UNIT - 1

Introduction to Management Accounting

Introduction:
Accounting is an ancient art as old as money itself. However the role of
accounting has been changing with the economic and social developments. Over a
period of time new dimensions have been added to the discipline of accounting.
Until recently accounting was regarded merely as an art of recording, classifying
and summarizing transactions and events which are of a financial character. Thus,
accounting can be rightly, termed as a ‘service activity’, a ‘descriptive, analytical
discipline’, and an ‘Information system’.

Accounting:
It involves the collection of recording, classification and presentation of financial
data for the benefit of management and outside agencies such as shareholders,
creditors, bankers and government.

Smith and Ashburne describe it as, “Accounting is the science of recording and
classifying business transactions and events, primarily of a financial character, and
the art of making significant summaries, analysis and interpretation of those
transactions and events and communicating the results to persons whom must
make decisions or form judgments.

The word accounting can be classified into three categories.

A) Financial Accounting

B) Cost Accounting ;and

C) Management Accounting.

Financial Accounting:
Financial accounting may be defined as the science and art of recording and
classifying business transactions and preparing summaries of the same for
determining year end profit or loss and the financial position of the concern. The
main objective of financial accounting is to find out the profitability and to provide
information about the financial position of the concern as a whole.

Objectives of financial accounting:

 A modem accounting system has to accomplish the following four
objectives:

a) To identify financial events and transactions that occurs in an organization;

b) To measure the value of these occurrences in terms of money;

c) To organize the accumulated financial data into meaningful information;

and

d) To analyze, interpret and communicate the information to a board range of

persons and groups, both with in and outside the organizations.

Functions of Financial Accounting:

1) Recording of information: It is not possible to remember each and every

transaction of the business. Accounting is necessary to supplement human
memory. The information is recorded in journal and other subsidiary books.
These books are used to record various transactions in such away that the
information is properly classified and analyzed so that the management may
make use of that information.

2) Classification of data: The classification of information means that data of

one nature is placed at one place. This is done in the book called ledger. The
entries relating to different items are brought at on e place so that full
information of these items may be collected under different heads. For
example, we may have accounts called, salaries, rent, interest,
advertisement etc.

3) Making summaries: The classified data is used to prepare final accounts,

i.e., Profit and Loss account and Balance sheet. The final accounts are
prepared to find out operational efficiency and financial strength of the
business.

4) Dealing with financial transactions: Only those transactions are recorded

which are measurable in terms of money. Money is taken as a common
medium and all economic transactions are expressed in monetary terms.
 5) Interpreting financial information: Accounting information is modified in
such a way that it is interpreted by the management for drawing
conclusions. The interpretation part is very important for decision-making.

Limitations of financial accounting:

1) Historical nature: financial accounting is historical, since the data are

summarized only at the end of the accounting period. There is no system of
computing day-to-day cost and also computing pre-determined costs.

2) Not helpful in price fixation: It is not helpful in fixing prices of products.

The cost of a product can be obtained only when all expenses have been
incurred. It is not possible to determine the price in advance.

3) Cost control not possible: It is not possible to control cost as the cost has
already been incurred. There is no technique in financial accounting which
can help to ascertain whether the cost is more or less while the expenses
are being incurred.

4) 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.

5) Only actual costs recorded: It records only actual costs figures. The
amount paid for purchasing materials, property or other assets is recorded in
account books. Financial accounts do not record price level changes. The
recorded costs cannot provide correct information or exact value of assets.

6) Fails to supply useful data to Management: It 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.

Cost accounting:
Introduction:
 Costing is specialized branch of accounting. It has been developed because of
limitations of financial accounts. In the present day it is absolutely necessary that a
business concern should operate its activities with utmost efficiency and at the
lowest cost.

Meaning of cost, costing and cost accounting:

Cost: The costing terminology of the institute of cost and works accountants,
London defines cost as” the amount of expenditure incurred on or attributable to a
given thing”. Thus cost refers to something that must be sacrificed to obtain a
particular thing.

Costing: It is a systematic procedure of determining the unit cost of product/service.

In the words of Harold j. wheldon, “costing is the classifying and appropriate
allocation of expenditure for the determination of the cost of products or services,
and for the presentation of suitably arranged data for purposes of control and
guidance of the management”.

Cost Accounting: The costing terminology of I.C.M.A, London defines cost

accounting as the process of accounting for cost from the point of which
expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centers and cost units.

Objectives and Functions of cost accounting:

The main objectives of cost accounting are as follows:

1) Ascertainment of cost: this is the primary objective of cost accounting. In

cost accounting, cost of each unit of production, job, process, or department
etc., is ascertained. Not only actual costs incurred are ascertained but costs
are also predetermined for various purposes.

2) Cost control and cost reduction: it aims at improving profitability by

controlling and reducing costs. For this purpose, various specialized
techniques like standard costing, budgetary control, inventory control, value
analysis, etc., are used.

3) Guide to business policy: it 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, utilization of idle plant capacity, introduction of a new product, etc.
 4) Determination of selling price: It 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.

5) Provides a basis for business policy: The objective of cost accounting is

to help the management in the formulation of business policy and I decision-
making. The gross-profit analysis, the cost-volume-profit relationship, the
break-even point of sales, and the differential costing method, etc. help the
management in profit planning and in deciding crucial matters.

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 tailor-
made 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 organization.
 6) Controllable costs: Controllable and non-controllable costs of each
responsibility centre should be separately shown.

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.

Advantages of cost accounting:

1) Cost accounting as an aid to management: It helps the management in

carrying out its functions, i.e. planning, organizing, controlling, decision-
making, budgeting and pricing efficiently by providing cost information to
the management. The importance of costing to the management is as
follows:

a. It provides reliable cost data in regard to materials, labour, overhead

and other expenses.

b. It helps in price fixation.

c. It provides information on which estimates and tenders are based.

d. It helps in channelizing production on right lines.

e. It guides future production policies and thus helps in planning.

f. It helps in determining profitable and unprofitable activities.

 g. It increases efficiency ad reduces wastages ad costs.

h. It helps management in periods of trade depression and competition by

determining actual cost of the product.

i. It provides cost data for comparison in different periods.

j. Costing aids in inventory control.

2) Advantages to Employees: 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.

3) Advantages to creditors, Investors and Bankers: It enables the

creditors, bankers, and investors to judge the financial position ad solvency
of a concern by providing reliable cost data. Cost accounting thus helps
bankers and others in evaluating the performance of a customer. The
various cost reports can be analysed before lending money to a concern.

4) Advantages to the government and the society: It increases the

efficiency of a concern, reduces costs and increases its profits. Thus, it
promotes the overall economic development of the country. Better and
cheaper goods are made available to the public. With the reduction in
wastages and increases in profits the revenue of the government in the form
of taxes increased.

Limitations of cost accounting:

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.

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.

3)It is inapplicable: another argument sometimes put word is that modern

methods of costing are not applicable to many types of 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.

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. If a system does
not produce the desired results, it is wrong to jump to the conclusions that
the system is at fault. The reasons for its failure should be probed.

Management Accounting:
Introduction:

The term management accounting is of a recent origin. This term was

first used in 1950 by a team of accountants visiting U.S.A under the auspices of
Anglo-American council of productivity. The terminology of cost accountancy had no
reference to the word management accountancy before the report of this study
group.

Meaning and definition:

Management accounting is comprised of two words management and

accounting. It is the study of managerial aspect of accounting. The emphasis of
management accounting is to redesign accounting in such a way that it is helpful to
the management in formation of policy, control of execution and appreciation of
effectiveness. It is that system of accounting which helps management in carrying
out its functions more efficiently.

