FINANCIAL REPORTING, STATEMENTS & ANALYSIS

Unit-1
Cost Accounting
Since the man became civilized and trade and commerce started as the products of the
business, it was felt to record the transactions of the business. This need resulted into the
development of accounting and we can say that accounting became the language of the business.
Financial accounting recorded the business transaction on double entry system which resulted into
preparing financial results through journal ledger, trial balance, trading and profit and loss accounts
and balance sheet. But there arose various limitation of the financial accounts specially on
revealing the cost of each product segment wise and these limitations paved the way for
development of cost accounting. Cost accounting is a branch of account which deals with the
accumulation (collection), classification, recording, analysis, interpretation, reporting and control
of current and prospective costs.

Actually financial accounting is to be considered as the father of the accounting system.

Accounting system has three parts:
1. Financial Accounting
2. Cost Accounting
3. Management Accounting

1. Financial Accounting
Financial accounting is mainly concerned with recording, classifying and summarising
financial transactions in accordance with the generally accepted principles of accounting. The
financial accounting records cash and credit transactions of a business according to the nature of
expenditure and income so that:
1. Trading Account and Profit and Loss A/c may be prepared for the concerned period.
2. Balance sheet which shows the financial position of the business at a point of time.
3. Statement of source and application and statement of cash flow which reveals the flow of
funds and uses of funds during the period.
2. Cost Accounting
Cost accounting explains the cost of production of a product or a service according to its
components per unit as well as total. Cost accounting is a specialised branch of accounting which
involves classification, accumulation, analysis, assignment and control of cost. The rules and
principles of cost accounting have developed over a period of time by experience. The cost
accounting need arose because of the limitation of financial accounting.
Costing is defined in simplest words as “The technique and process of ascertaining costs.”

3. Management Accounting
Management Accounting may be that part of the accounting which provides information
for planning and control to the management. All the information regarding organisation which are
useful to the management may be safely called as the subject matter of management accounting.
I.C.M.A. London defines management accounting as, “The presentation of accounting
information in such a way as to assist management in the creation of policy and in the day to day
operation of the organisation.”
 According to R.N.Anthony, “Management Accounting is concerned with accounting
information which is useful to management.”

Limitations of Financial Accounting or Need of Cost Accounting

As the result of the financial accounts are provided for the whole organisation and that too
after the end of the year (which means these results are nothing but the post-mortem of the dead
body) and hence these are of very little use to the management in planning and control and
decision-making under various conditions. These limitations can be explained under the following
headings:
(1) Financial Accounts show only the net results of the business: As we know that financial
accounts (i.e. trading account, profit and loss account and balance sheet) are prepared at the end
of the year and for the whole of the organisation and not the cost or profits of each product or cost
centre or cost unit or process or job or batch etc. and hence financial accounts fail to provide day
to day information regarding cost of product.

(2) Financial Accounts do not make any difference in direct cost and indirect cost: As
financial accounts fail to create any difference in direct and indirect expenses for the product,
controllable or uncontrollable expenses or variable and non-variable expenses so financial
accounts fail to help in taking effective decision making under crucial circumstances like
depression, low demand, competition or make or buy decisions etc.

(3) Financial Accounts fail to reveal the weal points of the business: If an organisation is
producing different products then it is difficult to analyse which product is profitable or not-
profitable and why so? Whether a product, process or centre is running into loses or profit this
information is not revealed. Rather the inefficiency of a process or department is not revealed due
to efficiency and profitability of other departments, products or cost centres.

(4) Financial Accounts fail to help in fixation of selling price of a product: As the total cost
incurred during the period divided by total output is the only system of calculating cost of
production per unit and that too at the end of the period thus it fails to help in fixation of selling
price of the product specifically on the different stages of production of goods and under the
various circumstances of business.

(5) Financial Accounts fail to provide control on material, labour and other expenses: In
financial accounts the control on cash movement gets very heavy attention in comparison to the
material, labour and other expenses. While the losses of these elements result into increase in cost
of production and thus more selling price resulting into the failure to face competition and thus,
untimely fading away from market of the business.

(6) Financial Accounts lack of reveal operating efficiency or inefficiency: There is no system
which can explain whether the organisation is running efficiently or not. The only judgment is
through increase in profits or decrease in profits. But the increase in profits if takes place through
controlling the cost of production or through controlling wastage of material or wastage of time or
by higher productivity of the labour that is what will be having positive effect on the working of
the organisation and in that lies the real efficiency and improvement of the organisation. This can
be revealed by cost accounting.

(7) Financial accounts fail to provide comparison of cost of products: As financial accounts
record the transaction after the transaction takes place so cost of production cannot be compared
with the expected cost or cost of different periods, different jobs, different departments or
operations. Without comparison it is difficult to analyse whether the cost are rising or falling and
the reasons responsible for this change. Efficiency of a department or of an organisation can be
judged by comparison only.

(8) Financial Accounts lack in performance appraisal of the organisation: There is no system
in financial accounting which can help to judge the various alternatives to improve the performance
and working of the different departments, products, markets or methods of production. Thus, the
profitability of various alternatives may not be analysed and the organisation may fail to maximize
the profits in the available circumstances.

(9) Financial Accounts fail to analyse the losses: If during the period there are losses in the
undertaking then there is no provision or system to analyse why the losses have taken place and if
any reason is assigned then in future it may not be possible to control the same. But cost accounts
can help to establish the reason of losses by applying management by exception and responsibility
accounting.

(10) Financial Accounts fail to keep proper records regarding use of machinery: There is no
system in financial accounts which the records of the working hours of the machinery and other
factors of production, records regarding idle time and reasons of idle time are kept. Scrap, wastage
of material or records, defective and spoiled outputs are not recorded and hence results into
wastage of working machine hours.

(11) Financial Accounts fail to reveal profits product wise: Which department, cost centre,
process is more profitable or less profitable or unprofitable, also this information is not revealed
by financial accounts and hence if any of the products or processes is running into loss then it is
reducing the overall profits of the whole organisation.

Suppose the profits revealed by the organisation is Rs.2,50,000 for a period of one year.
This position may be considered a very good performance in the areas of operation and in the given
market condition. The deeper analysis may reveal the following position:

Department A (+) = Rs.1,20,000 (profit)

Department B (+) = Rs.2,00,000 (profit)
Department C (-) = Rs.1,50,000 (loss)
Department D (+) = Rs. 80,000 (profit)
---------------------------
Total (+) =Rs.2,50,000 (profit)
---------------------------

The above analysis show that the department C is running into huge losses and if this department
is close down the profit of the organisation would have been Rs.4,00,000 which is a big change.
This also reveals that the working of department C needs deeper analysis and to think about various
alternative decision if the losses are to be controlled and profits are to be improved.

(12) Financial Accounts fail in helping decision making: The management has to take the
various critical and strategic decision in the interest of the organisation like, make or buy, product
mix, change in the method of production, change in selling price change in quality of product and
change in material used etc. These all are critical decisions which effect the whole of the
organisation’s working and functioning. There must be some system in the account on which the
management may depend while taking these critical and strategic decisions.

Meaning of Cost Accounting and Cost Accountancy

Cost Accounting: Cost Accounting is the classifying, recording and appropriate allocation of
expenditure for the determination of the costs of products or services and for the presentation of
suitably arranged data for the purposes of control and guidance of management. Cost accounting
includes the calculation of cost of every product, job, section, department, process, service.
According to Wheldon, “Cost Accounting is the application of accounting and costing principles,
methods and techniques in the ascertainment of costs and the analysis of variances as compared
with standards or previous experience.”
Cost accounting is the method of accounting for cost.

All the costs incurred from the very beginning of manufacturing operation till the final
stage of disposal of goods find their recording and accounting in cost accounting.
I.C.M.A. London defines Cost Accounting as, “The process of accounting for cost from
the point at which expenditure is incurred or committed to the establishment of its ultimate
relationship with cost centres and cost units. In its widest usage it embraces the preparation of
statistical data, the application of cost control methods and the ascertainment of the profitability
of activities carried out or planned.”
Special Features of Cost Accounting:
1. It provides information for cost.
2. It records income and expenditure relating to production of goods and services.
3. It helps to prepare the tenders and quotation prices.
4. It helps in cost control of the product job, process etc.
5. Its accounting is supplementary to financial accounts.
6. It helps in preparing budges and standards of cost and the variance analysis for
controlling cost.
7. Cost Accounting helps management in planning, control and decision-making.

MEANING AND SCOPE OF COST ACCOUNTANCY

The term cost accountancy is wider than the term cost accounting. Accounting to the Terminology
of Management and Financial Accountancy published by the Chartered Institute of Management
Accountants, London, cost accountancy means, “the application of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost control. It includsd the
presentation of information derived therefrom for the purpose of managerial decision making.”
Cost accountancy is thus the science, art and practice of a cost accountant. It is a science because
it consists of organised or systematic knowledge, which a cost accountant must possess for proper
discharge of his functions. As a matter of fact the cost accountant’s knowledge should not remain
restricted only to such subjects which cost accountancy embraces but it should extend to such
subjects like financial management, business economics, production control, operations research
which will help him in application of his cost accountancy knowledge to the problems of the
business.
Cost accountancy is also an art because it involves costing techniques and methods, such
as those of differential costing, marginal costing, standard costing etc. The application of these
techniques helps the cost accountant in deciding how to control costs, whether to go for
replacement of the existing plant by a new one or not etc.
Cost accountancy is also the practice of a cost accountant because he has to make constant
efforts in the field of cost accountancy. He has to endeavour constantly for reducing costs, present
cost data in a condensed but informative way to the management so that the management may take
proper action at the opportune time.
 Cost accountancy comprises of several areas. They are as follows:
Cost accounting
Cost accounting is the process of accounting for costs. It embraces the accounting
procedures relating to recording of all income and expenditure and the preparation of periodical
statements and reports with the object of ascertaining and controlling costs. It is thus the formal
mechanism by means of which cost of products or services are ascertained and controlled.
Costing
Costing is “the technique and process of ascertaining costs.” Cost accounting is different
from costing in the sense that the former provides only the basis and information for ascertainment
of cost. Once the information is made available, the costing can be carried out arithmetically, by
means of memorandum statements or by method of integral accounting.
However, the two terms-costing and cost accounting are often used interchangeably. No
such distinction has also been observed for the purpose of this book.

Wheldon has given an exhaustive definition of costing after expanding the ideas contained
in the definitions of the terms ‘costing’ and ‘cost accounting’. According to him costing is, “the
classifying, recording and appropriate allocation of expenditure for the determination of the costs
of products or services; the relation of these costs to salves values; and the ascertainment of
profitability.

Wilmot has summarised the nature of cost accounting as “the analysing, recording,
standardising, forecasting, comparing, reporting and recommending”, and the role of a cost
accountant as that of “a historian, news agent and prophet. As a historian he must be meticulously
accurate and sedulously impartial. As a news agent he must be up-to-date, selective and pithy. As
a prophet he must combine knowledge and experience for foresight and courage.”
Cost Control

A cost accountant now is not only concerned with the ascertainment of costs and fixing
selling prices of the products but also with furnishing such information as to enable the
management to control the costs of operating the business. As a matter of fact, the latter function
has become the prime function of the cost accountant these days.
According to the Institute of Cost and Works Accountants of India, Cost Control means
“The act of power of controlling or regulating or dominating or commanding costs through the
application of management tools and techniques to the performance of any operation to most
predetermined objectives of quality, quantity, value and time at an optimum outlay.”
Cost control is exercised by a variety of techniques such as those of standard costing,
budgetary control and quality control etc. Submission of periodical reports by the cost accountant
also helps management in exercising better control over costs. For example, a statement of value
of stocks (raw-materials, finished goods and work-in-progress) on hand together with relevant
ratios will show whether there is any tendency of over or under-stocking.
Cost reduction
This is new dimension to the function of a cost accountant. In this era of liberalization and
competition only those will survive who can deliver quality goods and services at the least cost.
This needs constant research and development in the areas of product design, production
procedures etc. Cost reduction is concerned with achieving real and permanent reduction on the
unit cost of goods produced or services rendered without impairing their quality or suitability.
Cost audit
Cost audit is the verification of cost accounts and check on the adherence to the cost
accounting plan. Thus, cost audit involves checking up the arithmetical accuracy of cost accounts
and verifying whether the principles laid down have been followed or not. It becomes essential in
case of a business where cost accounting is carried out on a large scale.

COST DRIVER
According to Chartered Institute of Management Accountants, cost driver refers to “an activity
which generates cost.” This factor suggests level of activity of volume that usually affects cost
over a given span of time. As a matter of fact, there is cause and effect relationship between
changing the level of activity of volume and a change in the level of the total cost of that cost
object (product, service, customer, department etc.) Cost driver (the cause for incurrence of the
cost) of a variable cost is the level of activity of volume which causes the variable cost to change
proportionately. For instance, the number of vehicles assembled is a cost driver of the cost of
steering wheels. Fixed costs in the short run have no cost driver. However, they may have a cost
driver in the long run. For instance, the cost of testing Personal Computers by HCL Limited
consists of Testing Department, equipment depreciation and staff cost. However, these costs do
not change in the short run even if the volume of production changes. Hence, volume of production
is not a cost driver of testing cost of the Testing Department to levels needed to support future
production volumes. Thus, volume of production becomes a cost driver of testing cost in the long
run. The following are the examples of cost drivers for different items of costs:

• Machine Set-ups
• Purchase Orders
• Quality Inspections
• Production Orders
• Shipments
• Maintenance Requests
• Power Consumed
• Kilometers Driven
• Projects or Working Hours
• Advertisements or Sales Volume
• Product Hours

All the above cost drivers may affect the cost depending upon the nature of the organisation.

COST ACCOUNTING VS FINANCIAL ACCOUNTING

Financial accounting, as pointed out previously, is concerned with recording, classifying

and summarizing financial transactions pertaining to an accounting period. The basic objective is
to provide a commentary to the shareholders and outside parties on the financial status of an
enterprise in the form of a profit and loss account and balance sheet. The profit or loss of business
operations is revealed through these statements year after year, observing the statutory
requirements of the Companies Act, 1956.

Cost accounting, on the other hand, aims a providing prompt cost data for managerial
planning, controlling and decision making. It offers a complete explanation as to how the scarce
inputs are put to use in business. The sources of efficiency or inefficiency are reveled through
periodic reports. The profit or loss relating to each job, department or product can also be found
out easily. The following table tries to draw the curtain between financial accounting arid cost
accounting:

Basic of Distinction Financial Accounting Cost Accounting

Statutory Requirements These accounts have to be prepared Maintenance of these
according to the legal requirements accounts is voluntary except
of Companies Act and Income Tax in certain industries where it
Act has been made obligatory to
keep cost records under the
Companies Act
Purpose The main purpose of financial The main purpose of cost
accounting is to prepare profit and accounting is to provide
loss account and balance sheet for detailed cost information to
reporting to owners and outside management i.e. internal users
agencies i.e. external users
Analysis of cost and Financial accounts reveal the profit Cost accounts show the
profit or loss of the business as a whole detailed Cost and profit data
during a particular period. It does not for each product line,
show the figures of cost and profit department, process etc.
for individual products, departments
and processes, etc
Periodically of Profit and Loss Account and Balance Cost reporting is a continuous
Reporting Sheet are prepared periodically, process and may be daily,
usually on an annual basis weekly, monthly, etc.
Control aspect It keeps records of financial It is used as a detailed system
transactions and does not attach any of controls. It takes the help of
importance to control aspect. certain special techniques like
standard costing and
budgetary control.
Nature It is concerned with historical Cost accounting does not end
records. The historical nature of with what has happened in the
financial accounting can be easily past. It extends to plans and
understood in the context of the policies to improve
purpose for which it was designed. performance in the future.
Nature of statements General purpose statements like It generates special purpose
prepared Profit and Loss Account and Balance statements and reports like
sheet are prepared by it. That is to Report of Loss of Materials,
say that financial accounting must Idle Times Report Variance
produce information that is used by Report etc. Cost accounting
many classes of people none of identifies the user, discusses
whom have explicitly defined his problems and needs and
information needs. provides tailored information.
Classification of Financial accounting classifies Cost accounting records and
Records of purpose records and analysis transactions in classifies expenditure
subjective manner i.e. according to according to the purpose for
nature of expenditure. which cost is incurred.

IMPORTANCE OF COST ACCOUNTING

The shortcomings inherent in financial accounting have made the management to realize the
importance of cost accounting. Whatever may be the type of business, it involves expenditure on
labour, materials and other items required for manufacturing and disposing of the product.
Moreover, big busyness requires delegation responsibility, division of labour and specialization.
Management has to avoid the possibility of waste at each stage. Management has to ensure that no
machine remains idle, efficient labour gets due initiative, proper utilization of by-products is made
and costs are properly ascertained. Besides management, creditors and employees are also
benefited in numerous ways by installation of a good costing system in an industrial organisation.
Cost accounting increases the overall productivity of an industrial establishment and, therefore,
serves as an important tool in bringing prosperity to the nation.

Thus, the importance of cost accounting in various spheres can be summarised under the following
headings:

Cost Accounting and Management: Cost accounting provides invaluable aid to

management. It is so closely allied to management that it is difficult to indicate where the work of
the cost accountant ends and managerial control begins. Adequate costing data help management
in reaching certain important decisions such as, whether hand labour should be replaced by the
machinery or not; whether a particular product line should be discontinued or not etc.

Costing checks recklessness and avoids occurrence of mistakes. Costs can be reduced by
proper organisation of the plant and executive personnel. As an aid to management it also provides
important information to enable management, to maintain effective control over stores and
inventory, to increase efficiency of the business, and the check waste and losses. It facilitates
delegation of responsibility for important tasks and rating of employees. However, for all this, it
is necessary for the managements on account of a good costing system can be put as follows:

1. Useful in periods of depression and competition: During trade depression the business
cannot afford to have leakages which pass unchecked. The management should know where
economies may be sought, waste eliminated and efficiency increased. The business has to wage
a war for its survival. The management should know the actual cost of their products before
embarking on any scheme for reducing the prices or giving tenders. Costing system facilitates
this.

2. Helps in, pricing decisions: Though economic law of supply and demand and activities of the
competitors, to a great extent, determine the price of the article, cost to the producer does play an
important part. The producer can take necessary guidance from his costing records.
3. Helps in estimates: Adequate costing records provide a reliable basis upon which tenders and
estimates may be prepared. The chances of losing a contract on account of over-rating or the loss
in the execution of a contract due to under-rating can be minimised. Thus, ascertained costs provide
a measure for estimates, a guide to policy, and a control over current production.
4. Cost Accounting helps in channelising production on right lines: Costing makes possible
for the management to distinguish between profitable and non-profitable activities. Profits can be
maximized by concentrating or profitable operations and eliminating non-profitable ones.
5. Helps in reducing wastage: As it is possible to know the cost of the article at every stage, it
becomes possible to check various forms of waste, such as of time, expenses etc., or in the use of
machinery, equipment and tools.
6. Costing makes comparison possible: If the costing records are regularly kept, comparative
cost data for different periods and various volumes of production will be available. It will help the
management in forming future lines of action.
7. Provides data for periodical profit and loss accounts: Adequate costing records supply to the
management such data as may be necessary for preparation of profit an loss account and balance
sheet, at such intervals as may be desired by the management. It also explains in detail the sources
of profit or loss reveled by the financial accounts, thus helps in presentation of better information
before the management.
8. Costing results into increased efficiency: Losses due to wastage of materials, idle time of
workers, poor supervision etc. will be disclosed if the various operations involved in
manufacturing a product are studied by a cost accountant. The efficiency can be measured and
costs controlled and through it various devices can be framed to increase the efficiency.
9. Costing helps in inventory control and cost reduction: Costing furnishes control which
management requires in respect of stock of materials work-in-progress and finished goods. Costs
can be reduced in the long-run when alternates are tried. This is particularly important in the
present-day content of global competition. Cost accounting has assumed special significance
beyond, cost control this way.
10. Helps in increasing productivity: Productivity of material and labour is required to be
increased to have growth and more profitability in the organisation. Costing renders great
assistance in measuring productivity and suggest ways to improve it.

