2021
6. Stock Valuation on
01-9-2021 (` per unit)
7. Percentage of wastage
8. Net Realizable Value of
wastage per unit (`)
Four thousand units of raw materials were introduced in Process I at a cost of Rupees
twenty thousand.
Stocks are valued and transferred to subsequent processes at weighted average cost. The
percentage of wastage is computed on the number of units entering the process concerned.
Prepare (i) Process A/cs; (ii) Process Stock A/cs; (iii) Normal Wastage A/c; (iv) Abnormal
wastage/Effective A/c.
Process Costing
8.39
Solution
Process I Account
Particulars
Units
`
To Units introduced
To Materials
To Direct wages
To Direct expenses
4,000
20,000
40,000
22,500
20,500
4,000
*Cost per unit of output =
Particulars
By Normal wastage
By Abnormal wastage*
@ `26 per unit
By Stock A/c @
`26 per unit
1,03,000
Units
`
80
1,080
20
520
3,900 1,01,400
4,000 1,03,000
`1,03,000 1,080
= ` 26.
4,000 80 units
Process I Stock Account
Particulars
Units
`
To Balance b/d
To Process I A/c
600
3,900
14,700
1,01,400
4,500
1,16,100
* Weighted average cost per unit =
Total cost
Total no. of units
`
Particulars
Units
By Process II A/c
@ `25.80*
By Balance c/d
4,000 1,03,200
500
12,900
4,500 1,16,100
`1,16,100
4500 units
` 25.80.
Process II Account
Particulars
Units
`
To Process I Stock A/c 4,000
To Materials
To Direct wages
To Direct expenses
To Abnormal gain
@ `31.50*
50
1,03,200
7,500
10,000
2,250
4,050
1,24,525
*Cost per unit =
`1,22,950
3,250
4,000 200 units
Particulars
Units
`
By Normal wastage
By Stock A/c
(@ `31.50 per unit)*
200
3,250
3,850 1,21,275
1,575
1,19, 700
3,800
4,050 1,24,525
`31.50.
Process II Stock A/c
Particulars
Units
`
To Balance b/d
To Process II A/c
550
3,850
17,050
1,21,275
4,400
1,38,325
* Weighted average cost
`1,38,325
4,400 units
`
Particulars
Units
By Process III A/c
@ `31.4375*
By Balance c/d
3,600 1,13,175
800
25,150
`31.4375 per unit.
4,400 1,38,325
Process Costing
8.40
Process III Account
Particulars
`
Units
To Stock A/c
To Materials
To Direct wages
To Direct expenses
Particulars
3,600 1,13,175
5,000
10,000
2,505
By Normal wastage
By Abnormal
wastage @ `38
By Stock A/c
3,600 1,30,680
Cost per unit =
`1,30,680
7,560
3,600
360 units
1, 23,120
3, 240
Units
`
360
7,560
40
1,520
3,200 1,21,600
3,600 1,30,680
`38.
Process III Stock Account
Particulars
To Balance b/d
To Process III A/c
`
Units
800 29,600
3,200 1,21,600
Units
By Cost of Sales A/c
4,000 1,51,200
4,000 1,51,200
Weighted average cost per unit =
`1,51,200
4,000 units
`
Particulars
4,000 1,51,200
`37.80.
Normal Wastage Account
Particulars
To Process I A/c
To Process II A/c
To Process III A/c
Units
`
Particulars
Units
`
80
200
360
1,080
3,250
7,560
By Cash A/c
80
150
360
50
1,080
2,437.50
7,560
812.50
640
11,890
I
II
III
By Abnormal Gain A/c
640 11,890
Abnormal Wastage Account
Particulars
Units
`
Particulars
Units
`
To Process I A/c
To Proces III A/c
20
40
520
1,520
By Cash A/c
20
40
—
270
840
930
60
2,040
60
2,040
Units
`
50
1,575
50
1,575
I
III
By Costing P&L A/c
Abnormal Gain Account
Particulars
To Normal wastage
(Shortfall in sale)
To Costing P&L A/c
Units
`
50
812.50
762.50
50
1,575
Particulars
By Process II A/c
Process Costing
Problem 8.6
8.41
The following particulars for the last process are given:
`
9,000
—
2,000
3,000
Units
4,000
3,240
—
—
Transfer from the previous process at cost
Transfer to finished stock from the process
Direct wages
Direct material used
The factory overheads in process is absorbed @ 400% of the direct materials. Allowance
for normal loss is 20% of units worked. The scrap value is `5 per unit.
You are required to prepare:
(a) Last Process Account; (b) Normal Wastage Account; and (c) Abnormal Effectives Accounts.
(B. Com.)
Solution
Last Process Account
Particulars
Units
`
By Normal Loss A/c
By Finished stock A/c
@ `6.875*
8,000
4,000
3,240
22,275
26,275
4,040
26,275
(9,000 + 3,000 + 2,000 + 12,000)
(5 × 800)
4,000 – (20% of 4,000)
22,000
= ` 6.875 .
3,200
Particulars
Units
To Transfer from
previous process
4,000
To Direct materials
To Direct wages
To Factory overheads
To Abnormal effectives
@ `6.875*
40
9,000
3,000
2,000
12,000
275
4,040
Cost per unit =
`
Normal Wastage Account
Particulars
Units
`
To Previous Process A/c
800
4,000
800
4,000
Particulars
By Sales A/c
By Abnormal effectives A/c
Units
`
760
40
3,800
200
800
4,000
Units
`
40
275
40
275
Abnormal Effectives Account
Particulars
To Normal wastage A/c
To Costing P&L A/c
Units
`
Particulars
40
200
75
By Previous process A/c
40
275
Problem 8.7 A product passes through three processes—A, B and C. The details of
expenses incurred on the three processes during the year were as under:
Processes
Units introduced
Cost per unit
A
10,000
`100
B
C
Process Costing
8.42
`
`
`
Sundry materials
10,000
15,000
5,000
Labour
30,000
80,000
65,000
Direct expenses
6,000
18,150
27,200
120
165
250
Selling price per unit of output
Management expenses during the year were `80,000 and selling expenses were
`50,000. These are not allocable to the processes.
Actual output of the three process was: A—9,300 units, B—5,400 units and C—2,100 units.
Two-thirds of the output of Process A and one-half of the output of Process B was passed on
to the next process and the balance was sold. The entire output of Process C was sold.
The normal loss of the three processes, calculated on the input of every process was :
Process A—5%, B—15% and C—20%. The loss of Process A was sold at `2 per unit, that of
B at `5 per unit and of Process C at `10 per unit.
Prepare the three Process Accounts and the Profit and Loss Account.
(CA Inter; B. Com. Hons. Delhi)
Solution
Process A Account
Particulars
Units
To Units Introduced
To Sundry materials
To Labour
To Direct expenses
`
10,000 10,00,000
10,000
30,000
6,000
Units
By Normal loss
By Abnormal loss*
By Process B A/c (Tr.)
By Profit & Loss A/c
(Cost of goods sold)
500
1,000
200
22,000
6,200 6,82,000
3,100 3,41,000
10,000 10,46,000
*Cost per unit
`10, 46, 00 1, 000
Units 10, 000 500
Cost of abnormal loss
Transfer to Process B
Cost of goods sold
`
Particulars
10,000 10,46,000
10, 45, 000
= `110
9,500
=
200 units @ `110
= 6,200 units @ `110
= 3,100 units @ `110
=
=
=
`22,000
`6,82,000
`3,41,000
Process B Account
Particulars
To Process A A/c
To Sundry materials
To Labour
To Direct expenses
To Abnormal gain*
Units
`
6,200 6,82,000
15,000
80,000
18,150
130
19,500
Units
By Normal loss
By Process C A/c*
By Profit & Loss A/c
(Cost of goods sold)
930
4,650
2,700 4,05,000
2,700 4,05,000
6,330 8,14,650
6,330 8,14,650
`7,95,150 4, 650
= `150
6, 200 930 units
*Cost per unit
=
Cost of abnormal gain
Transfer to Process C
Cost of goods sold
=
130 units @ `150
= 2,700 units @ `150
= 2,700 units @ `150
`
Particulars
=
=
=
`19,500
`4,05,000
`4,05,000
Process Costing
8.43
Process C Account
Particulars
Units
`
To Process B A/c
To Sundry materials
To Labour
To Direct expenses
2,700
4,05,000
5,000
65,000
27,200
2,700
5,02,200
Particulars
Units
`
By Normal loss
By Abnormal loss*
By Profit & Loss A/c
(Cost of goods sold)
540
60
2,100
5,400
13,800
4,83,000
2,700
5,02,220
Units
`
200
400
60
—
600
34,800
260
35,800
Particulars
Units
`
By Process B
130
19,500
130
19,500
Units
`
3,100
3,72,000
2,700
4,45,500
2,100
5,25,000
18,850
32,450
`5, 02, 200 5, 400
= `230
2, 700 540 units
*Cost per unit
=
Cost of abnormal loss
Cost of goods sold
= 60 units @ `230
= 2,100 units @ `230
=
=
`13,800
`4,83,000
Abnormal Loss Account
Particulars
Units
`
To Process A A/c
200
22,000
To Process C A/c
60
13,800
260
Particulars
By Sale of Process A’s
loss
By Sale of Process C’s
loss
By Profit & Loss A/c
35,800
Abnormal Gain Account
Particulars
To Normal loss
(shortfall in sale)
To Profit and Loss A/c
Units
`
130
650
18,850
130
19,500
Profit and Loss Account
Particulars
Units
`
To Process A A/c
3,100
3,41,000
To Process B A/c
2,700
4,05,000
To Process C A/c
2,100
4,83,000
To Management expenses
To Selling expenses
To Abnormal loss A/c
80,000
50,000
34,800
7,900 13,93,800
Particulars
By Sales (Process A’s
output @ `120
By Sales (Process B’s
output @ `165)
By Sales (Process C’s
output @ `250)
By Abnormal gain A/c
By Net loss
7,900 13,93,800
Note: A similar problem has been solved by two alternative methods in Illustration 8.6.
Process Costing
8.44
Problem 8.8 A product passes through two processes. The output of process I becomes
the input of process II. The quantity of raw materials introduced in process one is 20,000 kg
at `10 per kg. The cost and output data for the month as follows:
Process I
Process II
Direct materials (`)
60,000
40,000
Direct labour (`)
40,000
30,000
Production overheads (`)
39,000
40,250
Normal loss
8%
5%
Output (in units)
18,000
17,400
Loss realisation of `/unit
2.00
3.00
The company’s policy is to fix the selling price of the end product in such a way as to yield
a profit of 20% on selling price. Prepare process A/c and determine the selling price per unit
of end product.
Solution
Process I Account
Particulars
kg.
To Units introduced
@ `10 kg
To Direct Materials
20,000
To Direct Labout
`
2,00,000
60,000
40,000
To Production Overhead
20,000
Particulars
kg.
`
By Normal Loss @ `2
(8% of 20,000)
By Abnormal Loss
@ `18.25
By Process II A/c
(@ 18.25)*
1,600
3,200
400*
7,300
39,000
3,39,000
18,000 3,28,000
20,000 3,39,000
* Abnormal loss (in kg.) = 20,000 – 18,000 – 1,600 = 400 kg.
* Cost per kg.
`3,39,000 – `3,200
20,000 kg – 1,600 kg
=
`3,35,800
18,400 kg
= `18.25
Process II Account
kg.
`
18,000
300*
3,28,500
40,000
30,000
40,250
7,650
18,300
4,46,400
Particulars
To Process I A/c
To Direct Materials A/c
To Direct Labout A/c
To Production Overhead
To Abnormal gain
(@ `25.50)*
Add:
Particulars
kg.
`
By Normal Loss @ `3
(5% of 18,000)
By Finished Stock A/c
(@ `25.50)*
900
2,700
17,400 4,43,700
18,300 4,46,400
Cost price per kg.
` 25.50*
Profit 20% of selling price (or 25% of cost price)
` 6.375
Selling price of the end product
` 31,875
Process Costing
8.45
` 4,38,750  2,700
* Cost per kg. =
18,000  900 kg

