Cost accounting book

8/13/2019 Cost accounting book

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Cost

Accounting

Semester Two

Amity

UniversityThe principle concern of the book is to show how cost accounting

theory can be applied to solve the problems in practice. An attempthas been made to relate theory to practice to make it

understandable easily for all kind of students i.e. from accounts or

non-accounts background.

PAN AfricaneNetwork

Project


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PREFACE

This Cost Accounting module seeks to discuss the concept of cost accounting & theirapplication in the organization. The principle concern of the book is to show how costaccounting theory can be applied to solve the problems in practice. An attempt has been

made to relate theory to practice to make it understandable easily for all kind of studentsi.e. from accounts or non-accounts background.Each chapter is having various illustrations relating to each topic covered and followedby multiple choice questions, which are designed to reinforce concepts & procedurepresented in the body of chapter.I wish to express my sincere thanks to many of the authors who have received dueacknowledgements, without whom, this module would not have been completed.I have taken every possible effort to remove the errors either of principle or of printing.Even then, if the reader comes across any error, he/she is requested to point out the sameto me.I hope that many students will find this module interesting & helpful. Further suggestion

for the improvement of the module is solicited.

Tanu Agrawal2010


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INDEX

Chapter No. Chapter Name Page No.

Chapter 1 Introduction to Cost Accounting 2

Chapter 2 Material Costing 24

Chapter 3 Labor Costing 41

Chapter 4 Overheads Costing 59

Chapter 5 Marginal Costing and Cost Volume Profit

Analysis

90

Chapter 6 Standard Costing and variance analysis 121

Chapter 7 Budgets, cost reduction and control 151

Chapter 8 Introduction to Recent developments incosting

175

Answer Key to end chapter questions Page no 193

Syllabus Page no 194

References Page no195


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CHAPTER-1 INTRODUCTION TO COST ACCOUNTING

At the end of the chapter you will be conversant with:

1.1Introduction1.2Comparison Between Financial Accounting and Management Accounting1.3Difference Between Cost Accounting and Management Accounting1.4Difference Between Financial Accounting and Cost Accounting1.5Limitation of Financial Accounting1.6Advantages of Cost Accounting1.7Classification of Cost1.8Cost Centre1.9Cost Unit1.10 Cost Sheet1.1Introduction:Let us begin this subject by attempting to answer some questions such as: What isManagement Accounting? Is it the same as Cost Accounting? In what way it is differentfrom Financial Accounting?

Here is a list of questions, which can be answered with the help of ManagementAccounting.

1. If Tata McGraw-Hill (TMH) Publishing Company, the publisher of books onseveral topics, has an inventory of 8,000 copies of Management Accountingtextbook, at the end of the year, at what cost will it be reported in the CompanysBalance Sheet?

2. How many copies of this book must TMH sell before it makes any profit?3. How much does it cost TMH if the demands of its striking employees have to be

met?

4. How much does it cost a fertilizer manufacturing company like FACT Ltd. to stoppolluting the environment?

5. How much does it cost Icfai to start a new program on capital markets?6. What does the new economic policy cost India?

A keen observation of the above questions reveals that the word cost is common in all ofthem except the second question. The second question has its focus on the word profit.What is the meaning of the words: cost and profit?

Cost is defined as the resources consumed to accomplish a specified objective.


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TMH has to spend money to acquire the necessary resources; such as paper, ink,machinery and the services of the people; to publish the textbook. Publication of the bookmay consume some of these resources completely while it consumes others partly.

Profit is nothing but the difference between sales revenues and expired costs (calledexpenses) of earning those revenues. Thus, even for the second question, costs must bemeasured in order to ascertain the profit. This leads us to the conclusion thatmeasurement of cost is an integral part of Management Accounting. Then, how are costsidentified and measured? The answer to this question lies in Cost Accounting.

Cost Accounting is a system used to record, summarize and report cost information. Costinformation is presented in the form of special reports to the internal users, such asmanagers in the company, which is used in deciding how to operate the organization.These decisions are simply the choices managers make about how their organizationsshould do things. Some cost information, is provided to external users, such as

shareholders and creditors as part of the financial statements).

Thus, cost accounting involves the accumulation, recording and reporting of costs andother quantitative data. The information generated by the Cost Accounting system is usedby an organization for internal purposes and for external purposes. Providing costinformation to managers (internal purposes) to assist them in decision-making is calledManagement Accounting.

Figure1.1

You would have noticed that the definition of cost given earlier referred toaccomplishing a specific objective. Each of the questions listed above also implies aspecific objective or purpose as indicated in Table 1.1 below.

Table 1.1

The Purpose of Cost Information

Question Number Implied Specific Objective

1&2. Will publishing the book be profitable to the company?

3. Should the company offer a higher compensation to its strikingemployees to avoid the strike?

4. Should the company close its plant or install pollution control


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equipment?

5. Will the new program generate enough sales revenue to make itfeasible?

6. Are the benefits of liberalization worth its cost?

The table shows that most of the implied specific objectives are decisions or choices to bemade by managers or the management, whether it is a business concern, academicinstitute or even a country.

1.2 COMPARISON BETWEEN FINANCIAL AND MANAGEMENT

ACCOUNTINGThere are broadly three branches of accounting:- Financial Accounting, Cost Accountingand Management Accounting .Management accounting differs in several ways from financial accounting, they do havecertain similarities also, which have been enumerated as below:

Differences

1. Internal vs. External Uses

Management accounting focuses on providing information for internal users such assupervisors, managers etc. Financial accounting concentrates on providing information tothe external users - stockholders, creditors, etc. A manager is required to direct day-to-day operations, plan for the future, solve internal problems and make numerousdecisions, all of which require specialized information which is provided by ManagementAccounting.. However, such specialized information may be useless and confusing toothers like common shareholders.

2.Emphasis on the Future

Since a large part of the overall responsibilities of a manager involves planning, amanagers information needs have a strong orientation towards the future. Summaries ofpast costs and other past data are relevant only up to a point. Economic conditions,customer demands and competitive conditions are so dynamic that the managersplanning framework, based on estimated figures, may or may not be reflective of pastexperience.

On the other hand, Financial Accounting is concerned with the record of the financial

history of an organization. It has little to do with estimates and projections for the future.Generally Accepted Accounting Principles (GAAP)

Financial Accounting statements are prepared in accordance with GAAP, as theyprovide consistency and comparability and are relied on by outsiders for informationregarding the company. Management Accountants on the other hand, are not governed


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by GAAP. Managers set their own rules on the form and content of information. Whetherthese rules conform to GAAP is immaterial.

3. Relevance and Flexibility of INFORMATION

Financial Accounting information is expected to be objectively determined, and to beverifiable. For internal uses, the manager is often more concerned about receivinginformation that is (a) relevant to a particular decision situation, and (b) flexible enoughto be used in a variety of decision-making situations. Objectivity and verifiability assumesecondary importance.

4.Emphasis on Precision

Audited financial statements have to be precise to the last paisa. As far as a manager isconcerned, when information is needed, timeliness is more important than its precision.The more timely information comes to a manager, the more quickly problems are

attended to and solved. If a decision is to be made, waiting a week for slightly moreaccurate information may turn out to be costlier to the company compared to acting onthe relevant information readily available. Thus, in managerial accounting, estimates andapproximations may be more useful than numbers that are accurate to the last paisa. Forthis reason, managers are often willing to trade off some accuracy in information totimeliness of information.

5.Organizational Focus

Financial accounting is primarily concerned with the reporting on business activities ofa company as a whole. Management accounting, by contrast, focuses less on the companyas a whole and more on the parts or segments of a company. These segments may be theproduct lines, sales territories, divisions, departments, etc. While it is true that somecompanies do report some breakup of revenues and costs in their financial statements,such breakup tends to be of secondary importance. In management accounting,segmented concentration is primarily emphasized.

6. Use of Other Disciplines

Management accounting extends beyond the boundaries of traditional accountingpractices and draws heavily from other disciplines such as economics, cost accounting,finance, statistics, operations research and organizational behavior. Financial accountingon the other hand is bound by conventional accounting systems and practices.

7. Freedom of Choice

Financial accounting is mandatory for business organizations. They should compulsorilymaintain financial records as per various legal statutes like Companies Act, Income TaxAct, etc. By contrast, Management Accounting is not mandatory. There are no regulatorybodies specifying what is to be done and how it is to be done and presented. Thus in


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Management Accounting, the question Is the information useful? Is more importantthan the question Is the information required?