Cost Accounting and Employees: Employees have a vital interest in their employer’s
enterprise and the industry, in which they are employed. They are benefited by a number of ways
by the installation of an efficient costing system in their enterprise. They are benefited because of
systems of incentives, bonus plans etc. They get benefit indirectly through increase in consumer
goods and directly through continuous employment and higher remuneration.

Cost accounting and creditors: Investors, banks and other moneylenders have a stake in
the success of the business concern and, therefore, are benefited immediately by installation of an
efficient costing system. They can base their judgment about the profitability and further prospects
of the enterprise upon the studies and reports submitted by the cost accountants.

Cost accounting and national economy: An efficient costing system brings prosperity to
the concerned business enterprise resulting into stepping up of the government revenue. The
overall economic development of a country takes place due to increase in efficiency of production.
Control of costs, elimination of wastages and inefficiencies lead to the progress of the industry and
in consequence of the nation as a whole.

OBJECTIVES OF COST ACCOUNTING

The objectives of cost accounting are ascertainment of cost, fixation of selling price, proper
recording and presentation of cost data to management for measuring efficiency and for cost
control. The aim is to know the methods by which expenditure on materials, wages and overheads
is recorded, classified and allocated so that the cost of products and services may be accurately
ascertained; these costs may be related to sales and profitability may be determined. Yet with the
development of business and industry, its objectives are changing day by day. The following are
the main objectives of cost accounting:

• To ascertain the cost per unit of the different products manufactured by a business concern;
• To provide a correct analysis of cost both by process or operations and by different
elements of cost;
• To disclose sources of wastage whether of material, time or expense or in the use of
machinery, equipment and tools and to prepare such reports which may be necessary to
control such wastage;
 • To provide requisite data and serve as a guide for fixing prices of products manufactured
or services rendered;
• To ascertain the profitability of each of the products and advise management as to how
these profits can be maximized;
• To exercise effective control of stocks of raw materials, work-in-progress, consumable
stores and finished goods in order to minimise the capital locked up in these stocks;
• To reveal sources of economy by installing and implementing a system of cost control for
materials, labour and overheads;
• To advise management on future expansion policies and proposed capital projects;
• To present and interpret data for management planning, evaluation of performance and
control;
• To help in the preparation of budges and implementation of budgetary control;
• To organize and effective information system so that different levels of management may
get the required information at the right time in right form for carrying out their individual
responsibilities in an efficient manner;
• To guide management in the formulation and implementation of incentive bonus plans
based on productivity and cost savings;
• To supply useful data to management for taking various financial decisions such as
introduction of new products, replacement of labour by machine etc:
• To help in supervising the working of punched card accounting or data processing through
computers;
• To organise the internal audit system to ensure effective working of different departments;
• To organize cost reduction programmes with the help of different departmental managers;
• To provide specialised services of cost audit in order to prevent the errors and frauds and
to facilitate prompt and reliable information to management; and
• To find out costing profit or loss by identifying with revenues the costs of those products
or services by selling which the revenues have resulted.

ADVANTAGES OF COST ACCOUNTING

The main advantages of cost accounting are given below:

(i) Profitable and unprofitable activities are disclosed and steps can be taken to eliminate or
reduce those activities from which little or no benefit is obtained or to change the method of
production in order to make such activities more profitable.
(ii) It enables a concern to measure the efficiency and then to maintain and improve it. This
is done with the help of valuable data made available for the purpose of comparison. For example,
if material spent upon a pair of shoes in 2001 comes to Rs.160 and for a similar pair of shoes the
amount is Rs.180 in 2002, the increase may be due to increase in prices of material or more wastage
in the use of materials or inefficiency at the time of buying or unnecessarily high prices paid.

(iii) It provides information upon which estimates and tenders are based. In case of big
contracts of jobs, quotations cannot be given unless the cost of completing the contracts can be
found out.

(iv) It guides future production policies. It explains the cost incurred and profit made in various
lines of business and processes and thereby provides data on the basis of which production can be
appropriately planned.
(v) It helps in increasing profits by disclosing the sources of loss or waste and by suggesting
such controls so that wastages, leakages and inefficiencies of all departments may be detected and
prevented.

(vi) It enables a periodical determination of profits or losses without resort to stocktaking.

(vii) It furnishes reliable data for comparing costs in different periods, for different volumes of
output, in different departments and processes in different establishments. This helps in maintain
costs at the lowest point consistent with the most efficient operating conditions.

(viii) The exact cause of a decrease or an increase in profit or loss can be detected. A concern
may suffer not because the cost of production is high or prices are low but also because the output
is much below the capacity of the concern. This fact is revealed by cost accounts only.

(ix) Cost Accounting discloses the relative efficiencies of different workers and thereby
facilitates the introduction of suitable plans of wage payment to reward efficiency and to provide
adequate incentive to the less efficient workers. A good system of costing promotes prosperity of
the business and thus ensures greater security of service and adequate reward to workers.

LIMITATIONS OF COST ACCOUNTING

Cost accounting like other branches of accountancy is not an exact science but is an art which has
developed through theories and accounting practice based on reasoning and common sense. Many
theories can be proved or disproved in the light of conventions and basic principles of cost
accounting. These principles are not static but changing with the change of time and circumstances.
The following are the main limitations of cost accounting:
(i) Cost accounting lacks a uniform procedure. It is possible that two equally competent cost
accountant may arrive at different results from the same information. Keeping in view this
limitation all cost accounting results can be taken as mere estimates.
(ii) There are a large number of conventions, estimates and flexible factors such as
classification of costs into its elements, issues of materials on average or standard price,
apportionment of overhead expenses, arbitrary allocation of joint costs, division of overheads into
fixed and variable costs, division of costs into normal and abnormal and controllable and non-
controllable and adoption of marginal costs and standard costs due to which it becomes difficult
to have exact costs. Moreover, no one cost is suitable for all purposes and under all circumstances.
Virtually its calculation depends on the use to which the data are required to be put to. Because of
inclusion of some items of cost on estimated basis it is difficult to have actual true cost. On this
basis when the valuation of stock is done, that will not be based on true facts and naturally the
profit calculated from the cost records will not be true.
(iii) For getting the benefits of cost accounting many formalities are to be observed by a small
and medium size concern due to which the establishment and running costs are so much that it
becomes difficult for these concerns to afford its cost. Thus, cost accounting can be used only by
big concerns.
(iv) The contribution of cost accounting for handling futuristic situations has not been much.
For example, it has not evolves so far any tool for handling inflationary situation.

METHODS OF COSTING
The basic principles of ascertaining costs are the same in every system of cost accounting.
However, the methods of analyzing and presenting the cost may vary from industry to industry.
The method to be used in collecting and presenting costs will depend upon the nature of
production. Basically there are two methods of costing, namely. Job costing and Process costing.
Job costing: Job costing is used where production is not repetitive and is done against orders. The
work is usually carried out within the factory. Each job is treated as a distinct unit, and related
costs are recorded separately. This type of costing is suitable to printers, machine tool
manufacturers, job foundries, furniture manufactures etc. The following methods are commonly
associated with job costing:
Batch costing: Where the cost of a group of product is ascertained, it is called ‘batch costing’. In
this case a batch of similar products is treated as a job. Costs are collected according to batch order
number and the total cost is divided by the numbers in a batch to find the unit cost of each product.
Batch costing is generally followed in general engineering factories which produce components in
convenient batches, biscuit factories, bakeries and pharmaceutical industries.
Contract costing: A contract is a big job and, hence, takes a longer time to complete. For each
individual contract, account is kept to record related expenses in a separate manner. It is usually
followed by concerned involved in construction work e.g. building roads, bridge and buildings etc.
Process Costing: Where an article has to undergo distinct processes before completion, it is often
desirable to find out the cost of that article at each process. A separate account for each process is
opened and all expenses are charged thereon. The cost of the product at each stage is, thus,
accounted for. The output of one process becomes the input to the next process. Hence, the process
cost per unit in different processes is added to find out the total cost per unit at the end. Process
costing is often found in such industries as chemicals, oil, textiles, plastics, paints, rubber, food
processor, flour, glass, cement, mining and meat packing. The following methods are used in
process costing:
Output/Unit Costing: This method is followed by concerns producing a single article or a few
articles which are indential and capable of being expressed in simple, quantitative units. This is
used in industries like mines, quarries, oil drilling, cement works, breweries, brick works etc. for
example, a tone of coal in collieries, one thousand bricks in brick works etc. The object here is to
find out the cost per unit of output and the cost of each item of such cost. A cost sheet is prepared
for a definite period. The cost per unit is calculated by dividing the total expenditure incurred
during a given period by the number of units produced during the same period.
Operating Costing: This method is applicable where services are rendered rather than goods
produced. The procedure is same as in the case of unit costing. The total expenses of the operation
are divided by the units and cost per unit of service is arrived at. This is followed in transport
undertakings, municipalities, hospitals, hotels etc.

Multiple Costing: Some products are so complex that no single system of costing is applicable.
Where a concern manufactures a number of components to be assembled into a complete article,
no one method would be suitable, as each component differs from the other in respect of materials
and the manufacturing process. In such cases, it is necessary to find out the cost of each component
and also the final product by combining the various methods discussed above. This type of costing
is followed to cost such products as radios, aeroplanes, cycles, watches, machine tools,
refrigerators, electric motors etc.
Operation Costing: In this method each operation at each stage of production or process is
separately identified and costed. The procedure is somewhat similar to the one followed in process
costing. Process costing involves the costing of large areas of activity whereas operation costing
is confined to every minute operation of each process. This method is followed in industries with
a continuous flow of work, producing articles of a standard nature, and which pass through several
distinct operation sin a sequence to completion. Since this method provides for a minute analysis
of cost, it ensures greater accuracy and better control of costs. The costs of each operation per unit
and cost per unit up to each stage of operation can be calculated quite easily. This method is in
force in industries where toys, leather and engineering goods are manufactured.
Departmental Costing: When costs are ascertained department by department, such a method is
called ‘departmental costing’. Where the factory is divided into a number of departments, this
method is followed. The total cost of each department is ascertained and divided by the total units
produced in that department in order to obtain the cost per unit. This method is followed by
departmental stores, publishing houses etc.

TECHNIQUES OF COSTING
In addition to the different costing methods, various techniques are also used to find the
costs. These techniques may be grouped under the following heads:
Historical Absorption Costing: It is the ascertainment of costs after they have been incurred. It
is defined as the practice of charging all costs, both variable and fixed, to operations, process or
products. It is also known as traditional costing. Since costs are ascertained after they have been
incurred, it does not help in exercising control over costs. However, it is useful in submitting
tenders, preparing job estimates etc.

Marginal Costing: It refers to the ascertainment of costs by differentiating between fixed costs
and variable costs. In this technique fixed costs are not treated as product costs. They are recovered
from the contribution (the difference between sales and variable cost of sales). The marginal or
variable cost of sales includes direct material, direct wages, direct expenses and variable overhead.
This technique helps management in taking important policy decisions such as product pricing in
times of competition, whether to make or not, selection of product mix etc.

Differential Costing: Differential cost is the difference in total cost between alternatives-
evaluated to assist decision making. This technique draws the curtain between variable costs and
fixed costs. It takes into consideration fixed costs also (unlike marginal costing) for decision
making under certain circumstances. This technique considers all the revenue and cost differences
amongst the alternative courses, of action to assist management in arriving at an appropriate
decision.
Standard Costing: It refers to the ascertainment and use of standard costs and the measurement
and analysis of variances. Standard cost is a predetermined cost which is computed in advance of
production on the basis of a specification of all factors affecting costs. The standards are fixed for
each element of cost. To find out variances, the standard costs are compared with actual costs. The
variances are investigated later on and wherever necessary, rectificational steps are initiated
promptly. The technique helps in measuring the efficiency of operations from time to time.

Cost Accounting Systems

The mechanism of recording and organising costs as and when accumulated is known as the cost
accounting system. The two systems of costing, referred to very frequently in the cost accounting
literature are historical costing and standard costing.

1) Historical costing: Costing may be ascertained either after they are incurred or before they are
incurred. The process of accumulating costs after they are incurred in an orderly manner, costing
of actual costs in a systematic manner is known as historical costing system.
2) Standard costing: Standard costing is the technique of setting up of definite standards or targets
of performance in advance of the costing period. This is done even before production begins. The
standards are expressed in monetary terms. The establishment of standards provides management
with goals to attain and the bases for comparison with actual results.

Classification of Costs
Costs can be classified into different categories depending upon the purpose of classification. A
suitable classification of costs is of vital importance in order to identify the cost with cost centres
or cost units. The important ways of classification are as follows:

1) By Nature or element: According to this classification, the costs are divided into three
categories i.e. Material, Labour, and Expenses. These can be sub-classification of each element,
for example material into indirect materials, components, and spare parts, consumable stores,
packing material etc. This classification is important as it helps to find out the total cost, how such
total cost is constituted, and valuation of work in process.

2) By functions: According to this classification, cost is divided based on the purpose for which
it is incurred. It leads to grouping of cost according to broad division of activity i.e. production,
administration, selling, and distribution.

3) As direct and indirect costs: According to this classification, total cost is divided into direct
costs and indirect costs. Direct costs are those, which are incurred for and may be conveniently
identified with a particular cost center or cost unit. Whereas, indirect (residual) costs are those
costs, which are incurred for the benefit of a number of cost centers or cost units and therefore,
cannot be conveniently identified with a particular cost center or cost unit.
4) By controllability: On this basis, the costs can be classified into controllable costs and
uncontrollable costs. Controllable costs are those, which can be influenced by the action of a
specified member of an undertaking, that is to say, costs are at least partly within the control of
management. An organization is divided into a number of responsibility centers and controllable
costs incurred in a particular cost center can be influenced by the action of the manager responsible
for the center. Generally speaking, all direct costs including direct material, direct labour and some
of the overhead expenses are controllable by lower level of management.
Uncontrollable costs are those costs, which cannot be influenced by the action of a specified
member of an undertaking, that is to say, which are not within the control of management. Most
of fixed costs are uncontrollable. For example, rent of the building and managerial salaries, etc.,
are not controllable. Similarly, overhead costs, which are incurred by one service department and
apportioned to another department, are not controllable by the other. For canteen expenses
apportioned to other production and service departments are uncontrollable as regards other
departments.

The distinction between controllable and uncontrollable is left to the individual judgment and is
not sharply maintained. It is only in relation to a particular level of management or an individual
manager that we may say whether a cost is controllable or uncontrollable. A particular item of
cost, which may be controllable from the point of view of one level of management, may be
controllable from another point of view.

5) By normality: Under this, costs may be classified into normal costs and abnormal costs. Normal
cost is the cost, which is normally incurred at a given level of output in the conditions in which
that level of output is normally attained. It is a part of cost of production. Abnormal cost is the
cost, which is not normally incurred at a given level of output in the conditions in which that level
of output is normally attained. It is not a part of cost of production and is charged to costing profit
and loss account.
6) Capital and revenue: The cost, which is incurred in purchasing an asset either to each income
or increase the earning capacity of the business, is called capital cost, for example, the cost of
buildings, machineries, etc. If any expenditure is incurred in order to maintain the earning capacity
of the business as cost of maintaining an asset or running a business is revenue expenditure. This
distinction is important in costing as all items of revenue expenditure are considered for calculating
the profit while capital items are normally ignored.

7) By time: Under this, costs are classified as historical cost and predetermined cost. Historical
cost is the cost ascertained after it is incurred or past cost. Such cost is available only when the
production of a particular thing has already been done. Such cost is only of historical value and
not at all helpful for cost control purposes. Predetermined costs are estimated costs, i.e., computed
in advance of production taking into consideration the cost and the factors affecting the cost. Such
costs when compared with actual costs will give the reasons, of variances and help the management
to fix responsibilities and take remedial actions to avoid their recurrence in future.
8) By variability: Under this category, costs are classified as fixed costs, variable costs, and semi-
variable or semi-fixed costs.

• Fixed or period costs: It is commonly described as those, which remain fixed ore constant
in total amount with increase or decreases in the volume of output or productive activity
for a given period of time. Fixed cost per unit decreases as production increases and
increases as production decreases. Examples are rent, insurance, manager’s salary, etc.
These fixed costs are constant in total amount but fluctuate per unit as production changes.
• Variable or product costs: These costs vary in total in direct proportion with the volume
of output. These costs per unit remain relatively constant with changes in production.
Variable costs fluctuate in total amount, but tend to remain constant per unit as production
activity changes. Examples are, direct material cost, direct labour cost, power, repairs, etc.
• Semi-variable costs: These costs are partly fixed and partly variable. For example,
telephone charges include a fixed portion of annual charge plus variable charge according
to calls; thus the telephone expenses are semi-variable cost. Other examples are
9) For managerial decisions: Based on the relevance and irrelevance of costs of managerial
decision-making the costs may be classified into the following costs:

• Marginal cost: It is the total of variable cost i.e. prime cost plus variable overheads. It is
based on the distinction between fixed and variable costs. Fixed costs are ignored and only
variable costs are taken into consideration for determining the cost of products, and value
of work in progress and finished goods.

• Out of pocket costs: These are the costs, which involve the cash outflow due to a particular
management decision. Depreciation will not from part of out of pocket cost because it does
not entail cash outflows. Such costs are relevant for price fixation during recession or when
make or buy decision is to be made.

(ii) Sunk Cost: Sunk cost is the cost which cannot be altered and has taken place in specifically
for providing infrastructure to the organisation. Once the land is purchased, building constructed
and machinery is installed then you cannot change the factory site, it is very difficult to change
design of the building and to change the machinery immediately if it involve huge expenditure. He
these become sunk costs.
Thus sunk cost is very difficult to be changed by decision later on and hence the sunk becomes
irrelevant for decision-making in the future course of action. So the analysis of this cost is very
helpful to the management to know how future cost will differ under alternative course of action.

(iii) Shut Down Cost: Under various circumstances the business activities are suspended
postponed temporarily due to temporary problems like power cut, shortage of raw material,
financial problem, strike, lockout, lack of demand, (depression) etc. The cost which should be
incurred in the of a temporary suspension are known as shut down costs.
Fixed costs like rent and insurance of the factory building, repairs and maintenance, security guard
expenses are the example of shut down cost. The management has to decide whether to close down
business or to continue the production even if it is suffering losses under the prevailing condition.
The specifically important and vital in case if the market is in depression.
(iv) Differential Cost: The change in the cost due to change in the level of activity or metho
production or due to change in alternative course of action is known as the differential cost. If the
cha increases the cot it is known as incremental Cost and if there is a decrease in the cost it is
known Detrimental cost. This change can also take place due to the change in distribution method,
change sales volume or change in product mix or change in variety of product with the same
process or mate. Differential costs are helpful in planning and decision-making and help the
management to choose best alternative.

(vi) Imputed Cost or Notional Cost: This is not the actual cost but expected cost of the use the
asset. As the rent of the owners building is a notional cost. Interest on owned capital is not to be p
but only a notional cost for calculating cost. Actual payment of interest on capital is not made but
the ba concept is that had the funds been invested somewhere else they would have earned interest.
So inter on owners funds is to be charged in cost accounts as an item of expenditure. It is the
assumed (hypothetical) for which the benefit is enjoyed by the firm without incurring actual
expenditure. The costs are calculated only for decision making. Salary of owner, manager is
another example of notio cost. It makes a lot of difference to compare the net earning of two firms
where one firm is fully financed borrowing funds while another is fully financed by owners funds.
(vii) Replacement Cost: It is the current market cost of replacing an asset. If an old asset needs
replacement then new asset will be purchased at the prevailing market price and not the price of
10 years back when the old asset was purchased.
(viii) Conversion Cost: Conversion cost is the cost of converting raw material into finished
product. In other words conversion cost is the total of direct labour, direct expenses and factory
overheads. Conversion cost thus is a managerial decisions-making cost and helps to choose course
of action among the various available alternatives.