According to Robert N. Anthony, “Management accounting is concerned with

accounting information that is useful to management”.

According to Brown and Howard, “The essential aim of management accounting

should be to assist management in decision making and control”.

Characteristics:

1) Providing Accounting information: The collection and classification of

data is the primary function of accounting department. The information so
 collected is used by the management for taking policy decisions. It involves
the presentation of information in a way it suit managerial needs.

2) Cause and effect analysis: If there is a loss, the reason for the loss is
probed. If there is a profit, the factors directly influencing the profitability are
also studied. The figures of profits are compared to sales, different
expenditures, current assets, interest payables, share capital, etc. so the
study of cause and effect relationship is possible in management accounting.

3) Use of special techniques and concepts: The techniques used include

financial planning and analysis, standard costing, budgetary control, marginal
costing, project appraisal, control accounting, etc. the type of technique to be
used will be determined according to the situation and necessity.

4) Taking important decisions: It supplies necessary information to the

management, which may base its decisions on it. The historical data is
studied to see its possible impact on future decisions.

5) Achieving of objectives: In management accounting, the accounting

information is used in such a way that it helps in achieving organizational
objectives.

6) No fixed norms followed: In financial accounting certain rules re followed

for preparing different accounting books. On the other hand, no specific rules
are followed I management accounting.

7) Concern with forecasting: the management accounting is concerned with

the future. It helps the management in planning and forecasting.

Advantages of management accounting:

 1) Increases Efficiency: Management accounting increases efficiency of
business operations. The targets of different departments are fixed in
advance and the achievement of these goals is tool for measuring their
efficiency.

2) Proper planning: Management is able to plan various operations with the

help of accounting information. The technique of budgeting is helpful in
forecasting various activities.

3) Measurements of performance: The systems of budgetary control and

standard costing enable the measurement of performance. In standard
costing, standards re determined and then actual cost is compared with
standard cost. It enables the management to find out deviations between
standard and actual cost.

4) Maximizing profits: The thrust of various management techniques is to

control cost of production and increase efficiency of each and every
individual in the organization. The steps of controlling cost are able to reduce
cost of production.

5) Improves service to customers: The cost control devices employed in

management accounting enable the reduction of prices. All employees in the
concern are made cost conscious. The quality standards are pre-determined.
The customers are supplied god quality goods at reasonable prices.

6) Effective management control: The tools and techniques of management

accounting are helpful to the management in planning, co-ordination and
controlling activities of the cocern. The setting of standard and assessing
actual performance regularly enables the management to have management
by exceptions.

Disadvantages of management accounting:

1) Based on accounting information: The correctness and effectiveness of

managerial decisions will depend upon the quality of data on which these
decisions are based. If financial data is not reliable then management
accounting will to provide correct analysis.
 2) Lack of knowledge: The use of management accounting requires the
knowledge of a number of related subjects. Management should be
conversant with accounting principles, statistics, economic, principles of
management, etc., and only then management accounting can be effectively
utilized.

3) Intuitive (spontaneous) decisions: Though management accounting

provides scientific analysis of various situations and enables decision taking
based on facts and figures, there is a tendency to make decisions intuitively.

4) Not an alterative to administration: It does not provide an alternative to

administration. The tools and technique of management accounting provide
only information and not decisions. Decisions are to be taken by the
management and their implementation is also done by management.

5) Top heavy structure: The installation of a management accounting system

needs an elaborate organizational system. A large number of rules and
regulations are also required to make this system workable and effective. It is
a costly affair and can be used by big concerns only. Smaller units cannot
afford to use this system because of heavy cost.

6) Personal bias: the interpretation of financial information depends upon the

capability of interpreter as one has to make a personal judgment. There is
every likelihood of personal bias in analysis and interpretation.

Management accounting vs. Cost accounting vs. financial

accounting
Point of Management Cost accounting Financial
difference accounting accounting
Orientation It is concerned with all It is also concerned It is concerned
situations including with money as a with money as the
monetary and non- measure of economic economic resource
monetary economic performance. i.e. cash.
events from the point
of view of
 management.
Scope It is a way of It aims at measuring The financial
accounting which the economic aspect of the firm
covers financial performance of the is dealt with by
accounting, cost cost centres and the way of preparing
accounting and all main purpose of cost Trading A/c, Profit
aspects of financial accounting is to and Loss A/c and
management. It is provide suitable cost Balance sheet.
concerned with data to measure the
assisting the economic performance
management in its of cost centres.
functions as well as
evaluating the
performance of the
management.
Analysis of It can be applied for It is basically It indicates the
performance making the cost concerned with position of the
accounting more collection, business as a
purposeful and classification and whole in the final
management oriented. analysis of cost data. accounts prepared
Accordingly the for the purpose of
management reporting an
accounting directs its overall
attention to various performance of
departments of the the business.
business and report
about the profitability
performance of each of
the departments in the
business.
Time factor It concentrates on It also focuses Financial accounts
future operations, attention on past and focus attention on
profitability etc. current operations. past and current
operations.

Legal There is no legal Cost records are It became

compulsion compulsion as such in maintained voluntarily compulsory for
respect of a in order to meet the every company on
management requirement of the account of legal
accounting system and management. But now provision.
hence a company may companies act, 1956
keep the system of has made it obligatory
management to keep the cost
accounting voluntarily records in some
to assist the manufacturing
management in its industries.
functions as well as
evaluating the
performance of the
management.
 Difference between Cost accounting and Financial
accounting

Basis Financial Accounting Cost Accounting

Purpose The main purpose of financial The main purpose of cost
accounting is to prepare profit and accounting is to provide detailed
loss account and balance sheet for cost information to management,
reporting to owners or shareholders i.e., internal users.
and other outside agencies, i.e.,
external users.
Statuary These accounts have to be prepared Maintenance of these accounts is
requirement according to the legal requirements voluntary except in certain
s of companies act and income tax act. industries where it has been made
obligatory to keep cost records
under the companies act.

Analysis of Financial accounts reveal the profit or Cost accounts show the detailed
cost and loss of the business as a whole for a cost and profit data for each
profit particular period. It does not show product line, department, process,
the figures of cost and profit for etc.
individual products, departments and
processes.
Periodicity Financial reports are prepared Cost reporting is a continuous
of reporting periodically, usually on an annual process and may be daily, weekly,
basis. monthly, etc.
Control It lays emphasis on the recording of It provides for a detailed system of
aspect financial transactions and does not controls with the help of certain
attach any importance to the control special techniques like standard
aspect. costing and inventory control etc.

Format of It has a single uniform format of Cost accounting has varied forms
presenting presenting information, i.e., profit of presenting cost information
information and loss account, balance sheet and which are tailored to meet the
cash flow statement. needs of management and thus
lacks a uniform format
Types of Financial accounting records only Cost accounting records not only
transactions external transactions like sales, external transactions but also
recorded purchases, receipts, etc., with outside internal or inter-departmental
parties. transactions like issue of materials
by store keeper to production
department.

BASIC COST CONCEPT:

Introduction:

The term cost does not have a definite meaning and its scope is extremely
broad and general. 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.

Definition of Cost:

According to the ICMA, London, “Cost is the amount of expenditure incurred on

or attributable to, a specified thing or activity or cost unit”.

According to the oxford dictionary, cost means “The price paid for
something”.