` 4,36,050
17,100 kg
 ` 25.50
* Abnormal Gain = 18,000 kg – 17,400 – 900 = 300 kg.
Value
300 × `25.50 = `7,650
Problem 8.9 XY Company mixes powdered ingredients in two different processes to
produce one product. The output of Process 1 becomes the input of Process 2 and
the output of Process 2 is transferred to the packing department.
From the information given below, you are required to open accounts for Process 1, Process
2, Abnormal Loss and Packing Department.
Process 1
Input:
Material A
6,000 kilograms at 50 paise per kilogram.
Material B
4,000 kilograms at `1 per kilogram.
Mixing Labour
430 hours at `2 per hour
Normal Loss
5% of weight input, disposed off at 16 paise per kilogram
Output
9,200 kilograms
Process 2
Input:
Material C
6,600 kilograms at `1.25 per kilogram.
Material D
4,200 kilograms at `0.75 per kilogram.
Flavouring Essence
`300
Mixing Labour
370 hours at `2 per hour
Normal Waste
5% of weight input with no disposal value
Output
19,000 kilograms.
Overheads of `3,200, incurred by the two processes, to be absorbed on the basis of mixing
labour hours.
(ICWA Inter)
Solution
Process 1 Account
Particulars
kg
`
To Material A
To Material B
To Mixing labour
To Overheads*
6,000
4,000
3,000
4,000
860
1,720
10,000
9,580
Particulars
By Normal loss
By Abnormal loss*
By Transfer to Process 2
kg
`
500
300
9,200
80
300
9,200
10,000
9,580
Process Costing
8.46
Process 2 Account
`
Particulars
kg
To Process 1 (Tr.)
To Material C
To Material D
To Flavouring essence
To Mixing labour
To Overheads*
9,200
6,600
4,200
9,200
8,250
3,150
300
740
1,480
20,000 23,120
Particulars
By Normal waste
By Packing deptt.
kg
`
1,000
19,000
—
23,120
20,000
23,120
Abnormal Loss Account
Particulars
kg
`
Particulars
kg
`
To Process 1 A/c
300
300
By Sales A/c
By Balance to P&L A/c
300
48
252
300
300
300
300
Packing Department Account
`
Particulars
kg
`
19,000 23,120
By Balance
19,000
23,120
19,000
23,120
Particulars
To Process 2 A/c
kg
19,000 23,120
*Working Notes:
1. Total overhead expenses
= `3,200
Total labour hours in Process 1 and 2
= 430 + 370 = 800
Overhead absorption rate
hour
= `3,200 ÷ 800 hours = `4 per labour
Overheads under Process 1
= 430 × `4 = `1,720
Overheads under Process 2
= 370 × `4 = `1,480
2. In Process 1 cost of 9,500 kg of output is = `9,580 – 80, i.e., `9,500. Hence, normal
cost per kg of output is `1.00, i.e., `9,500 ÷ 9,500 kg.
Problem 8.10 The input to a purifying process was 16,000 kg of basic material purchased
@ `1.20 per kg. Process wages amounted to `720 and overhead cost was applied @
240% of the labour cost. Indirect materials of negligible weight were introduced into the
process at a cost of `336. The actual output from the process weighed 15,000 kg. The
normal yield of the process is 92%. Any difference in weight between the input of basic
material and output of purified material (product) is sold @ `0.50 per kg.
The process is operated under a licence which provides for the payment of royalty
@ `0.15 per kg of the purified material produced.
Prepare:
(i) Purifying Process Account
(iii) Abnormal Wastage/Yield Account
(ii) Normal Wastage Account
(iv) Royalty Payable Account
(CA Inter)
Process Costing
8.47
Solution
Purifying Process Account
Particulars
kg
Rate Amount
`
`
Particulars
kg
To Units introduced 16,000 1.20 19,200 By Normal wastage 1,280
To Wages
720 By Output
15,000
To Overhead
1,728
To Indirect materials
336
To Royalty
2,208
To Abnormal yield
280 1.60*
448
16,280
*Cost per unit =
24,640
Rate Amount
`
`
0.50
640
1.60* 24,000
16,280
24,640
` 24,192 – 640
= `1.60
16, 000 – 1,280 units
Normal Wastage Account
Particulars
kg
Rate
`
Amount
`
Particulars
To Purifying process 1,280
0.50
640
By Cash (Sale)
By Abnormal yield
1,280
640
kg
Rate Amount
`
`
1,000 0.50
280 0.50
500
140
1,280
640
kg
Rate Amount
`
`
Abnormal Yield Account
Particulars
kg
Rate Amount
`
`
To Normal wastage
To Costing P&L A/c
To Royalty payable
(on 280 kg)
280
0.50
0.15
280
140
266
Particulars
By Purifying process 280 1.60
448
42
448
280
448
Royalty Payable Account
Particulars
To Balance c/d
kg
Rate
`
Amount
`
15,000
0.15
2,250
15,000
2,250
Particulars
kg
By Purifying
process
14,720
By Abnormal yield
280
15,000
Rate Amount
`
`
0.15
0.15
2,208
42
2,250
Problem 8.11 From the following data, find out the equivalent units of production to
determine the per unit processing cost, which was incurred evenly during the month of
March.
Process Costing
8.48
Opening work-in-progress
Fresh units started
Finished goods
Closing work-in-progress
No loss was permissible in the process.
5,000 units (20% completed)
16,000 units
12,000 units
8,000 units (60% completed)
Entire stock of opening work-in-progress was completed during the month of March,
without any loss/rejection.
(B. Com. Hons. Delhi)
Solution
Statement of Equivalent Production
(FIFO method)
Input
units
Output
units
% of completion
Equivalent
units
16,000
Units completed from
opening WIP
Units introduced ad completed
Abnormal loss (B.F.)*
Closing WIP
5,000
7,000
1,000
8,000
80%
100%
100%
60%
4,000
7,000
1,000
4,800
21,000
Total
21,000
5,000
Item
16,800
*Note: Since loss is not permissible in the process, entire loss is treated as abnormal loss.
Problem 8.12 The following particulars are extracted from the books of Y Ltd for the
month of August:
Opening stock of WIP
Degree of completion:
Materials
Labour
Overheads
Units introduced in August
Completed units in August
Closing WIP (units)
Degree of completion:
Materials
Labour
Overheads
200 units
100%
40%
40%
1,050
1,100
150
100%
70%
70%
Prepare a statement of equivalent production.
Solution
Statement of Equivalent Production
Particulars
Opening stock of WIP
Units introduced and
completed
Closing stock of WIP
Equivalent units
Output
units
%
Materials
Units
200
—
—
60
120
900
150
100
100
900
150
100
70
900
105
1,050
Labour and overhead
%
Units
1,125
Process Costing
8.49
Problem 8.13
The accountant of a chemical company provides you the following data:
`
Units
2,000
Work-in-process beginning of period
Direct materials
Direct labour and manufacturing overheads
Addition to work-in-process in April
Direct materials
Direct labour and manufacturing overheads
4,200
1,950
4,000
9,000
7,500
Total
22,650
Work-in-process, end of period 1,500.
Further, work in process at the beginning of the period is completed to the extent:
materials 100% and labour and manufacturing overheads 75%. Work in process at end of
the period is completed to the extent: materials 100% and direct labour and manufacturing
overheads only 50%.
You are required to:
(i) Calculate the number of units of product transferred to finished goods stock during
the period. Assume no units are lost in process.
(ii) Calculate the number of equivalent whole units of work completed during the period.
(iii) Calculate the unit cost for materials during the month of April using a first-in,
first-out method of inventory issue.
(B. Com. Hons. Delhi)
Solution
(i) Transfer to finished stock
Units of opening
Additional units – Units of closing
= work-in-progress +
introduced
work-in-progress
= 2,000 + 4,000 – 1,500 = 4,500 Units
(ii )
Statement of Equivalent Whole Units
Particulars
Labour and
Opening WIP
Introduced and completed
(4,000 – 1,500)
Closing WIP
Total
units
Materials
overhead
Units
%
Units
%
2,000
—
—
500
25
2,500
1,500
2,500
1,500
100
100
2,500
750
100
50
Equivalent units
4,000
3,750
(iii) Unit cost of material by FIFO method
=
Problem 8.14
Direct material cost
Equivalent units
`9,000
= `2.25
4,000 units
The following data are available in respect of Process I for February 2022:
(1) Opening stock of work-in-progress: 800 units at a total cost of `4,000
(2) Degree of completion of opening work-in-progress:
Process Costing
8.50
Materials
100%
Labour
60%
Overheads
60%
(3) Input of materials at a total cost `36,800 for 9,200 units
(4) Direct wages incurred `16,740
(5) Production overheads `8,370
(6) Units scrapped: 1,200 units. The state of completion of these units was:
Materials
100%
Labour
80%
Overheads
80%
(7) Closing work-in-process: 900 units. The stage of completion of these units was:
Materials
100%
Labour
70%
Overheads
70%
(8) 7,900 units were completed and transferred to next process
(9) Normal loss is 8% of the total input (opening stock plus units put in)
(10) Scrap value is `4 per unit
You are required to:
(a) Compute equivalent production,
(b) Calculate the cost per equivalent unit for each element,
(c) Calculate the cost of abnormal loss (or gain), closing work-in-process and the
units transferred to the next process using the FIFO method, and
(d) Prepare the Process Account.
(B. Com. Hons. Delhi, CA Inter)
Solution
FIFO Method
Statement of Equivalent Production
(a)
Input
(units)
Items
Output
units
800 Opening WIP
9,200 Finished
Closing WIP
Normal Loss
Abnormal Loss
800
7,100
900
800
400
10,000
10,000
(b)
Material
% com- Units
pletion
—
100
100
—
100
Labour
% completion
—
7,100
900
—
400
40
100
70
—
80
8,400
Overheads
Units % com- Units
pletion
320
7,100
630
—
320
40
100
70
—
80
8,370
320
7,100
630
—
320
8,370
Statement of Cost
Element
of cost
Materials cost `
Less: Scrap
realisation
(800 units × `4)
Labour cost
Overhead
Total Cost
Cost
`
Equivalent
production
(units)
Cost per
equivalent unit
`
33,600
16,740
8,370
8,400
8,370
8,370
4
2
1
36,800
3,200
7
Process Costing
8.51
(c)
Statement of Evaluation
Item
Element of
cost
`
Total
cost
`
Abnormal Loss
Material
Labour
Overhead
400
320
320
4
2
1
1,600
640
320
2,560
Closing WIP
Material
Labour
Overhead
900
630
630
4
2
1
3,600
1,260
630
Finished
production
Opening WIP
Mat. + Lab.
+ Ohds
Material
Labour
7,100
7
—
320
—
2
Overhead320
(d)
Equivalent
production
Cost per
unit
`
Cost
1
320
5,490
49,700
—
640
960
Process Account
Particulars
Units
`
Particulars
Units
`
To Opening WIP
To Materials
To Labour
To Overhead
800
9,200
4,000
36,800
16,740
8,370
By Cost of finished
goods
By Closing WIP
By Abnormal loss
By Normal loss
7,900
900
400
800
54,660*
5,490
2,560
3,200
10,000
65,910
10,000 65,910
*Note: Cost of finished goods is computed as folows:
`
Cost of opening WIP b/f
Cost incurred during the month on opening WIP
4,000
960
Cost of 7,100 units completed
49,700
Total
54,660
Problem 8.15
The following data pertain to Process I for March, 2022 of Beta Ltd:
Opening work in progress: 1,500 units at `15,000
Degree of completion: Materials 100%; Labour and Overheads 33 1/3 %
Input of materials:
18,500 units at `52,000
Direct labour
`14,000
Overheads
`28,000
Closing work-in-progress: 5,000 units
Degree of completion: Materials 90%; Labour and Overheads 30%.
Normal process loss is 10% of total input (Opening work-in-progress units + Units
put in).
Scrap value `2 per unit.
Units transferred to the next process: 15,000 units.
You are required to:
(i) Compute equivalent units of production
Process Costing
8.52
(ii) Compute cost per equivalent unit for each cost element, i.e., material, labour and
overheads
(iii) Compute the cost of finished output and closing work-in-progress
(iv) Prepare the Process and other Accounts
Assume: (a) FIFO method is used by the company, and
(b) the cost of opening work-in-progress is fully transferred to the next
process.
(B Com Hons., Delhi, CA Inter)
Solution
Statement of Equivalent Production
Input
units
Particulars
Output
units
Equivalent production
Material
Labour & overhead
%
Units
%
Units
1,500
—
—
66 2 3
1,000
and completed
Normal loss
13,500
2,000
100
—
13,500
—
100
—
13,500
—
Closing WIP
5,000
90
4,500
30
1,500
Total
22,000
Less: Abnormal
gain
2,000
1,500
Opening WIP
18,500
Units introduced
20,000
18,000
100
16,000
2,000
100
2,000
20,000
Equivalent units
16,000
14,000
Statement of Cost per Equivalent Unit
Materials
Less: Scrap
Labour
Overhead
`52,000
4,000
Cost
`
Equivalent
units
Cost per unit
`
48,000
14,000
28,000
16,000
14,000
14,000
3
1
2
Statement or Evaluation
Items
Opening WIP
Units completed
Cost
element
Equivalent
units
Cost
per unit
`
Cost of
Eq. units
`
Total
cost
`
Material
Labour
Overhead
Nil
1,000
1,000
—
1
2
—
1,000
2,000
—
3,000
Material
Labour
Overhead
13,500
13,500
13,500
3
1
2
40,500
13,500
27,000
81,000
(Contd...)
Process Costing
Closing WIP
Abnormal gain
8.53
Material
Labour
Overhead
4,500
1,500
1,500
3
1
2
13,500
1,500
3,000
18,000
Material
Labour
Overhead
2,000
2,000
2,000
3
1
2
6,000
2,000
4,000
12,000
Process I Account
Particulars
To Opening WIP
To Units introduced
To Direct labour
To Overhead
To Abnormal gain
Units
`
Particulars
Units
`
1,500
18,500
—
—
2,000
15,000
52,000
14,000
28,000
12,000
By Normal loss
By Process II Tr.
By Closing WIP
2,000
15,000
5,000
4,000
99,000*
18,000
22,000
1,21,000
22,000
1,21,000
Abnormal Gain Account
Particulars
Units
`
Particulars
Units
`
To Normal loss
To Costing P&L A/c
2,000
—
4,000
8,000
By Process I
2,000
12,000
2,000
12,000
2,000
12,000
*Working Note: Transfer to Process II is valued as under:
`81,000 + (15,000 + 3,000 of opening WIP) = `99,000.
Problem 8.16 Process 2 receives units from Process l and after carrying out work on
the units, transfers them to Process 3. For the accounting period the relevant data were
as follows:
Opening WIP 200 units (25% complete) valued at
`5,000
800 units received from Process l valued at
`8,600
840 units were transferred to Process 3
Closing WIP 160 units (50% complete)
The costs of the period were `33,160 and no units were scrapped.
Required:
Prepare the Process Account for Process 2 using the Average Cost method of
valuation.
(CA Inter)
Solution
Computation of Equivalent Units
Units
1,000
Input (200 units + 800 units)
Output: 840 units, 100% complete
160 units, 50% complete
840
80
Output
Total cost (5,000 + 8,600 + 33,160)
Average cost per unit (`46,760 ÷ 920 units)
Cost of 840 completed units (840 units × 50.826)
Cost of WIP of 160 units (80 units × 50.826)
920
`46,760
`50.826
`42,694
`4,066
Process Costing
8.54
Process 2 Account
To Opening WIP
To Process 1 A/c
To Cost incurred
Problem 8.17
Units
`
200
800
—
5,000
8,600
33,160
1,000
46,760
Units
`
840
160
42,694
4,066
1,000
46,760
By Process 3 A/c
By Closing WIP
The following data relate to Process Q:
(i) Opening work-in-process:
4,000 units
Degree of completion:
Materials
100%
`24,000
Labour
60%
`14,400
Overheads
60%
`7,200
(ii) Received during the month of April from Process P:
40,000 units
`1,71,000
(iii) Expenses incurred in Process Q during the month:
Materials
`79,000
Labour
`1,38,230
Overheads
`69,120
(iv) Closing work-in-process
3,000 units
Degree of completion: Materials 100%; Labour and Overheads 50%
( v ) Units scrapped
4,000 units
Degree of completion: Materials 100%; Labour and Overheads 80%
(vi) Normal loss: 5% of current input.
(vii) Spoiled goods realized `1.50 each on sale.
(viii) Completed units are transferred to warehouse.
Required:
Prepare: (i) Equivalent units statement (ii) Statement of cost per equivalent unit and total
costs (iii) Process Q Account (iv) Any other account necessary.
(B.Com. Hons., Delhi, CA Inter)
Solution
FIFO method has been used here.
Statement of Equivalent Units
Units
Particulars
Units
of
input
of
output
4,000 Opening WIP
40,000 Units introduced
and completed
Closing WIP
Normal loss
Abnormal loss
4,000
33,000
3,000
2,000
2,000
Equivalent units
44,000
44,000
Equivalent production
Materials
%
–
Labour
Overheads
Units
%
Units
%
Units
–
40
1,600
40
1,600
100 33,000
100 3,000
–
–
100 2,000
100 33,000
50 1,500
–
–
80
1,600
100 33,000
50 1,500
–
–
80 1,600
38,000
37,700
37,700
Process Costing
8.55
Statement of Cost Per Unit
Cost
`
1,71,000
79,000
Material Cost :
From Process P
Current
Eq. units
Cost per unit
`
2,47,000
38,000
6.50
1,38,230
69,120
37,700
37,700
3.67
1.83
2,50,000
3,000
Less: Sale of scrap
Labour cost
Overhead
Total
12.00
Statement of Evaluation
Eq. units
Opening WIP
Material
Labour
Overhead
—
1,600
1,600
Cost per unit
`
—
3.67
1.83
Total cost
`
—
5,872
2,928
Units completed
—
33,000
12.00
3,96,000
Abnormal loss
Material
Labour
Overhead
2,000
1,600
1,600
6.50
3.67
1.83
13,000
5,872
2,928
Closing WIP
Material
Labour
Overhead
3,000
1,500
1,500
6.50
3.67
1.83
8,800
21,800
19,500
5,505
2,745
27,750
Process Q Account
`
Units
To Opening WIP
To Tr. from Process P
To Materials
To Labour
To Overhead
Units
`
4,000 45,600* By Normal loss
2,000
3,000
40,000 1,71,000 By Abnormal loss
2,000
21,800
79,000 By Tr. to warehouse
37,000 4,50,400
1,38,230 (3,96,000 + 8,800 + 45,600)
69,120 By Closing W.I.P.
3,000 27,750
44,000 5,02,950
44,000 5,02,950
*(24,000 + 14,400 + 7,200) = `45,600.
Abnormal Loss Account
To Process Q A/c
Units
`
2,000
2,1800
2,000
2,1800
By Cash
By Costing P&L A/c
Units
`
2,000
–
3,000
18,800
2,000
21,800
Process Costing
8.56
Problem 8.18 Roy & Johnson (P) Ltd gives the following particulars relating to process
A in its plant for the month of December 2021:
Work-in-progress
(opening balance) on 1.12.2021—500 units:
`
4,800
3,200
6,400
Material
Labour
Overheads
14,400
Units introduced during the month—19,500
Processing costs incurred during the month:
Materials
`1,86,200
Labour
72,000
Overheads
1,06,400
Output:
`3,64,600
Units transferred to Process B
18,200
Units scrapped (completely processed)
1,400
Work-in-process (closing balance)
400
[Degree of completion: Materials —100% Labour and overheads— 50%]
Normal loss in processing is 5% of total input and normal scrapped units fetch `1
each.
Prepare the following statements for process A for December 2021:
(a) Statement of equivalent production;
(b) Statement of cost;
( c ) Statement of evaluation;
(d) Process ‘A’ Account.
(ICWA Inter)
Solution
Average method is used here.
Statement of Production
Input
units
Particulars
500
19,500
Opening WIP
Units introduced
Units completed
Normal loss
Abnormal loss
Closing WIP
20,000
Output
units
18,200
1,000
400
400
%
Material
Eq. units
Lab. and ohds
%
Eq. units
100%
18,200
100%
18,200
100%
100%
400
400
100%
50%
400
200
20,000
Equivalent units