(ix) Opportunity Cost: Opportunity cost is the value of sacrifice made or benefit on opportunity
forgone in accepting the next best alternatives.Opportunity cost is not recorded in the books.
Opportunity cost is also known as alternative cost. Another example is the use of owner’s building
as factory then the rent forgone is the opportunity cost of the building.
(x) Avoidable and Unavoidable Costs: Avoidable cost is that cost which can be eliminated if a
particular product or department with which it is directly related is discontinued. As for example
the salary of the staff which is employed in that department which is closed down or the cost of
the material for the product which is discontinued can be avoided. But the factory will work and
hence the rent of the factory building will be unavoidable or the insurance charges will be
unavoidable expenses if other products are continued and the work is going on. Unavoidable costs
are also known as unescapable costs. Avoidable costs are helpful in managerial decision like
whether to continue or eliminate a product or department.
Elements of Cost
Cost is made up of three elements i.e. material, labour & expenses. Each of these can be direct or
indirect.
Now in the present age any product small or big, consumer or capital cannot be produced without
the combination of these three elements. Hence the detailed study of these elements for cost
purpose becomes necessary.
1. Material Cost

The material may be defined as the item (substance) from which products are
manufactured. I.C.M.A. “The material cost is the cost of commodities supplied to an undertaking.”
The material can be in raw shape or in manufactured state. As for example cotton is a raw material
for yarn factory while cloth is a raw material for ready-made garment factory. Material may be
Direct Material or Indirect Material.

(A) Direct Material: Direct material are those material which are either specially purchased for
the production of product or which are visible in the final product or which can be easily identified
in the finished product as leather in the shoes, wood in furniture, cloth in dress, plastic in the pen,
paper in the books, bricks in the house etc. The Direct material include the following:
(i) Material which are specially purchased for a job, process order or a contract like wood for
furniture, cloth for a dress, iron sheets for making drums or boxes, cement for a house, rubber for
making tyre or tubes etc.
(ii) Material which is visible in the final product and is of significant value in relation to product
as bricks, cement, plastic, for house and plastic products, graphite in pencil making, jute in making
gunny bags etc.

(iii) Primary packing materials like cartons, cardboard boxes, wrapping paper to protect the
product like cigarette, cartons for keeping cigarettes, inkpot for keeping ink, bottle for keeping
medicine etc.

(iv) Parts of components purchased or produced or a product like tyres for car, wires for T.V.
sets frames for spectacles etc.

Direct materials are also known as Process Material, Prime cost Material, Productive Material or
Store Material. I.C.M.A. defines direct material as, “Material cost which can be identified with
and allocated to cost centre or cost unit.”

(B) Indirect Material: These material do not form part of the product. Indirect material is not
visible in the final product as lubricant in machine, adhesive in the furniture making, glue in book
binding etc. or the cost of these material is so small in the final product that it is not easy to calculate
the cost of these per unit of product as thread in dress or gum in kite, or nails in the shoe-making.

I.C.M.A. defines indirect material, “The materials cost which cannot be identified with an
allocated to cost centre or cost units.”

2. Labour Cost

The term labour may be defined as the human effort by which materials are converted into
finished products. I.C.M.A. defines labour cost as, “The cost of remuneration (wages, salaries,
bonus, commission etc.) of the employees of an organisation.”
Labour cost may also be divided into direct and indirect.

(A) Direct Labour: Direct labour is the labour which is personally engaged in the production of
gods, running or machine, jobs or process or the production operation. All wages which are
conveniently, specifically related to a specific job, process or product are called direct labour. It is
also known as direct wages. Direct labour can be easily assigned to a specific physical unit. The
following may be the part of direct labour:

(i) Labour engaged on the actual production of the product.

(ii) Labour engaged in carrying out a job, process or operation in a factory.
(iii) Labour helping in a production by way of tool setting, repairs, transportation of
material and supervision etc.

If the organisation is engaged in providing services like transport or telephone etc then wages or
salary of drivers, conductors and operators will be the direct labour cost.
Direct labour is also known as process labour, operating labour or productive labour.

I.C.M.A. defines direct labour, “Wages which can be identified with and allocated to cost centre
or cost unit.”
(B) Indirect Labour: Those workers who are not directly engaged in the production or running
the machines but providing services or help to those who are operating the machines as
storekeeper, inspector, watchman, cleaner, waterman, chokidar, electrician or repair and
maintenance workers, gardner etc. These people provide their services to the whole of organisation
and their charges (wages or salary) are apportioned to the various departments or products but are
not allocated directly to a specific product or process.
Indirect labour may related to (i) Factory, (ii) Administration (iii) Selling and distribution
activities. I.C.M.A. defines indirect labour cost as, “The wages or labour charges which cannot be
allocated but which can be apportioned to or absorbed by cost centre or cost unit.”
3. Other Expenses

The expenses are incurred for producing a product or providing a service in addition to material
and wages as rent of factory, insurance, depreciation, telephone bill, etc.
I.C.M.A. defines expenses as, “The cost of services provided to an undertaking and the notional
cost of the use of owner’s asset.” Expenses can be of two types (A) Direct Expenses (B) Indirect
Expenses.

(A) Direct Expenses: Direct expenses or chargeable expenses are those expenses which are
directly identified with a particular job, process, product or operation. These are specially incurred
for a job and directly allocated to the job for which incurred. Direct expenses are also known as
Process Expenses, Productive Expenses or Prime Cost Expenses. The example of direct expenses
can be:

(i) Cost of special modules, designs and patterns for a specific job
(ii) Royalty paid to lessor for a particular lease contract
(iii) Cost of patents for a product
(iv) Cost of operating a machine on a particular job
(v) Hire charges of a special plant, machine or tools for a specific job
(vi) Fees paid to surveyors, architect and other consultant specially appointed for a
particular job
(vii) Research and experimental expenses related to a specific work order
 (viii) Carriage inward and freight charges on the material purchased for a specific job, work
or process
(ix) Cost of defective work e.g. where several trial costing are necessary before an
appropriate one is obtained.

The most important point about direct expenses is that these expenses relates to a specific work
order or process. I.C.M.A. defines direct expenses as, “Expenses which can be identified with an
allocated to centre or cost unit”

(B) Indirect Expenses: Indirect expenses are those which cannot be identified with a specific job,
order, or process but which are common and these are apportioned to all jobs on some appropriate
basis. Indirect expenses cannot be directly and conveniently allocated and incurred for a specific
cost or cost centre. As the factory rent on insurance of factory is for the various types of the product
produce the factory and these are apportioned (divided) among all the products during that period.
I.C.M.A., Londondefines it as, “Expenses other than direct expenses.”
So any expenses which are related to a number of work order or jobs are treated as Indirect
Expenses.
Indirect Expenses = Overheads-(Indirect Material + Indirect Labour)

Indirect Expenses broadly can be divided into:

(i) Factory Expenses
(ii) Office Expenses
(iii) Selling and Distribution Expenses

4. Overheads

Overheads can be aggregate of indirect material, indirect labour and indirect expenses.
Overheads may also be known as ‘On cost’ or ‘Burden’.

I.C.M.A. Defines overheads, “The aggregate of indirect material cost, indirect labour cost and
indirect expenses.” Thus, we can see that indirect expenses are only one part of overheads as
overheads also include indirect material and indirect labour. Overheads are classified according to
functions into the following:-
(i) Factory overheads
(ii) Office overheads
(iii) Selling and Distribution overheads

(i) Factory Overheads: Factory overheads are those expenses which are incurred at the place
production or work where the products are manufactured. It is because of this these are also known
production overheads or works overheads or manufacturing overheads. Factory overheads may
include the following:-
(a) Rent, Rates, Taxes of factory building

(b) Factory telephone charges

(c) Factory repair and maintenance
(d) Heating and lighting expenses in factory
(e) Salary to factory manager, foremen, supervisor, Inspectors etc. Powerhouse Expenses
 (f) Insurance of factory, building, factory machinery, factory workers etc
(g) Power and fuel
(h) Workers, canteen and welfare expenses

(i) Subscription to technical journal

(j) Bonus, overtime and leave wages to factory workers and other factory related staff
(k) Wages to chokidar, sweepers, waterman etc.
(l) Salary, fees to factory directors
(m) Contribution to provident fund, E.S.I. etc to factory employees

(n) Drawing office salary (drawing office is the office where maps, designs and patterns
are prepared) related to product
(o) Salary to storekeeper
(p) Expenses on consumeable store like oil, grease, lubricants, cotton waste, thread, etc
(q) Small tools used in factory and their depreciation

(r) Factory printing, stationery etc

(s) Water charges in the factory
(t) Cost or rectifying defective work
(u) Cost of training of new employees
(v) Purchase office expenses/Buying expenses

(w) Gas, steam, coal, charges

(x) Cleaning charges in factory
(y) Haulages charges in the factory. (big repair or overhauling of the machinery etc.)
(z) Indirect material, nut, bolts, screws, nails, rags, thread and other lubricants etc.
(ii) Office Overheads: Office overheads are related to the expenses incurred in running the
administration work and office work of the factory. Office is a place where policies are formulated
decisions are taken and directions are issued to implement those decisions and various records are
kept. It is a place from where direction and control is made on the activities going on in the
organisation. The expenses of office relate to management and administration of business. These
may also be named as administrative overheads or establishment overheads. These can be:-
(a) Office salaries
(b) Directors fees
(c) Office rent, rates, taxes, lighting etc
(d) Office cleaning charges
(e) Office insurance (building, staff, appliances etc)
(f) Printing, stationary, postage and stamp charges in the office
(g) Office telephone, telegrams, fax charges, mobile charges, photostat etc
(h) Legal charges
 (i) Public Relation expenses
(j) Trade subscription/subscription of trade journal
(k) Bank charges
(l) Office heating and lighting
(m) Repair and maintenance of office building, office appliances and office furniture
(n) Depreciation office building office appliances and office furniture
(o) Audit fees
(p) Counting house salary
(q) Cost of dusters, brushes
(r) Travelling expenses of office staff
(s) General expenses
(t) Hire charges of office machinery
(iii) Selling and Distribution Overheads: Those expenses incurred either to increase the sales or
to maintain the sales and also the expenses incurred to place the goods from producer’s place to
the place of the consumer. So these overheads are also known as marketing overheads as these are
related to creating demand, securing orders, dispatching goods and collecting payments for goods
sold. These may be:
(a) Travelling expenses salesman’s salary and commission to salesman
(b) Trade discount, cash discount allowed, brokerage, commission etc
(c) Sample expenses, branch expenses
(d) Expenses for catalogues and price list
(e) Printing and stationery, postage used in selling and distribution department
(f) Material used in packing of the product for transportation and for display of the product
(g) Delivery van expenses
(h) Salary, commission and wages of delivery van operators
(i) Rent, taxes on godown and warehouse
(j) Insurance of godown, warehouse, finished goods, workers working in sales and
distribution deptt.
(k) Window dressing expenses and showroom expenses.
(l) Carriage outward and loading and unloading charges of the finished goods.
(m) Advertisement expenses
(n) Bad debts
(o) Trade expenses, exhibitions and trade fairs expenses.
(p) Salary of sales manager and other staff related to sales deptt.
(q) After sales service expenses.
(r) Repair and maintenance of delivery van
(s) Depreciation of warehouse, delivery van
(t) Subscription to sales journals
(u) Free gifts
(v) Loss by fire and loss in transit of finished goods
(w) Collection charges

Components of Total Cost

The various components of total cost are as given below:

(i) Prime cost

(ii) Factory cost
(iii) Office cost or total cost of production
(iv) Total cost or cost of sales or selling cost
 Note: By adding profit to the cost of sales we get the selling price of the product.
(i) Prime Cost: Prime cost is the sum total of the Direct Material cost, Direct Labour cost and
Direct Expenses. It is also known as Direct cost or Basic cost. Prime cost=Direct Material Cost
+ Direct Expenses
(ii) Factory Cost: Factory cost is the sum total of Prime cost and Factory overheads. It is also
known as works cost of manufacturing cost or production cost. Factory cost = Prime Cost +
Factory Overheads.
(iii) Office Cost: It is the sum total of factory cost and office overheads. It is also known as
total cost of production.
(iv) Selling cost or Cost of Sales: It is the sum total of office cost plus selling and distribution
overheads.
(v) Selling Price: If profit is added to the cost of sales the resulting amount will be sales price.
Chart of Components of total cost

Direct Material + Direct Labour + Direct Expenses = Prime Cost

Prime Cost + Factory Overheads = Factory Cost or Works Cost
Works Cost + Office and Administrative Overheads = Office Cost or Total Cost of Production
Office Cost + Selling and Distribution Overheads = Total Cost or Cost of Sales
Cost of Sales + Profit = Selling Price or Sales

Calculation of Profit

(1) Profit as a percentage on cost (when the total cost is given).

Profit=Cost x Profit (%)/100
As if the cost is Rs.3,00,000 and profit is 25% on cost.
Then profit = 3,00,000 x 25/100=Rs.75,000

(2) Profit as a % on selling price (When total cost is given)

Profit=Cost x Profit (%) /100-Profit (%)

If cost is Rs.3,00,000 and profit 25% on sales is given then Profit=3,00,000 x 25/100-25
=3,00,000 x 25/125=Rs.60,000

Cost Sheet or Statement of Cost

Cost sheet is a statement which shows the output of a specific period along with the break
up of cost per unit as well as total. The data taken in cost sheet are collected from various records
related to that job or order or production.

The cost sheet is prepared in columnar form, a column for particulars, total cost and per
unit cost is provided in the cost sheet.
 Cost sheet is a memorandum statement. Therefore cost sheet does not form part of double
entry cost accounting record. But all the data of cost sheet are taken from financial accounting if
there is not the use of predetermined overhead rates. To create the confidence in cost accounting
and financial accounting periodical reconciliation of the two accounting system is undertaken.

Advantages of Cost Sheet

(i) It discloses total cost and per unit cost of production of goods.
(ii) It helps to keep control in the cost of production of products.
(iii) Comparative study of various elements of cost with past records.
(iv) It helps to fill up the tenders and quotation.
(v) It helps to lay down the production policy.
(vi) It helps to fix up the selling price more competitively and accurately.
(vii) It helps to minimise the cost of production under the prevailing market condition.

Specimen of Cost Sheet (Layout only)

Particulars Total Cost Per Unit

(Rs.) Cost
(Rs)
Opening stock of raw material -----
Add: Purchase of Raw Material -----
Add: Carriage Inward of freight inward -----
Add: other expenses on purchase like ort duties, Insurance etc. -----
Less: Closing stock of raw material -----
Cost of Material consumed -----
Add: Direct Labour -----
Add: Direct Expenses -----
Prime Cost -----
Add: Factory Overheads:
Power
Dep. on Machinery
Insurance of factory Machinery
Foremen Salary
Oil and Water charges
Repairs to factory
Factory lighting etc.
-----
Factory Cost
-----
Add: Opening work in progress
Less: Closing work in Progress -----
Factory Cost or Works Cost -----
Add: Office overheads:
Salary of office staff
Printing and Stationery
Postage
Telephone
Dep. of office Building and Office Appliances
Lighting in office
Bank charges
Donations
Rent of office Building
 Insurance of Office Staff
Directors fees
Legal charges
Audit fees etc.
Office Cost
or Cost of Production -----
Add: Opening stock of Finished Goods -----
Less: Closing stock of finished gods -----
Cost of goods sold
Add: Selling and Distribution overheads: -----
Salesman Salary
Advertisement
Bad Debts
Rent of warehouse
Delivery Van Expenses
Sales office expenses
Repair to warehouse
Insurance charges etc. -----
Cost of Sales -----
Add Profit -----
Sales
Items excluded from cost sheet or cost accounts or Items which are not taken in cost
accounts

There are certain items of pure financial nature which are not included in cost sheet or
statement cost. These items are included only in financial accounts. Items of experises which are
relating to cap assets, capital losses, distribution of profits of business and matters of pure finance
are excluded from sheet. These items can be:

(a) Items of purely financial expenses

(b) Items of purely financial incomes
(c) Items of appropriation of profits
(d) Items of abnormal expenses and losses
The list of these items can be:
Purely financial expenses:
(a) Loss on investment
(b) Capital losses
(c) Penalties and fines
(d) Interest on debenture, mortgage and bank loan
(e) Discount on debenture and bonds
(f) Damages payable
Purely financial incomes:
(a) Dividends Received
(b) Rent Received (by subletting)
(c) Interest on Investment
(d) Brokerage, commission or discount received
(e) Interest on Bank Deposits
(f) Capital Profits
(g) Transfer fees received
Items of Appropriation of Profit
(a) Transfer to general reserve.
 (b) Transfer to specific reserves like Debentures Redemption fund, Dividend Equalisation
Fund etc.
(c) Taxes on income and profits.
(d) Dividend paid
(e) Donations and charities
(f) Amount written off like goodwill, preliminary expenses, underwriting commission,
discount on issue of shares or discount on issue of debenture etc.

Items of Abnormal Losses and Expenses

1. Cost of abnormal wastage of material

2. Loss by fire.
3. Loss by theft

Illustration 1.1 Calculate the Prime cost, Total cost of production and Cost of sales from the
following particulars:

Rs Rs
Raw-Materials consumed --- --- --- --- 40,000
Wages paid to labourers 10,000
Directly chargeable expenses 2,000
Oil & waste 100
Wages of Foremen 1,000
Storekeepers Wages 500
Electric Power 200
Lighting: Factory 500
Office 200 700
Rent: Factory 2,000
Office 1,000 3,000
Repairs & Renewals:
Factory Plant 500
Machinery 1,000
Office Premises 200 1,700
Depreciation:
Office Premises 500
Plant & Machinery 200 700
Consumable Stores 1,000
Manager’s Salary 2,000
Director’s Fees 500
Office Printing & Stationery 200
Telephone Charges 50
Postage & Telegrams 100
Salesmen’s Commission & Salary 500
Travelling Expenses 200
Advertising 500
Warehouse Charges 200
Carriage Outward 150

Solution:
COST SHEET
Rs Rs Rs
Direct material Raw-material 40,000
consumed
Direct labour Wages paid to 10,000
labourers
Direct expenses Directly chargeable 2,000
expenses --------------
PRIME COST 52,000
Add: Factory
overheads:
Indirect material: 1,000
Consumable stores 100 1,100
Oil and waste
Indirect labour Wages of foreman 1,000
Storekeepers’ wages
500 1,500
-----------
Indirect expenses Electric power 200
Factory lighting 500
Factory rent 2,000
Repairs & Renewals
Plant 500
Machinery 1,000 1,500
Depreciation
Plant & machinery 200 4,400 7,000
------------ 59,000
FACTORY OR WORKS COST Rs Rs Rs
Add: Office and
administrative
overheads
Indirect Material Office printing and 200
stationery
Indirect Labour Manager’s salary 2,000
Director’s fees 500 2,500

2,050
Indirect expenses Office lighting 200
Office rent 1,000
Repairs and 200
renewals office
premises
Dep. on office 500
premises
Telephone charges 50
Postage & telegrams 100 2,050 4,750
63,750
TOTAL COST OF PRODUCTION Rs Rs Rs
Add: Selling and
Distribution
overheads
 Indirect labour: Salesman’s 500
commission and
salary
Travelling expenses 200
Advertising 500
Warehouse charges 200
Carriage outward 150 1,050 1,550
COST OF SALES 65,300

Illustration 1.2 Calculate (a) Cost of raw-materials consumed; (b) Total cost of production; (c)
Cost of goods sold and (d) The amount of profit from the following particulars:

Rs
Opening Stock Raw-materials --- --- 5,000
Finished goods --- --- 4,000
Closing Stock Raw-materials --- --- 4,000
Finished goods --- --- 5,000
Raw-material --- --- 50,000
purchased
Wages paid to --- --- 20,000
labourers
Chargeable --- --- 2,000
expenses
Rent, rates and --- --- 5,000
taxes
Power --- --- 2,400

Factory heating --- --- 2,000

and lighting
Factory --- --- 1,000
insurance
Experimental --- --- 500
expenses
Sale of wastage --- --- 200
of material
Office --- --- 4,000
management
salaries
Office printing --- --- 200
and stationery
Salaries of --- --- 2,000
salesman
Commission of --- --- 1,000
travelling agents
Sales --- --- 1,00,000

Solution: COST SHEET

Rs Rs
Raw-material purchased 50,000
Add: Opening Stock 5,000
 ----------
55,000
Less: Closing Stock 4,000
Cost of raw Material 51,000
Consumed
Less: Sale of wastage of 200 50,800
materials 20,000
Labour- direct 2,000
Chargeable expenses ----------
72,800
PRIME COST Rs Rs
Add: Production overheads 5,000
Rent, rates and taxes 2,400
Power 2,000
Heating & lighting 1,000
Insurance 500
Experimental expenses 10,900
----------
83,700
FACTORY COST
Add:Administrative
overheads 4,000
Office management salary 200 4,200
Office printing & stationery --------
87,900
TOTAL COST OF
PRODUCTION
Add: Opening Stock of 4,000
finished goods ----------
91,900
Less:Closing stock of finished ¤ 5,000
goods ---------
86,900
COST OF PRODUCTION OF
GOODS SOLD
Add:Selling and distribution
overheads:
Salaries of salesmen 2,000
Commission to travelling 1,000 3,000
agents ----------
COST OF SALES 89,900
PROFIT 10,100
SALES 1,00,000
Note: The amount of profit has been calculated by deducting the cost of goods sold from the amount of
sales.