Cost Vs. Expenses and Loss:

Often the terms cost and expense are used interchangeably. But cost should
be distinguished from expenses and loss.

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.

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 organization 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 for which costs may be ascertained and used for the purpose of
control”. Thus 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: consists of a location or an item of equipment or

group of these.

From 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 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 control. The person in charge of a cost centre is held
responsible for the control of cost of that centre.

Cost Unit:

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”. For example, in a sugar mill, the cost per
tone of sugar may be ascertained; in a textile mill the cost per meter of cloth may
be ascertained. Thus ‘a tonne’ of sugar and ‘a meter’ of cloth are cost units.

The concept of cost is thus not something definite; care must be taken to qualify it.
A cost accountant is mainly is mainly concerned with the following cost concepts:

1) Concept of objectivity: It is this concept that gives direction ot the

activities related to cost finding, cost analysis, recording and cost reporting.
This concept necessitates goal congruence, i.e., cost exercises have to be in
harmony with objectives. Cost treatments and cost strategies are influences
by objectives, which may include internal reporting for operational decisions,
internal reporting for specific non-repetitive decisions and external decisions.
 2) Concept of materiality: This concept that stress accuracy must be
tempered by good judgment, if no distortion of product cost is likely to result,
for example, overhead may include some items of direct cost, which may not
be as material as to justify tracing them to specific unit of production. A
particular decision may be useful, but benefits may not be material enough to
implement it. Materiality is determined with reference to nature of company’s
activities.

3) Concept of time span: All assumptions relating to different cost exercise

remain valid only during related time span. The statement that cost is fixed,
is based on a time span under consideration. No costs will remain fixed for all
the time. Time span selected by a company should be long enough to permit
the procedures to record the associated cost, output, labor hours and other
factors needed in the analysis. If time span is too short, leads and lags I
recording the cost data may be quite troublesome.

4) Concept of relevant range of activity: Relevant range of activity

represents the span of volume over which the cost behavior is expected to
remain valid. Different cost exercises are based o certain assumptions
relating to cost behavior patterns, which are valid only within the relevant
range of activity. The relevant range of activity may be different between
firms and for individual firm also, it may change from time to time.

5) Concept of relevant cost and benefits: this concept is vital for decision-
making purposes. In evaluating alternative curses of action, management
should consider only relevant cost and relevant benefit relating to
alternatives under consideration. Irrelevant cost and benefits, i.e., costs and
benefits which are not affected by decision under consideration are ignored.

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. Each classification serves a

different purpose.
1. Classification into Direct ad 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 are incurred for and conveniently
identified with a particular cost unit, process or department. Cost of raw
materials used and wages of a machine operator are common examples of
direct costs.

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
conveniently identified with a particular cost unit or cost centre. Depreciation
of machinery, insurance, lighting, power, rent, managerial salaries, materials
used in repairs, etc., are common examples of indirect costs. Depreciation of
machine for stitching a pair of trousers cannot be known and thus it is an
indirect cost.

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 o the basis of
behavior or variability, costs are classified into fixed, variable and semi-
variable.

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.

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 when volume of output decreases, total variable cost
also decreases, but the variable cost per unit remains fixed.
 Semi variable and semi fixed costs (mixed cost): These costs include
both a fixed and a variable component, i.e. these are partly fixed and partly
variable. The variable element in semi-variable costs changes wither at a
constant rate or in lumps. For example, introduction of an additional shift in
the factory will require additional supervisors and certain costs will increase
by steps. In the case of telephone connection, there is a minimum rent and
beyond a specified number of calls, the charges vary according to the
number of calls made.

3. Classification into committed and discretionary costs: fixed costs are

further classified into committed costs and discretionary 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.

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.

4. Classification into product costs and period costs: It 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.

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.
 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.
Show room rent, salary of company executives, travel expenses, etc., are
examples of period costs.

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 those 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.

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.

6. Classification into Historical cost and Pre-determined costs: on the

basis of time of computation, costs are classified into historical and pre-
determined costs.

Historical costs: These are those 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 cots 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: on the basis f normality
costs may be classified into normal and abnormal costs.

Normal Costs: it may be defined as a cost which is normally incurred on

expect lines at a given level of output. This cost is a part of production.

Abnormal cost: It 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.

8. 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.

Shut down cost: A cost which will still be required to be incurred even
though a plant is closed or shut-down for a temporary period, for example,
the cost of rent, rates, depreciation, maintenance expenses etc., is known as
shut-down cost.

Sunk cost: A cost which has been incurred in the past or sunk in the past
and is not relevant to the particular decision making, is a sunk cost. If it is
decided to replace the existing plant, the written down book value of the
plant less the sale value of the existing plant, is a sunk cost.

Opportunity cost: It is the value of a benefit sacrificed in favor of an

alternative course of action.

“The net selling price, rental value or transfer value which could be obtained
at a point in time if a particular asset or group of assets were to be sold,
hired, or put to some alternative use available to the owner at that time” is
the opportunity cost.
Imputed cost: It is hypothetical cost required to be considered to make
costs comparable. If the owner of the factory charges rent of the factory to
the cost of production to make cost comparable with that of those
undertakings which run production in rented factories, it is an imputed cost
as the rent has actually not been paid.

Out-of-pocket cost: It is the cost which involves current or future

expenditure/outlay, based on managerial decisions. For example, a company
has its own trucks for transporting goods from one place to another. It seeks
to replace these by employing public carriers of goods. While making the
decision management can ignore depreciation, but not the out-of-pocket
costs in the present situation i.e., fuel, salary to drivers and maintenance
paid in cash.

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,
machinery purchased in 1990 at Rs. 10,000 is discarded in 1998 and a new
machinery of the same type is purchased for Rs. 15,000. So the replacement
cost of machinery is Rs. 15,000.

Differential (Incremental cost) costs: It 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.

Marginal cost: It is the additional cost of producing one additional unit.

Marginal cost is the same thing as variable cost. It is a technique of charging
only variable costs to products. Inventory is also valued at variable cost only.
It helps in decisions like make or buy, pricing of products, selection of sales
mix, etc.
 Conversion cost: This term is used to denote the sum 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.

Elements of Costs:
A cost is composed of three elements, i.e., materials, labour and expenses.
Each of these elements may be direct or indirect.

1) Material: The substance form which the product is made is known as

material it may be in a raw or a manufactured state. It can be direct as well
as indirect.

a) Direct material: All material which becomes an integral part of the

finished product and which can be conveniently assigned to specific
physical units is termed as “Direct materials”.

• All material or components specifically purchased, produced or

requisitioned from stores.

• Primary packing material (ex. Carton, wrapping, cardboard boxes,

etc.)

• Purchase or party produced components.

b) Indirect material: All material which is used for purposes ancillary to the
business and which cannot be conveniently assigned to specific physical
units is termed as indirect material. Consumable store, oil and waste,
printing and stationery material, etc., are a few examples of indirect
materials.

2) Labour: For conversion of materials into finished good, human effort is

needed, such human effort is called labour, and labour can be direct as well
as indirect.

a) Direct labour: Labour which plays an active and direct part in the
production of a particular commodity is called direct labour. Direct labour
costs are, therefore, specifically and conveniently traceable to specific
 products. It is also described as process labour, productive labour,
operating labour, etc.

b) Indirect labour: labour employed for the purpose of carrying out tasks
incidental to goods produced or services provided, is indirect labour. Such
labour does not alter the construction, composition or condition of the
product. It cannot be practically traced to specific units of output. Wages
of store-keepers, foremen, time-keepers, director’s fees, salaries of
salesmen etc, are all examples of indirect labour costs.