19,000
18,800
Statement of Cost per unit
Materials
Opening work-in-progress
Add: Materials consumed
Cost
` (A)
4,800
1,86,200
1,91,000
Eq. units
(B)
Cost per unit
` (A ÷ B)
Process Costing
8.57
Less: Sale from normal loss
1,000
1,90,000
Labour: Opening work-in-progress
Add: Cost incurred
19,000
10
18,800
4
3,200
72,000
75,200
Overhead: Opening WIP
Add: Cost incurred
6,400
1,06,400
1,12,800
18,800
6
Total
20
Statement of Evaluation
`
3,64,000
Output completed 18,200 units @ `20
Abnormal loss
400 units @ `20
Work in progress (closing)
Material 400 units @ `10
Labour and overheads 200 units @ `10
8,000
4,000
2,000
6,000
Process ‘A’ Account
Units
`
To Opening WIP
500
To Units introduced 19,500
To Labour
To Overhead
14,400
1,86,200
72,000
1,06,000
20,000
3,79,000
By Tr. to Process B
By Normal loss
By Abnormal loss
By Closing WIP
Units
`
18,200
1,000
400
400
3,64,000
1,000
8,000
6,000
20,000
3,79,000
Problem 8.19 Data relating to work done in Process ‘A’ of a company during the
month of April is given below:
Opening Work-in-Progress (1,000 units):
`
Materials
40,000
Labour
7,500
Overheads
22,500
`
Materials introduced in Process ‘A’ (19,000 units)
7,40,000
Direct labour
1,79,500
Overheads
5,38,500
Units scrapped
:
1,500 units
Degree of completion:
Materials: 100%
Labour and overheads: 80%
Closing Work-in-progress
:
1,000 units
Degree of completion:
Materials: 100%
Labour and overheads: 80%
Units finished and transferred to Process ‘B’ = 17,500 units
Normal loss
:
5% of total input including opening W.I.P.
Scrapped units fetch `20 per piece.
Process Costing
8.58
Required:
(a) Statement of equivalent production
(b) Statement of cost
( c ) Statement of distribution of cost
(d) Process ‘A’ account and other accounts
(ICWA Inter)
Solution
Average method is used
Statement of Equivalent Production
Input
Particulars
Output
units
1,000
19,000
—
—
20,000
Opening WIP
Units introduced
Units completed
Normal loss
(5% of 20,000)
Abnormal loss
Closing WIP
Total
Equivalent units
(b)
Eq. Production
Material
Lab. and ohds
Units
%
Units
units
%
—
—
17,500
—
—
100
—
—
17,500
—
—
100
—
—
17,500
1,000
500
1,000
20,000
—
100
100
—
500
1,000
—
80
80
—
400
800
19,000
18,700
Statement of Cost
40,000
7,40,000
7,80,000
Less: Scrap value of normal loss 20,000
Labour—Op. stock
7,500
Add:
1,79,500
Overhead—Op. stock
22,500
Add:
5,38,500
Total
Cost `
(a)
Eq. Units
(b)
Cost per unit `
(a  b)
7,60,000
19,000
40
1,87,000
18,700
10
5,61,000
18,700
30
80
Materials—Op. Stock
Add:
(c)
Statement of Distribution of Cost
1. Completed and transferred to next process
17,500 units @ `80
2. Abnormal loss – Materials 500 units @ `40 =
20,000
Labour and overhead 400 units @ `40 =
16,000
3. Closing WIP – 1,000 units – Materials @ `40 =
40,000
Labour and overhead 800 units @ `40 =
32,000
= 14,00,000
36,000
72,000
Process Costing
8.59
Process ‘A’ Account
`
Units
To Opening WIP
1,000
70,000
To Materials
To D. Labour
To Overhead
19,000
7,40,000
1,79,500
5,38,500
15,28,000
20,000
`
Units
By Normal loss
1,000
20,000
By Abnormal loss
By Process B – Tr.
By Closing WIP
500
17,500
1,000
20,000
36,000
14,00,000
72,000
15,28,000
Units
1,000
1,000
`
20,000
20,000
Units
500
—
500
`
10,000
26,000
36,000
Normal Loss Account
To Process A
Units
1,000
1,000
`
20,000
20,000
By Cash
Abnormal Loss Account
To Process A
Units
500
`
36,000
500
36,000
By Cash
By Costing P&L A/c
Problem 8.20 The following details are given in respect of a manufacturing firm for
the month of April:
`
(i) Opening work-in-progress 5,000 units:
(a) Materials (100% complete)
18,750
(b) Labour (60% complete)
7,500
( c ) Overheads (60% complete)
3,750
(ii) Units introduced into the process 17,500 units.
(iii) 17,500 units are transferred to the next process.
(iv) Process cost for the period are:
Material `2,50,000, Labour `1,95,000, Overheads `97,500.
( v ) The stage of completion of units in closing WIP:
Material 100%, Labour 50% and Overheads 50%.
You are required to prepare a statement of equivalent production and statement of
cost. Also find the value of:
(i) Output transferred and (ii) Closing work-in-progress, using average cost method.
(ICWA Inter)
Solution
Statement of Equivalent Production
Input
units
Particulars
5,000
17,500
Opening WIP
Units introduced
Transferred to
next process
Closing WIP
22,500
Output
units
Equivalent production
Material
Labour
Overheads
%
Units
%
Units
%
Units
17,500
5,000
100 17,500
100 5,000
100
50
17,500
2,500
100
50
17,500
2,500
22,500
Equivalent
Production
22,500
20,000
20,000
Process Costing
8.60
Statement of Cost Per Unit
`
`
`
Opening WIP cost
Add: Current cost
18,750
2,50,000
7,500
1,95,000
3,750
97,500
Total `
Total cost (A)
2,68,750
2,02,500
1,01,250
Equivalent units (B)
Cost per eq. unit (A ÷ B)
22,500
11.9444
20,000
10.125
20,000
5.0625
27.1319
Statement of Evaluation
Cost of output transferred
Cost of closing WIP:
Material
Labour
Overheads
Total cost of output
Equivalent unit × Cost per unit
17,500
×
27.1319
5,000
2,500
2,500
×
×
×
11.9444
10.1250
5.0625
Total cost
4,74,809
59,722
25,314
12,655
97,691
5,72,500
Process Account
Particulars
Units
`
To Opening WIP
To Materials
To Labour
To Overhead
5,000
17,500
30,000
2,50,000
1,95,000
97,500
By Tr. to next process 17,500
By Closing WIP
5,000
4,74,809
97,691
22,500
5,72,500
22,500
5,72,500
Particulars
Units
`
Problem 8.21 The following information is given is respect of Process No. 3 for the
month of March.
Opening stock – 2,000 units, made up of:
Direct Material – I `12,350; Direct Material – II `13,200;
Direct Labour `17,500 ; Overheads `11,000.
Transferred from Process No. 2: 20,000 units @ `6 per unit.
Transferred to Process No. 4: 17,000 units.
Expenditure incurred in Process No. 3:
Direct Materials `30,000; Direct Labour `60,000; Overheads `60,000.
Scrap: 1,000 units – Direct Materials 100%; Direct Labour 60%; Overheads 40%.
Normal Loss 10% of production, Scrapped units realized `4 per unit.
Closing Stock: 4,000 units –
Degree of completion : Direct Material 80%; Direct Labour 60% and Overheads 40%.
Prepare Statement of Equivalent Production, Statement of Cost per unit, Statement
of Evaluation and Process 3 Account.
(CA Inter)
Process Costing
8.61
Solution
Average Cost Method has been used because degree of completion of opening stock is
not given.
Statement of Equivalent Production
Input
units
Particulars
Process No. 3
Output
units
2000
20,000
Opening stock
Tr. from Process 2
Fully processed 17,000
Normal Loss
1,800
10% of (2,000
+ 20,000 – 4000)
100 17,000 100 17,000 100 17,000 100 17,000
–
–
–
–
–
–
–
–
Closing Stock
4,000
22,800
100
4,000
21,000
800
22,000
100
800 100
800 100
800 100
800
20,200
19,400
18,600
17,800
Less: Abnormal
Gain
22,000 Eq. units (Total)
Material I
%
units
Equivalent units
Material II
Labour
Overheads
%
units
%
units
% units
80 3,200
20,200
60 2,400
19,400
40
1,600
18,600
Statement of Cost Per Unit
Total cost
(`)
Material I:
Opening balance (2000 units)
Cost of 20000 units @ `6
Less: Realisation from scrap
1,800 units @ `4
Material II:
Opening stock
Introduced in process
Labour:
Opening balance
Incurred in process
Overheads:
Opening balance
Incurred in process
Equivalent Cost per equivalent
unitsgfkdjkjj
unit (` )
(A)
12,350
1,20,000
1,32,350
(B)
(A ÷ B)
7,200 1,25,150
20,200
6.1955
13,200
30,000
43,200
19,400
2.2268
17,500
60,000
77,500
18,600
4.1667
11,000
60,000
71,000
17,800
3.9888
`16.5778
Total cost per unit
Statement of Evaluation
Equivalent units
Finished output
Abnormal gain
Closing work-in-progress:
Material I
×
Cost per unit (` )
Total cost ( `)
17,000
800
×
×
16.5778
16.5778
=
=
2,81,822
13,262
4,000
×
6.1955
=
24,782
(Contd...)
Process Costing
8.62
Material II
Labour
Overheads
3,200
2,400
1,600
×
×
×
2.2268
4.1667
=
=
=
7,126
10,000
6,382
48,290
Units
`
3.9888
Process Account
Particulars
Units
`
To Opening WIP
To Tr. from Process 2
To Direct Material II
To Direct Labour
To Overheads
To Abnormal gain A/c
2,000
20,000
By Normal Loss A/c
1,800
7,200
By Finished Goods A/c 17,000 2,81,822
By Closing WIP
4,000
48,290
800
54,050
1,20,000
30,000
60,000
60,000
13,262
22,800
3,37,312
22,800 3,37,312
Problem 8.22
Particulars
Following data are available for a product for the month of Sept.
Process I
Opening work-in-progress
Nil
Costs incurred during the month:
`
Direct materials
60,000
Labour
12,000
Factory overheads
24,000
Units of production:
Units
Received-in-process
40,000
Completed and transferred
36,000
Closing work-in-progress
2,000
Normal loss in process
2,000
Production remaining in process has to be valued as follows:
Materials
100%
Labour
50%
Overhead
50%
Process II
Nil
`
—
16,000
20,000
Units
36,000
32,000
?
1,500
There is no abnormal loss in Process II. Prepare Process Accounts after working
out the missing figures with detailed workings.
(ICWA Inter)
Solution
PROCESS I
Statement of Equivalent Production
Input
units
Particulars
Output
units
%
40,000
Units completed
and transferred
Normal loss
Closing WIP
40,000
36,000
2,000
2,000
100
—
100
Equivalent production
Materials
Labour and Overhead
Units
%
Units
36,000
—
2,000
100
—
50
36,000
—
1,000
40,000
Equivalent units
38,000
37,000
Process Costing
8.63
Statement of Cost per Equivalent Unit
Total cost
`
Equivalent units
60,000
12,000
24,000
38,000
37,000
37,000
Direct materials
Labour
Factory overhead
Cost per unit
`
1.5789
0.3243
0.6487
Total
2.5519
Statement of Evaluation
Equivalent
units
Cost per unit
`
Total cost
`
Closing WIP:
Material
Labour
Overhead
2,000
1,000
1,000
1.5789
0.3243
0.6487
3,158
324
649
Total
Units completed
36,000
2.5519
4,131
91,869
Process I Account
Particulars
To Units introduced
To Labour
To Overhead
`
Units
40,000
—
—
60,000
12,000
24,000
40,000
96,000
Particulars
By Normal loss
By Process II Tr.
By Closing WIP
Units
`
2,000
36,000
2,000
—
91,849
4,131
40,000
96,000
PROCESS II
Statement of Equivalent Production
Input
units
36,000
Particulars
Output
units
Units completed
Normal loss
Closing WIP (B.F.)
36,000
32,000
1,500
2,500
Equivalent production
%
Materials
Units
100
—
100
32,000
—
2,500
Labour and Overhead
%
Units
100
—
50
32,000
—
1,250
36,000
Equivalent units
34,500
33,250
Statement of Cost per Equivalent Unit
Material Cost (Tr. of
36,000 units from Process I)
Labour
Overhead
Total
Total cost
`
Equivalent
units
Cost per unit
`
91,869
16,000
20,000
34,500
33,250
33,250
2.6629
0.4812
0.6015
3.7456
Process Costing
8.64
Statement of Evaluation
Units completed
Closing WIP:
Material
Labour
Overhead
Equivalent
units
Cost per unit
`
Total cost
`
32,000
3.7456
1,19,859
2,500
1,250
1,250
2.6629
0.4812
0.6015
6,657
602
751
Total
8,010
Process II Account
Particulars
To Process I Tr.
To Labour
To Overhead
Units
`
36,000
—
—
91,869
16,000
20,000
36,000
1,27,869
`
Particulars
Units
By Normal loss
By Finished
Stock Tr.
By Closing WIP
1,500
—
32,000
2,500
1,19,859
8,010
36,000
1,27,869
Problem 8.23 Z Ltd manufactures product A, which yields two by-products B and C.
The actual joint expenses of manufacture for a period were `8,000.
It was estimated that profits on each product as a percentage of sales would be 30%,
25% and 15%, respectively. Subsequent expenses were:
A
B
C
`
`
`
Material
100
75
25
Direct wages
200
125
50
Overheads
150
125
75
450
6,000
Sales
325
4,000
150
2,500
Prepare a statement showing the apportionment of the joint expenses of manufacture
over the different products. Also presume that selling expenses are apportioned over the
products as a percentage to sales.
(B. Com. Hons. Delhi)
Solution
Apportionment of Joint Cost
A (` )
Products
B (`)
Total
C ( ` ) (A + B + C) ( `)
Sales
Less: Profit
6,000
1,800
4,000
1,000
2,500
375
12,500
3,175
Total Cost
Less: Selling expenses*
4,200
192
3,000
128
2,125
80
9,325
400
Cost of Production
Less: Subsequent expenses
4,008
450
2,872
325
2,045
150
8,925
925
Share in joint cost
3,558
2,547
1,895
8,000
Process Costing
8.65
* Working Notes: Selling expenses are not given in the question. These are calculated as
follows:
Total cost (as calculated above)
`9,325
Less: Cost of production (`8,000 + 450 + 325 + 150)
8,925
Selling expenses
400
400
Selling expenses as a percentage to sales:
× 100 = 3.20%
12,500
Problem 8.24 In a process line of XY Co., three joint products are produced. For the
month of May, the following data were available.
Products
L
`
M
`
10
5,000
1,000
N
`
20
15,000
1,500
Sales Prices per kg
5
Post-separation point costs
10,000
Output in kg
2,500
Pre-separation point costs amounted to `20,000.
The joint products are manufactured in one common process, after which they are
separated and may undergo further individual processing, the pre-separation point costs
are apportioned to joint products according to weight. You are required to prepare a
statement showing the estimated profit or loss for each product and in total.
(ICWA Inter)
Solution
Apportionment of Pre-separation-point Costs
Joint cost `20,000
Product
Output (kg)
L
2,500
M
1,000
N
1,500
Total
5,000
`
Share of pre-separation costs
2,500
× 20,000
5,000
1,000
× 20,000
5,000
1,500
× 20,000
5,000
= 10,000
= 4,000
= 6,000
Statement of Estimated Profit (Loss)
Products
L
M
N
Total
1. Output (kg)
2,500
`
5
12,500
10,000
10,000
20,000
(7,500)
1,000
`
10
10,000
4,000
5,000
9,000
1,000
1,500
`
20
30,000
6,000
15,000
21,000
9,000
5,000
`
2. Sale Price per kg
3. Sales Revenue (1) × (2)
4. Pre-separation costs
5. Post-separation costs
6. Total costs
7. Profit (Loss) (3) – (6)
52,500
20,000
30,000
50,000
2,500
Process Costing
8.66
Problem 8.25 In the course of manufacture of the main Product ‘P’, by-products ‘A’
and ‘B’ also emerge. The joint expenses of manufacture amount to `1,19,550. All the
three products are processed further after separation and sold as per details given below:
Main product
`
`
Sales
Cost incurred after separation
Profit as percentage on sales
By-products
‘P’
90,000
6,000
25
‘A’
60,000
5,000
20
‘B’
40,000
4,000
15
Total fixed selling expenses are 10% of total cost of sales which are apportioned to
the three products in the ratio of 20 : 40 : 40.
Prepare a statement showing the apportionment of joints costs to the main product
and two by-products.
(CA Inter)
Solution
Statement of Apportionment of Joint Cost
Total
(`)
Main product
P (`)
By-products
A (`)
B (`)
Sales
Less: Profit
Cost of sales
Less: Selling and distribution
expenses (10 % of `1,49,500,
i.e., `14,950 apportioned in
the ratio of 20 : 40 : 40)
Cost of production
Less: After split-off cost
1,90,000
40,500
1,49,500
90,000
22,500
67,500
60,000
12,000
48,000
40,000
6,000
34,000
14,950
1,34,550
15,000
2,990
64,510
6,000
5,980
42,020
5,000
5,980
28,020
4,000
Share in joint cost
1,19,550
58,510
37,020
24,020
Problem 8.26 A factory is engaged in the production of a chemical, X, and in the course
of its manufacture, a by-product Y is produced, which after a separate process, has a
commercial value. For the month of January, the following are the summarized costing data:
Joint expenses
Materials
Labour
Oncost
Separate expenses
`
X
`
Y
`
19,200
11,700
3,450
7,360
7,680
1,500
780
2,642
544
The output for the month was 142 tonnes of X and 49 tonnes of Y and the selling
price of Y averaged `280 per tonne.
Assume that the profit on Y is estimated at 50% of the selling price.
Prepare an account showing the cost of X per tonne.
Process Costing
8.67
Solution
Calculation of the Share of Y in Joint Cost
Sales value of Y by-product (49 tonnes @ `280 per tonne)
Less: Profit (50% of sales value)
`
13,720
6,860
Total cost of By-product Y
Less: Subsequent cost (Material + Labour + Oncost)
6,860
3,966
Share of Y in joint cost
2,894
Main Product X Account
To Materials:
Joint
Separate
To Labour:
Joint
Separate
To Oncost:
Joint
Separate
`
19,200
7,360
`
26,560
11,700
7,680
19,380
3,450
1,500
4,950
By Y By-product A/c
By Cost of production
50,890
`
2,894
47,996
50,890
Cost per tonne of X = `47,996 ÷ 142 tonnes = `338.
By-product Y Account
`
To X Chemical A/c
(Portion of joint expenses)
To Materials
To Labour
To Oncost
`
6,860
By Cost of production
2,894
780
2,642
544
6,860
6,860
Cost per tonne of Y = `6,860 ÷ 49 tonnes = `140.
Problem 8.27 A refinery has a single compact unit for refining crude oil. The cost of
processing 100 litres of crude oil is `75. The standard yield per 100 litres of crude oil
and the selling price of each product are indicated below:
Product mix
Motor spirit (petrol)
Diesel oil
Fuel oil
Kerosene
Gas (M 3 converted into litres)
Loss
Standard yield
(in litres per 100 litres
of crude)
Selling price
per litre
`
25
20
20
25
5
5
3.00
1.50
1.10
0.80
0.60
—
Process Costing
8.68
You are required to compute the unit cost of each product by selecting an appropriate
base for cost allocation.
(ICWA Inter)
Solution
Computation of Unit Cost of Each Product
Product mix
Motor spirit (petrol)
Diesel oil
Fuel oil
Kerosene
Gas
Loss
Standard
yield
Selling
price
Sales
(per litre)
`
`
3.00
1.50
1.10
0.80
0.60
—
75.00
30.00
22.00
20.00
3.00
—
150.00
25
20
20
25
5
5
Total
% of
total
sales value
Cost apportioned
(in ratio of sales)
Total
`
Pet litre
`
50%
20%
14.66%
13.34%
2%
—
37.50
15.00
11.00
10.00
1.50
—
1.50
0.75
0.55
0.40
0.30
—
100%
75.00
Problem 8.28 The yield of a certain process is 80% as to the main product, 15% as
to the by-product and 5% to the process loss. The material put in process (5,000 units)
costs `23.75 per unit and all other charges are `14,250, of which power cost accounted
for 33 1/3%. It is ascertained that power is chargeable as to the main product and byproduct in the ratio of 10 : 9. Draw up a statement showing the cost of the by-product.
(CA Inter)
Solution
Basic Calculations:
1. Cost of material = 5,000 units @ `23.75
2. Yield of main product = 5,000 × 80%
Yield of by-product = 5,000 × 15%
Process loss = 5,000 × 5%
Normal output = 4,000 + 750
=
=
=
=
=
`1,18,750
4,000 units
750 units
250 units
4,750 units
Statement of Cost of By-product
`
1.
750 