Illustration 1.3 The books and records of the Anand Manufacturing Co. present the following data
for the month of August 2020:

Direct labour cost Rs.16,000 (160% of factory overheads)

Cost of gods sold Rs.56,000
Inventory accounts showed these opening and closing balances:
 August 1 August 31
Raw-material 8,000 8,600
Work-in-progress 8,000 12,000
Finished goods 14,000 18,000
Other data
Selling expenses 3,400
General and administration expenses 2,600
Sales for the month 75,000
You are required to prepare a statement showing cost of goods manufactured and sold and profit
earned.

Solution:STATEMENT OF COST AND GOODS MANUFACTURED AND SOLD

AND PROFIT EARNED For the month of August 2020
Rs Rs Rs
Value of Raw-materials 8,000
consumed opening stock
Add: Purchases 36,000
Less: Closing stock 44,000 35,000
Direct labour 8,600 16,000
PRIME COST 51,400
Factory overheads 10,000
GROSS WORKS COST 61,400
Add: opening work-in- 8,000
progress ---------
69,400
Less: Closing work-in- 12,000
progress
WORKS COST 57,000
Add: General & 2,600
Administration expenses
COST OF PRODUCTION (of ¤ 60,000
goods manufactured)
Add: Opening Stock of 14,000
finished goods ----------
74,000
Less: Closing Stock of finished 18,000
goods
COST OF PRODUCTION OF 56,000
GOODS SOLD
Add: Selling expenses 3,400
COST OF SALES 59,400
PROFIT 15,600
SALES 75,000
Note: It is generally presumed that cost of goods sole means cost of production of goods sold (including General and
Administration Expenses). The value of raw-material consumed has therefore been calculated as follows:
Rs
Cost of good sold 56,000
18,000
Add: Closing stock of finished goods 74,000
Less: Opening stock of finished goods 14,000
 ---------
60,000
Add: Closing stock of work in progress 12,000
---------
72,000
Less: Opening stock of work in progress 8,000
----------
Cost of Production 64,000
Less: Direct Labour 16,000
Factory Overhead 10,000
Adm. Overhead 2,600 28,000
35,400
Value of raw materials consumed
R.M. Purchased=R.M. Consumed +el. Stock
Op. Stock
=35,400+8,600-800
=Rs.36,000

Basic Cost Concepts

Let us discuss the basic cost concepts in this section. These concepts would help you in learning
the cost accounting much better.

1) Cost centre: The cost centre is defined by CIMA as a location person or item of equipment
(or group of these) for which costs may be ascertained and used for the purpose of cost
control. It is the smallest organizational sub-unit for which separate cost collection is
attempted. For example, the production department of a Textile milling industry may be
divided into distinct parts such as Weaving, Colouring, and Finishing. Each of these
production lines or process forms one cost center. Cost centers may be classified as follows:
(a) Personal or Impersonal cost centers
(b) Production cost center or Service cost center
(c) Operation and Process cost centers.
• A personal cost center is one, which consists of a person or group of persons, while an
impersonal cost center consists of a department, plant or item of equipment.
• A production cost center is one, which is actually engaged in production activities, while
service cost centers render services to production centers, e.g. repair shop, boiler plant,
crane, etc.
• An operation cost center is one, which consists of those machines and/or persons or group
of persons, and where the same operation is carried out. If a cost center consists of a
continuous sequence of operations, it is called process cost center.

(2) Cost unit: After the cost of various cost centers has been ascertained, it becomes necessary to
express the cost of output (production, or service). Cost unit may be defined as the quantity upon
which the cost can be conveniently allocated. The official terminology defines a cost can unit as a
unit of quantity of product, service or time in relation to which costs are ascertained or expressed.’
According to this definition, the choice of a cost unit depends on what is being produced, whether
goods or services, and what is relevant to the purpose of cost ascertainment. The selected cost unit
should be simple, unambiguous, and commonly used.

A few examples of cost units are as follows:

 Industry Cost unit
Automobile Number of vehicles
Brick works Per 1000 bricks made
Bridge Construction Each contract
Chemical units Litre, Gallon, kilogram, tonne
Cement, sugar, steel, etc Tonne
Transport Kilowatt-hour
Power Kilometer or passenger kilometer
(3) Product and period costs: The product cost is aggregate of costs that are associated with a
unit of product. Such Costs may or may not include an element or overheads depending upon the
type of costing system in force-absorption or direct. Product costs are related to goods produced
or purchased for resale and are initially identifiable as past of inventory. These product or inventory
costs become expenses in the form of cost of goods sold only when the inventory is sold. Product
cost is associated with unit of output. The costs of inputs in forming the product viz., the direct
material, direct labour, factory overhead constitute the product costs.

The period cost is a cost that tends to be unaffected by changes in level of activity during a
given period of time. Period cost is associated with a time period rather than manufacturing activity
and these costs are deducted as expenses during the current period without having been previously
classified as product costs. Selling and distribution costs are period costs and are deducted from
the revenue without their being regarded as part of the inventory cost.

(4) Common and joint costs: The common cost is an indirect cost that is incurred for the general
benefit of a number of departments or for the whole enterprise and which is necessary for present
and future operations. The joint costs are the cost of either a single process or a series of processes
that simultaneously produce two or more products of significant relative sales value.

(5) Short-run and long-run costs: The short-run costs are costs that vary with output when fixed
plant and capital equipment remain the same and become relevant when a firm has to decided
whether or not to produce more in the immediate future. The long run-costs are those which very
with output when all input factors including plant and equipment vary and become relevant when
the firm has to decide whether to set up a new plant or to expand the existing one.

(6) Past and future cost: The past costs are actual costs incurred in the past and are generally
contained in the financial accounts. These costs report past events and the time lag between event
and its reporting makes the information out of date and irrelevant for decision-making. These costs
will just act as a guide for future course of action.

The future costs are costs expected to be incurred at a later date and are only costs that
matter for managerial decisions because they are subject to management control. Future costs are
relevant for managerial decision making in cost control, profit projections, appraisal of capital
expenditure, introduction of new products, expansion programmes and pricing etc.

(7) Controllable and non-controllable costs: The concept of responsibility accounting leads
directly to the classification of costs as controllable or uncontrollable. The controllable cost is a
cost chargeable to a budget or cost centure, which can be influenced by the actions of the person
in whom control the centre is vested. It is always not possible to predetermine responsibility,
because the reason for deviation from expected performance may only become evident later. For
example excessive scrap may arise from inadequate supervision or from latent defect in purchased
material. The controllable cost is a cost that can be influenced and regulated during a given a time
span by the actions of a particular individual within an organisation.
 The controllability of cost depends upon the level of responsibility under consideration.
Direct costs are generally controllable by the shop level management. The uncontrollable cost is a
cost that is beyond the control (i.e. uninfluenced by actions) of a given individual during a given
period of time.

The distinction between controllable and uncontrollable costs are not very sharp and may
be left to individual judgment. Some expenditure which may be uncontrollable on the short-term
basis can be controllable on long-term basis. Three are certain costs which are really difficult to
control due to the following reasons.

• Physical hazards arising due to flood, fire, strike, lockout etc.

• Economic risks such as increased competition, change in fashion or model, higher prices
of inputs, import restrictions, etc.
• Political risk like change in Government policy, political unrests, war etc.
• Technological risk such as change in design, know-how etc.

(8) Replacement and Historical Costs: The Replacement costs and Historical costs are two
methods for carrying assets in the balance sheet and establishing the amount of costs that are used
to determine income.

The Replacement cost is a cost is a cost which material identical to that is to be replaced
could be purchased at the date of valuation (as distinct, from actual cost price at the date of
purchase). The replacement cost is a cost of replacing an asset at any given point of time either at
present or the future (excluding any element attributable to improvement).

The Historical cost is the actual cost, determined after the event. Historical cost valuation
states costs of plant and materials, for example, at the price originally paid for them whereas
replacement cost valuation states the costs at prices that would have to be paid currently. Costs
reported by conventional financial accounts are based on historical valuations. But during periods
of changing price level, historical costs may not be correct basis for projecting future costs.
Naturally historical costs must be adjusted to reflect current or future price levels.

(9) Out of pocket and Book Costs: The out of pocket cost is a cost that will necessitate a
corresponding outflow of cash. The costs involving cash outlay or payment to other parties are
termed as out of pocket costs. Book costs are those which do not require current cash payments.
Depreciation, is a notinal cost in which no cash transaction is involved. The distinction between
out of pocket costs and book costs primarily shows how costs affect the cash position. Out of
pocket costs are relevant in some decision making problems such as fluctuation of prices during
recession, make or buy decision etc. Book-costs can be converted into out of pocket costs by selling
the assets and having item on hire. Rent would then replace depreciation and interest.
(10) Notional Cost/Imputed and Suck Costs: The imputed cost is a cost which does not involve
actual cash outlay, which are used for the purpose of decision making and performance evaluation.
Imputed cost is a hypothetical cost from the point of view of financial accounting. Interest on
capital is common type of imputed cost. No actual payment of interest is made but the basic
concept is that, had the funds been invested elsewhere they would have earned interest.

Thus, imputed costs are a type of opportunity costs.

The Sunk costs are those costs that have been invested in a project and which will not be
recovered if the project is terminated. The sunk cost is one for which the expenditure has taken
place in the past. This cost is not affected by a particular decision under consideration. Sunk costs
are always results of decision taken in the past. This, cost cannot be changed by any decision in
future. Investment in plant and machinery as soon as it is installed its cost is sunk cost and is not
relevant for decisions. Amortization of past expenses e.g. depreciation is sunk cost. Sunk, costs
will remain the same irrespective of the alternative selected. Thus, it need not be considered by
the, management in evaluating the alternatives as it is common to all of them. It is important to
observe that an unavoidable cost may not be a sunk cost. The Managing Director’s salary is
generally unavoidable and also out of pocket but not sunk cost.

(11) Relevant and Irrelevant Costs: The relevant cost is a cost appropriate in aiding to make
specific management decisions. Business decision involve planning for future and consideration
of several alternative courses of action. In this process the costs which are affected by the decision
are future costs. Such costs are called relevant costs because they are pertinent to the decisions in
hand. The cost is said to be relevant if it helps the manager in taking a right decision in furtherance
of the company’s objectives.

(12) Opportunity and Incremental Costs: The opportunity cost is the value of a benefit
sacrificed in favour of an alternative course of action. It is the maximum amount that could be
obtained at any given point of time if a resource was sold or put to the most valuable alternative
use that would be practicable. The opportunity cost of a good or service is measured in terms of
revenue which could have been earned by employing that good or service in some other alternative
uses. Opportunity cost can be defined as the revenue forgone by not making the best alternative
use. Opportunity cost is the prospective change in cost following the adoption of an alternative
machine process, raw materials etc. It is the cost of opportunity lost by diversion of an input factor
from use to another.

The Incremental cost is the extra cost of taking one course of action rather than another. It
is also called as different cost. The incremental cost is the additional cost due to a change in the
level of nature of business activity. The change may take several forms e.g. changing the channel
of distribution, adding a new machine, replacing a machine by a better machine, execution of
export order etc. Incremental costs are relevant to the management in the analysis for decision
making.

(13) Conversion cost: The conversion cost is the cost incurred for converting the raw material
into finished product. It is referred to as the production cost excluding the cost of direct materials.

(14) Committed cost: The committed cost is a cost that is primarily associated with maintaining
the organisation’s legal and physical existence over which management has little discretion. The
committed cost is a fixed cost which results froth decision of prior period. The amount of
committed cost as fixed by decisions which are made in the past and not subject to managerial
control in the short-run. Since committed cost does not fluctuate with volume and remains
unchanged until action is taken to increase or reduce available capacity. Committed cost does not
present any problem in cost behavior analysis. Examples of committed cost are depreciation,
insurance premium, rent, etc.

(15) Shutdown and Abandonment costs: The shutdown costs are the cost incurred in relation to
the temporary closing of a department/division/enterprise. Such costs include those of closing as
well as those of re-opening. The shutdown costs are defined as those costs which would be incurred
in the event of suspension of the plant operation and which would be saved if the operations are
continued. Examples of such costs are costs of sheltering the plant and equipment and construction
of sheds for storing exposed property. Further, additional expenses may have to be incurred when
operations are restored e.g. re-employment of works may involve cost of recruitment and training.
 The abandonment cost is the cost incurred in closing down a department or a division or in
withdrawing a product or ceasing to operate in a particular sales territory etc. The abandonment
costs are the cost of retiring altogether a plant from service; abandonment arises when there is a
complete cessation of activities and crates a problem as to the disposal of assets.

(16) Urgent and Postponable costs: The urgent costs are those which must be incurred in order
to continue operations of the firm. For example, cost of material and labour must be incurred if
production is to take place. The Postponable cost is that cost which can be shifted to the future
with little or no effect on the efficiency of current operations. These costs can be postponed at least
for some time, e.g. maintenance relating to building and machinery.

(17) Escapable and unavoidable costs: the Escapable cost is an avoidable cost that will not be
incurred if an activity is not undertaken or discontinued. Avoidable cost will often correspond-
with variable costs. Avoidable cost can be identified with an activity or sector did not exist. The
escapable costs refer to costs which can be reduced due to contraction in the activities of a business
enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the
contraction.

Ques:- Opening Inventories

Finished Goods - 80,000
Raw Material - 1,40,000
Work in Progress - 2,00,000 4,20,000
Office appliances - 17,400
Plant & Machinery - 460500
Building - 200000
Sales Return - 14000
Material Purchased - 320000
Carriage on Materials- 16000
Direct Labour - 160000
Indirect Labour - 18000
Factory Supervision - 10000
Repairs of Factory - 14000
Heat, Light & Power - 65000
Rates & Taxes - 6300
Mis. Factory Exp - 18700
Sales Commission - 33600
Sales Travelling - 11000
Sales Promotion - 22500
Distribution Department Salaries - 18000
Office Salaries - 8600
Interest on Borrowed Funds - 2000
Sales - 768000
Purchase Return - 4800

Additional Information:
(1) Closing Inventory
-Finished Goods 115000
-Raw Material 180000
-WIP 192000

(2) Accured Expenses

-Direct Labour 8000
-Indirect Labour 1200
-Interest on Borrrowed Funds 2000

(3) Depreciation on Office appliances = 5%, Plant & Machinery 10%, Building 4%

(4) Distribution of cost

-Heat, Light & Power to factory, Office and distribution in the ratio of 8:1:1
-Rates & Taxes 2/3rd to Factory & 1/3rd to office.
-Depriciation on Building to Factory, office & Sales in the ratio of 8:1:1
You are required to prepare statement of cost (cost sheet)
A statement of profit.

PRACTICAL PROBLEMS
1. From the following particulars prepare a cost sheet showing the total cost per tonne for the
period ended 31st Dec., 1998:

Rs.
Raw-Materials 33,000
Productive wages 35,000
Direct expenses 3,000
Unproductive wages 10,500
Factory rent and taxes 7,500
Factory lighting 2,200
Factory heating 1,500
Motive power 4,400
Haulage 3,000
Director’s fees (works) 1,000
Depreciation of
-Plant and Machinery 2,000
Office Building 1,000
Delivery Vans 200
Bad debts 100
Advertising 300
Sales Department salaries 1,500

Director’s Fees (office) 2,000

Factory cleaning 500
Sundry office expenses 200
Estimating 800
Factory stationery 750
Office stationery 900
Factory insurance 1,100
Office insurance 500
Legal e xpenses 400
Rent of warehouse 300
Upkeeping of delivery vans 700
Bank charges 50
Commission on sales 1500
Loose tools written off 600
Rent and taxes (office) 500
Water supply 1200

The total output for the period has been 10,000 tonnes.
[Ans. Prime cost Rs.71,000, Works cost Rs.1,08,050, Office cost Rs.1,13,600, Total cost
Rs.1,18,200, Cost per tonne Rs.11.82]

2. Prepare a cost sheet to show the total cost of production and cost per unit of goods manufactured
by a company for the month of July 1994. Also find out the cost of sales.

Rs.
Stock of raw-materials 1.7.1994 3,000
Raw-materials purchased 28,000
Stock of raw-materials 31.7.1994 4,500
Manufacturing wages 7,000
Depreciation on plant 1,500
Loss on sale of a part of plant 300
Factory rent and rates 3,000
Office rent 500
General expenses 400
Discount on sales 300
Advertisement expenses to be 600
charged fully
Income-tax paid 2000

The number of units produced during July 1994 was 3,000

The stock of finished goods was 200 and 400 units on 1.7.1994 respectively. The total cost of units
on hand on 1.7.1994 was Rs.2,800. All these had been sold during the month.
[Ans Prime Cost Rs.33,500, Factory Cost Rs.38,000; Cost of Production Rs.38,900; Cost of Sales
Rs.37,416]

3. The following particulars relating to the year 1994 have been taken from the books of a chemical
works manufacturing and selling a chemical mixture:

Kg Rs
st
Stock on 1 Jan, 1994
Raw-materials 2,000 2,000
Finished mixture 500 1,750
Factory store 7,250
Purchases
Raw-materials 1,60,000 1,80,000
Factory stores 24,250
Sales
Finished mixture 1,53,050 9,18,000
Factory scrap 8,170
Factory wages 1,78,650
Power 30,400
Depreciation of machinery 18,000
Salaries
Factory 72,200
Office 37,200
Selling 41,500
Expenses
Direct 18500
Office 18200
Selling 18,000
Stock on 31st December, 1994
Raw-Material 1,200
Finished Mixture 450
Factory Stores 5,550

The stock of finished mixture at the end of 1994 is to be valued at the factory cost of the mixture
for that year. The purchase price of raw-materials remained unchanged throughout 1994.
Prepare a statement giving the maximum possible information about cost and its break up for the
year 1994.
[Ans. Prime cost Rs.3,77,800, Factory Cost Rs.5,16,200, Cost of production of finished mixture
sold Rs.5,71,852, Cost of sales Rs.6,31,352]

4. Calculate (a) Value of raw-materials consumed (b) Total cost of production, (c) Cost of goods
sold and (d) The amount of profit from the following particulars:

Rs
Opening Stock
Raw-Materials 5,000
Finished Goods 4,000
Closing Stock:
Raw-Materials 4,000
Finished Goods 5,000
Raw-Materials Purchased 50,000
Wages paid to Labourers 20,000
Chargeable Expenses 2,000
Factory Rent, Rates and Taxes 5,000
Power 2,000
Factory Heating and Lighting 2,000
Factory Insurance 1,000
Experimental Expenses 500
Sale of Wastage of Materials 200
Office Management Salaries 4,000
Office Printing & Stationery 200
Salaries of Salesmen 2,000
Commission of Travelling Agents 1,000
Sales 1,00,000

[Ans. (a) Rs.50,800 (b) Rs.87,500 (c) Rs.89,500 (d) Rs.10,500] [Hint. Sale of raw-materials
wastage of Rs.200 has been deducted from the cost of raw-materials].