3) Expenses: Expenses may be direct or indirect.

a) Direct Expenses: These are expenses which can be directly,

conveniently and wholly allocated to specific cost centers or cost units,
examples of such expenses are: hire of some special machinery required
for a particular contract, cost of defective work incurred in connection with
a particular job or contract, etc.

b) Indirect Expenses: These are expenses which cannot be directly,

conveniently and wholly allocated to cost centres or cost units, examples
of such expenses are rent, lighting, insurance charges, etc.

4) Overhead: It is to be noted that the term overheads has a wider meaning

than the term indirect expenses. Overheads include the cost of indirect
material and indirect labour besides indirect expenses. Indirect expenses
may be classified under the following three categories:

a) Manufacturing (works, factoryor production) Expenses: such

indirect expenses which are incurred in the factory and concerned with
the running of the factory or plant are known as manufacturing expenses.
Expenses relating to production management and administration are
included therein. Factory overheads include:

• Indirect material used in the factory such as lubricating oil,

consumable stores, etc.

• Indirect labour such as gate-keeper’s salary, time-keepers salary,

works manager’s salary, etc.
 • Indirect expenses such as factory rent, factory insurance, factory
lighting, etc.

b) Office and Administrative Expenses: These expenses are not related

to factory but they pertain to the management and administration of
business. Such expenses are incurred on the direction and control of an
undertaking. Office overheads include:

• Indirect material used in the office such as printing and stationery

material, broom and dusters, etc.

• Indirect labour such as salaries payable to office manager, office

accountant, clerks, etc.

• Indirect expenses such as rent, insurance, lighting of the office.

c) Selling and Distribution Expenses: Expenses incurred for marketing of

a commodity, for securing orders for the articles, dispatching goods sold,
and for making efforts to find and retain customers, are called selling and
distribution expenses. Selling overheads include:

• Indirect material used such as packing material, printing and

stationery material, etc.

• Indirect labour such as salaries of salesmen ad sales manager, etc.

• Indirect expenses such as rent, insurance, advertising expenses,

etc.

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 of costing are as follows:
a. 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 customers’ specifications. Industries where this method is
used include printing repair shops, interior decoration, painting, etc.

b. 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 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, ship-building, etc.

c. Batch costing: In this method, the cost of a batch or group of identical

product 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.

d. Process costing: this method is used in mass production industries

manufacturing standardized 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.

e. 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.
 f. 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 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.

g. 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 undertaking (road transport,
railways, airlines, shipping companies), electricity companies, hotels,
hospitals, cinemas, etc., use this method. The cost units are passenger-
k8ilometer or tone-kilometer, 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.

h. 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
television set 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,
cars, locomotives, etc.

Techniques of Costing:
These techniques may be used for special purpose of control and policy in
any business irrespective of the method of costing being used there. These
techniques are:

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 actual costs are analysed to know the reasons for the
difference so that corrective actions may be taken.
 2) Budgetary control: A budget is an expression of a firm’s business plan in
financial form and budgetary control is 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 co-ordination of business
operations.

3) Marginal costing: In this technique, separation of cost into fixed and

variable is of special interest and importance. It regards only variable costs
as the cost of the products. 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 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 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.

Management Process and Accounting:

The chief objective of management accounting is to serve management by
providing information for decision-making. It is pertinent here to understand the
management functions, that management accounting serves:

1) Planning: It is the process of setting goals and allocating resources to

achieve those goals. The purpose of a plan is to anticipate future needs or
opportunities that require specific steps to be taken now or in the near future
– example, investment in new facilities to increase capacity and the
development of new products or markets. The planning process of
management answers to such questions as what does the firm desire and
when and how are the objectives to be accomplished.
 2) Control: It involves a comparison of actual performance with plans so that
deviations from plan can be identified and corrective action taken. It is
through control process that management comes to know, whether or not the
objectives under long-range plan are likely to be achieved. If objectives are
not likely to be achieved, the control process provides response for the
review of company’s objectives and long-range plans.

3) Organizing: This is the process that involves establishment of the

framework, within which activities are to be performed and the designation of
who should perform these activities. This involves departmentalization by
establishment of divisions, departments, sections, branches, and so on.
Management accounting performs a staff function. It provides line managers
and other staff managers with a specialized information service, which assist
them in decision-making planning and control activities.

4) Co-ordinating: It is necessary to coordinate and harmonizes the activities of

a company so as to facilitate its working and its success. Co-ordination
process results in the following advantages:

• Each department will work in harmony with others.

• Each department will know the specific role that it has to play
in accomplishment of organizational objectives.

• Sequential arrangement of activities is so governed that

overlapping and wastage of labour is avoided.

5) Motivating: It means influencing human behavior in such a manner that

participants identify with the objective of the organization. When workforce is
motivated, decisions taken harmonize with the objective. A good manager is
one, who motivates the subordinate to strive to achieve the target set by the
top management.

Cost control and cost reduction:

Cost control:
 The cost control is the function of keeping costs within prescribed limits.
According to C.I.M.A., cost control is “the regulation by executive action of the cost
of operating an undertaking, particularly where such action is guided by cost
accounting”. Cost control is based on the principle of predetermination of costs and
achieving these costs levels so that inefficiencies and wastages may be reduced. In
other words, cost control is compelling actual costs to conform to planned costs.
This involves:

a) Predetermining or preplanning costs.

b) Comparing the actual costs with planned costs.

c) Taking action to correct divergencies.

Among the techniques used for cost control, the two most popular are
Budgetary control and Standard costing.

Cost reduction:

Often cost reduction is confused with cost control. Cost reduction is defined by
C.I.M.A. as the “achievement of real and permanent reduction in the unit cost of
goods manufactured or services rendered without impairing their suitability for use
intended”. This definition reveals the following characteristics of cost reduction:

a) Cost reduction must be real – say, through increase in productivity.

b) Cost reduction must be permanent- temporary reductions in cost due to

windfalls, change in tax rates, changes in market prices, etc., do not come in
the purview of cost reduction.

c) Cost reduction must not impair the suitability of products or services for the
intended use.

In the other words, cost reduction should not be at the cost of essential
characteristics of the products or services. The cost reduction is, therefore,
the term used for planned and positive approach to the improvement of
efficiency. It can be viewed in many ways, such as increasing productivity,
elimination of waste, improvement of product design, better technology and
techniques, incentive schemes, new layouts and better methods, etc. if the
 cost reductions are not based on sound reasons, like improved methods, then
very quickly the costs will grow back to their original size.

UNIT – II

COST ANALYSIS AND CONTROL

Overheads:

Meaning and definition:

Overhead is the aggregate of indirect material cost, indirect labour cost

and indirect expenses which cannot be conveniently identified with and
directly allocated to a particular cost centre and cost object in an
economically feasible way. It is also known as indirect cost.

The CIMA of UK has defined overhead as “the aggregate of indirect

materials cost, indirect wages and indirect expenses”.

In the words of wheldon, “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”.

Advantages of overhead:

1) Calculates the full cost of outputs or activities

2) Manage and control costs

3) Reports to internal and external stakeholders

How to reduce overhead expenses?

 1) Advertising, as well as research and development, are often the first
activities to be cut because they can be reduced almost instantly.

2) We can also cut staff cost by restricting overtime or cutting staff hours.

3) We can reduce overheads, by delaying purchases of new equipment,

although this is a temporary measure.

4) Leasing new equipment rather than buying it outright.