Material cost  1,18, 750 

4,750 

18,750
2.
2
750
Other charges (except power) 14, 250  66 %  
3 
4,750

1,500
3.
1 
9

Power 14,250  33 %  
3  19

2,250
Total Cost
22,500
Process Costing
8.69
Problem 8.29 Two products, P and Q, are obtained in a crude from and require further
processing, at a cost of `5 for P and `4 for Q per unit before sales. Assuming a net
magin of 25 per cent on cost, their sale prices are fixed at `13.75 and `8.75 per unit,
respectively. During the period, the joint cost was `88,000 and the outputs were:
P
8,000 units
Q
6,000 units
Ascertain the joint cost per unit.
(CA Inter; B. Com. Hons. Delhi)
Solution
Statement of Apportionment of Joint Cost
Production
Output (units)
Selling Price per unit
Less: Profit (25% of cost is 20% of Selling Price)
Cost of sale
Less: After split-off cost
Shrae in joint cost per unit (before separation)
Total cost
P
Q
8,000
6,000
`
13.75
2.75
11.00
5.00
6.00
8,000 units × `6
= `48,000
`
8.75
1.75
7.00
4.00
3.00
6,000 units × `3
= `18,000
Ratio between P and Q is 48,000 : 18,000 or 8 : 3
Total joint cost of `88,000 is apportioned to P and Q in the ratio of 8 : 3, i.e., ` 64,000
for P and `24,000 for Q.
Cost per unit of A = `64,000 ÷ 8,000 units = `8
Cost per unit of B = `24,000 ÷ 6,000 units = `4
Problem 8.30 Work out the estimated pre-separation cost per tonne of by-products Y
and Z, from the following data:
Costs of manufacture before separation: `28,00,000.
Main product is X. There are two by-products Y and Z whose normal selling prices
are as under:
Sales price of Y: `500 per tonne ; Sales price of Z: `800 per tonne
Selling and distribution expenses have been estimated to be 25% of selling price and
the net profit is expected to be 10% of selling price. Costs to manufacture each tonne
after separation from the main products are:
`95 for by-product Y; `145 for by-product Z.
Assume equal weight for Y and Z.
(Adapted)
Solution
Statement of Estimated Pre-separation Costs Per Tonne of By-products
By-Products
Selling price
Less: Profit (10% of selling price)
Total cost
Y
Z
`Per tonne
`Per tonne
500
50
800
80
450
720
(Contd...)
Process Costing
8.70
Less: Selling & dist. exp. (25% of selling price)
125
200
325
520
95
145
230
375
Less: Cost after separation
Estimated Pre-separation Cost Per Tonne
Problem 8.31 In manufacturing the main product, a company processes the incidental
waste into two by-products A and B. From the following data relating to the products
you are required to prepare a Comparative Profit and Loss Statement, showing the
individual costs and other details. The total costs upto separation point was `3,10,400.
Main-product
X
`
Sales
800,000
Costs after separation
80,000
Estimated net profit percentage to sales value
Estimated selling expenses as
percentage of sales value20%
10%
15%
By-product
A
`
64,000
12,800
20%
By-product
B
`
96,000
14,400
20%
(Reverse Cost Method to be followed for separation of joint costs)
(CA Inter)
Solution
Cost Allocated to By-products
By-products A (` ) By-products B ( ` )
Sales
Less: Estimated net profit
Estimated selling expenses
Cost after separation
Share in joint cost
64,000
12,800
6,400
12,800
32,000
Total ( ` )
96,000
19,200
14,400
14,400
32,000
48,000
48,000
80,000
Comparative Profit and Loss Statement
Main product
X
`
By-product
A
`
By-product
B
`
Joint costs up to separation point
Less: Cost allocated to by-products
3,10,400
80,000
32,000
48,000
Costs after separation
Selling expenses
2,30,400
80,000
1,60,000
12,800
6,400
14,400
14,400
4,70,400
3,29,600
51,200
12,800
76,800
19,200
8,00,000
64,000
96,000
Net Profit
Sales
Problem 8.32 Three joint products are produced by passing chemicals through two
consecutive processes. Output from process 1 is transferred to process 2 from which
the three joint products are produced and immediately sold. The data regarding the
processes for April is given below:
Process Costing
8.71
Process 2
—
`6,900
`6,900
Nil
—
Joint products
A – 900 kilo
B – 800 kilo
C – 600 kilo
There were no opening or closing stocks in either process and the selling prices of
the output from Process 2 were:
Joint product A
`24 per kilo
Joint product B
`18 per kilo
Joint product C
`12 per kilo
Required:
(a) Prepare an account for process 1 together with any loss or gain accounts you
consider necessary to record the month’s activities.
(b) Calculate the profit attributable to each of the joint products by apportioning the
total costs from process 2: (i) According to weight of output; (ii) By the market
value of production.
(CA Inter)
Direct material 2,500 kilos at `4 per kilo
Direct labour
Overheads
Normal loss
Scrap value of loss
Output
Process 1
`10,000
` 6,250
`4,500
10% of input
`2 per kilo
2,300 kilos
Solution
Process 1 Account
Particulars
k g Rate per Amount
kg ( ` )
`
To Direct material 2,500
To Direct labour
—
To Overhead
—
To Abnormal gain
50
2,550
*Normal cost per unit
4
—
—
9
10,000
6,250
4,500
450
21,200
Particulars
kg
By Normal loss
(10% of 2,500)
250
By Process 2* 2,300
Rate per Amount
kg ( ` )
`
2
9
2,550
=
Total cost–scrap sales
Normal output
=
`10, 000  6,250 + 4,500 – 500
` 20,250
=
= `9
kgs 2,500 – 250
2, 250 kgs
500
20,700
21,200
Abnormal Gain Account
Particulars
To Normal Loss
Account
To Costing Profit &
Loss Account
k g Rate per Amount
kg ( ` )
`
Particulars
kg
50
By Process 1
50
50
2
100
350
450
50
Rate per Amount
kg ( ` )
`
9
450
450
Process Costing
8.72
Normal Loss Account
Particulars
k g Rate per Amount
kg ( ` )
`
Particulars
kg
To Process 1
250
By Sales
By Abnormal
gain
200
2
400
50
250
2
100
500
2
250
500
500
Rate per Amount
kg ( ` )
`
Statement of Profit
(Apportionment of joint cost according to weight of output and market value)
Joint cost `3,500*
Joint
prod-
Output
S.P.
Sales value
ucts
Joint cost apportionment
according to:
Profit
Profit
(Loss)
kg
`
`
Weight of
output
(9 : 8 : 6) `
1
2
3
4(2 × 3)
5
A
B
C
900
800
600
24
18
12
21,600
14,400
7,200
13,500*
12,000*
9,000*
17,250*
11,500*
5,750*
8,100
2,400
(1,800)
4,350
2,900
1,450
43,200
34,500
34,500
8,700
8,700
2,300
* Working Notes:
1. Joint cost of three products under Process 2
Transfer of output from Process 1
Direct labour
Overheads
Market value
of production
(3 : 2 : 1) `
`
`
6
(4–5)
(4–6)
`
20,700
6,900
6,900
Total
34,500
2.
Appointment according to weight:
This joint cost of `34,500 is apportioned to A, B and C in the ratio of output, i.e., 9 : 8 : 6 which is
A–900 kg, B–800 kg and C–600 kg.
3.
Apportionment according to market value:
Joint cost of `34,500 is apportioned to A, B and C in the ratio of Sales A–`21,600, B–`14,400 and C–
`720, i.e., 3 : 2 : 1
Problem 8.33 In an Oil Mill four products emerge from a refining process. The total
cost of input during the quarter ending March is `1,48,000. The output, sales and
additional processing costs are as under:
Products
Output in
litres
A
B
C
D
8,000
4,000
2,000
4,000
Additional processing
costs after split-off
point `
43,000
9,000
—
1,500
Total
value
`
1,72,500
15,000
6,000
45,000
In case these products were disposed of at the split-off point, that is before further
processing, the selling price would have been:
Process Costing
8.73
A
B
C
`15.00
6.00
3.00
Prepare a statement of profitability based on:
(1) If the products are sold after further processing.
(2) If they are sold at the split-off point.
D
7.50
(CA Inter)
Solution
(1)
Statement of Profitability
for the quarter ending March (after further processing)
Product
Sales Value
Share of
Further proafter further
joint cost
cessing cost
processing ( 2 0 : 4 : 1 : 5 )
Total Cost
Profit
(Loss)
(a)
(b)
(c)
(d)
(e) = (c) + (d)
(b) – (e)
A
B
C
D
`
1,72,500
15,000
6,000
45,000
`
98,667
19,733
4,933
24,667
`
43,000
9,000
—
1,500
`
1,41,667
28,733
4,933
26,167
`
30,833
(13,733)
1,067
18,833
Total
2,38,500
1,48,000
53,500
2,01,500
37,000
Working Notes:
(i) Sales value at split-off point:
A = 8,000 ×
`15 =
`1,20,000
B = 4,000 ×
`6 =
`24,000
C = 2,000 ×
`3 =
`6,000
D = 4,000 × ` 7.50 =
`30,000
Ratio of A, B, C and D = 20 : 4 : 1 : 5
(ii) The share in joint cost of products A, B, C and D has been determined by apportioning total
joint cost, of `1,48,000 in the ratio 20 : 4 : 1 : 5.
(2)
Statement of Profitability
for the quarter ending March (at the split-off point)
Product
A
B
C
D
Total
Selling
price at
split-off point
Output
in units
Sales value
at split-off
point
Share of
joint cost
Profit at
split-off
point
(1)
(2)
(3) = (1) × (2)
(4)
(3) – (4)
`
15
6
3
7.50
`
8,000
4,000
2,000
4,000
`
1,20,000
24,000
6,000
30,000
`
98,667
19,733
4,933
24,667
`
21,333
4,267
1,067
5,333
1,80,000
1,48,000
32,000
Conclusion Products A and D should be processed further while products B and C should
be sold at split-off point.
Process Costing
8.74
Problem 8.34 The Sunshine Oil Company purchases crude vegetable oil. It does
refining of the same. The refining process results in four products at the split-off point:
M, N, O and P.
Product O is fully processed at the split-off point. Products M, N and P can be
individually further refined into ‘Super M’, ‘Super N’ and ‘Super P’. In the most recent
month of October, the output at split-off point was:
Product M
3,00,000 gallons
Product N
1,00,000 gallons
Product O
50,000 gallons
Product P
50,000 gallons
The joint cost of purchasing the crude vegetable oil and processing it were `40,00,000.
Sunshine had no beginning or ending inventories. Sales of Product O in October were
`20,00,000. Total output of products M, N and P was further refined and then sold. Data
related to October are as follows:
Further processing costs to
make super products
`80,00,000
`32,00,000
`36,00,000
Super M
Super N
Super P
Sales
`1,20,00,000
`40,00,000
`48,00,000
Sunshine had the option of selling products M, N and P at the split-off point. This
alternative would have yielded the following sales for the October production:
Product M
`20,00,000
Product N
`12,00,000
Product P
`28,00,000
You are required to answer:
(i) How the joint cost of `40,00,000 would be allocated between each product under
each of the following methods: (a) sales value at split off; (b) physical output
(gallons); and (c) estimated net realizable value.
(ii) Could Sunshine have increased its October operating profits by making different
decisions about the further refining of product M, N or P? Show the effect of
any change you recommend on operating profits.
(CA Inter)
Solution
(i) Total joint cost = `40,00,000
(a) This is apportioned to joint products in the ratio of sales value at split-off
point, i.e., M–`20 lakh, N–`12 lakh, O–`20 lakh, P–`28 lakh.
Thus apportionment is in the ratio of 20 : 12 : 20 : 28
Thus share in joint cost M
=
`10,00,000
N
=
`6,00,000
O
=
`10,00,000
P
=
`14,00,000
(b) Apportionment in the ratio of output in gallons i.e. in the ratio of 30 : 10 : 5 : 5
Share of
M
N
O
P
=
=
=
=
`24,00,000
`8,00,000
`4,00,000
`4,00,000
Process Costing
(c)
8.75
Apportionment of joint cost in the ratio of net realisable value i.e. sales value
less further processing cost.
Net realisable value of M =
`1,20,00,000
– 80,00,000 =
`40,00,000
N =
`40,00,000
– 32,00,000 =
`8,00,000
O =
`20,00,000
–
=
`20,00,000
P =
`48,00,000
– 36,00,000 =
`12,00,000
Nil
Thus joint cost is apportioned in the ratio = 40 : 8 : 20 : 12
Share of M =
(ii)
`20,00,000
N =
`4,00,000
O =
`10,00,000
P =
`6,00,000
Statement of Profit/Loss due to Further Processing of M, N, & P
M
`
N
`
P
`
Sales after further processing
Less: Sales at split off point
1,20,00,000,
20,00,000
40,00,000
12,00,000
48,00,000
28,00,000
Incremental profit
Less: Further processing costs
1,00,00,000
80,00,000
28,00,000
32,00,000
20,00,000
36,00,000
20,00,000
(–)4,00,000
(–)16,00,000
Profit/Loss (–) due to further processing
Conclusion Thus only M should be processed further as it results in additional profit of
`20 lakh. Further processing of N and P result in decrease in profit by `4,00,000 and
`16,00,000, respectively and thus should not be processed further.
Problem 8.35 A company processes a raw material in its Department 1 to produce
three products, viz., A, B and X at the same split-off stage. During a period 1,80,000
kg of raw materials were processed in Department 1 at a total cost of `12,88,000 and
the resultant output of A, B and X were 18,000 kg 10,000 kg and 54,000 kg, respectively.
A and B were further processed in Department 2 at a cost of `1,80,000 and `1,50,000,
respectively. X was further processed in Department 3 at a cost of `1,08,000. There is
no waste in further processing.
The details of sales effected during the period were as under:
Quantity sold
Sales value
(kg)
(`)
A
B
X
17,000
12,24,000
5,000
2,50,000
44,000
7,92,000
There were no opening stocks. If these products were sold at split-off stage, the
selling prices of A, B and X would have been `50, `40 and `1C0 per kg, respectively.
Process Costing
8.76
Required:
(i) Prepare a statement showing the apportionment of joint costs to A, B and X.
(ii) Present a statement showing the cost per kg of each product indicating joint cost,
further processing cost and total cost separately.
(iii) Prepare a statement showing the product-wise and total profit for the period.
(iv) State with supporting calculations as to whether any or all the products should
be further processed or not.
(CA Inter)
Solution
(i)
Statement of Apportionment of Joint Cost
Joint cost `12,88,000
Product
Output
kg
(a)
S.P. at
Split-off point
(b)
Sales
value
(a × b)
Share in
joint cost
in ratio
of sales value
A
B
X
18,000
10,000
54,000
`
50
40
10
`
9,00,000
4,00,000
5,40,000
`
6,30,000
2,80,000
3,78,000
Total
(ii)
12,88,000
Statement of Cost per kg
Product
(A) Share in joint cost (`)
(B) Output in kg
(C) Cost per kg (A ÷ B) (`)
(D) Further processing cost per kg (`)
(Further processing cost ÷ Output)
(E) Total cost per kg (C + D)
(iii)
A
6,30,000
18,000
35
10
B
2,80,000
10,000
28
15
X
3,78,000
54,000
7
2
45
43
9
Statement of Profit
Product
A
Output (kg)
Sales (kg)
Closing stock (kg)
B
Total
X
18,000
17,000
1,000
10,000
5,000
5,000
54,000
44,000
10,000
Sales
Add: Closing stock (at cost)
`
12,24,000
45,000
`
2,50,000
2,15,000
`
7,92,000
90,000
`
22,66,000
3,50,000
(A) Value of production
12,69,000
4,65,000
8,82,000
26,16,000
Process Costing
8.77
Share in joint cost
Further processing cost
(B) Total cost
Profit (A – B)
(iv)
6,30,000
1,80,000
2,80,000
1,50,000
3,78,000
1,08,000
8,10,000
4,30,000
4,86,000
17,26,000
4,59,000
35,000
3,96,000
8,90,000
Statement of Incremental Profit/Loss
(By Further Processing)
Product
Selling price after further
processing per kg
Less: Selling price at split-off point
A
`
B
`
X
`
72
50
50
40
18
10
Incremental selling price
Less: Incremental cost (further
processing cost)
22
10
8
10
15
2
Incremental profit/loss (–)
12
(–) 5
6
Conclusion Products A and X should be processed further because these give incremental
profits. Product B should be sold at split-off point because by further processing, it results
in loss.
SUMMARY AND KEY TERMS

Process costing is a method of cost ascertainment, which is used in
mass production industries producing standard products, like steel,
sugar and chemicals.

In these industries, the production is continuous and the final product
is the result of a sequence of processes and costs are accumulated
process-wise.

An account is opened for each process which is debited with material
cost, labour cost, direct expenses and overheads.

The output of a process is transferred to the next process in the
sequence and the finished output of the last process is transferred
to the Finished Goods Account.

Process costing requires accounting adjustments relating to process
losses, valuation of work-in-progress and inter process profits.

Process losses are classified into normal and abnormal. The cost of
normal losses is borne by the good production. Abnormal losses
due to careless-ness, accidents, etc., is transferred to Costing Profit
and Loss Account.

Process costing mainly deals with continuous type of production. At
the end of the accounting period, there may be some work-inprogress. For costing purpose, work-in-progress at the end of an
Process Costing
8.78
accounting period is converted into equivalent completed units. This
is known as equivalent production.

Joint products are two or more products which are of almost equal
economic value and which are simultaneously and unavoidably
produced in natural proportions from the same input. For example,
in an oil refinery, when crude oil is processed, petrol, diesel,
lubricating oils, etc., are the joint products.

By-products are products of relatively small value which are
incidentally and unavoidably produced in the course of manufacturing
the main product. Examples are oil cake produced in the extraction
of edible oil, cotton seed produced in cotton textile industry, etc.
Joint products and by-products are generally distinguished on the
basis of their relative sales values and the purpose of production.

After joint products and by-products get separated from each other,
these may require further processing to make them saleable. The
costs incurred after separation are known as ‘subsequent costs’ or
‘after separation costs’ or ‘after split-off costs’.

Accounting for joint products requires the apportionment of joint
cost to each of the joint product on the basis of sales value of
products or physical quantities produced, etc.

In reverse cost method the joint cost is apportioned on the basis of net
value of each product. The net value is calculated by deducting the
following from the sales value: (a) Estimated profit margin; (b) Selling
and distribution costs, if any; and (c) After split-off processing costs.