5. The cost of the sale of product “X” is made up as follows

Rs.
Materials used in manufacturing 10,200
Materials use in packing materials 2,500
Materials used in selling the product 350
Materials used in office 75
Materials used in factory 125
Labour required in producing 2500
Salary paid to works manager and other principal 450
offices of the factory
Expenses-indirect-office 250
Expenses-direct-factory 1000
Bad debts 300
Packing expenses 150
Lighting and heating charges of the factory 200
Expenses-indirect-factory 125
Assuming that all the products manufactured are sold, what should be the selling price to obtain a
profit of 20% on cost price?
Illustrate in a chart form for presentation to your manager, the division of costs of product ‘x’.
[Ans. Prime cost Rs.16,200 Works cost Rs.17,100, Cost of sales Rs.18,225, Sales Rs.21,870]

6. Calculate the prime cost, factory cost, total cost of production and cost of sales from the
following particulars:
Rs

Raw-materials consumed 12,000

Directly chargeable expenses 500
Wages paid to labourers 2500
Grease, oil cotton waste etc 25
Salary of factory manager and clerks 1750
Insurance of stock of raw-materials 300
Consumable stores 400
Printing and stationery: Factory 50
Office 200
Sales deptt 100 350
Rent of office building 150
Depreciation: Factory premises 200
Office furniture 50
Delivery vans 75 325
Power and fuel 500
Contribution to provident fund of factory employees 1000
Salaries of administrative directors 100
Bank charges 75
Cost of samples 250
Salaries of sales manger 300
Advertising 500
Packing material 350
Shortage in stocks of finished goods 20
[Ans. Prime cost Rs.15,000, Factory cost Rs.19,225, Total Cost of production Rs.19,800, Cost of
and (d) the amount of profit from the following particulars

7. Rs
Opening Stock Raw-Materials 1350
Finished goods 2500
Closing Stock: Raw-Materials 750
Finished goods 1500

Raw-materials purchased 20000

Wages paid to labourers 8000
Direct expenses 1250
Experimental expenses 450
Factory printing and stationery 350
Rent: Factory 250
Office 120 370
Lighting-office 125
Audit fees 150
Telephone expenses 500
Advertising 1250
Market research expenses 550
Salary of godown-keepers 175
Travelling expenses 750
Commission of traveling agents 500
Sales 50,000
[Ans. (a) Value of raw-materials consumed Rs.20,600 (b) Total cost of production Rs.32,795, (c)
Cost of goods sold Rs.33,795 (d) Profit Rs.12,980].

8. Prepare a statement of cost from the following trading and profit and loss account for the year
ending 31st March, 1995
Particulars Rs. Particulars Rs
Opening Stock Sales 1,00,000
Materials 8,000 Closing stock
Finished goods 25,000 Materials 15,000
Purchas of materials 70,000 Finished goods 30,000
Direct labour 10,000
Grease, oil etc 500
Salary of storekeeper 700
Power and fuel 800
Gross profit c/d 30,000
---------- --------------
1,45,000 1,45,000

Lighting: 500 Gross profit b/d 30,000

Office 650 Dividends received 2,000
Sales deptt Interest on loan 600
Depreciation Transfer fees received 1400
Office premises 1000
Delivery vans 750
Fees of office manager 2000
Bank charges
Selling expenses 1500
Sales commission 1500
Preliminary expenses 500
Packing expenses 3000
Dividends paid on share 1100
capital of company 1000
Discount on debentures
Net profit
500
20000
----------- ----------
34,000 34,000
[Ans. Prime Cost Rs.73,000; Works Cost Rs.75,000 Total Cost of production Rs.80,000; Cost of
Goods Sold Rs.75,000, Cost of sales Rs.79,000; Profit Rs.21,000].
 Material Management
MEANING OF MATERIALS:
The term materials refers to the raw materials used for production, sub assemblies and fabricated
parts. It may be defined as “anything that can be stored or stockpiled”. The terms “materials” and
“stores” are sometimes used interchangeably. However, both the terms differ. The term “stores”
has wider meaning and includes not only the raw materials used in production but also other items
held in stock in the store room, such as components, tools patterns, maintenance materials,
consumable stores etc. It also includes stock of finished goods and partly finished goods.
“Consumable” stores are items used in, production but do not become a part of the finished
product, such as oil, grease, sand paper, soap, and other cleaning materials etc.

MATERIALS CONTROL: Concept and Objectives

Materials from an important past of the cost of a product and, therefore, proper control over
materials is necessary. No cost accounting system can become effective without proper and
efficient control of materials. Materials control basically aims at efficient purchasing of materials,
their efficient storing and efficient use or consumption. Materials or inventory control may be
defined as “systematic control and regulation of purchase, storage and usage of materials in such
a way that maintain smooth flow of production and at the same time avoids excessive investments
in inventories. Efficient material control cuts out losses and wastes of materials that otherwise pass
unnotied.”
The broad objectives of material control are listed below:
1. It eliminates the problem of understocking and, therefore, materials of the desired quality will
be available when needed for efficient and interrupted production.
2. Material will be purchased only when need exists: Hence, it avoids the chances of over-stocking.
3. By purchasing materials at the most favourable prices, the purchase is able to make a valuable
contribution to the reduction in cost.
4. Materials are protected against loss by fire, theft; handling with the help of proper physical
controls.
5. Issues of materials are properly authorized and properly accounted for.
6. Vouchers will be approved for payment only if the material has been received and is available
for issue.
7. Materials are, at all times, charged as the responsibility of some individual.

PROCEDURE OF PURCHASING AND RECEIVING MATERIALS

Purchasing procedure vary with different business firms, but all of them follow a general pattern
in the purchases and receipt of materials and payment obligations. The important steps may be
listed as follows:
Purchase Requisition: The initiation of purchase begins with the receipt of a purchase requisition
by the purchasing department. The purchase requisition is prepared by the storekeeper for regular
stock items and by the departmental head for special equipment or materials not stocked as regular
items. The requisition is approved by one or more executives in addition to one originating the
requisition. The requisition is prepared in triplicate, the original copy is sent to the purchasing
department, the second is retained by the storekeeper or executive initiating the purchase
requisition and the third copy is sent to the costing department. The requisition contains particulars
regarding quantity, the quality or material specifications, and the date by which purchase of
materials is required.
Purchase order: If the purchase requisition received by the purchasing department is in order,
then it will call for tenders and/or quotations from the suppliers of materials. Ti will send enquiries
to prospective suppliers giving details of requirement and requesting details of available materials,
prices, terms and delivery etc. Quotations will then be compared and will place order with those
suppliers who will provide the necessary goods at competitive price. The number of copies and
routing of purchase orders depend on the procedures followed in the organisation. Normally, the
copies of the purchase order will be sent to the supplier, the department originating purchase
requisition, Inspection department, Accounting department.

Materials inspection note: When materials are delivered, supplier’s carrier will usually provide
a document called Delivery note or Delivery advice to confirm the details of materials delivered.
When materials are unloaded the warehouse staff check the materials unloaded with the delivery
note. Then the warehouse staff prepares a Materials Receipt Note, a copy of which is given to the
supplier’s carrier as a proof of delivery. After receiving the materials is in accordance with the
purchase order a note called Material Inspection Note, copies of which are sent to the supplier and
stores department.
Goods Received Note: One the inspection if completed a Goods, Received Note (GRN) is
prepared by the store department, and copies of GRN is sent to the Purchasing department Costing
department, Accounts department and Production department; which initiated purchase
requisition.

After receipt of GRN from the store department and invoice from the supplier the Accounts
department will check the purchase order and take necessary steps for making payment to the
supplier.
Store Requisition Note: It is also called Materials Requisition Note. When Production or other
departments requires material from the store is raises a requisition, which is an order on the stores
for the material required for execution of the work order. This note is signed by the department
incharge of the concerned department incharge of the concerned department. It is a document
which authorize the issue of a specified quantity of materials. It will include the cost centre of job
number for which the requisition is being made. Any person who requires materials from the store
must submit Stores Requisition Note. The store keeper should only issue materials from stores
against such a properly authorised requisition and this will be sent to the Costing department for
recording the cost or value of materials issued to the cost centre or job.
Material Transfer Note: If materials are transferred from one department or job to another win
in the organisation, then material transfer note should be raised. It is record of the transfer of
materials between stores, cost centres of cost units showing all data for making necessary
accounting entries.
Material Return Note: If materials received from the stores is not of suitable quality of if there
is surplus material remaining with the department, they are returned to stores with another called
“Material Return Note” evidencing return of material from Department to Stores. A copy of
Material Return Note is sent to the Costing department for making necessary adjustments in
accounts.
Bin Card: It is attached to the concerned Bin, rack or place where the R.M. is stored. It gives
all the Basic information relating to physical movements of stock. It is a record of receipts, issues
& Balance of the quantity of an item of stock handled by a store.

Stores Ledger: Stores department will maintain a record called stores ledger in which a separate
folio is kept for each individual item of stock. It records not only the quantity details of stock
movements but also record the rates & values of stock movements. With the information available
in the stores ledger, it is easier to ascertain the value of any stock item at any point of time. The
maximum, Maximum & re-order levels of stock are also mentioned for taking action to replenish
the stock position.

Centralised Purchasing: There is a separate purchasing department entrusted with the task
of making all purchase of all types of materials the head of this department is usually designated
as purchase manager or chief buyer.

Decentralised Purchasing: Under this, each branch or department makes its own purchases.
If the branches of plants are located at different places it may not be possible to centralize all
purchases. In such case, decentralised purchasing can better meet the situation by making
purchases in the local market by plant or branch managers.
Advantages of Centralised Purchasing: Specialised & expert purchasing staff can be
concentrated in one department. A firm policy can be initiated which may result in favourable
terms of purchase, e.g. higher trade discount etc. Standardisation of quality of R.M. Keeping all
records of purchase transactions at one place also helps in control.
Disadvantages of Centralised Purchasing: Special purchasing department leads to higher
administration cost. It is not suitable for plants or branches located at different places which are
far apart.

METHODS OF PRICING MATERIAL ISSUES:

1. Actual Cost Method: Where materials are purchased specially for a specific job, actual cost
of materials is charged to that job. Such materials will normally be stored separately and issued
only to that particular job.

2. First in First out Method(FIFO): Under this method materials are issued out of stock in the
order in which they were first received into stock. His assumed that the first material to come into
stores will be the first material to be used. CIMA defined FIFO as “a method of pricing the issue
of material using, the purchase price of the oldest unit in the stock”.

Advantages:

1. It is easy to understand and simple to price the issues.

2. It is good store keeping practice which ensures that raw material have the stores in a
chronological order based on their age.
3. It is a straight forward method which involves less clerical cost than other methods of pricing.
4. This method of inventory valuation is acceptable under standard accounting practice.
5. It is consistent and realistic price in valuation of inventory and finished stock.
6. The inventory is valued at the most recent market prices and it is near to the valuation based on
replacement cost.

Disadvantages:
There is no certainty that materials which have been in stock longest will be used, if they are mixed
up with other materials purchased at a later date at different.

If the price of the materials purchased fluctuates considerably it involves more clerical work and
there is possibility of errors.

In the inflationary market there is a tendency to under pricing of material issues and deflationary
market this is the tendency to overprice such issues.

Usually mote that one price has to be adopted for a single issue of materials.

It makes cost comparison difficult of different jobs when they are charged with varying price for
the same materials.

This method is more suitable where the size of the raw materials is large and bulky and its price is
high and can be easily identified in the stores separately. This method is useful when the frequency
of material issued is less and the market price of the material is stable and steady.

Last in First out Method: Under this method most recent purchase will be the first to be issued.
The issues are priced out at the most recent batch received and continue to be charged until a new
batch is arrived into stock. It is method of pricing the issue of material using the purchase price of
the latest unit in the stock.

Advantages:

Stocks issued at more recent price represent the current market value based on the replacement
cost.

It is simple to understand and easy to apply.

Products cost will tent to be more realistic since material cost is charged at mere recent price.

In times of rising prices, the pricing of issues will be at a more recent current market price.

It minimise unrealised inventory gains and tends to show the conservative profit figure by
valuation of inventory at value before price rise and provides a hedge against inflation.

Disadvantages:

Valuation of inventory is not acceptable in preparation of financial accounts.

It is an assumption of cost flow pattern and is not intended to represent the true physical flow of
materials from the stores.

It renders cost comparison between jobs difficult.

It involves more clerical work and some times valuation may go wrong.

In times of inflation, valuation of inventory under this method will not represent the current market
prices.

Illustration:
 From the records of an oil distributing company, the following summarized information is
available for the month of March 1996:

Sales of month : Rs.19,25,000

Opening Stock as on 1.3.1996: 1,25,000 litre @ 6.50 per litre
Purchases (including freight and Insurance):
March 5 1,50,000 litre @ Rs.7.10 per litre
March 27 100,000 litre @ Rs.7.00 per litre
Closing stock as on 31.3.96 : 1,30,000 litres.
General administrative expenses for the month: Rs.45,000

On the basis of the above information, work out of the following using FIFO and LIFO
methods of inventory valuation assuming that pricing of issues is being done at the end of the
month after all receipts during the month:

(a) Value of closing stock as on 31.3.96

(b) Cost of goods sold during March 1996
(c) Profit or loss for March 1996

Solution:

(A) FIFO Method of Pricing Issues

Store Ledger

Date Particulars Receipts Issues Balance

Qty Rate Value Rs Qty Rate Value Qty Rate Value Rs
Litres Rs. Litres Rs. Rs Litres as
Per Litre Per
Litr s Litre
e s
1.3.96 Balance b/d 1,25,00 6.50 8,12,500
0
5.3.96 Purchases 1,50,00 7.10 10,65,00 2,75,00 18,77,50
0 0 0 0
27.3.9 Purchase 1,00,00 7.00 7,00,000 3,75,00 25,77,50
6 0 0 0
27.3.9 Issues (3,75,000- 1,25,00 6.50 8,12,500 2,50,00 17,65,00
6 1,30,000=2,45,00 0 0 0
0 units) 7.10 8,52,000
1,20,00 1,30,00 9,13,000
0
0
17,65,00 16,64,50
0 0

(B) LIFO Method of Pricing Issues

Store Ledger

Date Particulars Receipts Issues Balance

Qty Rate Value Rs Qty Rate Value Rs Qty Rate Value Rs
Litres Rs. Litres Rs. Litres as
Per Litres Per
Litre Litres
1.3.96 Balance b/d 1,25,000 6.50 8,12,500
5.3.96 Purchases 1,50,000 7.10 10,65,000 2,75,000 18,77,500
27.3.96 Purchase 1,00,000 7.00 7,00,000 3,75,000 25,77,500
Issues 1,00,000 7.00 7,00,000
1,45,000 7.10 10,29,500 1,30,000 8,48,000
2,50,000 17,65,000 2,45,000 10,29,500

Closing Stock, cost of goods sold, profit under FIFO

(a) Value of closing stock Rs.9,13,000

(b) Cost of goods sold Rs.16,64,500
(8,12,500+8,52,000)

(c) Profit

Sales Rs.19,25,000
Rs.16,64,500 Rs.16,64,500
General administration expenses Rs.45,000 17,09,500
-------------------
Profit Rs.2,15,500
Closing stock, cost of goods sold, profit under LIFO
(a) Value of closing stock Rs.8,48,000
(b) Cost of goods sold Rs.17,29,500
(7,00,000+10,29,500)
(c) Profit:

Sales Rs.19,25,000
Less: Cost of goods sold 17,29,500
General administration expenses 45,000 17,74,500
------------------
Rs.1,50,500
-----------------
4. Highest in First Out Method (HIFO): Under this method the materials with highest prices
are issued first, irrespective of the date upon which they were purchased. The basic assumption is
that in fluctuation and inflationary market, the cost of material are quickly absorbed into product
cost to hedge against risk of inflation. This method is used when the material is in short supply and
in execution of cost plus contracts. This method is not popular and not acceptable under standard
accounting practice.

5. Simple Average Cost Method: Under this method all the materials received are merged into
existing stock of materials, their identity being lost. The simple average price is calculated without
any regard to the quantities involved. The simple average cost is arrived at by addition the different
prices paid during the period for the batches purchased by dividing the number of batches. For
example, three batches of materials received at Rs.10, Rs.12 and Rs.14 per unit respectively.

= Rs.10+Rs.12+Rs.14/3 = Rs.36/3 = Rs.12 per unit.

This method is not popular because it takes into consideration the prices of different batches but
not the quantities purchased in different batches. This method is used when prices do not fluctuate
very much band the stocks are small in value.

Illustration:
Prepare a stores ledger account by following the simple average method on the basis of information
given below:
Date Rate per unit (Rs)
January 1,2000 Received 500 units 20
January 10, 2000 Received 300 units 24
January 15, 2000 Issued 700 units ---
January 20, 2000 Received 400 units 28
January 25, 2000 Issued 300 units ---
January 27, 2000 Received 500 units 22
January 31, 2000 Issued 200 units ---

Solution: Store Ledger Account

(Simple Average Price Method)
Date Receipts Issues Stock
Qty Rs Amount Qty Rs Amount Qty Rs Amount
1994
Jan.1 500 20 10,000 --- --- --- 500 20 10,000
Jan.10 300 24 7,200 --- --- --- 500 20 10,000
300 24 7,200
Jan.15 --- --- --- 700 22 15,400 100 1,800
Jan.20 400 28 11,200 --- --- --- 500 13,000
Jan.25 --- --- --- 300 26 7,800 200 5,200
Jan.27 500 22 11,000 --- --- --- 700 16,200
Jan.31 --- --- --- 200 25 5,000 500 11,200
Average price for different issues has been calculated, as follows:

Jan 15 700 units = (20+24)/2=Rs.22 per unit

Jan 25 300 units = (24+28)/2=Rs.26 per unit
Jan 31 700 units = (20+24)/2=Rs.22 per unit
6. Weighted Average : Under this method, issue of materials is priced at the average cost price
of the materials in hand, a new average being computed whenever materials are received. In this
method, total quantities and total costs are considered while computing the average price and not
the total of rates divided by total number of rates as in simple average. The weighted average is
calculated each time a purchase is made. The quantity bought into the new cash value of the stock.
The effect of early price is thus eliminated. This method avoids fluctuations in price and reduces
the number of calculations to be made, as each issue is charged at the same price until a fresh
purchase necessitates the computation of a new average. It gives an acceptable figure for stock
values.
Advantages:
1. The method is logical and consistent as it absorbs cost while determining the average for pricing
material issues.

2. The changes in the prices of materials do not much affect the materials issues and stock.
3. The method follows the concept of total stock and total valuation
4. Both cost of materials issued and in stock tend to reflect actual costs.
Disadvantages:
The weighted average method also the following disadvantages:
1. Simplicity and conveniences are lost when there is too much change in the prices of materials.
2. An average price is not based on actual price incurred, and therefore is not realistic. It follows
only arithmetical convenience.