5) Renegotiating your contracts with suppliers.

Steps for the distribution of overheads:

1) Classification of overheads.

2) Collection of overheads.

3) Allocation of overheads.

4) Apportionment of overheads.

5) Re-apportionment of service department’s overheads.

6) Absorption of overheads.

Collection of overheads:

Collection of overhead involves the act of recording individual items of cost in

the records kept for the purpose. Each document must have the correct cost centre
code as well as the correct cost accounts number. The following source documents
are used for the collection of overheads.

1) Invoices: These invoices relate to the services provided to the organization

by outside firms. Invoices are documents based on which payments are
made. The payments made are booked to expenses in financial accounts.
Collections of indirect expenses are done through these invoices.

2) Stores requisitions: The stores requisitions for indirect materials form the
basis of accounting for indirect materials. These documents have the cost
centre code which denotes the name of the cost centre requisitioning the
materials and the account head where the materials issued should be
booked.
 3) Subsidiary records: provisions have been made in the accounts for certain
expenses in the expectation of further cash payment. These provisions are
made in subsidiary records. Thus, outstanding rent, outstanding salaries are
examples.

4) Wages analysis books/ wages abstract sheet: the wages analysis book
shows the different control accounts. These accounts are to be for the
purpose of booking indirect wages and salaries.

5) Estimation from financial accounts: there are certain expenses which are
charged over a number of accounting periods. This includes pre-paid
expenses of previous periods which have been apportioned. The collections
of these expenses are directly made from the financial accounts.

Allocation of overhead:

Cost allocation is the process of identifying overheads to production or service

cost centre for which such overheads are directly incurred or charged. For example,
wages paid to maintenance staff, as revealed by the wages analysis booked, can be
allocated direct to the maintenance service cost centre. Again, indirect material
cost can be allocated to various cost centers based on stores requisitions.

Allocation means charging the full amount of overheads cost to a cost centre,
e.g., to a department, to a process, etc. It has been defined as “the allotment of
whole items of cost to cost centres or cost units.” Allocation depends on the nature
of cost. If a particular item of cost can be easily identified to a particular cost centre,
it is allocated. For example, salary of a foreman in a production department can be
easily identified and allotted to this department.

Format of statement showing the allocation of overheads

Statement showing the allocation of overheads

Items of overheads Production department Service department

allocated
P1 P2 S1 S2
 Direct material - - - -
Direct wages - - - -
Direct expenses - - - -
Indirect material - - - -
Indirect wages - - - -

Total overheads allocated - - - -

Apportionment of overheads:

Apportionment is “the allotment of proportions of items of cost to cost centres or

cost units”. Where an item of cost is common to various cost centres, it is allotted to
different cost centres proportionately on some equitable basis. For example, rent of
factory building is not allocated but apportioned to various departments on some
suitable basis, i.e., area occupied by departments concerned.

Format of statement showing the apportionment of overheads

Statement showing the apportionment of overheads

Items of overheads Basis of Production Service

apportioned apportionment department department
P1 P2 S1 S2
Lighting No. of light points - - - -
Depreciation Asset value - - - -
Insurance Asset value - - - -
Rent, rates, and Floor area - - - -
Taxes Floor area - - - -
Repairs Direct material - - - -
Stores overheads Direct wages - - - -
Employee’s No. of workers - - - -
insurance charges No. of workers - - - -
Staff welfare
expenses
Total overheads - - - -
apportioned

Distinguish between Allocation and Apportionment

Allocation Apportionment
 1 Allocation may be defined as “the Apportionment may be defined as “the
. allotment of whole items of cost to allotment of proportions of items of
cost centres or cost units”. cost to cost centres or cost units”.
Allocation deals with whole items Apportionment deals with proportions
2. of costs. of items of cost.
Allocation is a direct process Apportionment may be made only
3. indirectly and for which suitable bases
are to be selected.
Overheads should always be If an overhead cannot be allocated, it is
4. allocated, as far as possible apportioned.
It include indirect wages, overtime It include fire insurance, lighting and
5. and idle time cost, power (when heating, time keeping expenses,
sub-meters are installed in canteen expenses, medical and other
departments), depreciation of welfare expenses, etc.
machinery, supervision, etc.

Overheads should always be allocated, as far as possible. If an overhead cannot

be allocated, it is apportioned. This involves finding some basis of apportionment
that will enable the overhead to be equitably shared between various production
and service departments.

Production and service department:

A production department is one that engages in the actual manufacture of the

product by changing the shape, form or nature of material or by assembling the
parts into finished product. Examples are melting shop, weaving department,
spinning department, grinding department, etc.

A service department, on the other hand, is one rendering a service that

contributes in an indirect manner to the manufacture of the product but which does
not itself change the shape, form or nature of material that is converted into the
finished product. Examples are labour welfare department, purchasing department,
accounting department, canteen, etc.

Apportionment of service department costs (secondary distribution):

Once the overheads have been allocated and apportioned to production and service
departments and totaled, the next step is to re-apportion the service department
costs to production departments. This is necessary because our ultimate object is to
charge overheads to cost units, and no cost units pass through service
departments. Therefore, the costs of service departments must be charged to
production departments.
 There are various methods of apportionment of service department overheads

a) Apportionment to production department only

b) Apportionment to production as well as service departments.

Apportionment to production department only:

Here the total amount of each service department is distributed to only

production department. Some of the important bases of apportionment of service
department overheads are given below:

Service department Basis of apportionment

Purchases department Value of materials purchased, No. of

orders placed

Time office personnel department No. of employees, wages paid, labour

hours

Canteen labour welfare No of employees, wages paid

Accounts office No. of employees, No. of time cards

handled

laboratory Testing laboratory hours, Units of output

Maintenance department No. of hours worked in each department

Apportionment to production as well as service departments:

Quite often, a service department renders service 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 department like power-house, material
handling, etc. Similarly power-house supplies electricity not only to production
department but also to other service departments like canteen, maintenance
department, 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 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.
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:

a) Simultaneous equation method: This method is to be adopted to take

care of secondary distribution of cost of service cost centres to production
cost centres with the help of mathematical formulation and solution. It
involves the following steps:

Step 1: calculate the total costs of each service department by forming and
solving simultaneous equations.

Step 2: Re-apportion the total costs of each service department only to

production department on the basis of given percentages.

X = a+bY and Y =a+bX

b) Repeated distribution method: This method involves the following steps:

Step 1: Apportion the costs of first service department over other service
departments and production departments on agreed percentages.

Step 2: Apportion the costs of second service department plus the share
received from s1 over other departments on agreed percentages.

Step 3: Apportion the costs of third service department plus the share
received from s1 and s2, over other departments on agreed percentages.

Step 4: Repeat this process of distribution again beginning with S1 until the
total costs of the service departments are exhausted or reduced to too small
figure. The small figure should be apportioned over production departments
and not over other service departments.

c) Trial and error method: this method is to be followed when the question of
distribution of costs of service cost centres which are interlocked among
themselves, arises. In the first stage, gross costs of services of service cost
centres are determined and then in the second stage, costs of service centres
are apportioned to production cost centres.
 Step 1: The proportion at which the costs of a service cost centre to be
distributed to production cost centres and other service cost centres is
determined.

Step 2: Cost of first service cost centre is distributed to the other service
centres in the proportion of service they received from the first as assessed
in step (1).

Step 3: In the next step, total cost of second service cost centre so arrived
has to be distributed to the other service centres in the proportion of service
they received from the second as assessed in step(1).