For accounting of by-products, where these are of small total value,
the net income realized from their sale may be treated as
‘miscellaneous income’ and credited to Costing Profit and Loss
Account or credited to the process account in which the by-product
has arisen. Where by-products are of considerable sales value, it is
proper to apportion a part of the joint cost to by-products.
EXAMINATION QUESTIONS
Objective Type Questions
I. True or False? Give reason in brief.
1.
2.
3.
4.
5.
6.
In process costing, normal process loss is transferred to costing P&L Account.
Abnormal gain appears on the credit side of the Process Account
Normal process loss does not increase the per unit cost of production.
Cost per unit remains the same whether there is abnormal gain or abnormal loss.
Abnormal loss increases the cost per unit in process account.
Apportionment of joint cost to joint and by-products does not affect overall profit
or loss.
7. There is no difference between joint products and co-products.
8. Management may treat a joint product as a by-product.
Process Costing
8.79
9. By-product may not have any realizable value.
10. Raw material cost is always a part of joint cost and not of after separation cost.
II. Fill in the blank spaces.
1. The stage of production at which separate products are identified is known as....
2. The .................product usually has a greater sales value than by-products.
3. The ................of the products is the most important criterion for distinguishing
between scrap, by-products and joint products.
4. The costs incurred upto the point where individual products can be identified are
called ............. costs.
5. Under the ................. method of apportionment of joint costs, the cost per unit
of each product is the same.
Theoretical Questions
1. What are the basic differences between job order and process cost systems?
2. Describe the general features of process costing. In what type of industries is
process costing generally adopted? Discuss with figures the method of treatment
of process loss in process costing system.
3. Define normal and abnormal process losses explaining the possible causes. How
are these dealt with in cost accounts?
4. How will you deal with (i) Normal wastage, (ii) Abnormal wastage, and (iii)
Abnormal effectives in process cost accounts? Explain the effect of each of them
on the cost of an article.
5. What do you mean by abnormal gain? How will you treat the same in cost
accounts?
6. What is equivalent production? How is it computed?
7. ‘Job costing is more accurate than process costing.’ Comment.
8. Distinguish between joint products and by-products.
9. Define by-products and joint products and give examples of each.
10. Distinguish between joint products and by-products and explain briefly the methods
used for accounting for them.
11. How would you deal with by-products in costing:
(i) Where they are of small total value
(ii) Where they are of considerable total value
(iii) Where they require further processing
12. Distinguish between joint expenses and common expenses.
13. Explain in brief the concept of split-off point.
Practical Questions
1. 600 kg of a material was charged to Process A at the rate of `4 per kg. The direct
labour accounted for `200 and the other departmental expenses amounted to `760.
The normal loss is 10% of input and the net production was 500 kg. Assuming that
process scrap is saleable at `2 per kg, prepare a ledger account of Process A
clearly showing the values of normal and abnormal loss. (B. Com Delhi, CA Inter)
2. The output of Process X transferred to Process Y was 2,500 units. Normal loss
was 10% of input in Process X and was 300 units. Abnormal loss was reported
to be 200 units. The other information is as follows:
Process Costing
8.80
Materials introduced @ `5 per unit, Labour cost `4,000 and overheads `3,350.
Normal loss realized `2.50 per unit.
You are required to prepare:
(i) Process X Account
(ii) Abnormal Loss Account.
3. A product passes through two Processes A and B and thereafter it is transferred
to finished stock. The output of A passes to B and of B to finished stock. From
the following information you are required to prepare process accounts.
A
B
Materials consumed
`
24,000
14,000
Direct labour
`
28,000
18,000
Manufacturing expenses
`
23,100
26,468
Units 20,000
—
20,000
—
Units 18,800
16,600
5%
10%
`10 per 100 units
`10 per 100 units
Input in process A
Input in process A
Output
`
Normal wastage-% of input
Value of normal wastage
4. In a factory, the product passes through two Processes, A and B. A loss of 5% is
allowed in Process A and 2% in Process B, nothing realized by disposal of the wastage.
During April, 10,000 units of material costing `6 each were introduced in
Process A. The other costs were as follows:
Process A
Process B
Materials
`
—
`
6,140
Labour
10,000
6,000
Overheads
6,000
4,600
The output was 9,300 units from Process A. 9,200 units were produced by
Process B which were transferred to warehouse.
8,000 units of the finished product were sold @ `15 per unit, the selling and
distribution expenses being `2 per unit.
Prepare (i) Process Accounts; and (ii) a Statement of Profit or Loss of the
firm for April assuming there were no opening stock of any type.
5. A Product passes through three process to completion. During the quarter ending
31st March, 2021 the cost and production were as under:
Processes
Direct material
Direct labour
Direct expenses
Production overhead
Normal loss in input
Sale of scrap per unit
Production in units
Total (`)
84,820
1,20,000
7,260
60,000
–
–
–
A (`)
20,000
30,000
5,000
–
10%
`30
920 units
B (`)
30,200
40,000
2,260
–
5%
`50
870 units
C (`)
34,620
50,000
–
–
10%
`60
800 units
Process Costing
8.81
1,000 units of `50 per unit were introduced to Process A. There were no
stock of materials or work-in-progress in any process department at the beginning
or end to the period.
Production overhead is allocated each process on the basis of 50% of direct
labour cost.
Prepare process accounts.
(ICWA Inter)
6. The product of a company passes through three distinct processes to completion.
From the past experience it is ascertained that wastage is incurred in each process
as under: Process A 2%, Process B 5% and Process C 10%.
The wastage of Processes A and B is sold at `10 per 100 units and that of
Process C at `80 per 100 units.
Following is the information regarding the production of March 2005:
Process A
Process B
Process C
`
`
`
Materials
12,000
8,000
4,000
Direct labour
16,000
12,000
6,000
Machine expenses
2,000
2,000
3,000
Other factory expenses
3,500
3,800
4,200
20,000 units have been issued to Process A at a cost of `20,000. The output of
each process has been as under:
Process A 19,500 units
Process B 18,800 units
Process C 16,000 units
There was no stock of work-in-progress in any process in the beginning and
in the end of March. Prepare Process Accounts.
(B. Com., Delhi)
7. The product of a manufacturing concern passes through two Processes A and B
and then to finished stock. It is ascertained that in each process, normally 5% of
the total weight is lost and 10% is scrap which from Processes A and B realizes
`80 per tonne and `200 per tonne, respectively.
The following are the figures relating to both the processes:
Process A
Process B
Materials in tonnes
1,000
70
Cost of materials in rupees per tonne
125
200
Wages in rupees
28,000
10,000
Manufacturing expenses in rupees
8,000
5,250
Output in tonnes
830
780
Prepare Process Accounts showing cost per tonne of each process. There was
no stock of work-in-progress in any process.
(B. Com., Delhi)
8. Department A of ABC Chemicals conducts a process which requires mixing of
materials and cooking of the mixture in batches of 1,000 kg each. Cooking results
in 10 per cent loss of weight of the mixture. Also, past experience shows that
two batches out of every ten started in the process are spoiled. The production
records for March 2012 are the following:
(i) Production started in the Process: 50 batches of 1,000 kg each.
(ii) Production completed and transferred to finished goods: 34,200 kg.
(iii) There is no inventory of work-in-progress at the beginning or at the end of
the month.
Costs recorded during the month totalled `70,000.
Prepare the Account of the Process conducted by Department A.
(B. Com. Hons., Delhi)
8.82
Process Costing
9. A product is completed in three consecutive processes. During a particular month,
the input to Process I of the basic raw material was 5,000 units at `2 per unit.
Other information for the month was as follows:
Processes
I
II
III
Output (units)
4,700
4,300
4,050
Normal loss as % of input
5
10
5
Scrap value per unit (`)
1
5
6
Direct wages (`)
3,000
5,000
8,000
Direct expenses (`)
9,750
9,910
15,560
Overheads total `32,000 chargeable as percentage of direct wages.
There were no opening or closing work-in-progress stock. Compile the three
process accounts and finished stock account with details of abnormal loss and
gain, whereever applicable.
(CS Inter)
10. The finished product of a manufacturing company passes through three processes, viz.,
I, II and III. The normal wastage in each process is 5%, 7% and 10% for the processes
I, II and III, respectively (calculated with reference to the number of units fed into each
process). The scrap generated out of wastage has a sale value of 70 paise per unit, 80
paise per unit and `1 per unit, in the processes I, II and III, respectively. The output of
each process is transferred to the next process and the finished output emerges from the
Process III and transferred to stock. There was no stock of work-in-progress in any
process in a particular month. The details of cost data for the month are given below:
Processes
I
II
III
Materials used (`)
1,20,000
40,000
40,000
Direct labour cost (`)
80,000
60,000
60,000
Production expenses (`)
40,000
40,000
28,000
Output in units (actuals)
38,000
34,600
32,000
Process I was fed with 40,000 units of raw input at cost of `3,20,000.
Prepare the process accounts.
(ICWA Inter)
11. A product is obtained after passing it through three processes. The following
information is collected for January 2018.
Processes
I
II
III
Direct material (`)
5,200
3,960
5,924
Direct wages (`)
4,000
6,000
8,000
Output in the month (units)
950
840
750
Normal loss
5%
10%
15%
Value of scrap per unit (`)
4
8
10
Additional data:
1,000 units, at `6 each, were introduced in Process I. There was no stock of
materials of work-in-progress at the beginning or at the end of the month.
Production overheads was `18,000 for the month. Prepare process accounts
indicating normal loss, abnormal loss and abnormal gain.
12. A Dabur Co. Ltd. produces a harbal shampoo which is made by subjecting certain
crude herbs to two successive processes: A and B. The following data is respect
of processing have been obtained from the accounting records of the company
for a cost period:
Process Costing
8.83
Particulars
Input (units)
Normal loss
Cost incurred:
Material (Herbs)
Direct labour
Production overheads
Realisable scrap value/unit
Process A
Process B
50,000
10%
46,000
?
`
9,00,000
4,26,000
2,84,000
7
`
1,96,000
2,47,000
1,78,000
20
The output of process A is transferred to process B. The output of process B was
43,200 units, which were sold at `60 per unit showing a profit of 20% on costs.
You are required to prepare the process cost accounts assuming that there was
no closing stock of W.I.P and finished goods.
13. A product is finally obtained after it passes through three distinct processes. The
following information is available from the cost records.
Process I
Process II
Process III
Total
`
`
`
`
Materials
2,600
2,000
1,025
5,625
Direct wages
2,250
3,680
1,400
7,330
Production overheads
—
—
—
7,330
500 units @ `4 per unit were introduced in process I. Production overheads
are absorbed as a percentage of direct wages.
The actual output and normal loss of the respective processes are given below:
Output
Normal loss as a Value of scrap
(units)
percentage of input
(per unit)
Process I
450
10%
`2
Process II
340
20%
`4
Process III
270
25%
`5
Prepare the Process accounts and the abnormal gain/loss accounts. (ICWA Inter)
14. The product of a manufacturing unit passes through two distinct processes. From
past experience the incidence of wastage is ascertained as under:
Process A – 2%
Process B – 10%
In each case, the percentage of wastage is computed on the number of units
entering the process concerned. The sales realization of wastage in Processes A
and B are `25 per 100 units and `50 per 100 units, respectively. The following
information is obtained for the month of April:
40,000 units of crude material were introduced in Process A at a cost of `16,000.
Process A
Process B
Other materials
`16,000
5,000
Direct labour
`9,000
8,000
Direct expenses
`8,200
1,500
Output
Units 39,000
36,500
Finished product stock in units:
1 April
6,000
5,000
30 April
5,000
8,000
8.84
Process Costing
Value of stock per unit on 1 April:
Process A—`1.20, Process B—`1.60
Stocks are valued and transferred to subsequent process at weighted average costs.
Prepare the respective Process Accounts and Stock Accounts.
(ICWA Inter)
15. A product passes through three process, namely, 1, 2 and 3. From the following
information, prepare the process accounts:
Process I
Process II
Process III
Raw materials used (tonnes)
1,000
—
—
Cost per tonne (`)
200
—
—
Manufacturing wages and expenses (`) 72,500
40,800
10,710
Weight loss
5%
10%
20%
Scrap (sold at `50 per tonne)
50
30
51
Two-thirds of output of process I and one-half of process 2 output passes to
the next process and the balance is sent to warehouse for sale.
16. Department I of Coromandel Chemicals conducts a process which requires mixing
of materials and cooking of the mixture in batches of 1,000 kg each.
Cooking results in 10 per cent loss of weight of the mixture. Since cooking
requires considerable skill and constant watching, there is generally a further loss
from spoilage which is not discovered unless processing has been completed. Past
experience shows that normally two batches out of every ten started in the process
are spoiled in this way.
The production records for the month of April 2018 give the following details:
(i) Production started in the process – 50 batches of 1,000 kg each.
(ii) Production completed and transferred to finished goods is 34,200 kg.
(iii) There is no inventory of work-in-process at the beginning or at the end of the
April 2018.
(iv) Costs recorded during the month amounted to `45,000.
Prepare the account of the process conducted in department I of Coromandel
Chemicals for April 2018.
17. Product X in a manufacturing unit passes through three processes—A, B and C.
The expenses incurred in the three processes during the year 2018 were as under:
A
B
C
Units of input issued
9,000
`
`
`
Cost per unit
150
—
—
Sundry materials
23,500
25,000
15,000
Direct labour
80,000
2,07,200
26,110
Direct expenses
2,250
7,200
8,100
Selling price per unit of output
200
280
600
The actual outputs obtained vis-a-vis normal process losses from the three
processes were:
Output (units)
Process loss (%)
Process A
8,400
5
Process B
5,700
10
Process C
3,660
3
Process Costing
8.85
During the year, three-fourth of the output of process A and two-third of the
output of process B were transfered to the next process and the balances were
sold outside. The entire output of process C was however, sold outside. The
losses of the three processes were sold at `5 per unit for process A, `10 per unit
for process B and `15 per unit for process C.
Prepare the three process accounts and a statement of income, considering a
total selling and distribution expenses of `45,000 which is not allocated to
processes.
(ICWA Inter)
18. A company that produces a chemical compound in a single process accumulated
a total cost of `50,400 during the month of march.
The production record prepared at the end of the month showed the following:
Started in process
1,00,000 kg
Loss through evaporation—10% of input
10,000 kg
Spoiled through improper processing
90,000 kg
20,000 kg
Good production completed
70,000 kg
Calculate the cost per kg, separately, under every one of the following assumptions:
(a) Processing is highly technical and normal spoilage is 20% of input.
(b) The spoilage does not normally exceed 10 per cent of input.
( c ) Processing is routine and only the carelessness on the part of the operators
can result in spoilage; normally no spoilage occurs. (B. Com. Hons., Delhi)
19. You are given the following information:
Input 3,800 units; Output 3,000 units; Closing work-in-progress 800 units.
Degree of completion
Process costs
`
Materials
80%
14,560
Labour
70%
21,360
Overheads
70%
14,240
Find out (a) Equivalent production, (b) Cost per unit of equivalent production
and (c) Prepare process account assuming that there is no opening work-inprogress and process loss.
20. During January, 1,000 units costing `6,000 were introduced in process I. There
was no work-in-progress at the beginning. At the end of January, 600 units were
transferred to Process II. 250 units were incomplete and 150 units had been
scrapped. The normal process loss was 10% of input. It was estimated that
incomplete units had reached the following stages:
Materials
Labour
Overheads
— 80%
— 60%
— 60%
The cost uncurred during the month are as under :
Direct materials introduced
— `2,700
Direct wages
Production overheads
— `3,200
— `1,600
Value of scrap is `2 each. The units scrapped have passed through the process
and are 100% complete as regards material, labour and overheads.
8.86
21.
22.
23.
24.
Process Costing
You are required to:
(a) Prepare a statement of equivalent production
(b) Statement of cost for each element
(c) Statement of apportionment of process cost
(d) Process I Account
(e) Abnormal Loss Account
The Vega Manufacturing Co. uses FIFO method of inventory valuation in process
costing. The following data relate to Process I for the month of April 2021:
(a) Beginning work in process:
Quantity
:
1,500 units
Value
:
`4,500
(b) Introduced during the month
:
5,000 units
(c) Transferred to Process II
:
5,500 units
(d) Ending work-in-process
:
1,000 units
(e) Degree of completion:
Beginning WIP
Ending WIP
Materials
100%
100%
Conversion costs
80%
60%
( f ) Costs added during the month:
Materials
:
`10,000
Labour
:
`9,800
Overheads
:
`4,900
You are required to:
(i) Prepare a statement of equivalent production;
(ii) Prepare Process I account.
Opening work-in-process 2,000 units, completed as to:
Materials 80%, Labour 60%, Overheads 60%
Units introduced – 8,000 units
Closing work-in-process – 3,000 units, completed as to:
Materials 80%, Labour 60%, Overheads 60%.
Find out equivalent production using average method and FIFO method,
assuming that there is no process loss.
A company manufactures a product which involves two consecutive processes,
viz., Pressing and Polishing. For the month of September, the following information
is available:
Pressing
Polishing
Opening stock
—
—
Input of units in process
1,200
1,000
Units completed
1,000
500
Units under process
200
500
Materials cost
`96,000
`8,800
Conversion costs
`2,88,000
`52,000
For incomplete units in process, charge material cost at 100 per cent and
conversion costs at 60 per cent in the Pressing Process and at 50 per cent in the
Polishing Process. Prepare a statement of cost and calculate the selling price per
unit which will result in 25 per cent profit in sale price.
(CA Inter)
XYZ Co. Ltd has a single process.
Work-in-process (opening) 8,000 units; Cost: Material `29,600; Wages `6,600;
Overheads `5,800.
Process Costing
8.87
During the period the input was 32,000 units.
Additional costs were: Material `1,12,400; Wages `33,400; Overheads `30,200.
At the end of the year 28,000 units were fully processed and 12,000 units
were in process. The value of the closing stock includes the full cost of materials
and only one-third of the cost of wages and overheads. Tabulate the production
and cost figures of give quantities, unit values, total value of completed output
and detailed values for the closing work-in-process.
(CA Inter, Adapted)
25. Prepare a statement of Equivalent Production, Cost Statement, Statement of
Valuation and Process Account from the following particulars using FIFO method:
(a) Opening work-in-progress – 900 units at `4,500
Degree of completion: Material – 100%, Labour and overheads – 60%
(b) Input of materials – 9,100 units at `27,300
Expenses: Labour – `12,300, Overheads – `8,200
(c) Units scrapped – 1,200 units, Degree of completion: Material – 100%, Labour
and overheads – 70%
(d) Closing work-in-progress – 1,000 units, Degree of completion: Material –
100%, Labour and overheads – 80%
(e) Finished units transferred to next process – 7,800
(f) Normal scrap – 10% of input; scrap realization @ `3 per unit
If the above statements are prepared under Average Cost Method, do you
need any more details?
(B.Com. Hons., Delhi, ICWA Inter)
26. From the following information for the month of October, 2017, Prepare Process
III Cost Accounts:
Opening WIP in Process III
Transfer from Process II
Transferred to Warehouse
Closing WIP of Process III
Units scrapped
Direct material added in Process III
Direct wages
Production overheads
1,800 units at `27,000
47,700 units at `5,36,625
43,200 units
4,500 units
1,800 units
`1,77,840
`87,840
`43,920
Degree of completion:
Material
Labour
Overheads
Opening stock
80%
60%
60%
Closing stock
70%
50%
50%
Scrap
100%
70%
70%
The normal loss in the process was 5% of the production and scrap was sold @
`6.75 per unit.
(CA PE II)
27. Bawa Ltd, furnishes you the following information relating to Process B for the
month of March.
(i) Opening work-in-progress – Nil
(ii) Units introduced – 10,000 units @ `3 per unit.
8.88
Process Costing
(iii) Expenses debited to the process:
Direct materials
`14,650
Direct labour
`21,148
Overheads
`42,000
(iv) Normal loss in process – 1 per cent of input
(v) Closing work-in-progress – 350 units
(vi) Degree of completion:
Material
– 100%
Labour and overheads – 50%
(vii) Finished output
– 9,500 units
(viii) Degree of completion of abnormal loss:
Materials
– 100%
Labour and overheads – 80%
(ix) Units scrapped as normal loss were sold at `1 per unit
(x) All the units of abnormal loss were sold at `2.50 per unit
Prepare:
(i) Statement of Equivalent Production
(ii) Statement of Cost
(iii) Process B Account
(B.Com. Hons., Delhi, ICWA Inter)
28. From the following details, prepare Statement of Equivalent Production, Statement
of Cost and find out the value of:
(a) Output transferred; and
(b) Closing work-in-progress
Opening work-in-progress – 2,000 units
Materials (100% complete)
`7,500
Labour (60% complete)
`3,000
Overheads (60% complete)
`1,500
Units introduced into this process – 8,000
There are 2000 units in closing work-in-progress and the stage of completion
is estimated to be:
Materials
100%
Labour
50%
Overheads
50%
8,000 units are transferred to next process.
The process costs for the period are:
Materials
`1,00,000
Labour
`78,000
Overheads
`39,000
Also prepare Process Account. Use the following methods:
(a) Average method, and (b) FIFO method. (B.Com. Hons., Delhi, CA Inter, Adapted)
29. The product manufactured by a light engineering factory undergoes two operations.
The following data are available relating to expenses incurred on production during
November.
Machining
Finishing
Units as input
90,000
60,000
`
`
Expenses incurred in process:
(Contd...)
Process Costing
30.
31.
32.
33.
8.89
Direct material
2,70,000
Nil
Direct labour
1,28,000
45,000
Overheads
64,000
1,35,000
At the end of the month, there were 30,000 units lying incomplete in Machining
Operation. While the full quantity of materials had been consumed for the total
production, the expenditure on labour and overheads was estimated to be 66 2 3 %
in respect of the incomplete products.
You are required to prepare a detailed Cost Statement showing the final cost
per unit assuming:
(i) Completed units of Machining Operation are transferred to the Finishing Operation;
(ii) Finishing Operation has completed all the units received from the earlier
operation during November, leaving no work-in-progress at the end of the
month.
(ICWA Inter)
One tonne of raw material put into a common process yields four products A, B,
C and D, their weights being 63 kg, 117 kg, 180 kg and 540 kg, respectively.
The balance in weight is considered as normal loss. Based on the total processing
cost of `20,000 per tonne of raw material input, you are required to apportion
the joint cost to products A, B, C and D.
(B. Com.)
A coke manufacturing company produces the following products by putting 5,000
tonnes of coal @ `25 per tonne into common process:
Coke
3,500 tonnes
Tar
1,200 tonnes
Sulphate
52 tonnes
Benzol
48 tonnes
Apportion the joint cost amongst the products on the basis of physical units
method.
(B. Com., Madras)
P K Limited produces four joint products A, B, C and D, all of which emerge
from the processing of one raw material. The following are the relevant data:
Production for the period:
Joint products
Number of units
Selling price per unit
`
A
500
18.00
B
900
8.00
C
400
4.00
D
200
11.00
The company budgets for a profit of 10% of sales value. The other estimated
costs are:
`
Carriage
1,000
Direct wages
3,000
Manufacturing overheads
2,000
Administration overheads
10% of sales value
You are required to:
(a) Calculate the maximum price that may be paid for the raw material.
(b) Prepare a comprehensive cost statement for each of the products allocating
the materials and other costs based upon:
(i) Number of units
(ii) Sales values
(B. Com. Hons., Delhi Adapted; CA Inter)
Z X Ltd manufactures product A which yields two by-products B and C. In a
period, the amount spent up to the point of separation was `20,600. The subsequent
expenses were:
Process Costing
8.90
Materials
Direct wages
Overheads
A
`
300
400
300
1,000
B
`
200
300
270
770
C
`
150
200
280
630
The sale values of the production A, B and C were `15,000, `10,000 and
`5,000, respectively. It was estimated that the net profits as percentage of sales
in B and C would be 25% and 20%, respectively.
Ascertain the profit earned on A.
(CA Inter)
34. In the course of manufacture of the main product ‘P’, by-products ‘A’ and ‘B’
also emerge. The joint expenses of manufacture amount to `1,19,550. All the
products are processed further after separation and sold as per details given below:
Main product
By–products
P (`)
A (`)
B (`)
Sales
90,000
60,000
40,000
Cost beyond split-off stage
6,000
5,000
4,000
Profit as percentage of sales
25
20
15
Selling and administration overheads are absorbed as percentage of cost of sales.
Prepare a statement showing the apportionment of joint cost to the main product
and by-products. Also prepare main product ‘P’ account. (B. Com. Hons. Delhi)
35. From the following information find the profit made by each product apportioning
joint costs on sales-value basis:
`
Joint costs:
Direct material
1,26,000
Power
25,000
Petrol, oil, lubricants
5,000
Labour
7,500
Other charges
4,100
Product Y
80,000
1,68,000
(B. Com)
36. In manufacturing the main product A, a company processes, the resulting waste
material into two by-products M 1 and M 2 . Using the method of working back
from sales value to an estimated cost, you are required to prepare a comparative
Profit and Loss Statement of the three products from the following data:
(i) Total cost up to separation point was `1,36,000
M2
A
M1
(ii) Sales (all production) `
3,28,000
32,000 48,000
(iii) Cost after separation `
—
9,600 14,400
(iv) Estimated net profit % to sales value
—
20%
30%
(v) Estimated selling expenses as % of sales value 20
20
20
(ICWA Inter)
37. A factory is engaged in the production of chemical Bomex and in the course of
its manufacture, a by-product Brucil is produced, which after further processing,
has a commercial value. For the month of April, the following are the summarized
cost data:
Selling costs
Sales
Product X
`20,000
`1,52,000
Process Costing
8.91
Joint
expenses (` )
Materials
1,00,000
Labour
50,000
Overheads
30,000
Selling price per unit
Estimated profit per unit on sale of Brucil
Separate expenses
Bomex ( ` )
6,000
20,000
10,000
98
Brucil ( ` )
4,000
18,000
6,000
34
4
No. of units produced
2,000
2,000
The factory uses reverse cost method of accounting for by-products whereby
the sales value of by-products, after deduction of the estimated profit, post
separation costs and selling and distribution expenses relating to the by-products,
is credited to the joint process cost account.
You are required to prepare statements showing:
(i) Joint cost allocable to Bomex,
(ii) Product-wise and overall profitability of the factory for April. (CA Inter)
38. Calculate the estimated cost of production of by-product X and Y at the point of
separation from the main product.
By-product
By-product
X
Y
Selling price per unit
`12
`24
Cost per unit after separation from the main product
`3
`5
Units produced
1,500
2,000
Selling expenses amount to 25% of total works cost, i.e., including both presparation and post-separation works cost.
Selling prices are arrived at by adding 20% of total cost, i.e., the sum of
works cost and selling expenses.
(CA Inter, Adapted)
39. A food-processing company produces four products from a single raw material.
These four products are obtained simultaneously at the point of separation. The
product R does not require further processing before being taken to the market.
The other three products P, Q and S require further processing before being
sold. The company follows the net market value method for allocating common
costs to products. The cost of the raw material used for the year just ended was
`18,000. The initial processing costs were `30,000 for the same period. The
output, sales and further processing costs for the last year were as follows:
Product
Output (units)
Sales ( ` )
Further processing costs ( ` )
P
4,000
36,000
5,000
Q
3,500
14,000
1,750
R
2,500
20,000
—
S
1,200
12,000
3,250
You are required to:
(a) Prepare a comparative profit and loss statement showing the profit/loss made
on each of the four products;
(b) Assess the change in the profit/loss [given in answer to (a) above], if a
proposal (stated below) made by the top management is accepted.
PROPOSAL: To sell all the products directly to other processors just after
separation without any further processing. The expected price per unit for
the products are:
P-`7, Q-`3.50, R-`8, and S-`9.
(ICWA Inter)
Process Costing
8.92
40. A firm manufactures three joint products A, B and C and a by-product X by processing a
common stock of raw material which costs `8 per kg. The details of output, market price
and the initial processing cost for an input of 10,000 kg of raw material is as follows:
Product
Output
(kg)
Current market
Price/kg ( ` )
Initial processing cost
A
B
C
X
5,000
2,500
1,500
500
18
20
24
4
Direct labour: 1000 hrs @ `20/hr
Variable overheads: 80% of direct
labour Fixed overheads: `21,000
The company apportions common cost among joint products on physical units basis.
All the products including the by-product can be processed further and sold at
a higher market price, with some sales promotion effort. The estimated further
processing cost, marketing cost and the final selling price are given below:
Product
Further processing
cost per kg ( ` )
Further marketing
cost per kg ( ` )
Final
Price/kg
A
B
C
X
4
5
6
2
2
2
2
1
28
26
34
6
Required:
(a) Cost of joint products at the point of separation after initial processing.
Comment on the method of apportioning joint costs.
(b) Profit or loss if the products are sold without further processing.
(c) Which of the products have to be processed further for maximizing profits?
Show workings.
(ICWA Inter)
ANSWERS
Objective Type Questions
I. True or False? Give reason in brief.
True — 4, 6, 8;
False — 1, 2, 3, 5, 7, 9, 10
II. Fill in the blank spaces.
1. Split-off stage,
2. Main,
3. Sales value,
4. Joint,
5. Average cost.
Practical Questions
1. Abnormal loss 40 kg at `240; Tr. to B 500 kg at `3,000.
2. Abnormal loss `1,600.
3. Abnormal loss in Process A = 200 units @ `5; Process B = 320 units @ `9;
Tr. to finished stock = `1,49,400.
4. Net Profit `23,260.
5. Tr. from Process A to B 920 units at `1,19,600
Tr. from Process B to C 870 units at `2,08,800
Tr. from Process C to finished stock 800 units at `3,20,000
Process Costing
8.93
6. Tr. to Process B 19,500 units at `53,187; Tr. to Process C 18,800 units at `80,060;
Tr. to Finished stock 16,000 units at `90,550.
7. Cost per tonne A `180, B `210.
8. Cost per unit `2; Abnormal loss 800 units @ `2 = `1,600;
Tr. to finished stock 34,200 units @ `2 = `68,400.
9. Cost per unit at Process I `6, at II `12 and at III `22,
Abnormal loss I 50 units `300, III. 35 units at `770, Abnormal gain II 70 units at `840.
10. Tr. to Process II 38,000 units @ `14.70 = `5,58,600
Tr. to Process III 34,600 units @ ` 19.7078 = `6,81,888
Tr. to Finished stock 32,000 units @ `25.896 = `8,28,700.
11. Cost per unit — Process I `20, II `40 and III `76,
Abnormal loss 15 units in Process II. Abnormal gain 36 units in Process III.
12. Tr. from Process A to B 46,000 units at `16,10,000; Profit in Process B `4,32,000.
13. Tr. to Process II 450 units at `9,000 to Process III 340 units at `17,000
Tr. to Finished goods 270 units at `21,600.
14. Cost per unit A `1.25; B `1.728;
Closing stock value A `1.2433 per unit, B `1.713 per unit.
15. Cost per unit—Process 1 `300, 2 `430, 3 `770.
16. Tr. to finished stock `42,750.
17. Cost per unit: Process A `170, B `230, C `250, Net profit `13,69,740.
18. Cost per kg (a) 72 paise; (b) 63 paise, (c) 56 paise.
19. Equivalent units: Materials 3,640; Labour and overheads 3,560 each;
Cost per unit – Materials `4, Labour `6 and Overheads `4.
20. Eq. units – Materials 850, Labour and overhead, 800 each.
Cost per unit: Materials `10, Labour `4, Overheads `2
Tr. to Process II: 600 units at `9,600.
21. Eq. units Materials 5,000, Labour and Overheads 4900, Cost per unit, Material `2,
Labour ` 2, Overheads `1, Closing WIP `3,800, Tr. next process 5,500 units at `25,400.
22. Average: Eq. units: Materials: 9,400, Labour 8,800, Overheads 8,800
FIFO–Material 7,800; Labour 7,600; Overheads 7,600.
23. Selling price `613.33 per unit i.e., `460 + 153.33.
24. Average method can be use here. Eq. units – Material 40,000; Labour 32,000;
overhead 32,000. Cost per unit– Material `3.55, Labour `1.25, Overheads `1.125
Closing WIP `52,100; Completed output `1,65,900.
25. Tr. to next process 7,800 units at `43,350
Closing work-in-progress 1,000 units at `5,000;
(Hint: For use of average cost method, element-wise cost of material, labour and
overheads of opening work-in-progress is required.)
26. Eq. units – Material A-45,450, Material B-44,460, Labour and Overhead – 43,920 each.
Cost per unit – Material A-`11.473, Material B-`4, Labour `2 overhead `1.
Closing WIP – 4,500 units at `70,978, Tr. to finished goods 43,200 untis at `7,95,372.
27. Eq. units – Materials 9,900; Labour and Overheads—9,715;
Cost per unit – Materials `4.50; Labour `2.18 and Overheads `4.32; Ab. loss
`485; Closing WIP `2,713; Finished output – `1,04,500.
28. (a) Eq. units – Materials 10,000; Lab. and Ohds.–9,000 each. Cost per unit –
Mat. `10.75; Lab. `9; Overheads `4.50; Closing WIP – `35,000; Tr. to next
process `1,94,000.
8.94
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
Process Costing
(b) Eq. units – Mat. 8,000; Lab. and Ohds 7800; FIFO Cost per unit – Mat.
`12.50; Labour – `10; Overheads – `5; Closing WIP `40,000; Tr. to next
process `1,89,000.
Final cost per unit `8.40.
Apportioned cost A–`1,400; B–`2,600; C–`4,000 and D–`12,000
(Hint: Normal loss is 100 kg)
`91,146; `31,250; `1,354, `1,250
(Hint: Difference between total input of 5,000 tonnes and total output of 4,800
tonnes is assumed to be a normal loss.)
(a) `10,000; (b) Cost allocation to A, B, C and D (i) `4,500; 8,100, 3,600;
1,800; (ii) `8,100; 6,480; 1,440; 1,980
Shares of B and C in joint-cost: `6,730; and `3,370; Share of A in joint cost
= 20,600 – (6,730 + 3,370) = `10,500; Profit on A = `3,500
Selling and adm. expenses `14,950; It is a balancing amount.
Share in joint cost P–`54,750; A–`38,200; B–`26,600
Profit X `52,390; Y `10
Profit main product `1,45,600
Cost allocated to Bomex `1,48,000; Profit–Bomex `12,000; Brucil `8,000
Cost per unit X `5, Y `11
Profit (a) P `10,333; Q `4,083; R `6,667; S `2,917;
(b) P `7,333; Q `4,083; R `6,667; S `4,967
(Hint: Joint cost of `48,000 is apportioned in the ratio of net sales, i.e., sales
minus further processing costs. It is in the ratio of
31,000 : 12,250 : 20,000 : 8,750).
Joint cost to be apportioned = Raw material `80,000 + Direct labour `20,000
+ Varitable overheads `16,000 + Fixed overheads `21,000 minus sale value of
by-product X `2,000 = `1,35,000. Share in joint cost A `75,000, B `37,500 and
C `22,500
Profit—A `1,500; B `12,500; C `13,500.
Products A and C should be processed further while B and X should be sold at
split-off point.
CHAPTER
9
OPERATING COSTING
(Service Costing)
Learning Objectives
After studying this chapter, you should be able to:
• Understand the meaning of operating costing and the type of undertakings in
which this method is used
• Know the types of cost units—simple and composite
• Understand the method of computing the number of cost units
• Know how to prepare an operating cost sheet and determine cost per unit in
transport undertakings
Service costing, also known as operating costing, is a method of cost ascertainment
used in those undertakings which are engaged in providing services, such as transport,
electricity, etc. These undertakings do not manufacture tangible products. The cost
of providing a service is termed as ‘operating cost’. In many manufacturing companies,
service costing is used in certain departments which render services, within the
organization, e.g., internal transport and personnel department.
According to CIMA London,
Operating costing is that form of operation
Operating Costing is applicable
costing which applies where standardized
in:
services are rendered either by an
• Road transport companies
undertaking or by a service cost centre
• Railways
within an undertaking.
• Airways
Operating costing should not be
• Shipping companies
confused with operation costing. While
• Electricity companies
operating costing is applied to determine
• Water supply companies
the cost of providing a service, operation
• Gas supply companies
costing is a refinement and more detailed
• Hospitals and nursing homes
application of process costing.
• Cinemas
• Canteens and hotels
Characteristics
• Computer centres
The following characteristics are usually
• Schools and colleges
found in industries where operating costing
• Local authority
is used:
• Power house in a factory
Operating Costing (Service Costing)
9.2
(a) Services rendered to customers are of unique and standardized type.
(b) A large proportion of the total capital is invested in fixed assets and
comparatively less working capital is required.
(c) The distinction between fixed cost and variable cost is of particular
importance. This is because the economics and scale of operations
considerably affect the cost per unit of service rendered. For example, fixed
cost like insurance per passenger will be lower if buses in transport company
run capacity packed.
Cost Unit
The selection of a suitable cost unit (unit of service) is very important. The cost units
may be of the following two types:
(1) Simple cost unit
Undertaking
1. Transport
2. Water works
3. Municipality
4. Canteen
A few examples are given below:
Cost unit
Per kilometre or per mile
Per 1,000 litres
Per km of road maintained
Per meal or per dish
(2) Composite cost unit In service undertakings, generally a composite cost unit is
used. In this type, two units are rolled into one. For example, in a transport company,
weight of goods as well as distance covered should be taken into account in evolving
a cost unit, i.e., a tonne-kilometre, which means 1 tonne of goods transported to
1 km. Other examples are:
Undertaking
1. Transport
2. Hospital
3. Hotel
4. Cinema
5. Electricity
Cost unit
Per passenger-km or Per tonne-km
Per bed per day
Per room per day
Per seat per show (or per man show)
Per kilowatt hour (kWh)
TRANSPORT COSTING
Transport costing is a type of service costing which is used for cost ascertainment in
those undertakings which provide transport services.
Objectives
The main objectives of transport costing are:
1. To fix the rates of carriage of goods or passengers on the basis of operating
costs.
2. To decide the hire charges where vehicles are given on hire.
3. To determine what should be charged to departments or others using the
service.
4. To compare the cost of using own motor vehicles and that of using alternate
forms of transport.
5. To compare the cost of maintaining one vehicle with another or one group
of vehicles with another group.
Operating Costing (Service Costing)
9.3
Determination of Number of Cost Units
The cost unit in passenger transport is usually a passenger kilometre and in goods
transport it is a tonne-kilometre. The calculation of the total number of cost units is
illustrated below:
Illustration 9.1 A Delhi-Jaipur Transport Co. runs four buses between two towns which are
50 km apart. The seating capacity of each bus is 50 passengers and actual passengers carried
are 80% of the seating capacity. All the 4 buses run on 25 days in a month and each bus
makes one round trip per day. Calculate passenger-km.
Solution
Passenger
km
=
No. of
buses
× Distance ×
Capacity of
each bus
×
Capacity
utilised
×
Round
trip
×
No. of
days
= 4 × 50 × 50 × 80% × 2 × 25
= 4,00,000 passenger kilometres per month.
Absolute tonne-km and Commercial tonne-km
In transport costing, composite cost units may be computed in two ways—
(a) absolute tonne-km, and (b) commercial tonne-km
In absolute tonne-km, cost units between each two stations is calculated
separately in tonne-km and then totalled up. But in commercial tonne-km, the trip is
considered as a whole and it is arrived at by multiplying the total distance in km by
average load quantity.
Illustration 9.2 A truck starts with a load of 10 tonnes of goods from station P. It unloads
4 tonnes at station Q and rest of the goods at station R. It reaches back directly to station
P after getting reloaded with 8 tonnes of goods at station R. The distances between P to
Q, Q to R and then from R to P are 40 km, 60 km and 80 km, respectively. Compute absolute
tonne-km and commercial tonne-km.
(B. Com. Hons., Delhi, CA Inter)
Solution
Absolute tonne-km
= (40 km × 10 tonnes) + (60 km × 6 tonnes)
+ (80 km × 8 tonnes)
= 400 + 360 + 640 = 1,400 tonne-km
Commercial tonne-km
= Average load × Total km
 10  6  8 
= 
 tonnes × 180 km
3