Illustration:
Prepare a store ledger account on the basis of information given in above illustration by following
the weighted average method.
Solution: Store Ledger
Date Receipts Issues Stock
Qty Rate Amount Qty Rate Amount Qty Rate Amount
2000
Jan.1 500 20 10,000 --- --- --- 500 20 10,000
Jan.10 300 24 7,200 --- --- --- 500 20 17,200

Jan.15 --- --- --- 700 21.50 15,050 800 21.50 2,150
Jan.20 400 28 11,200 --- --- --- 500 26.70 13,350
Jan.25 --- --- --- 300 26.70 8,010 200 5,340
Jan.27 500 22 11,000 --- --- --- 700 23.34 16,340
Jan.31 --- --- --- 200 23.34 4,668 500 23.34 11,672

7. Periodic Average Cost Method: Under this method, instead of recalculating the simple or
weighted average cost every time there is a receipt an average for the accounting period as a whole
is computed. The average price calculated for all the materials issued during the period is computed
as follows:
Cost of Opening Stock+ Total Cost of all receipts during the period
______________________________________________________
Units in Opening Stock + Total Units received during the period

8. Standard Cost Method: Under this method, material issues are period at a predetermined
standard issue price. Any variance between the actual purchase price and standard issue price is
written off to the profit and loss account. Standard cost is a predetermined cost set by the
management prior to the actual material costs being known and the standard issue price is used for
all issues to production and for valuation of closing stock. If initially the standard price
Illustration:
Enter the following transactions in the stores ledger account for material Y, using-
(a) The first in first out method, (b) The average cost method, (c) the last in first out method.

July 1. Balance, 100 units @ 10 p. per unit Rs.10

1. Ordered 400 units, purchase order 5, expected July 6.
2. Issued 25 units, requisition 100 Dept. A
4. Ordered 200 units, purchase order 10 expected July 8.
6. Received 400 units, purchase order 5 @ 11 p. per unit
7. Issued 150 units, requisition 102, production order No.201.
8. Returned to stock room 10 units from Dept A requisition 100.
10. Received 150 units, purchase order 10 @ 12 p. per unit
12. Ordered 100 units, purchase order 15 expected July 20.
15. Issued 160 units requisition 125 production order No.210.
 18. Received 50 units, balance of purchase order 10 @ 12 p per unit
21. Issued 60 units, requisition 130 Dept B.
23. Returned to vendor 20 units from purchase order No 10 received July 18.
25. Received 100 units, purchase order 15 @ 10 per unit
27. Freight on purchase order 15 Rs.2.50
29. Issued 125 units requisition 140 production order No.250.

Solution: STORE LEDGER: FIRST IN FIRST OUT MEHOD

Ordered Received Issued Balance
Date Purchased Qty Date Date Purchase Qty Unit Total Date Requisiti Dept Qty Unit Total Qty Unit Total
cost
order No expected Order cost cost on No or cost cost cost
No prod
order
No
2020 Rs.P Rs.P 1994 Rs.P Rs.P Rs.P

July1 5 400 July 6 --- --- --- --- --- ---

---- ---- --- --- 100 0.10 10.00
--- 0.10 7.50
July 10 200 July 8 --- --- --- --- --- July 2 100 D-A 25 0.1 2.50 75
4 July 6 5 400 0.11 44.00
--- [75
--- --- --- --- [0.10 51.50
July 15 July 7 400] 0.11]

12 102 P- [75 [.10 15.75

July July 8 201 75 1.00 35.75
150 0.12 0.11 325 [0.11
10 10
18.00 0.10] [10 0.10
--- Retur --- 0.11] 36.75
--- --- --- 325] 0.10
ned [10
100 July 20 0.11
July 325 0.12] 54.75
125 --- [0.11
July 15 [10 [0.10 150]
50 0.12 P- 17.50 0.12]
10 0.11] [175 [0.11
18 6.00 210 150] 37.25
--- 150] 0.12]
---- --- [175 [0.11
--- --- 0.12] 43.25
130 --- 200]
0.12 2.40 0.11 6.60 [0.11
July 23 *Retd 20 --- July D-B 60 [115 0.12]
vendor ---- 200] [0.11 36.65
0.125 12.50 21 0.12]
July 25 15 100 --- --- --- [115
--- [0.11
34.25
---- ---- 180] 0.12
--- [115 0.12
--- --- 5] 46.75
180
---- ---- ----
[115
100] [0.12
[0.11 0.12 32.90
10] 0.12] 13.85 [170
P- 5]
July 100]
29 140 250

*Ink red Ink. Units returned to vendor are out of stock received from vendor at Re.0.12
Freight on purchases has been added to material cost.

STORE LEDGER: AVERAGE COST MEHOD

Ordered Received Issued Balance
Date Purchased Qty Date Date Purchase Qty Unit Total Date Requisiti Dept Qty Unit Total Qty Unit Total
cost
order No expected Order cost cost on No or cost cost cost
No prod
order
No
2020 Rs.P Rs.P 1994 Rs.P Rs.P Rs.P

July1 15 400 July 6 --- --- --- --- --- ---

---- ---- --- --- 100 0.10 10.00
--- 0.10 7.50
200 July 8 --- --- --- --- --- July 2 100 D-A 25 0.1 2.50 75
July 6 5 400 0.11 44.00 --- [75
--- --- --- --- [0.10 51.50
July 7 400] 0.11]

102 P- [75 [.10 15.75

July July 8 201 75 1.00 35.75
150 0.12 0.11 325 [0.11
10 10
18.00 0.10] [10 0.10
--- Retur --- 0.11] 36.75
--- --- --- 325] 0.10
ned [10
100 July 20 0.11
July 325 0.12] 54.75
125 --- [0.11
July 15 [10 [0.10 150]
50 0.12 P- 17.50 0.12]
10 0.11] [175 [0.11
18 6.00 210 150] 37.25
--- 150] 0.12]
---- --- [175 [0.11
--- --- 0.12] 43.25
130 --- 200]
0.12 2.40 0.11 6.60 [0.11
July 23 *Retd 20 --- July D-B 60 [115 0.12]
vendor ---- 200] [0.11 36.65
0.125 12.50 21 0.12]
July 25 15 100 --- --- --- [115
--- [0.11
34.25
---- ---- 180] 0.12
--- 0.12
--- [115
--- 5] 46.75
180
---- ---- ----
[115 100] [0.12
[0.11 0.12 32.90
10] 0.12] 13.85 [170
P- 5]
July 100]
29 140 250

*Ink red Ink. Units returned to vendor are out of stock received from vendor at Re.0.12
Freight on purchases has been added to material cost.
 AVERAGE COST MEHOD
STORE LEDGER
Ordered Received Issued Balance
Date Purchased Qty Date Date Purch Qty Unit Total Date Requ Dept Qty Unit Total Qty Unit cost Total
order No expected ase cost cost isitio or cost cost cost
Order n No prod
No order
No
2020 Rs.P Rs.P 1994 Rs.P Rs.P Rs.P

July1 5 400 July 6 --- --- --- --- --- ---

---- ---- --- --- 100 0.10 10.00
--- 0.10 7.50
July 10 200 July 8 --- --- --- --- --- July 2 100 D-A 25 0.10 2.50 75
4 July 6 5 400 0.11 44.00 ---
--- --- --- --- ---
July 7
102 P-201 0.10 16.26 475 0.1084 51.50
July July 8 Returne 150 1.00 325
0.1084
35.24
150 0.12 84 0.10818
10 10 d
10 335 0.11184 36.24
18.00 0.10
--- 17.89 0.11185 54.24
--- --- 485 0.11292
36.35
P-210 --- --- --- 325 0.11292
July 0.11292 42.35
125 375 35.57
15 --- 6.78
July 160 0.11 315 33.31
10 50 0.12
18 6.00 --- D-B 184 295
---- ---
0.11292 July 130 60 --- ---
20 2.26
July Retd 21 ---- 0.11
23 to 0.125 12.50 ---- --- 293 ---
100
vend ---- ----
or --- ---
July 15 ---- P-250
25 ---- ---
July 125 395 0.11597 45.81
0.11597
29 0.11 14.50 270 31.31
140 597

*Ink red Ink. Units returned to vendor at latest cost.

AVERAGE COST MEHOD

STORE LEDGER
Ordered Received Issued Balance
Date Purchased Qty Date Date Purchase Qty Unit Total Date Requisiti Dept Qty Unit Total Qty Unit Total
cost
order No expected Order cost cost on No or cost cost cost
No prod
order
No
2020 5 Rs.P Rs.P 1994 Rs.P Rs.P 100 Rs.P

July1 400 July 16 --- --- --- --- --- --- 75

---- ---- --- --- 0.10 10.00
--- 0.10 7.50
July 10 200 July 8 July 6 5 0.11 July 2 100 D-A 25 0.10 2.50 [75
4 400 44.00 400]
---
--- --- --- [75 [0.10 51.50
July 7 250] 0.11]
0.10
July 102 P- 150 0.11 16.50 [75 0.11]
0.12 July 8 0.10
10 10 201 250 35.00
150 0.11
18.00 10 0.10 10] 0.10]
--- Retur 1.00 [0.10 36.00
--- 0.11]
ned
--- [75 [0.10
July --- 0.12] 54.00
July 125 --- ---- 250
0.12 15 [0.10
18 10 P- 10 0.11]
50 [0.11
[0.10
July 15 100 July 12 6.00 210 [10 0.12] 19.00 150] 0.11] 35.00
12 --- ---- 150] [75 0.12]
0.111 --- [0.10
July Returne 130 --- 250 41.00
20 --- --- 0.11
23 d to 2.40 July D-B 50] 0.10
---- [75 33.90
vendor 100 0.125 21 [50 [0.12 7.10 [0.10
15 10] 0.11] 240] 0.11
0.125 31.70
July 12.50 ---- ---- [75
---- --- --- 0.10
25 220] 0.11]
44.20
---- ---- ---- [75
--- ---
[0.125
220 28.95
P- [100 100]
July 25]
0.11]
15.25
29 140 250 [75
195]
*Ink red Ink. Units returned to vendor price at last units received and in stock.

Illustration:
At Ltd furnishes the following store transactions for September, 1994:

1.9.94 Opening Balance 25 units Rs.162.50

4.9.94 Issues Req No 85 8 Units
6.9.94 Receipts from B & Co GRN No 26 50 units @ Rs.5.75 per unit
7.9.94 Issues Req No 97 12 units
10.9.94 Returns to B & Co 10 units
12.9.94 Issues Req No 108 15 units
13.9.94 Issues Req No 110 20 units
15.9.94 Receipts from M & Co GRN No 33 25 units @ 6.10 per unit
17.9.94 Issues Req No 121 10 units
19.9.94 Received replacement from B & Co 10 units
GRN No 38
20.9.94 Returned from department material of 5 units
M & Co MRR No 4
22.9.94 Transfer from Job 182 to Job 187 in 5 units
the dept MTR 6
26.9.94 Issues Req No 146 10 units
29.9.94 Transfer from Dept A to Dept B MTR 5 units
No 10
30.9.94 Shortage in stock taking 2 units
Write up the period stores ledger on FIFO Method and discuss how would you treat the shortage in stock
taking.

AT LTD STORES LEDGER FOR SEPTEMBER 1994 (FIFO METHOD)

Receipts Issued Balance

Date GRN Qty Rate Amount Requisiti Qty Rate Amount Qty Rate Amount
No/MRR Units Rs P No on No Units Rs P Rs P Units Rs P Rs P
No
1.9.94 --- --- --- --- --- --- --- --- 25 6.50 162.50
4.9.94 --- --- --- --- 85 8 6.50 52 17 6.50 110.50
6.9.94 26 50 5.75 287.50 --- --- --- ---
 [17 [6.50 398.00
7.9.94 --- --- --- --- 97 12 6.50 78 50] 5.75]

10.9.94 --- --- --- --- Nil 10 5.75 57.50 [5 [6.50 320.00
50] 5.75]
12.9.94 --- --- --- --- 108 5] [6.50
10] 5.75] 90 [5 [6.50 262.50
13.9.94 --- --- --- --- 110 20 5.75 115 40] 5.75]

15.9.94 33 25 6.10 152.50 --- --- --- --- 30 5.75 172.50

10 5.75 57.50
17.9.94 --- --- --- --- 121 10 5.75 57.50
[10 [5.75
19.9.94 38 10 5.75 57.50 --- --- --- --- 25] 6.10] 210.00

20.9.94 4 5 5.75 28.75 --- --- --- --- 25 6.10 152.50

26.9.94 --- --- --- --- 146 [5 [5.75 --- [25 [6.10 210.00
5] 6.10] 59.25 10] 5.75]
30.9.94 ---- --- --- --- Shortage 2 6.10 12.20
[5 [5.75 23.8.75
25 6.10
10] 5.75]

[20 [6.10 179.50

10] 5.75]

[18 [6.10 138.55

5] 5.75]

Techniques of Inventory Control:

(1) ABC Analysis:-

(a) It is a management tool which enables top management to place the effort where the results will be
greatest.

(b) The items in inventory are classified according to value of usage. The higher value items have lower
safety stocks because the cost of production is very high. The lower value items carry higher safety stocks.

(c) The item may be divided into three categories A,B, & C category “A” may include more costly items,
while category “B” may consist of less costly items & category “C” of the least costly items.

(d) It divides the total inventory list into three classes using the rupee volume.

Category % of item % of value

A 15 80
B 35 15
C 50 5
--------- -----
100 100

(2) Economic Order Quantity: (EOQ)

(a) It refers to the size of the order which gives maximum economy in purchasing any material. It is
also referred as optimum or standard ordering quantity.
(b) The optimum level will be that quantity which minimizes the total costs associated with inventory.
(c) It takes into consideration the following costs:-
(i) ordering cost
(ii) Inventory carrying cost or storage cost.
(iii) In adequate inventory or stock-out cost EQQ=√2AB/C where, A=Annual usuage
B=Buying/ordering cost C=carrying/storage cost

Ques:- Annual demand 12000 units ordering cost Rs.90 order inventory carrying cost per annum Rs.15
Find out EOQ
Ans:- EOQ=√2AB/C EOQ=√12000x2x90/15 EOQ=3079.47 EOQ=380 units (Rounded)

Ques: Annual usuage units 6000 cost of placing an order Rs.30 carrying cost as a percent of inventory
20% cost per unit of material Rs.5 find out EOQ. How many order will be placed in a year.

Ans: A=6000 B=30 C=20/100x5=1 Rs. EOQ=√2x6000x30/1 EOQ=600 units Total=6000 So order is
10 order placed in a year.

(3) Stock Levels:-

Maximum Stock Level-

(a) It is the largest quantity of a particular materials which should be kept in a store at any one time
the fixation of maximum level is necessary to avoid un-necessary blocking up of the capital in
inventories absolescence of materials, spoilage etc.
(b) It insures that the stocks will not exceed this limit although there may be low demand for materials
or quick delivery from the suppliers.

Max Stock Level = EOQ + Minimum Stock OR Max Stock Level = Roll + EOQ- (Maximum
consumption X min Re-order period)

Minimum Stock Level/Safety Stock Level

(a) It is the lowest quantitative balance of materials which must be maintained in hand at all times so
that the production may not be stopped on A/c of non-availability of materials.

(b) It is always advisable to carry a reserve or safety stock to prevent stock out (Shortage)

Min Level = Rol-(Avg rate of consumption x Avg Re-order period)

OR

Min Level= (Max rate of consumption-Avg rate of consumption) x Lead time

Lead time is the time interval between initiating an order & its receipts.

Re-Order Level

(a) It is the level at which if the material in store reaches further supplies must be ordered.
(b) The EOQ determines how much to buy at a particular time & ROL determines when to order.
(c) It is fixed some where between the max level & the min level.

- ROL = Max Re order period x Max Usuage.

Danger Level

It is the level of stock below which the material stock should never be allowed fall in normal
circumstances. It is slightly less than the minimum level. Sometimes the danger level is detrained
between ROL & Min level.

Avg Stock Level

The level indicates the average stock held by the concern avg stock level = Max Level + Min Level/2
Avg stock level = Min Level + ROQ/2

Ques: The following information is available in respect of materials.

 Re-order quantity 1500 units
Re-order period 4 to 6 weeks
Max consumption 400 units/week
Normal consumption 300 units/week
Calculate
(1) ROL
(2) Minimum Level
(3) Maximum Level
(4) Avg Stock Level

(1) ROL=400x6=2400 units

(2) Minimum Level = 2400 – (300 *5) = 2400-(300x5) = 900 units
(3) Maximum Level = EOQ = EOQ + Minimum = 1500+900=2400 units
(4) Average Stock Level = 2400+900/2=1650

Ques- From the following information you are required to calculate maximum level minimum level
and Re-order level ordering level for material X & Material Y

X Y
Normal consumption per week 150 units 200
Re-ordering Quantity 900 1500
Maximum consumption per week 225 250
Minimum consumption per week 75 100
Reorder period in weeks 12 to 18 6 to 12

Ques: Prepare the stores ledger on the basis of FIFO Method & LIFO Method

Jan. 1:- Received 1000 units @ Rs.20 per unit

Jan. 10:- Received 260 units @ Rs.21 per unit
Jan. 20:- Issued 700 units
Feb 4: Received 400 units @ Rs.23 per unit
Feb 21: Received 300 units @ Rs.25 per unit
March 16: Issued 620 units
April 10: Issued 240 units
May 10: Received 500 units @ Rs.22 unit
May 23: Issued 380 units

Ques:- March – Opening Balance 500 units @ Rs.25

(1) March 3- Issued 70 units
(2) March 4- Issued 100 units
(3) March 10-Issued 80 units
(4) March 13-Received from vendor 200 units @ Rs.24.50
(5) March 14-Refund of surplus from a work out 15 units @ Rs.24
(6) March 16- Issued 180 units
(7) March 20-Received from ventor 240 units @ Rs.24.37
(8) March 24- Issued 304 units
(9) March 25- Received from vendor 320 units @ Rs.24.31
(10)March 26-Issued 112 units
(11) March 27- Refund of surplus from a work order 12 units @ 24.50
(12) March 28-Received from vendor 100 units @ Rs.25
(13) March 29- Return to vendor 50 units

The store verifier of the factory noted that on 15th he had found a shortage of 5 units & on adjustment
done first 27th another shortage of 8 units. Prepare shores ledger on the basis of LIFO method.

Ques: (1) 1 Jan.-Received 40 units @ Rs.15

(2) 8 Jan.-Received 20 units @ Rs.16.50
 (3) 13 Jan.-Issued 30 units
(4) 17 Jan-Received 50 units @ Rs.17.10
(5) 23 Jan- Issued 20 units
(6) 31 Jan- Issued 40 units. FIFO, LIFO, Simple & Weighted Avg.

Ques. The following information is available in respect of material of No.30:

Re-order quantity = 1,500 units
Re-order period = 4 to 6 weeks
Maximum consumption = 400 units per week
Normal consumption = 300 units per week
Minimum consumption = 250 units per week

Calculate:

(a) Re-order levels;

(b) Minimum level;
(c) Maximum level; and
(d) Average Stock level
[Ans (a) 2,400 units; (b) 900 units; (c) 2,900 units; (d) 1,900 units]

Ques. In manufacturing its product, Z a company uses two types of raw materials A and B in respect of
which the following information is supplied: One unit of Z requires 10 kg of A and 4 kg of B materials.
Price per kg of material is Rs.10 and that of B is Rs.20. reorder quantities of A and B materials are 10,000
kg and 5,000 kg. Reorder level of A and B materials are 8,000 kg and 4,750 kg respectively. Weekly
production varies from 175 units to 225 units averaging 200 units. Delivery period of A materials is 1 to 3
weeks and B materials is 3 to 5 weeks.

Compute: (i) Minimum Stock Level of A

(ii) Maximum Stock Level of B

Ques. Medical Aids Co. manufactures a special product “A” The following particulars were collected for
the year 1991:

(a) Monthly demand of A 1,000 units

(b) Cost of placing an order Rs.100
(c) Annual carrying cost per unit Rs.15
(d) Normal usage 50 units per week
(e) Minimum usage 25 units per week
(f) Maximum usage 75 units per week
(g) Re-order period 4 to 6 weeks
Compute from the above:
(1) Re-order Quantity; (2) Re-order level; (3) Minimum Level; (4) Maximum Level; (5) Average Stock
Level.