SIMILARITIES

1. Reliance on Common Accounting Information SystemIt would be a total waste of money to have two different data collection systems existingside-by-side. For this reason, Management Accounting makes extensive use of routinelygenerated financial accounting data, which will be improved upon as per therequirements of the decision to be taken or the problem to be resolved.2. Responsibility Accounting

Both Financial Accounting and Management Accounting rely heavily on the concept ofresponsibility. Financial Accounting is concerned with the concept of responsibility orstewardship over the company as a whole; while Management Accounting is concernedwith stewardship over its parts; and this concern extends to the last person in the

organization who has responsibility over cost.

1.3 COST ACCOUNTING AND MANAGEMENT ACCOUNTING

The terms cost accounting and management accounting have sometimes been usedsynonymously by many accountants in recent years. But these two systems of accountingare not the same. Despite the fact that the subject matter of cost accounting has broadenedover the years, it is, however, concerned mainly with the techniques of product costingand deals with only cost and price information. It is limited to product costing proceduresand related information processing. It helps management in planning and controllingcosts relating to both production and distribution activities.

By nature, management accounting refers to reports prepared to fulfill the needs ofmanagement. The accounting statements and reports in management accounting aresituation-specific. That is, management accounting reports attempt to fill the informationneeds of managers with respect to a specific problem, situation, or decision.

Management accounting is not confined to the area of product costing, cost and priceinformation. In management accounting, the objective is to have a data pool which willprovide any and all information that management may need. For example, if managementdecides to depend on long-term debt for expansion of business, it may be investigated asto what effect this decision will have upon the earnings per share? Should debt in thecapital structure be too large or small? Similarly, management may be interested in

knowing the adequacy of cash inflows to pay current obligations or the effect of inflationon business decisions and performance. Thus, management accounting helpsmanagement deal with the total situation. In achieving this goal, management accountingmakes use of information drawn from financial accounting and other disciplines, such aseconomics, cost accounting, finance, statistics, operational research and the like.

Now-a-days, the terms cost accounting and management accounting are usedinterchangeably.


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1.4Difference between Financial Accounting and Cost AccountingThe point of difference between cost accounting & financial accounting may besummarized as follows:

1. Objective:Financial accounting aims at safeguarding the interest of the business & itsproprietors & others connected with it, by providing suitable information to variousparties- internal as well as external.Cost accounting on the other hand, renders information for the guidance of themanagement for proper planning organizational control & decision making.2. Mode of presentation: Financial accounts are prepared according to some acceptedaccounting concepts & conventions. They are kept in a manner so as to comply with therequirements of the companies Act, Income Tax Laws & other statutes.Whereas maintenance of cost records is purely voluntary & therefore there are nostatutory forms regarding their presentation.3. Recording: In case of financial accounts stress is on the ascertainment & exhibition of

profits earned or losses incurred in the business. On account of this reason in financialaccounts the transactions are recorded, classified & analyzed in a subjective manner i.e.according to the nature of expenditure.In cost accounts the emphasis is more on aspects of planning & control, thereforetransactions are recorded in an objective manner i.e. according to the purpose for whichcosts are incurred.4. Analyzing Profit: Financial accounting reveals the profits of the business as a whole,while cost accounting shows the profit made on each product, job or process.5. Periodicity of reporting: Financial accounting is largely concerned with thetransitions between undertaking & the third parties and therefore it has to observe theaccounting period convention which is usually a year. Accounts are prepared & presentedat the end of the year only.While cost accounting is mainly concerned with the people in the organization & costreports are frequently submitted to the management & concerned departments, wheneverit is required.

1.5 LIMITATION OF FINANCIAL ACCOUNTING:

Following are the limitations of financial accounting, which led to the development ofCost Accounting:

1. It does not classify the accounts so as to give data regarding costs by departments,processes, products, in the manufacturing division, by units or product-lines &sales territories in the selling & distribution division.

2. it does not classify the expenses as direct & indirect items nor does it assign themto the product at each stage of production. Thus, controllable and uncontrollableitems of overhead costs are not shown separately.

3. it does not provide day-to-day cost confirmation because the data are summarizedat the end of accounting period.

4. it does not provide analysis of losses due to idle plant & equipment, defectivematerial, inefficient labour or seasonal condition.


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5. it doesnt provide adequate information for reports to outside agencies such asbanks, government, insurance companies & trade associations.

1.6 ADVANTAGES OF COST ACCOUNTING

1. The cost accounting system provides data about profitable & unprofitableproducts & activities.

2. All items of costs can be analyzed to minimize the losses & wastage emergingfrom the manufacturing processes & reduce the costs associated with differentactivities.

3. Production/manufacturing methods may be improved or changed so that costs canbe controlled & profit increased.

4. Cost data can be obtained & compared with standard cost within the form orindustry.

5.

Cost accounting helps management in avoiding losses arising due to many factors,such as low demand, competitive conditions, change in technology, seasonaldemand for the product.

6. Cost accounting also provides data cost data & information to determine the priceof the product.

7. Negotiation with government & labour unions can easily be made with theinformation provided by the cost accounting system.

8. more accurate & reliable financial accounts can be prepared promptly for use ofmanagement.

9. An adequate cost accounting system ensures maximum utilization of physical &human resources, checks fraud & manipulations & helps employees as well as theemployers in their basic goals of getting higher earnings & maximizing the profitsof the concern.

1.7 CLSSIFICATION OF COST

Cost classification is the process of grouping costs according to their commoncharacteristics. A suitable classification of costs is very helpful in identifying a givencost with cost centers or cost units. Costs may be classified according to their nature,i.e., material, labor and expenses and a number of other characteristics. Depending uponthe purpose to be achieved and requirements of a particular concern the same costfigures may be classified into different categories. The classification of costs can bedone in the following ways:

1. By Nature of Element2. By Functions3. By Traceability4. By Variability5. By Controllability6. By Normality


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7. By Capital or Revenue8. By Time9. By Association with Product10.According to Planning and Control11.For Managerial Decisions12.Others.

Each classification will be discussed in detail in the following paragraphs:

1. By Nature of ElementThe costs are divided into three categories i.e. Materials, Labor and Overheads. Furthersub-classification of each element is possible; for example, material can be classifiedinto raw material components, spare parts, consumable stores, packing material, etc.

Materials: Materials are the principal substances that go into the production processand are transformed into finished goods. Materials are further classified as directmaterials and indirect materials. Direct materials are that materials that can be directly

identified with and easily traced to finished goods. In manufacturing organizations, thecost of direct materials constitutes a major proportion of the finished product cost. Allthe other materials that go into the production of the finished goods are called indirectmaterial costs. Indirect materials generally form a part of the manufacturing overheads.For example. a furniture manufacturer, teak wood is a direct material as it can be tracedeasily to the furniture made, and the nails, adhesives and other sundry materials can betreated as indirect materials.

Labor:Labor refers to the human effort to produce goods and services. It is a factor ofproduction; the talents, training, and skills of people which contribute to the productionof goods and services. It involves the physical and mental effort. It can be furtherclassified into direct and indirect labor. Direct labor is the effort of employees whotransforms direct materials into a finished product and it is physically traceable to thefinished good or service. In some industries labor cost forms a significant portion oftotal costs. The labor which cannot be traced to a product is considered to be theindirect labor. The indirect labor forms part of factory overhead. In the above example,the cost of the workers who directly expend their energy on making the furniture withthe help of tools and machines is considered to be the direct labor. The salary paid to asupervisor, who oversees the activities of a team of workers is considered as indirectlabor.

Overheads: Those elements of costs necessary in the production of an article or theperformance of a service which are of such a nature that the amount applicable to theproduct or service cannot be determined accurately or readily. Usually they relate to thoseobjects of expenditures which do not become an integral part of the finished product orservicesuch as rent, heat, light, supplies, management, supervision, etc. In other words,overheads consist of indirect materials, indirect labor and other indirect expenses. Theoverheads can be classified into factory overheads, office and administration overheadsand selling and distribution overheads. Continuing with the above example, cost of


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factory lighting, rent of the factory, rent of administrative building, salary ofadministrative staff and managers, depreciation of machinery etc. constitute overheads.

2. By Functions

It leads to grouping of costs according to the broad divisions of functions of a businessundertaking or basic managerial activities, i.e. production, administration, selling anddistribution. According to this classification costs are divided as follows:

Manufacturing and Production Costs

This category includes the total of costs incurred in manufacture, construction andfabrication of units of production. The manufacturing and production costs comprise ofdirect materials, direct labor and factory overheads.