= 8 tonnes × 180 km = 1,440 tonne-km
Log Sheet
Most of the details required for transport costing are obtained from log sheet. A log
sheet is maintained for each vehicle to record details of trips, running time, capacity,
mileage, etc., on daily basis. These details also enable the management to avoid
idleness of vehicles, to prevent waste of capacity and to guard against unnecessary
duplication of trips. A specimen of a log sheet is given in Fig. 9.1.
Operating Costing (Service Costing)
9.4
DAILY LOG SHEET
Vehicle No. ..................................
Date of purchase ...........................
Make and specification ................
.........................................................
Route No. ...............................
Driver ......................................
Time left .................................
Time returned ........................
Particulars of Trips
Trip No.
From
To
Tons or Packages
Out
Collection
en-route
Distance
km
Out
Time
Remarks
In Hrs.
taken
Supplies
Worker’s time
Abnorma
Petrol/Diesel ...................
Driver .....................
Loading/Unloading .................
Oil ....................................
Conductor ..............
Traffic delays .........................
Grease ..............................
Cleaner ...................
Accidents ................................
Fig. 9.1
Supplies
Daily log sheet.
Transport Costing Procedure
Costs are classified and accumulated under the following heads:
1. Standing or fixed charges These are constant costs and are incurred irrespective
of the mileage run. Such costs, therefore, should not be allocated to specific journeys
on the basis of mileage. Some of these are direct or traceable fixed costs and can be
allocated to specific vehicles, other such costs are suitably apportioned to each
vehicle. Opinions differ as to whether depreciation is to be regarded as a fixed cost or
a variable cost. It is thus sometimes regarded as a variable cost and sometimes as a
fixed cost. Interest on capital may also be included in fixed charges.
2. Running or variable charges These costs are those which vary in direct
proportion to mileage run and so variable cost per unit may be computed straightaway.
Wages of drivers, conductors and cleaners are sometimes regarded as variable costs
if payment is made according to distance or trips.
These two types of costs are compiled periodically in an operating cost sheet as
shown in the proforma given in Fig. 9.2.
Operating Costing (Service Costing)
9.5
Operating Cost Sheet for the period..............
Cost unit ................................
No. of cost units ..................
Particulars
Total
`
Per unit
`
Standing Charges:
Licence fee
Road tax
Garage rent
Insurance
Driver’s wages
Conductor’s wages
Cleaner’s wages
Administration cost
(A) Total
Variable Charges:
Petrol/diesal
Oil, grease
Depreciation
Repair and maintenance
Tyres and tubes
(B) Total
Grand Total (A) + (B)
Fig. 9.2
Operating cost sheet in transport companies.
Illustration 9.3 From the following data relating to two different vehicles A and B, compute
the cost per running mile:
Vehicle A
Vehicle B
Mileage run (annual)
`15,000
`6,000
Cost of vehicle
`25,000
`15,000
Road licence (annual)
`750
`750
Insurance (annual)
`700
`400
Garage rent (annual)
`600
`500
Supervision and salaries
`1,200
`1,200
Driver’s wages per hour
`3
`3
Cost of fuel per gallon
`3
`3
20 miles
15 miles
`1.65
`2.00
Miles run per gallon
Repairs and maintenance per mile
Tyre allocation per mile
Estimated life of vehicles
`0.80
`0.60
1,00,000 miles
75,000 miles
Charge interest at 5% per annum on cost of vehicles. The vehicles run 20 miles per hour
on an average.
(B.Com. Hons., Delhi, ICWA Inter)
Operating Costing (Service Costing)
9.6
Solution
Operating Cost Sheet
for the year ending.........
No. of cost units A: 15,000
B: 6,000
Cost unit: One mile
Particulars
Vehicle A
`
Vehicle B
`
750
700
600
1,200
1,250
750
400
500
1,200
750
4,500
3,600
0.30
0.60
0.15
0.15
1.65
0.80
0.25
0.15
0.20
2.00
0.60
0.20
Variable cost per mile (B)
3.00
3.15
Total Cost Per Running Mile (A + B)
3.30
3.75
Fixed Cost Per Annum:
Road licence
Insurance
Garage rent
Supervisory salaries
Interest 5% on cost of vehicle
Total
Fixed cost per mile (A)
Variable Cost Per Mile:
Driver’s wages (`3 per hour for 20 miles)
Fuel cost per mile
Repairs and maintenance
Tyre allocation
Depreciation (Cost ÷ Estimated life)
Price Quotations
Transport companies may have to quote prices for specific trips on contract basis or
mileage basis. The method of preparing price quotations is similar to that as explained
in earlier chapter on Output or Unit Costing, i.e., price quotation is usually based on
cost plus desired profit. A Statement of Quotation is thus prepared to determine the
Quotation Price as shown in the following Illustration.
Illustration 9.4 Union Transport Company supplies the following details in respect of a
truck of 5-tonne capacity:
Cost of truck
Estimated life
Diesel, oil, grease
Repairs and maintenance
Cleaner’s wages
Driver’s wages
Insurance
Tax
General supervision charges
`90,000
10 years
`15 per trip each way
`500 per month
`250 per month
`500 per month
`4,800 per year
`2,400 per year
`4,800 per year
The truck carries goods to and from city covering a distance of 50 miles each way.
While going to the city, freight is available to the extent of full capacity and on return
20% of capacity.
Operating Costing (Service Costing)
9.7
Assuming that the truck runs on an average 25 days a month, work out—
(i) Operating cost per tonne-mile, and
(ii) Rate per trip that the company should charge if profit of 50% on freightage is to be
earned.
Solution
(i)
Operating Cost Statement
for the month ending......
Tonne-miles = 7,500*
Per month
`
1. Fixed Costs:
Driver’s wage
Cleaner’s wage
Insurance
Taxes
General supervision
2. Running (or Variable) Costs:
Diesel oil, etc. (15 × 2 × 25)
Repairs and maintenance