Ques. Pumpkin Pump C. uses about 75,000 values per year and the usage is fairly constant at 6,250 values
per month. The values cost Rs.1.50 per unit when bought in quantities and the carrying cost is estimated to
be 20% of average inventory investment on the annual basis. The cost to place an order and process the
delivery is Rs.18. It takes 45 days to received delivery from the date of an order and a safety stock of 3,200
values is desired.

You are required to determine:

(i) the most economical order quantity and frequency of orders;
(ii) the order point; and
(iii) discuss the problems that most firms would have in attempting to apply the economic order quantity
(EOQ) formula to their inventory problems.
 LABOUR COST CONTROL
The second Major element of cost in most of the manufacturing undertakings is labour
cost. Proper accounting and control of labour cost, therefore, constitutes one of the most important
problem is complicated by the human element. This is so because labour consists of a lot of
different individuals, each with a different mental and physical capacity and each with a different
personality.

Proper control over labour cost involves the following:

1. Appropriate systems for recruitment and selection, training and placement of workers.
2. Satisfactory methods of labour remuneration.
3. Healthy working conditions consistent with legal requirements and competitive
undertaking.
4. Method of assuring efficient labour performance.

Direct and Indirect Labour Costs: For the purpose of accounting, labour costs are classified
into (i) Direct Labour cost and (ii) Indirect Labour cost.

Direct Labour Cost: The labour cost incurred on the employees who are engaged directly in
making the product, their work can be identified clearly in the process of converting the raw
materials into finished product is called direct labour cost. For example, wages paid to the workers
engaged in machining department, fabrication department, assembling department etc.

Indirect Labour Cost: The indirect employees are not directly associated with the conversion
process but assist in the process by way of supervision maintenance, transportation of materials,
material handling etc. Their work benefits all the items being produced and cannot be specifically
indentified with the individual products. Hence, the indirect labour cost should be treated as
production overhead. These costs will be accumulated and apportioned to different cost centres on
equitable basis and absorbed into product cost by applying the overhead absorption rates.

Items of Labour Cost:

The labour cost can be analysed into the following:

• Monetary benefits payable immediately
• Salaries and Wages, Dearness and other allowances, production incentive or bonus.
Employer’s contribution to P.F., E.S. I, Pension, Gratuity, Profit linked bonus, etc.
• Non-monetary benefits (Fringe benefits)
Free or subsidised food, free medical or hospital facilities, free or subsidised education to
the employees children, free or subsidised housing etc.

Job Evaluation: Job evaluation is the technique of analysis and assessment of jobs to determine
their relative value within the firm so that a fair wage and salary structure can be established for
the various job positions. In other words, job evaluation aims at providing a rational and equitable
basis for differential salaries and wages for different classes of workers. Following are the
objectives (or benefits) of job evaluation:

1. It aims at developing a systematic and rational wage structure as well as job structure.
2. It aims at establishing consistency between the wage and salary adopted with the firm and that
of other firms with in the industry or geographical area.

3. Controversies and disputes relating to salary between the employers and employees can be
settled by designing job evaluation techniques within the firm which can satisfy employers both.

4. Stability and fairness in the wages and salary structure are very useful for the administration
which can formulate business policies and plans as workers cooperation is fully ensured.

Methods of Job Evaluation:

Point Ranking Method: This method analyses each job in terms of job factors. Job factors may
consist of elements like skill, effort, working conditions, hazards, responsibility. However,
different job factors may emerge in different jobs. After specifying job factors, each of them is
assigned weightage or points depending its value for the job. For example, in a particular job,
education may be given the higher point as compared to supervision, if the job requires a high
degree of education. Finally, the jobs are ranked in the order of points or weights secured by them.
Grades are further developed for these different weightages so-that wages rates or wage structure
can be suitably designed for them. For example, the following wage scales can be worked out
depending on the weights grade. This method is theoretically sound and objective, but it is difficult
to operate.

Weights Grade Salary Scale (Rs)

201-250 I 4000-5000
251-300 II 5000-6000
301-350 III 6000-7000
351-400 IV 7000-8000
401-500 V 10000-12000

Ranking Method: Under this method different jobs in an organisation are rearranged in an order
which can be done either from the lowest to the highest or in the reverse. Before doing ordering of
jobs, all jobs should be properly studied in terms of job requirements, worker’s qualification,
responsibilities, working conditions, etc. Finally, wage scales are determined in terms of ranks.

This method is very simple to operate, less costly and easy to understand. However, this method
may be useful for small organisations Only, where are few arid well defined: But in a large
organisation where jobs are complex and highly involved, this method cannot be beneficial.

Grading Method: Under this method, a hypothetical scale or standard of job values is determined
and each job after being analysed in terms of a predetermined grade, is given a grade or class.
Predetermined grades or yardsticks are formulated after examining existing jobs in the enterprise.
The grades or the class should be established after making an investigation of job factors, such as
complexity in the job, supervision, responsibility, education etc.

This method is simple, less costly and administratively feasible. It attempts at applying a
rational basis for grading jobs.

Merit Rating: Merit rating is the comparative evaluation and analysis of the individual merits
of the employees. It analyses the differences in performance between employees who are working
on similar jobs and would therefore earn the same wages. In this task, merit rating accomplishes
more than job evaluation. Merit rating has the following objectives:
 a) To evaluate the merit of an employee for the purpose of promotion, increment, reward and
other benefits.
b) To establish and develop a wage system and incentive scheme.
c) To analyse the merits (or demerits) of a worker and help him in developing his capability
and competence for the job.
The characteristics and factors that are considered in merit appraisal of the workers includes:
cooperation, quality of work done, attendance and regularity, education skill, experience, and
character and integrity.

Merit rating has the following drawbacks:

1. The rating of employees maybe subjective and this creates dissatisfaction among them.
2. Evaluators or raters tend to give much premium to past ratings of an employee who might
have improved himself in the course of time.
3. Rates may be influenced by raters own attitudes and self-made rating factors which are not
consistent with the merit rating process.

Job Evaluation Vs Merit Rating:

Job evaluation and merit rating differ on the following counts:

1. Job evaluation is the assessment of the relative worth of jobs within a business enterprise
and merit rating is the assessment of the relative worth of an employee with respect to a
job. Another words, job evaluation rates the jobs, but merit rating rates employees on their
jobs.
2. Job evaluation helps in establishing a rational wage and salary structure. But merit rating
helps in, fixing fair wages for each worker in terms of his competence and performance.
3. Job evaluation brings uniformity in wage and salary rates. But merit rating aims at
providing a fair rate, of pay for different workers on the basis of their performance.

Idle Time

It is that time for which the employer pays, but from which he obtains no production or output. It
is of two types:-

(i) Normal Idletime:- This represents the time, the wastage of which cannot be avoided &
therefore the employer must bear the labour cost of this time. But every effort should be mode to
reduce it to the lowest possible level. Examples-
• Going from the factory gate to the deptt in which the worker is to work.

• Time taken in picking up the work.

• Gap between completion of one job & commencement of next job.
• Tea breaks, etc.
• Machine Maintenance
• Waiting for job, instructions, prints materials etc which are normal to production.

(ii) Abnormal Idletime:

It is that time, the wastage of which can be avoided if proper precautions are taken.
Examples-
• Breakdown of machinery on account of the inefficiency of works engineer.
 • Failure of the power supply
• Shortage of materials on account of inefficiency of store keeper or the purchasing deptt.
• Un-necessary waiting for instructions, tools & R.M. etc.
• Strikes & Lockouts in the factory.

Remuneration Methods:

The important labour remuneration methods are discussed below:

Flat Time rate method: Under this system the worker is paid on hourly, daily or weekly wage
rate and his remuneration is based on the time spent for production and wages are calculated as
follows.

Wages = Hours worked x Hourly wage rate

For example, if the hourly rate is Rs.12 and worker has worked 42 hours in a week, his weekly
wage are:

40 hours x Rs. 12 per hour = Rs.480

In an organisation where quality is given priority or if it is difficult to measure the production on

time basis, this method is more appropriate. But this will not give consideration to hard, sincere
and skilful work.

High day rate system: Under thus method, employees are paid a highly hourly wage rate than the
rate paid at different organisations in the industry or region expecting that the workers will work
more efficiently. To implement this method, the efficient, skilled and, experienced workers are
selected expecting an efficient and hard work from them in expectation of that the organisation
will pay wages at higher rates than prevailing in the industry.

For example, the normal wage rate prevailing in the other similar companies is Rs.12 per hour, X
Ltd. has adopted high day rate of Rs.15 per hour. A worker who worked for 40 hours in a week
will be paid as under:

Wages = 40 hours x Rs 15 = Rs.600

The supervision cost will reduce under this method and there will be reduction in overall labour
cost per unit. The main draw back is that there is no guarantee that high day rate system will act
as an incentive. The high wages may become the accepted level of pay for normal working and
supervision may be necessary to ensure increased productivity and units cost would rise. Another
disadvantage is that the worker will get only fixed hourly rate for their effort and it will not act as
an individual incentive for extracting efficient and more output from him.

Sometimes, this wage plans is used as an incentive to achieve present targets and problem arises
if the anticipated production targets are not achieved.

Measured Day work (Guaranteed): Under this method, the employee is assured of agreed level
of wages for the specified level of performance. The wage rates consists of two components. The
first component is of fixed nature depending on the time spent the wages are paid and the other
part is variable in nature linked to merit rating and cost of living. The main disadvantage in this
method is that it is more complicated in computation of wages and it is not popular.
Different Time rates: Under this method, different time rates are fixed for different efficiencies
and skills. Normal wages are paid upto the level of standard efficiency and increase in efficiency,
will be paid at graduated scale of payment. This method of wage payment is also not popular due
to its complication in calculations.

Straight piece rate method: Under this method, a fixed wage rate is paid for each unit of
production, job completed or number of operations completed irrespective of the time spent on it.
The wages are calculated as follows:

Wages No of pieces produced x Rate per piece

This method is used where the production is repetitive in nature and it cannot be applied to the
work which require skill and artistic work. The workers pays depends upon his output and not
upon the time he spends in the factory. The supervision cost is reduced as workers are paid
depending on their actual units produced. This method will act as an incentive to efficient works
and act as disincentive to inefficient workers.

The main disadvantage is that the productions may need to be thoroughly inspected for its quality.
The stoppage of work due to adnormal causes like machine break down, power failure, shortage
of power etc. may cause the workers to loose this wages and they feel insecure under this method
of wage payment. The spoilage, defectives and wastage of materials is more, if this wage plan is
adopted, due to reckless use to achieve higher output.

Different piece rate method: Under this method, an incentive is offered to workers to increase
their output by paying higher rates for increased levels of production.

For example:
Production Units Rate Per Unit (Rs)
Upto 40 2.00
41 to 60 2.50
61 to 80 3.00
Above 80 3.50

Under the straight piece rate system, the time factor is not taken into consideration but under
differential piece rate plan, a series of production targets will be established and as each target is
reached a new piece work rate will apply.

In this plan the fast doing skilled workers can able to reach higher levels of targets and will be
compensated at higher Piece rates. The extra rates of pay can act as an inducement to the employee
to aim for higher productivity to increase their earnings by putting more efforts. Differential piece
work plan is normally accompanied by the guaranteed day rates.

Halsey Premium Bonus Plan: Under this method, for each unit or Job a standard time is
calculated and 50% of the time saved is allowed as bonus. The time rate paid for the time taken
plus 50% of the time saved, if the job is completed in less than the standard time, and time rate is
guaranteed. The total wages of a worker is calculated as follows:

Total Wages: (Time taken x Hourly rate) + [Time saved x Hourly rate)]

Illustration:
A worker X is allowed 60 hours time for completion of the job and the hourly rate is Rs.4.The
actual time taken by the worker is 40 hours. Calculate the wages of worker A. under Halsey Plan.

Time saved = Time allowed – Time taken

= 60 hours – 40 hours = 20 hours
Total Wages = (40hrs x Rs.4) + [50/100 (20hrs x Rs.4)
= Rs.160 + Rs.40 = Rs.200

Rowan Premium Bonus Plan: Under this method, a standard time is calculated for every job or
process and a bonus is paid upon the time saved calculated as a proportion of the time taken in
which the time saved bears to the time allowed. In contrast of Halsey Plan, instead of fixed
percentage of time saved, bonus is paid in the proportion of time saved to time allowed.

The total wages calculated under Rowan plan are as follows:

=(Time taken x Hourly rate) + [Time saved/Standard time x Hourly rate]

Illustration:

In continuation of the illustration given under Halsey Plan, calculate the total wages of Worker X
under Rowan Plan.

Total wages
=(40 hrs x Rs.4) + [20hrs/60hrsx40hrs x Rs.4]
=Rs.160 +Rs.53.33
= Rs.213.33

Comparison of Halsey and Rowan Plan:

• Where the worker completes his work within half the time allowed; the bonus under both
the plans will be same.
• If time saved is less than 50% of standard time, the Rowan plans is beneficial for the
worker.
• If time saved is more than 50% of the standard time, the Halsey Plan is advantageous to
the worker.

Requisites of good wage incentive Plan:

For design and introduction of good wage incentive plan the following points are considered:

• It should be simple to Understand by the workers and should enable themselves to calculate
their earnings.
• It should be simple to administer and reduce clerical work.
• It should be capable of using computers for increase in speed of calculations.
• It should be introduced only after full consultation and agreement with the workers and
unions.
• It should act as a motivational scheme.
• It should guarantee the minimum day wages.
• It should cover as many employees as possible.
• The incentive should be paid as quickly as possible after the completion of the work.
• The incentives should relate to the efforts and efficiency of the workers.
 • The standards of work should be set after scientific study of work and the performance
levels should be fair to reach.
• It should conform to labour laws and regulations of the land.
• It should minimise labour turnover absenteeism.

Ques- Calculate the amount of BONUS under Halsey Premium Bonus plan & Rowan premium
bonus plans for the workers A,B, & C Standard time allowed=10 hrs Hourly Wages=Rs.50 Time
taken by A:5 hrs B; 6 hrs C;4 hrs

Ans. Worker A
(i) Halsey
(5x50) + ½ (5x50)
250+1/2(250)
250+125=375

(ii) Rowan Method

(5x50)+5/10x5x50
250+125=375

Worker B
(i) Halsey
(6x50)+1/2(4x50)
300+1/2(200)
300+100=400

(ii) Rowan Method

(6x50)+4/10x6x50
300+120=Rs.420

Worker C
(i) Halsey
(4x50)+1/2(6x50)
200+1/2(300)
200+150=350

(ii) Rowan
(4x50)+6/10x4x50=200+120=320

If he saves 50% time: wages are same.

If he saves less than 50%: Rowan Plan is beneficial.
If he saves more than 50%: Halsey plan is best for him.

Labour Turnover:-
• Some workers leave the employment and new workers join in place of those leaving. This
change in work force is known as Labour Turnover.
• It is the movement of people into & out of the organisation.
• It is the rate of change in the no of employees of a concern during a definite period.
• It is helpful in manpower planning.
 • A high index of labour turnover rate is a warning to management that something is wrong
with the health of the organisation. It may mean poor personnel policies, poor supervisory
practices or poor company policies.
• Too lower a rate of turnover can also be a danger signal

Causes of Labour Turnover:-

Avoidable Causes:-
(1) Dissatisfaction with wages and rewards.
(2) Dissatisfaction with working conditions.
(3) Dissatisfaction with personnel policies.
(4) Lock of transport accommodation, medical & other facilities
(5) Dissatisfaction with working hours, overtime etc.
(6) Bad relations with co-workers and supervisors
(7) Dissatisfaction with the Job.

Unavoidable Causes:-
(1) Personal Betterment
(2) Family circumstances
(3) Climatic conditions
(4) Community conditions
(5) Health conditions
(6) Marriage (in case of women)
(7) Retirement & Death
(8) Migratory nature of workers
(9) Dismissal or discharge due to incompetence, inefficiency, indifferent attitude towards
work.
(10) Redundancy due to seasonal changes.
(11) Illness or accident.

Measures to reduce labour Turnover:-

(1) Devising a suitable & satisfactory wage policy.
(2) Providing working conditions conductive to health & efficiency.
(3) Impartial & sympathetic attitude of personnel management.
(4) Encouraging labour participation in management.
(5) Strengthening the welfare measures
(6) Providing better career opportunities.
(7) Extending opportunities for training.

Measurement of Labour Turnover:-

(1) Separation Method:-
It takes into account only those workers who have left during a particular period.
L.T. Rate= 100xNo of works left during a period/Average no of works during a period.
(Both are included: those who left on their own and those who are discharged by company.)

(2) Replacement Method:-

This method takes into account only those workers who are new & who have joined in place of
those who have left.
L.T. Rate=No of workers replaced during period/Avg No of workers during period x 100

(3) Flux Method:-

This method shows the total change in the composition of labour force due to separation &
additions of workers.
L.T. Rate=No of workers left + No of workers replaced /Avg no of workers x 100

Ques- From the following particulars, calculate labour turnover under all the three methods-total
no of employees recruited during Jan 50
No of employees left + during Jan 40
st
Total No of employees on 31 Jan 1990

Ans. Avg No of workers=2010+1990/2=2000

(1) L.T Rate by separation method=40/2000x100=2%

(2) L.T Rate by replacement=50/2000x100=2.5%
(3) Flux Method=40+50/2000x100=4.5%

Ques- No of workers on 1st April 950

th
No of workers on 30 April 1050
No of workers discharged in April 10
No of workers engaged in April 140
(Including 120 on account of expansion scheme). Calculate L.T Rate

Ans. Avg No of workers=1050+950/2=1000

(1) Seperation Method = 100 x (10+30)/1000=4%

(2) Replacement method=20/1000x100=2%
(3) Flux Method=40+20/1000x100=6%

Practical Questions
1. A job can be done in 15 minutes by an average worker. Give three different methods of payment
by results and show the cost per article for each method if job is done in 10 minutes (Assuming
basic time-rate of Rs.3 per hour).
[Ans.(i) Halsey Premium Plan-Rs.0.625(ii) Rowan Premium Plan-Re.0.667; (iii) Piece Rate
Method-Re.0.75]

2.From the following particulars, you are required to work out the earnings of a worker under: (a)
Halsey Premium Plan (50% Bonus) (b) Rowan Plan. Weekly hours-48 hours, Hourly Wage Rate-
Rs.7.50 Piece rate per unit-Rs.3.00 Normal time taken per piece-20 minutes Normal output per
week-120 pieces Actual output for the week-150 pieces.