Administrative Costs

This category includes costs incurred on account of planning, directing, controlling andoperating a company. For example, salaries paid to managers and other administrativestaff.

Selling and Distribution Costs

Selling costs and distribution costs are most often confused to be one and the same.However, there is a distinction between the two. Selling costs are defined as the cost ofseeking to create and stimulate demand and of securing orders. Example of selling costsare advertisement, salesman salaries, etc. Whereas, distribution costs are defined as thecost of sequence of operations which begin with making the packed product available fordispatch and ends with making the reconditioned, returned empty packages, if anyavailable for re-use. For example, insurance on goods in transit, warehousing etc. aredistribution costs.

3. By Traceability

According to this classification, total cost is divided into direct costsand indirect costsDirect costs are those costs which are incurred for and may be conveniently

identified with or easily traced to a particular cost center or cost unit. The commonexamples of direct costs are materials used and labor employed in manufacturing anarticle or in a particular process of production.

Indirect costs are those costs which are incurred for the benefit of a number ofcost centers or cost units and cannot be conveniently identified with a particular costcenter or cost unit. Examples of indirect costs include rent of building, managementsalaries, machinery depreciation, etc. The nature of the business and the cost unit chosenwill determine the costs as direct and indirect. For example, the hire charges of a mobilecrane used onsite by a contractor would be regarded as a direct cost since it is identifiablewith the project/site on which it is employed, but if the crane is used as a part of the


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services of a factory, the hire charges would be regarded as indirect cost because it willprobably benefit more than one cost center or department. The distinction between directand indirect cost is essential because the direct costs of a product or activity can beaccurately identified with the cost object while the indirect costs have to be apportionedon the basis of certain assumptions about their incidence.

4. By Variability

The basis for this classification is the behavior of costs in relation to changes in the levelof activity or volume of production. On this basis, costs are classified into three groupsviz. fixed, variable and semi-variable.

Fixed Costs

Fixed costs are those which remain fixed in total with increase or decrease in thevolume of output or activity for a given period of time or for a given range of output.

Fixed costs per unit vary inversely with the volume of production, i.e. fixed cost per unitdecreases as production increases and increases as production decreases. Examples offixed costs are rent, insurance of factory building, factory managers salary, etc. Thesecosts are constant in total amount but fluctuate per unit as production level changes.These costs are also termed as capacity costs.

Variable Costs

Variable costs are those which vary in total directly in proportion to the volume ofoutput. These costs per unit remain relatively constant with changes in volume ofproduction or activity. Thus, variable costs fluctuate in total amount but tend to remainconstant per unit as production level changes. Examples: direct material costs, directlabor costs, power, repairs, etc.

Semi-variable Costs

Semi-variable costs are those which are partly fixed and partly variable. For example,telephone expenses include a fixed portion of monthly charge plus variable chargeaccording to the number of calls made; thus total telephone expenses are semi-variable.Other examples of such costs are depreciation, repairs and maintenance of building andplant, etc. These are also called semi-fixed costs or mixed costs.

5. By Controllability

On this basis costs are classified into two categories:

Controllable Costs

If the costs are influenced by the action of a specified member of an undertaking, that isto say, costs which are at least partly within the control of management they are called


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controllable costs. An organization is divided into a number of responsibility centers andcontrollable costs incurred in a particular cost center can be influenced by the action ofthe manager responsible for the center. Generally speaking, all direct costs includingdirect material, direct labor and some of the overhead expenses are controllable by lowerlevel of management.

Uncontrollable Costs

If the costs cannot be influenced by the action of a specified member of an undertaking,that is to say, which are not within the control of management they are calleduncontrollable costs. Most of the fixed costs are uncontrollable. For example, rent of thebuilding is not controllable and so is managerial salaries. Overhead cost, which isincurred by one service section or department and is apportioned to another whichreceives the service is also not controllable by the latter.

Controllability of costs depends on the level of management (top, middle or lower) and

the period of time (long-term or short-term).

6. By Normality

On this basis, is the costs are classified into two categories.

Normal Cost

It is the cost which is normally incurred at a given level of output in the conditions inwhich that level of output is normally attained. It forms a part of production cost.

Abnormal Cost

It is the cost which is not normally incurred at a given level of output in the conditionsin which that level of output is normally attained. It is not considered as a part ofproduction cost, hence it is charged to Costing Profit and Loss Account.

7. By Capital and Revenue or Financial Accounting Classification

If the cost is incurred in purchasing assets either to earn income or increasing theearning capacity of the business it is called capital cost, for example, the cost of a rollingmachine in case of steel plant. Though the cost is incurred at one point of time thebenefits accruing from it are spread over a number of accounting years. Revenueexpenditure is any expenditure done in order to maintain the earning capacity of theconcern such as cost of maintaining an asset or running a business. Example, cost ofmaterials used in production, labor charges paid to convert the material into production,salaries, depreciation, repairs and maintenance charges, selling and distribution charges,etc. While calculating cost, revenue items are considered whereas capital items arecompletely ignored.


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8. By Time

Costs can be classified as (i) Historical costs and (ii) Predetermined costs.

Historical Costs

The costs which are ascertained after being incurred are called historical costs. Suchcosts are available only when the production of a particular thing has already been done.Such costs are only of historical value and not at all helpful for cost control purposes.

Predetermined Costs

Such costs are estimated costs, i.e. computed in advance of production taking intoconsideration the previous periods costs and the factors affecting such costs. If they aredetermined on scientific basis they become standard cost. Such costs when comparedwith actual costs will give the variances and reasons of variance and will help the

management to fix the responsibility and to take remedial action to avoid its recurrence infuture.

Historical costs and predetermined costs are not mutually exclusive. Even in a systemwhen historical costs are used, predetermined costs have a very important role to playbecause a figure of historical cost by itself has no meaning unless it is related to someother standard figure to give meaningful information to the management.

9. By Association with Product

Costs on this basis are classified as Product Costs and Period Costs. This distinction isrequired for the purpose of profit determination. This is because product costs are carriedforward to the next accounting period in the form of unsold finished stock. Whereasperiod costs are written off in the accounting period in which it is incurred.

Product Cost

Product costs are associated with unit of output. Product costs are the costs absorbedby or attached to the units produced. These costs go into the determination of inventoryvaluation (finished goods and partly completed goods) hence are called Inventoriablecosts. This consists of direct materials, direct labor and factory overheads (partly orfully). The extent of inclusion of factory costs depends on the type of costing system inforce absorption or direct costing. If absorption costing method is adopted, both thefixed and variable factory overheads are included as part of product costs. If directcosting method is adopted only variable factory overheads are included as part ofinventoriable cost.

Period Costs


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Period costs are costs associated with period for which they are incurred, rather than theunit of output or manufacturing activity. These costs are not treated as part of inventoryand hence they are treated as expenses of the period for which they are incurred.Administrative, Selling and Distribution costs are treated as period costs and are deductedas an expense for the determination of income and are not regarded as a part of inventory.

10 According to Planning and Control

Cost accounting furnishes information to the management which is helpful indischarging the two important functions of management i.e. planning and control. For thepurpose of planning and control, costs are classified as budgeted costs and standard costs.

Budgeted Costs

Budgeted costs represent an estimate of expenditure for different phases or segments ofbusiness operations, such as manufacturing, administration, sales, research and

development, for a period of time in future which subsequently becomes the writtenexpression of managerial targets to be achieved. Various budgets are prepared fordifferent phases/segments of business, such as sales budget, raw material cost budget,labor cost budget, cost of production budget, manufacturing overhead budget, office andadministration overhead budget. Continuous comparison of actual performance (i.e.,actual cost) with that of the budgeted cost is made so as to report the variations from thebudgeted cost to the management for corrective action.

Standard Cost

The Institute of Cost and Management Accountants, London defines standard cost asthe predetermined cost based on a technical estimate for materials, labor and overhead

for a selected period of time and for a prescribed set of working conditions. Thus,standard cost is a determination, in advance of production, of what should be its costunder a set of conditions.

Budgeted costs and standard costs are similar to each other to the extent that both ofthem represent estimates of cost for a period of time in future. In spite of this, theydiffer in the following respects:

Standard costs are scientifically predetermined costs of every aspect of businessactivity whereas budgeted costs are mere estimates made on the basis of pastactual financial accounting data adjusted to future trends. Thus, budgeted costsare projection of financial accounts whereas standard costs are projection of costaccounts.