Step 4: Similarly, the cost of other service cost centres are to be apportioned
to the service cost centres.

Step 5: this process as described in (3) and (4) is to be continued till the
figures remaining undistributed in the service cost centres are negligibly
small.

Step 6: At the last, total cost of service cost centres to be distributed to

production cost centres.

Absorption of factory overhead:

After the allocation, apportionment and re-apportionment of overheads to

production departments is complete, the total overhead cost of production
department will consist of:

a) Its own expenses, e.g., indirect materials, indirect wages, etc.

b) Share of the costs of service departments re-apportioned to it.

c) Share of the costs of service department re-apportioned to it.

This gives the total overheads cost of each production department. The total
cost of production department is then to be absorbed by the products
manufactured in the respective production departments. This is known as
absorption.

The absorption of overheads is the last step in the distribution plan of

production overheads. It is the process of charging to the product or output of
the production department, 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 of
overhead is also known as recovery or application of overheads.

Steps in absorption of overheads:

There are two steps in the absorption of overheads:

i) Computation of overhead absorption;

ii) Application of theses rates to cost units.

Computation of overhead 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, by dividing the total amount of overheads of the department by the number
of units in the base, such as number of cost units, machine hours, labour hours,
direct labour cost, and prime cost, etc.

Overhead absorption rate = Total overhead of cost centre or department /

Total units of base used

Percentages on direct materials: In this method overheads are absorbed on the

basis of direct materials consumed in producing the product. A percentage of
factory overheads to the total value of materials consumed are determined.

Overhead rate = factory overhead/ direct material X100

Percentage on direct wages: This is another simple and easy method. In this
method percentageof factory overhead to direct labour cost is computed as follows:

Overhead rate = factory overhead/direct labour cost X100

Percentage on prime cost: This method takes into consideration both direct
materials and direct wages for the absorption of overhead. Overhead rate in this
method is calculated by dividing the factory overhead by the prime cost.

Overhead rate = factory overhead / prime costX100

Direct labour hour rate: The direct labour hour rate is the overhead cost of a
direct worker working of one hour. This rate is determined by dividing the overhead
expenses by the total number of direct labors hours.

Overhead rate = factory overhead/direct labour hoursX100

Advantages:

a) It gives due consideration to time factor.

b) It is most suitable where labour constitutes the major factor of production.

 c) This rate is not affected by the method of wage payment, i.e., time rate or
piece rate method.

Disadvantages:

a) Additional records of labour (i.e., time spent on different jobs) must be

maintained if this method is to be used. This may add to the cost of clerical
work.

b) This method does not take into account factors other than labour.

Machine hour rate:

This method is applicable where work is performed mainly on machines. A

separate rate is usually computed for each machine or a group of similar machines.

Machine hour rate means the cost of running a machine for one hour. This
rate is obtained by dividing the amount of factory overheads chargeable to a
machine by the number of machine hours. Overhead charge to a job is made on the
basis of number of machine hours worked on that job.

Machine hour rate = factory overhead for machine X/no. of machine hours

Computation of machine hour rate: The following steps are taken for the
computation of machine hour rate:

• The factory overheads are first apportioned to departments as

discussed earlier under allocation and apportionment.

• Overheads of the department are further apportioned to different

machines or group of machines. For this purpose each machine or a
group of machine is treated as a cost centre or a small department.
Bases of apportionment of different expenses are given here.

• Specific overheads like power, depreciation, etc., should be directly

allocated to the machine.

• The overheads relating to the machine should be divided between

Fixed or standard charges, variable charges.

• The working hours of the machine are estimated for the period.

• Overheads pertaining to the machine are totaled and divided by the

number of machine hours. The resultant figure will be machine hour
rate. The time required for setting the machine should be deducted
from the total working hours.

Bases of apportionment of different expenses to machines

 Items of expenses Basis of apportionment

Rent and rates Ratio of floor area occupied by each

machine

Insurance Insured value of each machine

Supervision Estimated time devoted by the

supervisor to each machine

Lighting No. of light points used for the machines,

of floor area occupied by each machine

Depreciation Capital values or machine hours or both

Repairs and maintenance Capital values or machine hours

Lubricating oil and other consumable Capital values or machine hours

stores

Advantages:

a) It is a scientific and accurate method of absorption of factory overheads.

b) It gives due consideration to time factor and thus produces more equitable
results.

c) This is an ideal method where production is carried out on machines.

d) When separate rates are calculated for fixed and variable overheads, the cost
of idle machines can be measured without difficulty.

Disadvantages:

a) This method can be used only in those departments where work is done by
machines.

b) It is quite difficult to estimate total machine hours in advance.

c) This method requires the maintenance of detailed records about machine

time taken by various jobs. This increases the clerical cost.

Rate per unit of production: It is the simplest of all the methods. The total
overheads of a department are divided by the number of units produced to give an
overhead rate per unit of output.

Overhead rate = factory overheads/units produced

This method can be used only where one product of uniform size, quality and
standard is being produced. For example, mining, brick laying, foundries etc.
 Unit III
Costing for specific industries
Introduction:

The profit of every business organization depends upon their selling price for
the product. The determination of selling price is done through the process of
identifying the cost of that product which is known as costing for the product.

Under costing the role of unit costing is an inevitable tool for the industries
not only to identify the volume of costs incurred but also to determine the rational
price.

Unit costing:

“It is a method of cost ascertainment, which is used in those industries where

production is uniform and continuous and production consists of a single product”.
This is also known as output costing or single costing. Examples of industries in
which this method is commonly used are cement, steel, sugar, paper, brick works,
quarries, breweries, dairies, etc.

Cost sheet:

In order to ascertain cost of products, a statement known as 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.

Definition:

Cost sheet is a document that provides for the assembly of the detailed cost
of a cost centre or cost unit.

“Cost sheet is a periodical statement of cost designed to show the various

elements of costs of goods produced like prime cost, factory cost, and total cost”.

Advantages:

1. It is helpful in revealing the total cost and cost per unit of goods produced.

2. It acts as a guide to management in fixation of selling prices and quotation of

tenders.
 3. It provides a comparative study of the cost of current period with that of
previous year.

4. It discloses the break-up of total cost into various elements of cost.

Job costing:

The ultimate aim of every business organization is to earn profits by

customer satisfaction, customer loyalty. To fulfill these specific requirements of
customer, every firm is expected to determine the cost of the job, to fix the
righteous price.

To find out the cost of the job, the firm should adopt job order costing
which is one of the costing methods, meant for calculating the cost of a particular
job.

Definition:

“It is a costing system for attaining the cost control and performance
through the available source of cost information of a specific job”.

“It is cost ascertainment method used in job order industries like printing
press, interior decoration, general engineering etc.”

Objectives:

1. Ascertaining the cost of each job separately.

2. Helps identifying the job that are profitable.

3. Provides the basis for determining the cost of similar jobs undertaken in
future.

4. Helps management in controlling cost by comparing actual cost with

estimated cost.

Procedure: It contains the following steps

i. Job number: This is first step of job costing where an individual job number
must be assigned to each job for identification and future references.

ii. Production order: The production control department prepares a production

order thereby authorizing to start the work on the job. Generally the orders
are of various colours to distinguish between various departments.

iii. Job cost sheet: This is a unique accounting document prepared by the
accountant after receiving job production order. It consists of the cost
information regarding material, machinery and labour. These are not made
for specified periods but they are made out for each job regardless the time
taken for its completion.

Process costing:
 All companies will not produce their finished products in single step. Some
organizations manufacture the product through many stages of production. Such
system is known as process of production.