Depreciation  90,000 ×
1 1
× 
10 12 
500
250
400
200
400
Per tonne-mile
`
1,750
0.233
2,000
0.267
3,750
0.500
750
500
750
Total
*Note: Tonne-miles are computed as under:
[(50 × 5) + (50 × 1)] × 25 days = 7,500 tonne-miles
(ii) Calculation of Freight Rate and Quotation
Cost per tonne-mile
Profit per tonne-mile (50% on freightage is 100% on cost)
Freight rate per tonne-mile
Freight rate per trip both ways = `1 × 300 tonne-miles = `300.
`0.50
`0.50
`1.00
Note: In one trip (both ways) there are 300 tonne-miles, i.e., (50 × 5) + (50 × 1) = 300.
PROBLEMS AND SOLUTIONS
Problem 9.1 A lorry starts with a load of 20 tonnes of goods from station A. It unloads
8 tonnes at station B and rest of goods at station C. It reaches back directly to station A
after getting reloaded with 16 tonnes of goods at station C. The distance between A to B,
B to C and then from C to A are 80 km, 120 km and 160 km, respectively. Compute ‘Absolute
tonne-km’ and ‘Commercial tonne-km’.
(B.Com. Hons., Delhi, CA Inter)
Solution
Absolute tonne-km
Commercial tonne-km
= (20 tonne × 80 km) + (12 tonnes × 120 km)
+ (16 tonne × 120 km)
= 5,600 tonne-km
 20 +12 + 16 
= 
 tonne × 36 km
3
= 5,760 tonne-km
Operating Costing (Service Costing)
9.8
Problem 9.2 A transport company, is running a fleet of six buses between two towns
75 km apart. Seating capacity of each bus is 40 passengers. The following particulars are
available for the month of June:
`
Wages of drivers, conductors
3,600
and cleaners
Salaries of office and supervisory staff 1,500
Diesel and other oils
10,320
Repairs and maintenance
1,200
Taxation, insurance, etc
`
2,400
Depreciation
Interest on capital
3,900
3,000
Actual passengers carried were 80 per cent of the seating capacity. All the buses ran on
all days of the month. Each bus made one round trip per day.
Find out the cost per passenger-kilometre.
Solution
Passenger-km for the month are calculated as under:
Actual
No. of
Capacity of
Round
No. of
 Distance 
 capacity 

buses
each bus
trip
days.
utlised
= 6 × 75 × 40 × 80% × 2 × 30 = 8,64,000 passenger-km
Operating Cost Sheet
for the month of June
Passenger-km = 8,64,000
`
`
Standing Charges:
1. Wages of drivers, conductors and cleaners
2. Salaries of office and supervisory staff
3. Taxation, insurance
4. Interest on capital
3,600
1,500
2,400
3,000
10,500
Variable Charges:
1. Diesel and other oils
2. Repairs and maintenance
3. Depreciation
10,320
1,200
3,900
15,420
Total Cost
Cost per passenger-km = Total Cost ÷ No. of passenger-km
= `25,920 ÷ 8,64,000 = 3 Paise
Problem 9.3
his records:
25,920
Devi Lal owns a fleet of taxis and the following information is available from
Number of taxis
10
Cost of each taxi
Salary of manager
Salary of accountant
Salary of cleaner
Salary of mechanic
Garage rent
Insurance premium
Annual tax
`
20,000
600 p.m.
500 p.m.
200 p.m.
400 p.m.
600 p.m.
5% per annum
600 per taxi
Operating Costing (Service Costing)
9.9
Driver’s salary
Annual repair
200 p.m. per taxi
1,000 per taxi
Total life of a taxi is about 2,00,000 km. A taxi runs in all 3,000 km in a month of which
30% it runs empty. Petrol consumption is one litre for 10 km @ `6.80 per litre. Oil and other
sundries are `5.00 per 100 km. Calculate the cost of running a taxi per km.
(B.Com. Hons., Delhi, ICWA Inter)
Solution
Operating Cost Sheet for the period......
`
Fixed cost per month (for 10 taxis)
Manager’s salary
Accountant’s salary
Salary of cleaner
Salary of mechanic
Garage rent
Total
Fixed cost per taxi (2,300 ÷ 10)
5
1

 
Insurance Preminum  20,000 
100 12 

Taxes (600 ÷ 12)
Driver’s salary
Per km
`
600.00
500.00
200.00
400.00
600.00
2,300.00
230.00
83.33
50.00
200.00
563.33
Fixed cost per km (`563.33 ÷ 2,100 km)*
Variable costs per km
Depreciation per effective km (`20,000 ÷ 1,40,000 km*)
6.80
× 3,000 km = `2,040
10
Per effective km = `2,040 ÷ 2100 km* = `0.97
0.27
0.14
Petrol monthly =
 1,000 

Repairs 
 12  2,100 
Oil and other sundries (`150 ÷ 2,100 km*)
Cost per km per taxi
0.97
0.04
0.07
1.49
* Working Notes: The effective km run of a taxi is only 70% as a taxi runs 30% empty.
Therefore, all costs have been calculated taking into account its effective
km. In other words, costs have been inflated presuming that 30% run of the
taxis is normal loss.
Effective km per month = 3000 less 30% = 2,100 km
Effective working life = 2,00,000 less 30% = 1,40,000 km
Problem 9.4 Mr Singh started transport business with a fleet of 10 taxis. Expenses of
operating the fleet are given below:
(i) Cost of each taxi
(ii) Salary of office and garage staff
(iii) Rent of garage
`
3,80,000
38,000 p.m.
12,000 p.m.
Operating Costing (Service Costing)
9.10
(iv) Driver’s salary per taxi
(v) Insurance, tax and sundry expenses per taxi
4,000 p.m.
55,200 per yr
The life of a taxi is 3,00,000 km at the end of which, it is estimated to be sold at `20,000.
A taxi is expected to run on an average 4,000 km per month. Petrol consumption is
12 km per litre of petrol costing `30 per litre. You are required to:
(i) Calculate the cost of running a taxi per km by preparing a statement of operating
cost; and
(ii) Find out the profit Mr Singh may expect to earn during the first month of operations
if the hire charge is `10 per km.
Assume that during the month each taxi runs on an average 4,000 km of which
800 km it runs empty.
(B.Com. Hons., Delhi)
Solution
(i)
Operating Cost Sheet
Per Taxi Per month
`
Fixed Expenses:
Rent (12,000 ÷ 10)
Salary of driver
Salary of office and garage staff (38,000 ÷ 10)
Insurance, tax etc. (55,200 ÷ 12 months)
Total
Fixed expenses per taxi per km (13,600 ÷ 4,000)
Variable Expenses:
Depreciation =
Per km
`
1,200
4,000
3,800
4,600
13,600
3.40
3,80,000  20,000
3,00,000
1.20
Petrol
2.50
Total
7.10
(ii) Calculation of Profit
Takings (3,200 km × 10 taxis × `10)
Less: Cost (4,000 km × 10 taxis × `7.10)
Note:
=
=
`
3,20,000
2,84,000
Profit
36,000
Empty run of the taxis is given for the first month only. It has thus been not applied to
whole life run.
Problem 9.5 A person owns a bus which runs between Delhi and Chandigarh and back, for
10 days in a month. The distance from Delhi to Chandigarh is 240 km. The bus completes
the trip from Delhi to Chandigarh and back in the same day. The bus goes another 10 days
in a month to Agra and the distance covered being 200 km. The trip is also completed in
the same day. For the rest of 4 days it runs in the local city. Daily distance covered in local
city is 60 km. Calculate the rate, the person should charge from passenger when he wants
to earn a profit of 33½% on his takings. The other particulars are given below:
Cost of bus `2,00,000
Depreciation 20% per annum
Salary of driver `1,600 per month
Operating Costing (Service Costing)
9.11
Salary of conductor `1,500 per month
Salary of part time accountant `400 per month
Insurance `2,000 per annum
Diesel consumption: 6 km per litre costing `4.00 per litre
Token tax `600 per annum
Repairs `1,000 per month
Normal capacity 50 passengers
The bus is generally occupied 90% of the capacity when it goes to Chandigarh and 80%
when it goes to Agra. It is always full when it runs within the city.
(CA Inter, B. Com., Adapted)
Solution
Passenger-km are calculated as under:
1. Delhi to Chandigarh
= 50 passengers × 90% Capacity × 10 days × 480 km
= 2,16,000 passenger-km
2. Delhi to Agra
= 50 passengers × 80% Capacity × 10 days × 400 km
= 1,60,000 passenger-km
3. Local city
= 50 passengers × 4 days × 100% × 60 km
= 12,000 passenger-km
Total passenger-km
= 2,16,000 + 1,60,000 + 12,000 = 3,88,000
Total km travelled in month:
Delhi to Chandigarh (480 km × 10 days)
=
4,800 km
Delhi to Agra (400 km × 10 days)
=
4,000 km
Local (60 km × 4 days)
=
240 km
9,040 km
Operating Cost Sheet
for the month......
Per month
`
`
Standing Charges:
Salary of Driver
Salary of Conductor
Salary of Part-time Accountant
Insurance (`2,000 ÷ 12 months)
1,600
1,500
400
167
Token Tax (`600 ÷ 12 months)
Variable Cost:
Depreciation (`40,000 ÷ 12 months)
Repairs
Diesel consumption
Total Cost Per Month:
50
3,333
1000
4

 9,040 km  
6

6,027
10,360
14,077
Cost per passenger km (14,077 ÷ 3,88,000)
Profit (1/3 of takings or 1/2 of cost)
0.0363
0.0181
Rate Per Passenger km
Rate Per Passenger to be Charged
(i) Delhi to Chandigarh = 240 km @ `0.0544
(ii) Delhi to Agra
= 200 km @ `0.0544
3,717
= ` 13.06
= ` 10.88
0.0544
Operating Costing (Service Costing)
9.12
Problem 9.6 Vinay has been promised a contract to run a tourist car on a 20 km long route
for the chief executive of a multinational firm. He buys a car costing `1,50,000. The annual
costs of insurance and taxes are `4,500 and `900, respectively. He has to pay `500 per month
for a garage where he keeps the car when it is not in use. The annual repair costs are
estimated at `4,000. The car is estimated to have a life of 10 years, at the end of which the
scrap value is likely to be `50,000.
He hires a driver who is to be paid `300 per month plus 10% of the takings as commission.
Other incidental expenses are estimated at `200 per month.
Petrol and oil will cost `100 per 100 km. The car will make 4 round trips each day.
Assuming that a profit of 15% on takings is desired and that the car will be on the road for
25 days on an average per month, what should he charge per round trip?
(B.Com. Hons., Delhi Adapted)
Solution
Operating Cost Sheet
Per annum
`
Standing Charges:
Depreciation
Insurance
Taxes
Garage (`500 × 12 months)
Annual repairs
Driver’s salary (`300 × 12 months)
Other expenses (`200 × 12 months)
Per month
`
10,000
4,500
900
6,000
4,000
3,600
2,400
Total
31,400
2,616.67
Variable Expenses:
1


km  `100 
 4,000 * km 
100


Total Cost (without commission)
Petrol and oil:
* Working Note: Total km during the month is calculated as follows:
25 days × 20 km × 2 × 4 round trips = 4,000 km
Calculation of Charge per Round Trip
Let X be the total takings per month:
Driver’s commission
= 10% of X =
Profit = 15% of X
=
X
10
15
3X
X 
100
20
Total taking per month = Total Cost + Driver’s Commission + Profit
X
X –
3X X
–
20 10
= `6,616.67 +
= `6,616.67
X 3X