The primary emphasis of budgeted costs is on the planning function ofmanagement whereas the main thrust of standard costs is on control.

Budgeted costs are extensive whereas standard costs are intensive in theirapplication. Budgeted costs represent a macro approach of business operationsbecause they are estimated in respect of the operations of a department. Contraryto this, standard costs are concerned with each and every aspect of business


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operation carried in a department, budgeted costs are calculated for differentfunctions of the business, i.e. production, sales, purchases, etc. whereas standardcosts are compiled for various elements of costs, i.e. materials, labor andoverhead.

11. For Managerial Decisions

On this basis, costs may be classified into the following categories:

Marginal Cost

Marginal cost is the additional cost to be incurred if an additional unit is produced. Inother words, marginal cost is the total of variable costs, i.e. prime cost plus variableoverheads. It is based on the distinction between fixed and variable costs.

Out of Pocket Costs

This is that portion of the cost which involves payment, i.e. gives rise to cashexpenditure as opposed to such costs as depreciation, which do not involve any cashexpenditure. Such costs are relevant for price fixation during recession or when make orbuy decision is to be made.

Differential Costs

If there is a change in costs due to change in the level of activity or pattern or method ofproduction they are known as differential costs. If the change increases the cost, it will becalled incremental cost and if the change results in the decrease in cost it is known asdecremental cost.

Sunk Costs

Sunk cost is another name for historical cost. It is a cost that has already been incurredand is irrelevant to the decision making process. A good example is depreciation on afixed asset. Depreciation on a given asset is a sunk cost because the cost (of purchasingthe asset) has already been incurred (when it was purchased) and it cannot be affected byany future action, though we allocate the depreciation cost to future periods the originalcost of the asset is unavoidable. What is relevant in this context is the salvage value of theasset not the depreciation. Thus, sunk costs are not relevant for decision making and arenot affected by increase or decrease in volume.

Imputed (or notional) Costs

These costs appear in cost accounts only. For example notional rent charged on businesspremises owned by the proprietor, interest on capital for which no interest has been paid.When alternative capital investment projects are being evaluated it is necessary toconsider the imputed interest on capital before a decision is arrived as to which is themost profitable project.


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Opportunity Cost

It is the maximum possible alternative earnings that will be foregone if the productivecapacity or services are put to some alternative use. For example, if an owned building is

proposed to be used for a project, the likely rent of the building is the opportunity costwhich should be taken into consideration while evaluating the profitability of the project.Since opportunity costs are not actually costs incurred but only are benefits foregone,they are not as a matter of fact recorded in the accounting books. However, they arerelevant costs for decision making purposes and are considered while evaluating differentalternatives.

Replacement Cost

It is the cost at which there could be purchase of an asset or material identical to thatwhich is being replaced or revalued. It is the cost of replacement at current market price.

Avoidable and unavoidable Cost

Avoidable costs are those which can be eliminated if a particular product or departmentwith which they are directly related to, is discontinued. For example, salary of the clerksemployed in a particular department can be eliminated, if the department is discontinued.Unavoidable cost is that cost which will not be eliminated with the discontinuation of aproduct or department. For example, salary of factory manager or factory rent cannot beeliminated even if a product is eliminated.

12. Other Types of Costs

Future Costs

Are those costs that are expected to be incurred at a later date.

Programmed Cost

Certain decisions reflect the policies of the top management which results in periodicappropriations and these costs are referred to as programmed cost. For example, theexpenditure incurred by the company under the Jawahar Rojgar Yojana program initiatedby the prime minister is a programmed cost which reflects the policy of the topmanagement.

Joint Cost

Joint cost is the cost of manufacturing joint products up to or prior to the split-off point.Cost incurred after the split-off point is called separable cost. Joint cost is common to theprocessing of joint products and by-products till the point of separation and cannot betraced to a particular product before the point of split-off.


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Conversion Cost

Conversion cost is the cost incurred in converting the raw material into finished product.It can be calculated by deducting the cost of direct materials from the production cost.

Discretionary Costs

Discretionary costs are those costs which do not have obvious relationship to levels ofcapacity or output activity and are determined as part of the periodic planning process. Ineach planning period the management decides on how much to spend on certaindiscretionary items such as advertising, research and development, employee

Committed Cost

Committed cost is a fixed cost which results from the decisions of the management inthe prior period and is not subject to the management control in the present on a short run

basis. They arise from the possession of production facilities, equipment, an organizationsetup, etc.

Some examples of committed costs are: plant and equipment depreciation, taxes,insurance premium and rent charges.

1.8 COST CENTRE

The smallest segment of activity or area of responsibility for which costs areaccumulated. In the manufacture and sale of a product or in the rendering of a service,several activities may have to be performed. These activities are usually carried out bydifferent departments or sections of the company. For example, in a pharmaceutical

company, the raw materials may be purchased by a purchase department, stocked up ina store, processed in one or more processing departments, packed in a packingdepartment and sold by a sales and distribution department. Hence cost statistics areconveniently accumulated for each department. In Cost Accounting each departmentwould be called a Cost Center. Typically cost centers are departments, but in someinstances, a department may contain several cost centers. For example, a machiningdepartment may be under one foreman but it may contain various groups of machines,such as lathes, milling machines, etc.

As each department is managed by a departmental manager, the cost of a departmentwould be a measure of how the departments manager is performing. In fact, byreporting departmental costs to the concerned managers, they will better understand the

cost consequences of their actions so that departmental performance becomes more costeffective.

Box 1.1: Kyocera Cost Centers

Kyocera is a Japanese company that makes packages which hold the silicon chips in electroniccomputers. The packages or containers are made from alumina powder.


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The powder is first made into sheets and wiring patterns are then screen printed on the sheets.The sheets are next converted into interconnected stacks and the stacks are baked in ovens.The final step is quality control.

Based on the above description can you decide on the main cost centers of Kyoceras factory?

The following cost centers are clearly suggested by the above description.

Sheet Making Department

Screen Printing Department

Stack Making Department

Baking Department

Quality Control Department.

1.9 COST UNITS

Managers are often interested in knowing the cost of something. The something forwhich the cost has to be ascertained is known as cost objective or cost object or cost unit.Examples of cost units include products, activities, departments, number of patientstreated, sales regions, etc.

For example, if a factory produces motor cars then the cost unit would be a motor carbecause the costs are all incurred in producing motor cars.

Let us take up a more complex situation. Consider a bus operator providing bus servicesto the public between most of the major cities of the country. Suppose the bus operator

wants to fix a cost unit, what is it?

Note that here there is no production, what is provided is a service.

Each trip between two cities may be taken as a cost unit. Alternatively cost per kilometerof travel may be taken as a cost unit. However, neither of the above cost units relates tothe passenger who buys the service.

If the operator wants to fix a price to be charged to each passenger, the above cost unitswould have to be adjusted further.

Assume that a bus covers a distance of 700 km per day carrying 30 passengers on anaverage, the output is 700 x 30 = 21,000 passenger kilometers per day. On an average thepassenger kilometers covered by each bus per week is 1,00,000. The total cost ofoperation per bus per week is Rs.80,000, the cost per passenger kilometer is = Rs.0.80.

Cost per passenger kilometer= (80,000/1,00,000)= Re.0.80


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The implication is that the bus operator must charge, on an average, over Rs.0.80 perkilometer to each passenger in order to make a profit.

1.10 COST SHEET

Cost sheet is a statement which is prepared usually to present the detailed costs of totalproduction during the period in question. It provides information relating to cost per unitat different stages of the total cost of production or at different stages of completion ofthe product.

ADVANTAGES OF COST SHEET :

It discloses the total cost and the cost per unit

It enables a manufacturer to keep a close watch and control over the cost ofproduction

It provides a comparative study of various elements of current cost with pastresults and std cost.

It acts as a guide to the manufacturer and helps him in formulating productionpolicies

It helps in fixing up the sales price more accurately

It helps in minimizing the cost of production

It helps in submission of accurate quotations of tenders for supply of goods.