In these organizations the output of one process will become the input of
another process. Costing procedure for these organizations gives rise to process
costing.

Definition:

Process costing is technique that is used in those organizations where the

production aspects take place in several steps

“If the cost of a product are ascertained by compiling of various stages of

production cost of that product, such costing technique is known as process
costing”. Examples are textile mills, sugar industry, chemical industry, oil refining,
paper industry, food processing, soap industry etc.

Characteristics:

1) Production is continuous, final product results from a sequence of processes.

2) Costs are accumulated process-wise.

3) The products are standardized ad homogeneous.

4) The cost per unit is average cost.

5) The finished product of one process will become the opening material of
another process.

6) The sequences of operations are pre-determined.

7) Some loss of material is unavoidable.

8) Processing of raw material gives rise to by-products.

9) The finished product will be derived only from the final stage of production.

Distinguish between Process costing and job costing

Process costing Job costing

1. Costs are compiled process-wise and Costs are separately ascertained for
cost per unit is the average cost, i.e. each job, which is cost unit.
the total cost of the process divided by
the number of units produced.

2. Production is of standardized products Production is of non-standard items

and cost units 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 Costs are calculated when a job is
specified period. completed.

5. The cost of one process is transferred Cost of a job is not transferred to

to the next process in the sequence. another job but to finished stock
account.

6. On account of continuous nature of There may or may not be work-in-

production, work-in-progress in the progress in the beginning and end of
beginning and end of the accounting the accounting period.
period is a regular feature.

7. Cost control is comparatively easier. Cost control is comparatively more

This is because factory processes and difficult because each cost unit or job
products are standardized. needs individual attention.

Process costing procedure:

The essential stages in process costing procedure are:

• The factory is divided into a number of processes and an account is

maintained for each process.

• Each process account is debited with material cost, labour cost, direct
expenses and overheads allocated or apportioned to the process.

• 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.

• The finished output of the last process (i.e. the final product) is transferred to
the finished goods account.

Accounting adjustments in process costing:

In process costing the following four types of adjustments need to be made in

accounts.

• Process losses – normal and abnormal

• Valuation of work-in-progress – equivalent production

• Joint products and by-products

• Inter-process profits.
Process losses and wastages:

The industries that employ process costing, a certain amount of loss occurs
at various levels of production. Such loss may arise due to chemical reaction,
evaporation, inefficiency etc. So, it is necessary to maintain accurate records of
both input and output.

The process loss may be classified as

1) Normal process loss:

“The amount of loss that is unavoidable because of the nature of

material or process is known as normal loss”.

Such loss is quite expected under normal conditions. When scrap is

having any value this amount is credited to the process account. This
quantity is generally decided as a percentage of input.

2) Abnormal loss:

“The amount of loss that can be avoidable and arises due to

carelessness, break-downs and accidents etc”.

These losses are unexpected and are valued the units of loss and
shown at the debit side of the process account.

The cost per unit of normal loss is usually calculated by the following
formulae:

Cost per unit = Total cost – value of normal loss/units introduced –

normal loss units

Abnormal gains:

In some cases the expected loss may be less than the actual loss. Such
variation leads to some additional benefit to the organization which is known as
abnormal gain.

It is shown on the debit side of the process account and credit side of the
abnormal gain account.

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. The valuation of such
stock is done in terms of equivalent production.

Equivalent production represents the production of a process in terms of

completed units. Here the work-in-progress units are converted into equivalent
completed units at the end of accounting period.
 This can be calculated with the following formulae:

Equivalent units = (No. of units of work-in-progress) X (degree of

completion)

Evaluation of equivalent production:

• Find out the total net cost of each element.

• Ascertain cost per unit of equivalent production separately for each element.

• At this rate to finished production cost is ascertained.

To calculate theses values we need to prepare

 Statement of equivalent production

 Statement of cost per unit

 Statement of evaluation.

Internal process profits:

In some businesses, it is a practice to change the output of each process to

the next process not at cost but at a price showing profits to the transferor process.
The transferer price may be either the current market price or cost plus a fixed
percentage.

Each process is charged with its input at current price and no process obtains
the benefits of savings of the earlier processes.

Objects: It consists of the following objects:

 To show whether the cost in each process computes with the market prices.

 To make each process stand on its own efficiency.

 To assist in making decisions such as make or buy some parts or work.

Joint Products and By-Products:

In many industries, 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 raw material. Examples of these products are petrol,
kerosene, diesel, grease, etc. such products are known as joint products or by-
products.

Joint products:
 The term joint products is used two or more products of almost equal 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 a
nature that no single one of them can be regarded as the main product.

Characteristics:

• Joint products are produced from the same raw material in natural proportions.

• They are produced simultaneously by a common process.

• They are comparatively of almost equal value.

• They may require further processing after their point of separation.

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. By-
products may be:

• Those sold in their original form without further processing.

• Those which require further processing in order to be saleable.

Unit – IV
Marginal costing
Introduction:

There are mainly two techniques of product costing and income determination:

Meaning of marginal costing:

Marginal cost is the additional cost of producing an additional unit of product. It

is the total of all variable costs. It is composed of all direct costs and variable
overheads.

“The increase in one unit of output, the total cost is increased and this increase
in total cost from the existing to the new level is known as marginal cost”.

Definition:
 ‘The CIMA of UK has defined marginal cost as the amount at any given
volume of output by which aggregate costs are charged, if volume of output is
increased or decreased by one unit’.

Characteristics:

The essential characteristics and mechanism of marginal costing technique

may be summed up as follows:

1. Segregation of costs into fixed and variable elements: In marginal

costing, all costs are classified into fixed and variable. Semi-variable costs are
also segregated into fixed and variable elements.

2. Marginal costs as product costs: Only marginal costs is charged to

products produced during the period. In other words, marginal costs are
treated as products cost.

3. Fixed cost as period costs: Fixed costs are treated as period costs and are
charged to the costing Profit and Loss Account of the period in which they are
incurred.

4. Valuation of inventory: The work-in-progress and finished stocks are

valued at marginal cost only.

5. Contribution: Contribution is the difference between sales value and

marginal cost of sales. The relative profitability of products or departments is
based on a study of contribution made by each of the products or
departments.

6. Pricing: In marginal costing, prices are based on marginal cost plus

contribution.

Assumption of marginal costing:

The technique of marginal costing based upon the following assumptions:

• Elements of cost-production, administration and selling and distribution – can

be segregated into fixed and variable components.

• Variable cost remains constant per unit of output irrespective of the level of
output and thus fluctuates directly in proportion to changes in the volume of
output.

• The selling price per unit remains unchanged or constant at all levels of
activity.

• Fixed costs remain unchanged or constant for the entire volume of

production.
 • The volume of production or output is the only factor, which influences the
costs.

Advantages of marginal costing:

1. Simple to operate and easy to understand: The technique of marginal

costing is very simple to operate and easy to understand. Since, fixed costs
are kept outside the unit cost; the cost statements prepared on the basis of
marginal cost are much less complicated.

2. Removes complexities of under-absorption of overheads: It does away

with the need for allocation, apportionment and absorption of fixed
overheads and hence removes the complexities of under-absorption of
overheads.

3. Helps management in production planning: Marginal cost remains the

same per unit of output irrespective of the level of activity. It is constant in
nature and helps the management in production planning.

4. No possibility of fictitious profits by over-valuing stocks: It prevents

the carry forward of current year’s fixed overheads through stocks, there is
no possibility of factitious profits by over-valuing stocks.