10 20
4,000.00
6,616.67
Operating Costing (Service Costing)
or
or
X=
9.13
20 X – 3 X – 2 X
20
= `6,616.67
` 6,616.67 × 20
15
= `8,822.22.
Total number of round trips per month: 25 days × 4 round trips per day = 100
Hence the charge per round-trip =
`8,822.23
= `88.23.
100
Problem 9.7 A transport company has been given a 40 km long route to run 5 buses. The
cost of each bus is `6,50,000. The buses will make 3 round trips per day carrying on an
average 80% passengers of their seating capacity. The seating capacity of each bus is 40
passengers. The buses will run on an average 25 days in a month. The other information for
a year are given below:
Garage rent
Annual repairs and maintenance
Salary of 5 drivers
Wages of 5 conductors
Manager’s salary
Road tax etc.
Office expenses
Cost of diesel per litre
km run per litre for each bus
Annual depreciation
Annual insurance
`4,000 per month
`22,500 per bus
`3,000 each per month
`1,200 each per month
`7,500 per month
`5,000 per quarter
`2,000 per month
`33
6 km
15% of cost
3% of cost
Calculate the bus fare to be charged from each passenger per km, if the company wants
(CA CPE)
to earn a profit of 33 1/3% on takings (total receipts from passengers)
Solution
Calculation of total km run during the year
5 buses × 40 km × 2 Returns km × 3 trips × 25 days × 12 months = 3,60,000 km
Total passenger km
= 3,60,000 km × 40 passengers × 80% = 1,15,20,000 passenger km
Operating Cost Statement for the Year
Total for 5 buses
`
Standing or Fixed Charges:
Garage rent (`4,000 × 12 months)
Salary of 5 drivers (`3,000 × 5 × 12 months)
Conductors wages (`1,200 × 5 × 12 months)
Road tax etc. (`5,000 × 4 quarters)
Salary of manager (`7,500 × 12 months)
Office expenses (`2,000 × 12 months)
Insurance (`6,50,000 × 5 buses × 3%)
Total (A)
48,000
1,80,000
72,000
20,000
90,000
24,000
97,500
5,31,500
Per passenger km
`
0.046
(Contd.)
9.14
Operating Costing (Service Costing)
Variable Charges:
Depreciation `6,50,000 × 5 buses × 15%
Repairs and maintenance (`22,500 × 5 buses)
4,87,500
1,12,500
Diesel (`3,60,000 km
`33
)
6 km
19,80,000
Total (B)
Total cost (A + B)
Add: Profit 1/3 of takings (or 50% of cost)
Bus fare per passenger km
25,80,000
31,11,500
0.224
0.270
0.135
0.405
Problem 9.8 A chemical factory runs its boiler on furnace oil obtained from Indian Oil
and Bharat Petroleum, whose depots are situated at a distance of 12 and 8 miles from the
factory site. Transportation of furnace oil is made by the Company’s own tanker lorries of
5 tonnes capacity each. Onward trips are made only on full load and the lorries return empty.
The filling-in time takes an average 40 minutes for Indian Oil and 30 minutes for Bharat
Petroleum. But the emptying time in the factory is only 40 minutes for all. From the records
available, it is seen that the average speed of the company’s lorries works out to 24 miles
per hour. The varying operating charges average 60 paise per mile covered and fixed charges
give an incidence of `7.50 per hour of operation. Calculate the cost per tonne-mile for each
source.
(CA Inter)
Solution
Operating Cost Sheet
Indian oil
Bharat petroleum
24
16
60
40
40
40
30
40
Distance covered (miles)
Time per trip (minutes):
Running time (at 24 m.p.h.)
Filling-in-time
Emptying Time
Total time in minutes
*Fixed Cost @ `7.50 per hour
*Variable cost @ 60 paise per mile
Total Cost
Effective tonne-miles
Cost per tonne-mile (Total Cost ÷ Tonne-miles)
140
110
`
17.50
14.40
`
13.75
9.60
31.90
23.35
(12 miles × 5 tonnes)
= 60
31.90 ÷ 60
= 53 Paise
(8 miles × 5 tonnes)
= 40
23.35 ÷ 40
= 58 Paise
* Working Notes:
1. Fixed cost is calculated on time basis as follows:
Indian Oil = 7.50 ×
140 minutes
= `17.50
60 minutes
Bharat Petroleum = `7.50 ×
110 minutes
= `13.75
60 minutes
2. Variable cost is calculated on mileage basis as under:
Indian Oil = 24 miles @ `0.60 per mile = `14.40
Bharat Petroleum = 16 miles @ `0.60 per mile = `9.60
Operating Costing (Service Costing)
9.15
Problem 9.9 DAS is a public school having five buses each plying in different directions
for the transport of its school students. In view of a large number of students availing of
the school bus service, the buses work two shifts daily, both in the morning and in the
afternoon. The buses are garaged in the school. The workload of the students have been so
arranged that, in the morning, the first trip picks up senior students and, the second trip
plying an hour later, picks up the junior students. Similarly, in the afternoon, the first trip
drops the junior students and an hour later the second trip takes the senior student back
home.
The distance travelled by each bus one way is 8 km. The school works 25 days in a month
and remains closed for vacation in May, June and December. Bus fee, however, is payable by
students for all the 12 months in a year.
The details of expenses for a year are as under:
`
Driver’s salary (per month per driver)
450
Cleaner’s salary (per month)
350
(Salaries are payable for all the twelve months and one cleaner
is employed for all the five buses)
Licence fee, taxes, etc. (per bus per annum)
860
Insurance (per bus per annum)
1,000
Repairs and maintenance (per bus per annum)
3,500
Purchase price of bus (each)
1,50,000
Scrap value of bus (each)
30,000
Diesel cost (per litre)
2
Estimated useful life 12 years
Each bus gives an average mileage of 4 km per litre of diesel. Seating capacity of each
bus is 50 students which is fully occupied during the entire year.
Students picked up and dropped within a range of 4 km of distance from the school are
charged half fare and fifty per cent of the students travelling in each trip are in this category.
Ignore interest.
Since the charges are to be based on average cost, you are required to:
(i) Prepare a Statement showing the expenses of operating a single bus and a fleet of five
buses for a year; and
(ii) Work out the average cost per student per month in respect of—(a) students coming
from distance of 4 km from the school; and (b) students coming from a distance beyond
4 km from the school.
(B. Com. Hons., Delhi, CA Inter)
Solution
Operating Cost Statement
for the period....
` per year per bus
5,400
840
860
1,000
3,500
10,000
7,200
Salary of driver (`450 × 12 months)
Salary of cleaner [(`350 × 12) ÷ 5]
Licence fees
Insurance
Repairs and maintenance
Depreciation [(1,50,000–30,000) ÷ 12 years]
*Diesel cost
Total
28,800
(Contd.)
Operating Costing (Service Costing)
9.16
Operating cost per month (28,800 ÷ 12)
*Number of half fare students
Operating cost per half fare student (2,400 ÷ 150)
Operating cost per full fare student (`16 × 2)
*Working Notes:
1. Diesel cost—It is calculated as under:
Number of trips of 8 km each day by each bus
Distance travelled by each bus per day (8 × 8)
Distance travelled in one month (64 km × 25 days)
Distance travelled per year (1,600 km × 9 months)
Diesel required (14,400 km ÷ 4 km per litre)
Diesel cost (3,600 litres × `2 per litre) per bus
2. Calculation of number of students
Seating capacity of each bus
50% half fare students
50% full fare students
Full fare students as equivalent
to half fare students (25 × 2)
Total number of half fare students per trip
Total number of half fare students in 2 trips
2,400
150
`16
`32
8
64 km
1,600 km
14,400 km
3,600 litres
`7,200 p.a.
50 students
25 students
25 students
50 students
50 + 25 = 75 students
150
Problem 9.10 Global Transport Ltd charges `90 per tonne per lorry load for its 6-tonne
truck, from city ‘A’ to city ‘B’. The charges for the return journey are `84 per tonne. No
concession or reduction in these rates is made for any delivery of goods at intermediate
station ‘C’. In January the truck made 12 outward journeys for city ‘B’ with full load, out
of which, 2 tonnes were unloaded twice in the way at city ‘C’. The truck carried a load of
8 tonnes in its return journey for 5 times but once caught by police and `1,200 were paid
as fine. For the remaining trips, the truck carried full load, out of which all the goods on
load were unloaded once at city ‘C’. The distance from city ‘A’ to city ‘C’ and city ‘B’ are
140 km and 300 km, respectively.
Annual fixed costs and maintenance charges are `60,000 and `12,000, respectively. Running
charges spent during January are `2,944.
You are required to find out the cost per absolute tonne-kilometre and the profit for
January.
(B. Com. Hons, Delhi; CA Inter)
Solution
Basic Calculations
1. Calculation of Tonne-km
Onward
(i) From city A to B
(ii) From city A to C
(iii) From city C to B
Return
(i) From city B to A
(ii) From city B to C
(300 km × 6 tonnes × 10 journeys)
(140 km × 6 tonnes × 2 journeys)
(160 km × 4 tonnes × 2 journeys)
18,000
1,680
1,280
(300 km × 8 tonnes × 5 journeys)
(300 km × 6 tonnes × 6 journeys)
(160 km × 6 tonnes × 1 journey)
12,000
10,800
960
Total Tonne-km
2. Calculation of Revenue
From city A to B (12 trucks × 6 tonnes × `90)
44,720
6,480
Operating Costing (Service Costing)
9.17
From city B to A ( 6 trucks × 6 tonnes × `84)
From city B to A ( 5 trucks × 8 tonnes × `84)
From city B to C ( 1 truck × 6 tonnes × `84)
3,024
3,360
504
Less: Fine
Total
13,368
1,200
Net revenue
12,168
Operating Cost Statement
for the month of January
`
5,000
1,000
2,944
Fixed cost per month (`60,000 ÷ 12 months)
Maintenance charges (`12,000 ÷ 12 months)
Running charges
Total operating cost
Operating cost per km `8,944 ÷ 44,720 tonne-km
Net revenue
Less: Total operating cost
Net Profit for January
8,944
= `0.20
`12,168
8,944
3,224
Problem 9.11 A company is considering three alternative proposals for conveyance facilities
for its sales personnel who have to do considerable travelling, approximately 20,000 kilometres
every year. The proposals are as follows:
(i) Purchase and maintain its own fleet of cars. The average cost of a car is `1,00,000.
(ii) Allow the Executive use his own car and reimburse expenses at the rate of `1.60 per
kilometre and also bear insurance costs.
(iii) Hire cars from an agency at `20,000 per year per car. The company will have to bear
costs of petrol, taxes and tyres.
The following further details are available:
Petrol
Repairs and maintenance
Tyres
Insurance
Taxes
`0.60 per km
`0.20 per km
`0.12 per km
`1,200 per car per annum
`800 per car per annum
Life of the car: 5 years with annual mileage of 20,000 km
Resale value: `20,000 at the end of the fifth year
Work out the relative costs of three proposals and rank them.
(B. Com. Hons., Delhi; CA Inter)
Solution
Comparative Operating Cost Sheet
Fixed Costs:
Taxes
Depreciation
Use of
co. car
`
per km
Use of
own car
`
per km
Use of
hired car
`
per km
0.04
0.80
—
—
0.04
—
(Contd.)
Operating Costing (Service Costing)
9.18
Insurance
Reimbursement/Hire
0.06
0.06
1.60
—
1.00
Variable Costs:
Petrol
Repairs and maintenance
Tyre
0.60
0.20
0.12
—
—
—
0.60
—
0.12
Total cost (per km)
1.82
1.66
1.76
36,400
33,200
35,200
III
I
II
Total cost of 20,000 km
Ranking
Problem 9.12 A practising Chartered Accountant now spends `0.90 per kilometre on taxi
fares for his clients’ work. He is considering two other alternatives, the purchase of a new
small car or an old bigger car. The estimated cost figures are:
Items
New small
car
`35,000
`19,000
`1,000
`1,700
10 km
`3.50
Purchase price
Sale price, after 5 years
Repairs and servicing per annum
Taxes and insurance per annum
Petrol consumption, per litre
Petrol price, per litre
Old bigger
car
20,000
12,000
1,200
700
7 km
3.50
He estimates that he travels 10,000 km annually. Which of the three alternatives will be
cheaper? If his practice expands and he has to do 19,000 km per annum, what should be his
decision?
At how many km per annum will the cost of the two cars break-even and why? Ignore
interest and income-tax.
(B. Com. Hons., Delhi, CA Inter)
Solution
Statement Showing Comparative Costs of
Alternative Modes of Conveyance
Item
New small car
Old bigger car
Fixed Costs Per Annum:
Depreciation
Repairs and servicing
Taxes and insurance
`
3,200
1,000
1,700
`
1,600
1,200
700
(A) Total
Variable Costs Per Annum:
(B) Petrol : 10,000 km
(C) Petrol : 19,000 km
Total Cost:
10,000 km (A + B)
19,000 km (A + C)
5,900
3,500
3,500
6,650
5,000
9,500
9,400
12,550
8,500
13,000
Taxi
`
9,000
17,100
Conclusion For the present practice of 10,000 km the total cost for the old big car is the
lowest and thus this is the cheapest alternative. But when practice expands, the new small car
will be the cheapest.
Operating Costing (Service Costing)
Break-even point

9.19
Difference in fixed cost between old and new car
Difference in variable cost per unit between old and new car
`5,900 – 3,500
35 Paise – 50 Paise
2,400
= 16,000 km
0.15
At 16,000 km per year, the cost of operation of the two cars will break-even. This is shown
below:
Total cost = Fixed cost + Variable cost at 16,000 km
For new car, total cost = 5,900 + 5,600 = `11,500
For old car, total cost = 3,500 + 8,000 = `11,500
Problem 9.13 Carryall Enterprise has been permitted to run a minibus on a route covering
20 km. The minibus has been purchased at a cost of `1 lakh, part of which was financed
through bank loan and balance by loan from other sources.
The annual charges for the minibus are insurance `4,000, road tax `2,000 and garage rent
`1,200. Cost of repairs and maintenance is estimated at `6,000 per annum while replacement
of tyre and tube will cost `480 per month. Office expenses are estimated at `600 per month.
Petrol and oil will cost @ 45 paise per km.
Two drivers and two conductors are engaged at a monthly salary of `500 and `350
respectively. In addition, drivers and conductors are entitled to 5% of the sale of tickets.
The effective life of the vehicle is estimated at 5 years, at the end of which the vehicle
will have scrap value of `10,000.
The minibus is 24-seater and is expected to run 6 two-way trips during the day for 25
days in a month.
You are required to submit passenger fare structure for approval by the transport authority
which allows 20% profit on net sales. Interest on loan is allowed as cost, if instalments are
paid regularly, assume the amount of interest to be `6,720 p.a.
(ICWA Inter)
Solution
Operating Cost Sheet
Per annum
`
Standing Charges:
Insurance
4,000
Garage rent
1,200
Road tax
2,000
Repairs & maintenance
6,000
Office expenses (600 × 12)
7,200
Depreciation (1,00,000 – 10,000)  5 yrs
18,000
Salary of drivers (500 × 2 × 12 months)
12,000
Salary of conductors (350 × 2 × 12 months)
8,400
Interest on loan
6,720
65,520
Per month
`
5,460
(Contd.)
Operating Costing (Service Costing)
9.20
Variable Charges:
Petrol and oil
(25 days × 12 trips × 20 km × `0.45)
Tyres and tubes
Total cost before charging commission*
Commission of drivers and conductors
Total cost
Profif (20% of sales is 25% of total cost)*
Sales
Rate per passenger km = `11,520  1,44,000* =
*Working Notes:
Calculation of commission
Total cost before charging commission
Commission
Profit
Commission + Profit
2,700
480
8,640
576
9,216
2,304
11,520
`0.80
= `8,640
= 5% of sales
= 20% of sales
= 25% of sales is 33
1
of cost
3
1
= 8,640 × 33 % = `2,880
3
Commission
= 2,880 ×
5
= `576
25
= 2,880 + 20 = `2,304
25
Total km = 25 days × 12 trips × 25 km
= 6,000
Total Passenger km = 6,000 × 24 seats
= 1,44,000
Rate per passenger km = `11,520  1,44,000 = `0.8
Profit
Problem 9.14 Keerti Transport Ltd. operates a fleet of lorries. The records for lorry
L-14 reveal the following information for September, 2021:
Days maintained
:
30
Days operated
:
25
Days idle
:
5
Total hours operated
:
300
Total km covered
:
2,500
Total tonnage carried
:
200 (4 tonne-load per trip, return journey empty)
Total cost for the month
:
`2,70,000
Prepare a performance statement showing:
(i) Cost per day operated
(ii) Cost per kilometer
(iii) Cost per hour
(iv) Cost per round-trip
(v) Cost per commercial tonne-km.
(B. Com. Hons., Delhi)
Solution
Total cost = ` 2,70,000
(i) Cost per day operated
=
` 2,70,000
25 days
= ` 10,800
Operating Costing (Service Costing)
` 2,70,000
2,500 km
` 2,70,000
=
300 hr
(ii) Cost per km
=
(iii) Cost per hour
(iv) Cost per round trip
` 2,70,000
50 trips
` 2,70,000
=
5,000 km
=
(v) Cost per commercial km
Working Notes:
1. No. of trips
2. Kilometre per trip
3. Commercial tonne km
9.21
= Total tonnage  4 tonne = 200  4
= 2,500 km  50 tips
= 50 km × 4 tonne × 25 days
=
` 108
=
` 900
=
` 5,400
=
` 54
= 50 trips.
= 50 km.
= 5,000.
Problem 9.15 SR Airlines has been permitted to operate three flights per week between A
and B cities (both sid