Specimen of Cost Sheet

Cost Sheet for the Period__________________

Production_____________________Units

Total cost (Rs) Cost per unit (Rs)

Direct materials consumed:Opening stock..Add: Purchases..Carriage inwards.Less: Closing stock.Less: Scrap.. xxxxDirect wages xxxxDirect expenses xxxx

I. Prime CostAdd: Factory Overheads:Indirect materialsLoose toolsIndirect wagesRent & rates (Factory)Lighting & Heating of factoryPower & fuel

xxxx


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Repairs & maintenanceCleaningDepreciation of P&MWorks stationeryWelfare service expenses

Insurance of fixed assets, stocks & finishedgoodsWorks managers salaryAdd: Opening WIP xxxxLess: Closing WIP xxxx

II. Factory or works cost

Add: Office & administrative overheads:Rent & Rates of officeOffice salariesLighting & HeatingInsurance of office building & equipments

Telephone & postagePrinting & stationeryDepreciation of office furnitureLegal expensesAudit feesBank charges

III Cost of productionAdd: Opening stock of finished goodsLess: Closing stock of finished goods

IV Cost of goods soldAdd: Selling & Distribution Overheads:

Showroom expensesLighting & heatingSalesmens salariesCommissionsTraveling expenses of salesmanSales printing & stationeryAdvertisingBad debtsPostageDepreciation & expenses of delivery vanDebt collection expensesCarriage freight outwardsSample & other free giftsV Cost of Sales

Net Profit (or loss)Sales

xxxx

xxxx

xxxx

xxxxxxxxxxxx

Note: Items of expenses which are an appropriation of profit should not form a part of thecosts of a product. Example of such expenses are : (i) Income tax (ii) Dividends to


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shareholders (iii) commission (out of profit) to managing directors or partners (iv) Capitalloss, that is loss arising out of sales of assets (v) interest on loan (vi) Donations (vii)Capital expenditures (viii) Discount on shares & debentures (ix) underwritingcommission (x) writing off goodwill.

Illustration 1:From the following particulars, prepare a cost sheet for the year ended 31.12.2007

RsStock of finished good (1.1.2007) 6000Stock of raw material (1.1.2007) 40000WIP (1.1.2007) 15000

Purchase of raw material 4,75,000

Carriage inward 12,500Factory rent, taxes 7250Other production exp 43000

Stock of finished goods (31.12.2007) 15000

Wages 1,75,000

Work manager salary 30000Factory employees salary 60000Power expenses 9500General expenses 32500

Sales for the year 8,60,000

Stock of raw materials (31.12.07) 50,000WIP (31.12.2007) 10000

SOLUTION

Particulars Amount (Rs) Amount (Rs)

Raw Material consumed:Opening stock of raw material 40,000Add: Purchases 4,75,000

Carriage inward 12,500Less: Closing stock of raw material 50,000WagesI Prime CostAdd: Factory overheads:

Factory rent, taxesOther production expWork manager salaryFactory employees salaryPower expensesAdd: Opening stock of WIP 15000Less Closing stock of WIP 10,000

4,77,5001,75,0006,52,500

72504300030,00060,0009,500


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II Works or factory costAdd: Office overheadsGeneral Expenses 32500III Cost of productionAdd: Opening stock pf finished goods 6000

Less: Closing stock pf finished goods 15,000IV Cost of goods soldProfitSales

8,07,250

8,39,750

8,30,75029,2508,60,000

MULTIPLE CHOICE QUESTIONS

Q1Which of the following statements is/are true?Cost accounting is not a part of management accounting.Cost accounting is a system to record, summarize and report cost information.

Cost accounting is a post mortem of past costs.Cost accounting is not necessary if financial accounting provides necessary analysis.

Q2 The relationship between cost and activity is called(a) Cost analysis(b) Cost behaviour(c) Cost prediction(d) Cost estimationQ3 Which of the following is least likely to be an objective of cost accounting system?(a) Product costing(b) Optimum sales mix determination(c) Maximization of profit(d) Sales commission determinationQ4 Costing Technique in which all costs, variable as well as fixed, are charged toproduct, operations or services is(a) Historical costing(b) Absorption costing(c) Marginal costing(d) Direct costingQ5 Product costs in financial statements include(a) Direct material, direct labor, overheads and interest(b) Direct material, direct labor, overheads(c) Selling & administrative cost(d) Interest & selling costQ6 The costing approach wherein actual costs are ascertained after they have beenincurred is


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(a) Marginal costing(b) Direct costing(c) Standard costing(d) Historical costingQ7 The cost which reflects the policies of the top management which result in periodicappropriations are called as(a) Future cost(b) Discretionary cost(c) Committed cost(d) Programmed costQ8 In a given situation if a product is not produced the company can save on the salary ofworkers to the tune of Rs.1,00,000. In this case the salary of the worker is(a) Imputed cost(b) Unavoidable cost(c)

Avoidable cost(d) None of the above

Q9 Depreciation charged on Plant & Machinery is(a) Future cost(b) Discretionary cost(c) Committed cost(d) Programmed costQ10 Costs that are not relevant for decision-making and are not affected by increase ordecrease in volume are(a) Out of pocket cost(b) Sunk cost(c) Differential cost(d) Imputed cost


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CHAPTER 2 MATERIAL CONTROL & COSTING

At the end of the chapter, you will be conversant with:

2.1 Classification Of Material2.2 Concept & Objectives Of Materials Control

2.3 Purchase Of Material:2.4 Material Control Techniques

2.4.1 Economic Order Quantity (Eoq)2.4.2 Stock Levels:2.4.3 Selective Inventory Control: Abc Analysis2.4.4 Just-In-Time (Jit) System

2.5 Pricing Of Inventories

2.1 CLASSIFICATION OF MATERIALThe term materials refers to all commodities consumed in the process of production.

The material is an important part of cost of a product. Without material no manufacturingis possible. Material may be direct or indirect.

(i) Direct Material: All materials which can be conveniently identified orattributed wholly to a particular cost unit are termed as directmaterials. It is an integral part of the finished product. For example,timber used in manufacturing furniture, cotton in textile, sugarcane insugar etc.

(ii) Indirect Material: All materials which can not be convenientlyassociated with a particular cost unit are called indirect materials.Though such materials also become a part of finished product but theyare used in such small quantities that their allocation to a particular

cost centre is difficult & futile, for example, nails used in themanufacture of furniture, thread in shoe, oil, grease etc.

2.2 CONCEPT & OBJECTIVES OF MATERIALS CONTROL

Materials cost constitutes a prime part of the total cost of production of manufacturingfirms. Proper accounting, therefore, for & control over materials purchase, consumptions,& inventories are important for effective management of a business firm. Materialscontrol basically aims at efficient purchasing of materials, their efficient storing &efficient use or consumption.Material control consists of control at two levels: (i) Quantity controls, and (ii) financecontrols. For instance, the production department in a manufacturing company aims at

quantity controls, i.e. lesser and lesser units should be used in the production department.Although lesser units would result in lower investments on purchase of materials, yet theuser (production) department normally does not think in terms of expenditure. In contrast,the finance manager is interested in keeping the investments on materials at the lowestpoint. In material control, balance has to be maintained between two opposing needs, thatis(i) Maintenance of sufficient material for efficient production


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(ii) Maintenance of investment in inventory at the lowest level. IN detail, the followingare the objectives in a good system of material control:

1. Material of the desired quality will be available when needed for efficient& uninterrupted production.

2. Material will be purchased, only when it is required, and in economicquantities.3. The investment in material will be made at lowest level consistent withoperating requirement.

4. Purchase of material will be made at the most favorable prices under thebest possible terms.

5. Material will be protected against loss by fire, theft, spoilage etc.6. Material should be stored in such a way that they can provide minimum of

handling time & cost.7. Vouchers will be approved for payment only if the material has been

received & is available for issue.8. Issues of material are properly authorized & properly accounted for.9.

Materials are, at all times, charged as the responsibility of someindividual.

2.3 PURCHASE OF MATERIAL:The most important point of material control is purchasing of materials. Carelessness &inefficiency in this respect may become the cause of heavy losses. To guard against this,the following procedure for the purchase of materials should be adopted in a largeconcern:

1. Purchase requisition: A form known as a purchase requisition serves three generalpurposes:

(i) It automatically starts the purchasing process & informs the purchasingdepartment of the need for the purchase materials.

(ii) It fixes the responsibility of the department/personnel making the purchaserequisition.