5. Facilitates calculation of important factors: It facilitates the calculation

of various important factors, viz., break-even point, expectation of profits at
different levels of production, sales necessary to earn a predetermined target
of profit, effect on profit due to changes of raw materials prices, increased
wages, change in sales mixture, etc.

6. Aid to management: It is a valuable aid to management for decision-

making and fixation of selling prices, selection of a profitable product/sales
mix, make or buy decision, problem of key or limiting factor, determination of
the optimum level of activity, close or shut down decisions, evaluation of
performance and capital investment decisions, etc.

7. Facilitates the study of relative profitability: It facilitates the study of

relative profitability of different product lines, departments, production
facilities, sales divisions, etc.

8. Complimentary to standard costing and budgetary control: It is

complimentary to standard costing and budgetary control and can be used
along with them to yield better results.

9. Helps in cost control: Since fixed costs are not controllable and it is only
variable or marginal cost that is controllable, marginal costing, by dividing
costs into controllable and non-controllable, help in cost control.

10.Profit planning: It helps the management in profit planning by making a

study of relationship between cost, volume and profits. Further, break-even
charts and graphs make the whole problem easily understandable even to a
layman.

Disadvantages of Marginal Costing:

1. Segregation into fixed and variable-a difficult task: it is difficult to
classify all the costs into fixed and variable with accuracy since some costs
have no relation to volume of output or even with the time. For example,
management’s decision regarding bonus to workers may not be directly
related to time or output.

2. Ignores fixed overheads: always pricing the products ignoring fixed

overheads may not be appropriate.

3. Not appropriate for job/contract costing: it cannot be easily applied in

job and contract costing.

4. Based on number of assumptions: the technique of marginal costing is based

upon a number of assumptions which may not hold good under all
circumstances.

5. Problem in regard to under and over absorption: although the

technique of marginal costing overcomes the problem of under or over
absorption of fixed overheads, the problems still exists in regard to under or
over absorption of variable overheads.

6. Unable to fix selling prices: fixation of selling prices in the long run cannot
be done without considering fixed costs. Thus, pricing decisions cannot be
based on marginal cost alone.

7. Useful only in short profit planning and decision-making: marginal

costing is especially useful in short profit planning and decision-making. For
decision of far reaching importance, one is interested in special purpose cost
rather than variability of costs.

Marginal cost statement

Particulars Tota
l

Sales XXX

Less: Variable cost XXX

Contribution XXX

Less: Fixed cost XXX

Profit or Loss XXX

Absorption costing:

This is a total cost technique under which total cost (i.e., fixed cost as
well as variable cost) is charged as production cost. In other words, in
 absorption costing, all manufacturing costs are absorbed in the cost of the
products produced. In this system, fixed factory overheads are absorbed on
the basis of a predetermined overhead rate based on normal capacity.
Under/over absorbed overheads are adjusted before computing profit for a
particular period. Closing stock is also valued at production cost which
includes variable cost and fixed factory overhead. Absorption costing
approach is the same as used in cost sheet. Absorption costing is a traditional
approach and is also known as ‘conventional costing’ or ‘full costing’.

Distinction between absorption and marginal costing:

1. Treatment of fixed and variable cost: in marginal costing, only variable costs
are charged to products. Fixed costs are treated as period costs and charged
to Profit and Loss Account of the period. In absorption costing, all costs (both
fixed and variable) are charged to the product. The fixed factory overhead is
absorbed in units produced at a rate predetermined on the basis of normal
capacity utilization (and not on the basis of actual production).

2. Valuation of stock: in marginal costing, stock of work-in-progress and finished

goods are valued at marginal cost only. In absorption costing, stocks are
valued at total cost which includes both fixed and variable costs. Thus stock
values in marginal costs are lower than that in absorption costing.

3. Measurement of profitability: in marginal costing, relative profitability of

products or departments is based on a study of relative contribution made by
respective products or departments. The managerial decisions are thus
guided by contribution. In absorption costing, relative profitability is judged
by profit figures which are also a guiding factor for managerial decisions.

Managerial Applications of Marginal Costing:

It is a valuable technique aid to management in taking many managerial
decisions. It is a useful tool for making policy decision, profit planning and cost
control. The information supplied by the total cost method is usually not sufficient to
solve managerial problems. The following are some of the important managerial
problems where marginal costing technique can be applied.

Cost control:

One of the features of marginal costing is the segregation of costs on the

basis of behavior i.e., fixed and variable elements. There are a number of situations
in which fixed costs remain unchanged in the short run and hence it is stated that
the element of fixed cost is not relevant for decision making. In this way marginal
costing technique helps indecision-making.

If there is any increase in variable cost. P/v ratio will come down. Thus,
there will be fall in contribution. The study of P/v ratio will help the management in
controlling the variable costs. Fixed costs are shown separately as deduction from
contribution and it helps the management in controlling the fixed costs also. Thus,
marginal costing techniques help in controlling cost-fixed as well as variable cost.

Profit planning and maintaining a desired level of profit:

Marginal costing technique can be applied for profit planning as well. Profit planning
involves the planning of future operations to achieve maximum profits or to
maintain a desired level of profits. The change in the sales price, variable cost and
product mix affect the profitability of a concern. With the help of marginal costing,
the required sales for maintaining or attaining desired level of profit may be
ascertained as follows:

Desired sales = Fixed cost + Desired Profit ÷P/v ratio

Shut down decisions/closing down a plant:

A factory may have to cease operation for sometime due to various reasons such as
labour troubles, material shortage, major break down, market depression, etc. this
shut down may be of temporary nature and operations are renewed when the
situation improves. Shut down costs are classified as follows:

• Costs incurred on suspension of operations. These include cost of notifying

customers about shut down, retrenchment and lay off costs, etc.

• Costs incurred during continued shut down such as cost of care and custody
of plant and machinery and other equipments, etc.

• Costs incurred on remaining operations after shut down e.g. cost of recruiting
and training new workers, time lag in picking up production and sales,
additional promotional costs, etc.

Adding or dropping a product line:

In a multi-product company, the management may have to decide on adding or

dropping a product line. When a new product line is added, its sales and certain
costs will also be increased and reverse will happen when a product line is dropped.
In order to arrive at such a decision, the management should compare the
differential cost and incremental revenue and study its effect on the overall profit
position of the company.

Factors to be considered before taking a decision about dropping a product line:

• Contribution given by the product

• Capacity utilization

• Availability of product to replace the product

• Long-term prospects in the market

• Effect on sale of other products

Fixation of selling prices:

Fixing of selling prices is one of the most important functions of management.

Although prices are generally determined by market conditions and other economic
factors yet marginal costing technique assists the management in the fixation of
selling prices under various circumstances as:
 a) Pricing under normal conditions

b) During stiff competition

c) During trade depression

d) For accepting special bulk orders

e) For accepting additional orders utilizing idle capacity

f) For accepting export orders and exploring new markets.

Make or Buy decisions:

Components and spare parts may be made in the factory instead of buying from the
market. In such cases, the marginal cost of manufacturing the components or spare
parts should be compared with market price while taking decision to make or buy. If
marginal cost is lower than the market price, it is more profitable to make than
purchasing from market. Additional or specific fixed cost may be a relevant cost.
However, the decision shall depend on capacity utilization. If unused capacity is
available, then comparing only variable cost with market price will hold good. But if
the factory operates on full capacity, then such decision has to be taken after
adding opportunity cost of the products which is replaced by the manufacture of the
component.

Factors:

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