(iii) it can be used for future reference.Usually, purchase requisitions are prepared by the storekeepers for regular store itemswhich are below or approaching the minimum level of stock or to replace stock ofmaterials & parts in stores. The production control department can also givenrequisitions for the purchase of specialized materials. A typical purchase requisitioncontains details, such as number, date, department, quantity, description,specification, signature of the person initiating the requisition, & signature of one ormore officers approving the purchase. Copies of purchase requisition are sent to thepurchase department & accounting department.2. Purchase order After the requisition is received duly approved, the purchase

department places an order with a supplier, offering to buy certain materials atstated prices & terms. The purchase order is a formal contract for the supply ofmaterials. The order should clearly state the materials required & the price, andprovide information, such as delivery period & the department for whom thematerials are purchased. Copies of purchase order are sent to the departmentsconcerned, the sender of the purchase requisition, and the store department


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advising them to expect the materials as specified & where to send them uponreceipt. Copies of the purchase requisition & purchase order are sent toaccounting department, to be used in checking the suppliers invoice when avoucher is being prepared for payment.

3. Receiving materials: The receiving department performs the function ofunloading & unpacking materials which are received by an organization. This willneed an inspection report which is sometimes incorporated in the receiving report,indicating the items accepted & rejected, with reasons. Several copies of thereceiving report or goods received note are prepared, one going to eachdepartment interested in the arrival of materials, including stores, buying &accounts departments.

4. Approvals of invoices: Invoice approval indicates that goods according to thepurchase order have been received & payment can now be made. However, if thegoods or equipment received are not of type ordered, or are not in accordancewith specifications, or are damaged, the purchasing department issues a returnorder indicating that the goods are to be returned to the supplier.

5.

Making payment: After the purchase invoice total is approved, the process ofmaking payment begins. Payment depends on the terms agreed upon on anyparticular order, & any terms which differ from normal practice should beconsidered individually. When it is found that items written on the invoicequalify for payment, a remittance advice is prepared after providing for deductionon discounts, if any.

2.4 MATERIAL CONTROL TECHNIQUESAs we have already discussed that every management technique should be in consonancewith the shareholders, wealth maximization principle. To achieve this, the firm shoulddetermine the optimum level of inventory.Efficiently controlled inventories make the firm flexible. Inefficient inventory controlresults in unbalanced inventory and inflexibility-the firm may sometimes run out of stockand sometimes may pile up unnecessary stocks. This increases the level of investmentand makes the firm unprofitable.To manage inventories efficiency, we should seek answers to the following twoquestions:

How much should be ordered? When should it be ordered?

The first question, how much to order, relates to the problem of determining economicorder quantity (EOQ), and is answered with an analysis of costs of maintaining certainlevel of inventories.The second question, when to order, arises because of uncertainty and is a problem ofdetermining the re-order point.

2.4.1 ECONOMIC ORDER QUANTITY (EOQ)

One of the major inventory management problems to be resolved is how much inventoryshould be added when inventory is replenished.


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1. If the firm is buying raw materials, it has to decide lots in which it has to bepurchased on replenishment.

2. If the firm is planning a production run, the issue is how much production toschedule (or how much to make).

These problems are called order quantity problems, and the task of the firm is todetermine the optimum or economic order quantity (or economic lot size).Assumptions of EOQ:

1. Constant or uniform demand: Although the EOQ model assumes constantdemand, demand may vary from day-to-day. If demand is stochastic that is, notknown in advance the model must be modified through the inclusion of asafety stock.

2. Constant unit price: The EOQ formula derived is based on the assumption thatthe purchase price Rs.P per unit of material will remain unaltered irrespective ofthe order size. Quite often, bulk purchase discounts or quantity discounts areoffered by suppliers to induce customers for buying in larger quantities.

The inclusion of variable prices resulting from quantity discounts can be handled quiteeasily through a modification of the original EOQ model, redefining total costs andsolving for the optimum order quantity.

3. Constant carrying costs:Unit carrying costs may vary substantially as the sizeof the inventory rises, perhaps decreasing because of economies of scale orstorage efficiency or increasing as storage space runs out and new warehouseshave to be rented. This situation can be handled through a modification in theoriginal model similar to the one used for variable unit price.

4. Constant ordering costs:While this assumption is generally valid, its violationcan be accommodated by modifying the original EOQ model in a manner

similar to the one used for variable unit price.

5. Instantaneous delivery:If delivery is not instantaneous, which is generally thecase, the original EOQ model must be modified by including of a safety stock.

6. Independent orders: If multiple orders result in cost savings by reducingpaperwork and transportation cost, the original EOQ model must be furthermodified. While this modification is somewhat complicated, special EOQmodels have been developed to deal with this.

Determining an optimum inventory level involves two types of costs:(a) Ordering costs and

(b) Carrying costs.The economic order quantity is that inventory level, which minimizes the total ofordering and carrying costs.

Ordering CostsLets see if you remember what ordering costs are?The term ordering costs is used in case of raw materials (or supplies) and includes theentire costs of acquiring raw materials. They include costs incurred in the following


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activities: requisitioning, purchase ordering, transporting, receiving, inspecting andstoring (store placement).Ordering costs increase in proportion to the number of orders placed.The clerical and staff costs, however, do not vary in proportion to the number of ordersplaced, and one view is that so long as they are committed costs, they need not be

reckoned in computing ordering cost. Alternatively, it may be argued that as the numberof orders increases, the clerical and staff costs tend to increase. If the number of ordersare drastically reduced, the clerical and staff force released now can be used in otherdepartments. Thus, these costs may be included in the ordering costs. It is moreappropriate to include clerical and staff costs on a pro rata basis.Ordering costs increase with the number of orders; thus the more frequently inventory isacquired, the higher the firm's ordering costs. On the other hand, if the firm maintainslarge inventory levels, there will be few orders placed and ordering costs will berelatively small. Thus, ordering costs decrease with increasing size of inventory.

Carrying Costs

Do you have any idea what carrying costs are?Costs incurred for maintaining a given level of inventory are called carrying costs. Theyinclude storage, insurance, taxes, deterioration and obsolescence. The storage costscomprise cost of storage space (warehousing cost), stores handling costs and clerical andstaff service costs (administrative costs) incurred in recording and providing specialfacilities such as fencing, lines, racks etc.

EXAMPLES OF ORDERING AND CARRYING COSTSLets take a quick look at the various cost items that come under ordering and carryingcosts respectively.

Ordering Costs Requisitioning Order placing Transportation

ving, inspecting and storing Clerical and staff

Carrying Costs Warehousing Handling Clerical and staff Insurance Deterioration and obsolescence

Carrying costs vary with inventory size. This behavior is contrary to that of orderingcosts, which decline with increase in inventory size. The economic size of inventorywould thus depend on trade-off between carrying costs and ordering costs.


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Where,A = annual demandO = ordering cost per orderC = carrying cost per unitLets take an example so that you understand it better.Example:Your firm buys casting equipment from outside suppliers @Rs.30/unit. Total annualneeds are 800 units. You have with you following further data:Annual return on investment: 10%

Rent, insurance, taxes per unit per year: Re.1Cost of placing an order: Rs.100How will you determine the economic order quantity?Solution:

2.4.2 STOCK LEVELS:

Re-order Point/Level

We have now solved the problem of how much to order by determining the economicorder quantity, we have yet to seek the answer to the second problem, when to order.This is a problem of determining the re-order point. Lets see what re-order point is?


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The re-order point is that inventory level at which an order should be placed to replenishthe inventory.To determine the re-order point under certainty, we should know:(a) Lead time,(b) Average usage, and

(c) Economic orders quantity.Under such a situation, re-order point is simply that inventory level which will bemaintained for consumption during the lead-time. That is:

Reorder point = (lead time in days x daily usage ) + Safety Stock

Or

Maximum re-order period *Maximum Usage

Lead-time

It is the time normally taken in replenishing inventory after the order has been placed. Bycertainty we mean that usage and lead-time do not fluctuate.

Safety stock

The demand for material may fluctuate from day to day or from week to week. Similarly,the actual delivery time may be different from the normal lead-time. If the actual usageincreases or the delivery of inventory is delayed, the firm can face a problem of stock-out, which can prove to be costly for the firm. Therefore, in order to guard against thestock-out, the firm may maintain a safety-stock-some minimum or buffer inventory ascushion against expected increased usage and/or delay in delivery time.

Maximum and minimum Level:

Maximum Level: It represents that level of stock above which the stock should not beallowed to rise. It is to be foxed keeping in mind unnecessary blocking of capital in

stores.Maximum Level= Re=order Level + Re-order quantity-(Minimumconsumption*Minimum re-order period)

Minimum Level:It is that level which below which the inventory of any item should not be allowed to fall.It is also known as safety or buffer stock. The main object of fixing this level is to avaoidunnecessary delay or hampering of production due to shortage of materials.Minimum Level= Re-order level- (Normal consumption*Normal re-order period)Average Level:This level of stock may be determined by using the following formula:

Average Level= (Maximum Level + Minimum Level) / 2Or= Minimum level+1/2(Re-order quantity)

Danger Level:This level is generally determined below the minimum level & representsthe level where immediate steps are taken for getting stock replenished. In some cases,danger level of stock is fixed above the minimum level, but below the re-order level.Danger Level= Average consumption * Lead time for emergency purchases


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Figure2.1 : Inventory Level and Order Point for Replenishment

From the figure, it can be noticed that the level of inventory will be equal to the orderquantity (Q units) to start with. It progressively declines (though in a discrete manner)to level O by the end of period 1. At that point an order for replenishment will be madefor Q units. In view of zero lead time, the inventory level jumps to Q and a similarprocedure occurs in the subsequent periods. As a result of this the average level ofinventory will remain at (Q/2) units, the simple average of the two end points Q andZero.

From the above discussion the average level of inventory is known to be (Q/2) units.

From the previous discussion, we know that as order quantity (Q) increases, the total

ordering costs will decrease while the total carrying costs will increase.

The economic order quantity, denoted by Q*, is that value at which the total cost ofboth ordering and carrying will be minimized. It should be noted that total costsassociated with inventory

=

where the first expression of the equation represents the total ordering costs and thesecond expression the total carrying costs. The behavior of ordering costs, carryingcosts and total costs for different levels of order Quantity (Q) is depicted in figure 2.2.

Figure 2.2: Behavior of costs associated with inventory for changes in order

quantity


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From figure, it can be seen that the total cost curve reaches its minimum at the point ofintersection between the ordering costs curve and the carrying costs line. The value of Qcorresponding to it will be the economic order quantity Q*. We can calculate the EOQformula.

The order quantity Q becomes EOQ when the total ordering costs at Q is equal to thetotal carrying costs. Using the notation, it amounts to stating:

(i.e.) 2UF = Q2PC

or Q = units

To distinguish EOQ from other order quantities, we can say

EOQ = Q* =

In the above formula, when U is considered as the annual usage of material, the valueof Q* indicates the size of the order to be placed for the material which minimizes thetotal inventory-related costs. When U is considered as the annual demand Q* denotes

the size of production run.

Suppose a firm expects a total demand for its product over the planning period to be10,000 units, while the ordering cost per order is Rs.100 and the carrying cost per unit isRs.2. Substituting these values,

EOQ = = 1,000 units

Thus if the firm orders in 1,000 unit lot sizes, it will minimize its total inventory costs.


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2.4.3 SELECTIVE INVENTORY CONTROL: ABC ANALYSIS

Usually a firm has to maintain several types of inventories. It is not desirable to keep thesame degree of control on all the items. The firm should pay maximum attention to thoseitems whose value is the highest. The firm should, therefore, classify inventories toidentify which items should receive the most effort in controlling. The firm should be

selective in its approach to control investment in various types of inventories. Thisanalytical approach is called the ABC analysis and tends to measure the significance ofeach item of inventories in terms of its value.The high-value items are classified as 'A items' and would be under the tightest control.'C items' represent relatively least value and would be under simple control.'B items' fall in between these two categories and require reasonable attention ofmanagement.The ABC analysis concentrates on important items and is also known as control byimportance and exception (CIE). As the items are classified in the importance of theirrelative value, this approach is also known as proportional value analysis. (PVA). .The following steps are involved in implementing the ABC analysis:

1. Classify the items of inventories, determining the expected use in units and the priceper unit for each item.2. Determine the total value of each item by multiplying the expected units by its unitsprice3. Rank the items in accordance with the total value, giving first rank to the item withhighest total value and so on.4. Compute the ratios (percentage) of number of units of each item to total units of allitems and the ratio of total value of each item to total value of all items.5. Combine items on the basis of their relative value to form three categories: -A, B andC.Let us understand this with the help of an example.

ExampleA firm has 7 different items in its inventory. The average number of each of theseitems held, along with their unit costs, is listed below. The firm wishes tointroduce an ABC inventory system. Suggest a breakdown of the items into A, B& C classifications.


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its objective is to minimize inventory investment, a JIT system uses no, or verylittle, safety stocks. Extensive coordination must exist between the firm, itssuppliers, and shipping companies to ensure that material inputs arrive on time.Failure of materials to arrive on time results in a shutdown of the production lineuntil the materials arrive. Likewise, a JIT system requires high-quality parts from

suppliers. When quality problems arise, production must be stopped until theproblems are resolved.The goal of the JIT system is manufacturing efficiency. It uses inventory as a toolfor attaining efficiency by emphasizing quality in terms of both the materials usedand their timely delivery. When JIT is working properly, it forces processinefficiencies to surface and be resolved. A JIT system requires cooperationamong all parties involved in the process-suppliers, shipping companies, and thefirm's employees.

2.5 PRICING OF INVENTORIES

There are different ways of valuing the inventories and knowledge of these methods ofvaluing stocks is essential for an efficient inventory management process. Thefollowing methods can be adopted to value the raw material:

First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its rawmaterial, the issue of material from the stores will be in the order which it wasreceived. Thus the pricing will be based on the cost of material that wasobtained first.

Last-In-First-Out (LIFO): In the LIFO method, the material issued will be pricedbased on the material that has been purchased recently.

Weighted Average Cost Method: The pricing of materials will be done on

weighted average basis (weights will be given based on the quantity).

Standard Price Method: Material is priced based on a standard cost which ispredetermined. When the material is purchased the stock account will be debitedwith the standard price. The difference between the purchase price and thestandard price will be carried into a variance account.

Replacement/Current Price Method: In this method, material is priced at thevalue that is realizable at the time of the issue.

Illustration

The following information is extracted from the stores ledger of M/s Meena Ltd.

Material: X

Opening Stock: NIL

Purchases:

July 1 175 units @ Re.1 per unit

July 12 175 units @ Re.2 per unit


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Issues:

July 21 105 units

July 30 70 units

i. Complete the receipts and issues valuation by adopting the FIFO, LIFO andWeighted Average Method.

ii. If the standard price is Rs.1.25 per unit for the year and the replacement costs ofthe material on July 21 and July 30 are Rs.1.25 and Rs.1.75 respectively, thenshow the stock ledger account using the standard price method and thereplacement price method.

The illustration has been solved in the following tables.

Valuation of Work-in-process and Finished Stock

The valuation of work-in-process and finished goods inventory depends to a certainextent on the method of pricing the raw material and to a large extent on the method of

costing used to apportion the fixed manufacturing overheads. Direct Costing andAbsorption Costing are the two techniques used for allocation of costs to the inventory.

Direct costing is based on the traceability of cost to the cost objective. All indirect costs(which may include fixed manufacturing overheads) are charged to the incomestatement and are known as period costs. If the fixed costs are directly identifiable, thenit is considered for inventory valuation.

Absorption costing is a technique which treats the fixed manufacturing overheads asproduct costs. Thus, all costs i.e., both fixed and variable will be assigned to theinventory value.

This difference in approach to costing will affect the inventory value and also the

profits. The direct costing method lowers the inventory value (by not considering theindirect costs) and increases profits with a decrease in inventory level (when theinventory level decreases the direct costs come down while the fixed costs remain thesame). Contrary to this the inventory valuation will be higher for stocks valued underabsorption costing method as it considers all the fixed manufacturing overheads.

Statement showing the valuation of raw material using FIFO, LIFO and WeightedAverage Methods, standard price & replacement price methods:

FIFO

Receipts Issues Balance

Date Particulars Qty Rate Value Qty Rate Value Qty Value

1-Jul Purchase175units Re 1 175 175 175



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21-Jul Issue105units 105 1 105 245 420

30-Jul issue70units 70 1 70 175 350

Value of Closing stock:- 175 Units of Rs350

LIFO




12-Jul Purchase

175

units Re 2 350 350 525

21-Jul Issue105units 105 2 210 245 315

30-Jul issue70units 70 2 140 175 175

Value of Closing stock:- 175 Units of Rs175

Weighted Average Method


Date Particulars Qty Rate Value Qty Rate Value Qty Rate Value

1-Jul Purchase175units Re 1 175 175 1 175

12-Jul Purchase175units Re 2 350 350 1.5* 525

21-Jul Issue105units 105 1.5 157.5 245 1.5 367.5

30-Jul issue70units 70 1.5 157.5 175 1.5 262.5

* Wighted Average Rate: =

1.5

Value of Closing stock:- 175 Units of Rs262.5


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Standard Price Method



1-Jul Purchase

175

units Re 1 175 175 17512-Jul Purchase

175units Re 2 350 350 525

21-Jul Issue

105units 105 1.25 131.25 245 393.75

30-Jul issue

70units 70 1.25 87.5 175 306.25

Value of Closing stock:- 175 Units of Rs 306.25

Current Price/Replacement MethodReceipts Issues Balance



12-Jul Purchase

175units Re 2 350 350 525

21-Jul Issue

105units 105 1.25 131.25 245 393.75

30-Jul issue

70units 70 1.75 122.5 175 271.25

Value of Closing stock:- 175 Units of Rs271.25

Now that you have understood the concepts, lets have a review to test your knowledge

Multiple Choice Questions:

Q1 Which of the following is not an advantage if a company that follows a policy ofcentralized purchases and payments to suppliers?


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Q2 Which of the following statements is not true of pricing of inventories?

Q3 Which of the following statements is false?

Q4 Mr Ram has annual sales of 209,000 units at an average selling price of Rs19.95. Theordering costs are Rs80 per order and the carrying costs per year are Rs70.46 per unit.What is the optimal order quantity?

(a) 78(b) 209(c) 487(d) 689

Q5 Sakthi's Specialty Items maintains an average inventory of 129,000 items. Each itemis totally unique and hand-crafted. The ordering costs are Rs160 each due to the timerequired to find such unusual items. The carrying costs are Rs254.00 a year per item.Sakthi's sells about 49,000 items per year. What are the total ordering and carrying costsper year for Sakthi's Specialty Items?

(a) Rs29,134,690(b) Rs32,785,520(c) Rs32,797,520


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(d) Rs33,160,870

Q 6Which one of the following is a disadvantage of the just-in-time (JIT) inventory

system?(a) lower inventory carrying costs(b) less inventory storage space(c) more efficient use of assets(d) production shutdowns for lack of parts

Q7 Material control system would be most useful to a:(a)Manufacturer(b)Wholesaler(c)Hospital(d)Retailer

Q8 Economic order quantity (EOQ) model is used by a business to(a)Minimize the cost of placing orders(b)Minimize the unit purchase price of inventory(c)minimize the number of orders placed during a year(d)Minimize the combined costs of placing orders & carrying inventory.

Q9 A material pricing method in which the oldest cost incurred rarely have an effect onthe closing inventory valuation is:

(a)LIFO(b)FIFO(c)Weighted average(d)Simple average

Q10 Alpha Company was using FIFO for material pricing & its value of closinginventory was found lower. Assuming no opening inventory, what direction did thepurchase prices move during the period?

(a)Up(b)Down(c)Steady(d)Can not be determined


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CHAPTER 3 LABOUR COSTING

At the end of the chapter, you will be conversant with:

3.1 Types of Labour3.2 Labour Costs3.3 Control Over Labour Costs3.3.1 Labour Turnover3.4 Idle Time3.5 Overtime3.6 Methods Of Remuneration

INTRODUCTION

Labour cost is a second major element of cost. Under the present political conditions with

a restive labour in organized industry, it is very difficult to reduce labour cost. Therefore,proper control and accounting for labour cost is one of the most important problems ofbusiness enterprise. But control of labour cost presents certain practical difficulties unlikethe control of material cost. The human element in labour makes difficult the control oflabour cost whereas materials, being inanimate in nature, could be subjected to a rigidcontrol. Labour is the most perishable commodity and as such should be effectivelyutilized immediately. Labour, once lost, cannot be recouped and is bound to increase thecost of production. On the other hand, materials, being durable, can be used as and whenrequired and can be stored without having to incur immediate loss.

3.1 TYPES OF LABOUR

Just like materials, labour is also two types (a) direct labour, and (b) indirect labour.

(a)Direct LabourDirect labour is that labour which is directly engaged in the production of goods orservices and which can be conveniently allocated to the job, process or commodityunit. For example, labour engaged in making the bricks in a kiln is direct labourbecause charges paid for making, 1,000 bricks can be conveniently allocated to thecost of 1,000 bricks.

(b)Indirect LabourIndirect labour is that labour which is not directly engaged in the production of goodsand services but which indirectly helps the direct labour engaged in production. Theexamples of indirect labour are mechanics, supervisors, chowkidars, sweepers,foremen, watchmen, timekeeper, cleaners, repairers etc. the cost of indirect labourcannot be conveniently allocated to a particular job, order, process or article.


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It may be mentioned that it may not always be possible to classify individual workersas direct labour or indirect labour. For example, a worker who is engaged in actualproduction may sometime required to do supervisory work. In such a case, the timedevoted to actual production should be treated as direct labour and that spent onsupervisory work taken as indirect labour.

The distinction between direct and indirect labour must be observed carefully becausepayment of direct labour is a direct expenditure and is a part of prime cost whereaspayment of indirect labour is an item of indirect expenditure and is shown as works,office, selling and distribution expenditure according to the nature of the time spentby the indirect worker.

3.2 LABOUR COSTS

Labour costs represent the various items of expenditure incurred on workers by theemployer and would include the following:

(a)

Monetary Benefits e.g. : (i) Basic Wages (ii) Dearness Allowance; (iii)Employers Contribution to Provident Fund; (iv) Employers Contribution toEmployees State Insurance (ESI) Scheme; (v) Production Bonus; (vi) ProfitBonus; (vii) Old Age Pension; (viii) Retirement Gratuity.

(b) Fringe Benefits or Labour Related Costs e.g.: (i) Subsidised Food; (ii) SubsidisedHousing; (iii) Subsidised Education to the children of workers; (iv) MedicalFacilities; (v) holidays pay; (vi) Recreational Facilities.

Fringe benefits are indirect forms of employee compensation. The total of thesebenefits given to workers should be sufficient enough to attract and retain the labourforce. In other word, the will to work among workers should be created with theconsequent increase in efficiency.

3.3 CONTROL OVER LABOUR COSTS

Labour costs constitute a significant portion of the total cost of a product. Labour costmay be excessive due to inefficiency of labour, high labour turnover, idle time andunusual overtime work, inclusion of bogus workers in the wages sheet and many otherrelated factors. Inefficiency of labour is also a cause of excessive material and overheadcosts. Therefore, economic utilization of labour is a need of the present day industry toreduce the cost of production of the products manufactured or services rendered.Management is interested in labour costs on account of the following;

to use direct labour cost as a basis for increasing the efficiency of workers;

to identify direct labour cost with products, orders, jobs or processes forascertaining the cost of every product, order, job or process;

to use direct labour cost as a basis for absorption of overhead, if percentage ofdirect labour cost to overhead is to be used as a method of absorption of overhead;

to determine indirect labour cost to be treated as overhead; and

to reduce the labour turnover.


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Hence, control of labour costs is an important objective of management and therealization of this objective depends upon the cooperation of every member of thesupervisory force from the top executive to the foreman. From functional point of view,control of labour costs is effected in a large industrial concern by the coordinated effortsof the following six departments:

1)

Personnel Department,2) Engineering Department,3) Rate or Time and Motion Study Department,4) Time-keeping Department,5) Pay-roll Department, and6) Cost Accounting Department.

The functioning of some of these departments in relation to control of labour cost isgiven below:

1) PERSONNEL DEPARMENTPersonnel department with the help of various department supervisors and heads isresponsible for the execution of policies regarding the recruitment, discharge,classification of employees and wages which have been laid down by the Board ofDirectors or a committee of executives. The main functions of the personneldepartment are to recruit workers, train them and place them to the jobs they are bestfitted.

3.3.1 LABOUR TURNOVERLabour turnover denotes the percentage change in the labour force of an organization.High percentage of labour turnover denotes that labour is not stable and there are frequentchanges in the labour force because of new workers engaged and workers who have leftthe organization. A high labour turnover is not desirable. The definitions of labourturnover are given below:

(1)Labour turnover according to separation method= Number of employees left during a period x 100

Average number of employees during a period

This definition does not take into consideration the fact of surplus labour. This definitionwill give incorrect result whe

Cost accounting book

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