3. Three workers Ganesh, Om Narayan and Shri Ram produced 80,100 and 120 pieces of a product
X on a particular day in May 2001 in a factory. The time allowed for 10 units of product X is one
hour and their hourly rate is Rs.4. Calculate for each of these three workers the followings:
(1) Earnings for the day, and (2) Effective rate of earning per hour;
(a) Straight piece rate;
(b) Halsey Premium Plan (50% sharing)
(c) Rowan Premium Bonus methods of labour remuneration.
[Ans. (1) Ganesh Rs.32(2) Om Narayan Rs.40 (3) Shri Ram Rs.48; (2) (a) Genesh=Rs.4; Om
Narayan Rs.4; Shri Ram Rs.4; (b) Ganesh=Rs.4; Om Narayan Rs.4.50; Shri Ram Rs.5.00; (c)
Ganesh = Rs.4; Om Narayan Rs.4.80; Shri Ram Rs.5.33]

4. The following information is available from the records of M/s A.K.& Sons for the month of
March:
Number of employees at the beginning of the month 1900
Number of employees at the end of the month 2100
Number of employees resigned 20
Number of employees discharged 60
Number of replaced in the vacancies 40
Number of employees appointed due to expansion scheme 240
Calculate the labour turnover rate and equivalent annual rate under different methods.
[Ans. (a) Separation method: 48.67% (b) Replacement method: 24.33% (c) Flux method:73%

5. What earnings will a worker received under Halsey Plan and Rowan Plan if the executes piece
of work in 300 hours as against 375 hours allowed? His hourly rate is Rs.10 and he is paid 50% of
the time saved under Halsey Plan. He gets a dearness allowance of Rs.40 per day of 8 hours worked
in addition to his wages. [Ans. (i) Rowan Plan=5,100 (ii) Halsey Plan=4,875]

6. The following are the particulars given to you: Standard Time:10 hours; Time rate Rs.3 per
hour. Prepare a comparative table under Halsey Plan and Rowan Plan if time taken is 9 hours, 8
hours, 6 hours, 4 hours, and 3 hours. The table should clearly show the amount of bonus payable,
the amount of total wages and labour cost per hour under the two methods. State at least one point
of distinction between Halsey Plan and Rowan Plan in the light of your calculations.
[Ans. Halsey Plan is beneficial if worker saves more than 50% of time. Rowan Plan is beneficial
if worker saves less than 50% of time]

7. A worker under the Halsey method of remuneration has a day rate of Rs.12 per weeks of 48
hours, plus a cost of living bonus of 10 paise per hour worked. He is given an 8 hour task to
perform, which he accomplishes in 6 hours. He allowed 30% of the time saved as premium bonus.
What would be his total hourly rate of earnings, and what difference would it make if he was paid
under the Rowan method?

8. From the following particulars you are required to work out the earnings of a worker for a week
under (a) Straight piece-rate, (b) Halsey premium scheme (50% sharing), and (c) Rowan premium
scheme.

Weekly working hours 48 Normal output per week 120 pieces

Hourly wage rate Rs.7.50 Actual output for the week 150 pieces
Piece rate per unit Rs.3.00
Normal time taken per piece 20 minutes

Overheads Cost Control

INTRODUCTION TO OVERHEADS:
Overheads are the indirect costs which cannot be allocated to any specific job or process
because they are not capable of being identified with any specific job or process. Overheads
include cost of indirect material, indirect labour, indirect expenses which cannot be conveniently
charged to any Job, Process, Cost unit etc. For example, costs like rent, rates, administration and
supervision, depreciation, maintenance, selling and distribution expenses, cleaning materials etc.
cannot be directly attributed to cost units produced. The costing treatment of overheads deals with
methods whereby these indirect expenses can be related to cost units.
CIMA defines Overheads Cost as “the total cost of indirect materials, indirect labour and
indirect expenses.”
 Overheads is the cost of materials, labour and expenses which cannot be economically
unidentified with specific saleable cost unit.
The direct expenses refers to expenses that are specifically incurred and charged for
specific or particular job, process, service, cost unit or cost centre. These expenses are also called
chargeable expenses. The sum of direct material, direct labour and direct expenses is called price
cost. Sometimes, if the direct expenses are negligible or small amount, it will be treated as
overhead.
Distinction between Direct Expenses and Overhead: Direct expenses are directly
allocable to a job, process, service, cost unit or cost centre. It is not possible to allocate the
overheads to jobs etc. and only through apportionment and absorption, it can be charged to
different jobs, process, services, cost units or cost centres.
An expense is whether a direct expense or overhead depend on the extent of
departmentalisation and specific circumstances of a particular expense.

For example, a machine is hired for general purpose, the hire charges are treated as
overhead. But if that machine is hired or used for specific job, then the hire charges will be direct
charge to that particular job.
Another example is that, power consumption is normally treated as direct expense if it is
consumed for single plant or machinery. But if number of machines consume the power, then
power will be treated as overhead and will be apportioned to the different machine centers opn
some equitable basis, which have used power.

CLASSIFICATION OF OVERHEADS COSTS:

Overhead costs may be classified according to:
(a) Functions
(b) Element or Nature, and
(c) Behaviour.

(a) Classification According to Functions: The main groups of overheads on the basis of this
classification are:

(a) Production overhead,

(b) Administration overhead,
(c) Selling overheads
(d) Distribution overhead

Production Overhead: Also termed as factory overhead, works overhead or manufacturing

overhead, if means indirect expenditure incurred in connection with production operations. It is
the aggregate of factory indirect material cost, indirect wages and indirect expenses. Unlike direct
materials and direct labour, production overhead is an invisible part of the finished product.
Example of these costs are: lubricants, consumable stores, indirect wages, factory power and light,
depreciation of plant and machinery.

Administration overhead: This consists of all expenses incurred in the direction, control and
administration (including secretarial, accounting and financial control) of an undertaking which is
not related directly to production, selling and distribution function. Examples are: general
management salaries audit fees, legal charges, Postage and telephone, stationary and printing,
office rent and rates, office lighting, and salaries of office staff etc.
Selling overhead: These are the cost of seeking to create and simulate demand or scoring orders.
Examples are advertising, salaries and commission of sales personnel, showroom expenses,
travelling expenses, bad debts, catalogues and price lists etc.

Distribution overhead: It comprises all expenditure incurred from the time product is completed
in the factory until it reaches its destination or customer. It includes packing cost, carriage outward,
delivery can costs, warehousing costs, etc.

Both selling and distribution costs are incurred after the production work is over and thus taken
together, these are known as “After Production Costs’.

(b) Classification According to Elements: The main classes under this head are: indirect
materials, indirect wages, and indirect expenses. The readers should refer to lesson two for
meaning and examples of these classes of overhead.

(c) Classification According to Behaviour: Different overhead costs behave in different ways
when volume of production changes. On the basis of behavior, overheads may be classified into:
(a) Fixed overhead, (b) Variable overhead, and (c) Semi-fixed or semi variable overhead.

Fixed overhead: These overheads remains unaffected or fixed in total amount by fluctuations in
volume of output. Examples are rennet and rates managerial salaries, building depreciation,
postage, stationery, legal expenses etc.

Variable overhead: This is the cost which, in aggregate, teds to vary in direct proportion to
changes in the volume of output. Variable overhead per unit remain fixed. Examples are indirect
materials, indirect labour, ‘salesmen’s commission, power, light, fuel, etc.

Semi- variable overhead: This overhead is partly fixed and partly variable. In other words, such
costs vary in part with the volume of production and in part they are constant, whatever be the
volume of production. Examples: supervisory salaries, depreciation, repairs and maintenance, etc.

FACTORY OVERHEADS
These are costs which have been incurred in connection with production of a manufactured
commodity before it has come out of the workshop. They are also termed as Factory On cost,
Factory Burden, Factory Loading etc. They consist of:

(a) Indirect material

(i) Cost of consumable stores such as cotton waste, lubricating oil, brushes for sweeping etc.
(ii) Cost of stationery used in the works.

(b) Indirect Labour

(i) Salary paid to the Works Manager and other principal officers of the factory including fees
payable to the directors devoting attention to factory problems.
(ii) Pay for holiday and sick leave.
(iii) Salaries of store-keepers
(iv) Contribution of any social security schemes such as to the Employee’s State Insurance
Corporation.
(v) Contribution to provident fund of factory employees
(vi) Salary paid to the supervisory as well as clerical staff of the factory.
(vii) Overtime wages.
(viii) Wages for normal idle time if not directly charged.
(c) Indirect Expenses
(i) Rent of factory buildings and land.
(ii) Insurance of factory buildings, plant and machinery and stocks of raw-materials.
(iii) Municipal taxes in respect of factory buildings.
(iv) Works’ canteen and welfare expenses.
(v) Experimental and research work; designing for production and drawing office expenses.
(vi) Power and Fuel
(vii) Stores expenses including work; designing for production and drawing office expenses.
(viii) Cost of training new employees.
(ix) Lighting and heating charges of the factory.
(x) Carriage inward on materials purchased, if such carriage has not been included in the cost of
materials.
(xi) Works’ telephone expenses.

OFFICE AND ADMINISTRATIVE OVERHEADS

They represent “the cost of formulating the policy, directing the organisation and controlling the
operations of an undertaking, which is not related directly to a research, development, production,
distribution or selling activity or function.” These costs are of a general nature and are not directly
related to other functions namely production, sales and distribution. They generally comprise of
the following costs:

(a) Indirect Material

(i) Printing and stationery used in the office .
(ii) Cost of dusters, brushes etc for cleaning.

(b) Indirect Labour

(i) Salaries and allowances or fees of directors, chief executive and his staff, cost accountant and
financial accountant and their staff, secretary and his staff.
(ii) Salaries and allowances of legal adviser and his staff, public relations officer and his staff,
remuneration of both statutory and internal auditors.

(c) Indirect Expenses

(i) Office rent, rates and insurance.
(ii) Office lighting, heating and cleaning.
(iii) Depreciation and repairs of office buildings, furniture and fittings.
(iv) Legal charges
(v) Bank charges
(vi) Trade subscriptions
(vii) Sundry office expenses

SELLING AND DISTRIBUTION OVERHEADS

Selling Overheads constitute ”the cost incurred in promoting sales and retaining customers”, while
the distribution overheads constitute “ the cost of the process which begins with making the packed
product available for dispatch and ends with making the reconditioned returned empty packages
available for re-use.” Selling and distribution overheads, therefore, include the following:

Selling overheads
(a) Indirect material. This includes the cost of printing and stationery, mailing literatures,
catalogues, price lists etc.
 (b) Indirect labour. This includes the salaries, commission etc of salesmen, technical
representatives, sales manager etc.
(c) Indirect expenses. They include advertising, bad debts, rent of the showroom, insurance
of showroom, collection charges, travelling and entertainment expenses, expenses of
branch establishment, sales office expenses, fees of directors who pay attention to sales.

Distribution overheads
(a) Indirect material. This includes the cost of packing cases; oil, grease, spare parts used in
maintenance of delivery vehicles.
(b) Indirect labour.This includes wages of packers, van drivers, dispatch clerks etc.
(c) Indirect expenses. They include godown expenses including rent, insurance, freight,
carriage outwards and other transport charges, depreciation and running expenses of
delivery vans.

The distinction between selling expenses and distribution expenses is to be noted. Selling
expenses are incurred for promoting sales by convincing the customer to place an order with the
firm. Distribution expenses strictly begin when an order has been obtained and generally ends
when goods have been dispatched. In other words, distribution expenses are incurred in moving
the goods from the company’s godown to customer’s premises.

STAGES OF OVERHEADS-DISTRIBUTION
There are three stages involved in the distribution of overheads:

1. Collection and classification of overheads

After the overheads have been classified as factory, office and selling, it will be advisable
to group items covered by each category under suitable account headings. For example,
depreciation may relate to factory buildings, factory, plant, factory furniture, etc. It will be
appropriate to group all items of depreciation relating to factory assets at one place under a
common heading ‘Depreciation’ with suitable sub-headings. The grouping of like items with the
like is necessary to collect overhead items in a convenient and expeditious manner. The guiding
principle in selecting such headings must be that the headings are clear and unambiguous so that
these may not be confused with each other. Usually, a code number is allotted to each heading of
expense.
It may be defined as allotment of codes to individual heads of expense is termed as
codification of overheads a technique of short description of a particular head, which is otherwise
lengthy. It also ensures secrecy and ease in classification, accounting and control. Codes are
particularly useful under computerized system of accounting. Codification may be done according
to anyone of the following methods.

(i) Numerical method. According to this method numbers are allotted to each heading and
sub-heading of expense.
Example:
Item Code Number
Depreciation
Plant 11
Furniture 12
Building 13
Repairs
 Plant 21
Furniture 22
Building 23

Thus, the first digit of the code number stands for the main expenditure and the subsequent digit
for its sub-division.

(ii) Alphabetical or mnemoric method. According to this method, the alphabets are used for
identifying the expenses of cost centres. For example:

AE-Administrative Expenses
RE-Repairs
MC-Maintenance Cost
AC-Assembly Cost
CE-Canteen Expenses

(iii) Alphabetical cum numerical Method. According to this method the alphabet denotes the
main expenditure while the numerical denotes its sub-division.

Example
Item Code Number
Depreciation Plant D1
Depreciation of Furniture D2
Depreciation of Building D3

Code numbers given to different items of overheads are listed in a schedule or manual for ready
reference. No standard list of these code numbers can be suggested since the number and types
under which the overheads may be grouped depend upon the size of the factory, the nature of
industry and the degree of control required.

Entries in the card are made periodically from purchases journal, stores requisitions, petty cash
book, wages analysis book etc. For example, consumable stores is an item of factory overhead. If
the stores have been purchased and supplied directly to the factory, the information will be there
in the Purchases Journal. In case stores were first received by the storekeeper and then issued, the
information can be obtained from the stores requisitions. The details regarding the source of
information are entered in the reference column.

2. Departmentalisation of overheads

After collecting and classifying overheads under suitable account headings the next step
involved overhead distribution is the departmentalisation of these overheads to different cost
centers on a suitable basis. This involves two stages:

Allocation of overheads. Allocation is the process of charging the full amount of overhead
costs to a particular cost centre. This is possible when the nature of expenses is such that it can be
easily identified with a particular cost centre. For example, the salary paid to a foreman of a
particular production department can be directly identified with that department and therefore it
will be directly charged to that department.

Apportionment of overheads. It is the process of splitting up an item of overhead cost

and charging it to the cost centes on an equitable basis. This is done in case of those overhead
items which cannot be wholly allocated to a particular department. For example, the salary paid to
the works manager of the factory cannot be charged wholly to a particular production department
but will have to be charged to all departments of the factory on an equitable basis.
The following table will help the students in remembering the conventional basis of apportionment
of overheads:

Overhead Basis of apportionment

1. Factory Rent 1. According to the floor area
[Depreciation of Factory occupied or capital value of the asset.
Building (if owned) Insurance of
Buildings.
2. Heating and Lighting 2. Number of light points or floor
area occupied, hours used or watts if
separate meters are available.
3.Depreciation and Insurance of 3. Value of Machinery
Machinery
4. Electric Power 4. Horse Power of machines or
machine hours
5. Supervision 5. Number of workmen or amount of
wages paid or floor area
6. Stores overhead 6. Value of direct materials
7. Material handling charges 7. Weight of materials of each
department subject to any special
factor affecting handling costs

3. Absorption of overheads

The term absorption refers to charging of overheads of a cost centre to different cost units in such
a way that each cost unit bears an appropriate portion of its share of overheads. This is done by
means of overhead rates. The term ‘Overhead Rate’ refers to the rate at which the overheads are
to be charged to different cost units. It may be in the form of a percentage or a rate per unit. For
instance, if the overheads of a department are Rs.10,000, the total wages paid for different jobs
completed in the department are Rs.40,000 and the overheads are to be charged as a percentage of
wages to different jobs, the overhead rate will be 25% of wages. The share of overheads of each
job completed in the department will now be calculated on this basis.

Different overhead rates are used for absorption of different categories of overheads. However, the
following factors should be taken into account for determining the rate of overheads absorption:

(i) Adequacy. The rate should be such as would not give rise to large difference between the
amount of recovered overheads and actual overheads, otherwise the cost of jobs or products
determined on such basis would not be correct.

(ii) Convenience. The computation of overhead rates should not require unnecessary clerical
labour. For example, the apportionment of works manager’s salary according to time spent by him
on different jobs would not be of much use. It will be better to distribute it on the basis of wages
charged to different jobs since this basis is more convenient, thought not more equitable, than the
former basis.

(iii) Time factor. Time factor should be given due consideration while determining overhead rate
in those cases where different jobs require different time for their completion. For example, the
overheads of a machine cost centre should be charged to different jobs on the basis of hours for
which the machine cost center has worked for each of them. It will be, therefore, appropriate to
charge overheads in such a case on an hourly rate method.

(iv) Skill factor. Different jobs require different degrees of skill. It will not therefore be
appropriate to charge all jobs with the same overheads rate. This factor should be taken care of
while determining the rate.

(v) Rational productivity factor. The overhead rate should also be related to the method of
production followed. For example, in a department where work is done mainly by machines, the
machine hour rate should be adopted as a rate for the recovery of overheads. While in a department
where work is done mostly by manual labour, the overhead should be absorbed on a labour hour
rate basis.

(vi) No frequent changes in overhead rates. The overheads should be charged on the same basis
from year to year. In case the basis is frequently changed, the costing results will not be
comparable.

Illustration:
Following figures have been extracted from the accounts of a manufacturing concern for the month
of December, 1994:
Rs.

Indirect Materials:
Production Deptt. X 950
Production Deptt. Y 1200
Production Deptt. Z 200
Maintenance Deptt P 1500
Stores Deptt Q 400

Indirect Wages:
Production Deptt. X 900
Production Deptt. Y 1100
Production Deptt. Z 300
Maintenance Deptt P 1000
Stores Deptt Q 650
Power and Light 6000
Rent and Rates 2800
Insurance on assets 1000
Meal Charges 3000
Depreciation @ 6% on capital value of assets.

From the following additional information, calculate the share of overheads of each Production
Department:

Item Production Deptts Services Deptt

X Y Z P Q
Area (Sq feet) 4000 4000 3000 2000 1000
Capital value of assets (Rs) 1,00,000 1,20,000 80,000 60,000 40,000
Kilowatt hours 4000 4400 1600 1500 500
Number of employees 90 120 30 40 20
 Direct labour hours 3600 3200 2200
Number of materials 900 600 500
requisitions

Solution:
DEAPRTMENTAL OVERHEADS DISTRIBUTION SUMMARY

Item Basis of apportionment Total Production Departments Service Departments

Indirect Material Allocation 4250 950 1200 200 1500 400
Indirect Labour Allocation 3950 900 1100 300 1000 650
Power and Light Kwh 6000 2000 2200 800 750 250
Depreciation
(for one month) Value of assets 2000 500 600 400 300 200
Insurance Value of assets 1000 250 300 200 150 100
Rent and Rates Sq. ft. 2800 800 800 600 400 200
Meal Charges No of employees 3000 900 1200 300 400 200
23,000 6300 7400 2800 4500 2000
Costs of Service Direct Labour
Deptt P Hours --- 1800 1600 1100 -4500
Costs of Service Number of material
Deptt Q Requisitions --- 900 600 500 -2000

Total Overheads 23,000 9,000 9,600 4,400 --- ---

Illustration:
In a light engineering factory, the following particulars have been collected for the three monthly
period ending 31st December, 1994. Compute the departmental overhead rates for each of the
production department assuming that overheads are recovered as a percentage of direct wages.

Item Production Deptts Services Deptt

A B C D E
Direct Wages Rs 2000 3000 4000 1000 2000
Direct Materials Rs 1000 2000 2000 1500 1500
Staff Nos 100 150 150 50 50
Electricity Kwh 4000 3000 2000 1000 1000
Light Points Nos 10 16 4 6 4
Assets Value Rs 60000 40000 30000 10000 10000
Area Occupied Sq. Yds 150 250 50 50 50

The expenses for the period were:

Rs
Motive Power 550
Lighting Power 100
Stores Overhead 400
Amenities to Staff 1500
Depreciation 15000
Repairs & Maintenance 3000
General Overheads 6000
Rent & Taxes 275

Apportion the expenses of service department E proportionate to direct wages and those of service
department D in the ratio of 5:3:2 to departments A,B, and C respectively.
Solution:
STATEMENT OF APPORTIONMENT OF OVERHEADS
Production Deptts Service Deptts Total
1. Direct Wages --- --- --- 1000 2000 3000
2. Direct Materials --- --- --- 1500 1500 3000
3. Motive Power @ 5 200 150 100 50 50 550
paise per kwh
4. Lighting Power @ 25 40 10 15 10 100
Rs.2.50 per point
5. Stores Overhead @ 50 100 100 75 75 400
5% of direct material
6. Amenities to Staff 300 450 450 150 150 1500
@ Rs.3 per employee
7. Depreciation @ 6000 4000 3000 1000 1000 15000
10% of the value
8. Repairs and 1200 800 600 200 200 3000
Maintenance @ 2%
of value
9. General Overheads 1000 1500 2000 500 1000 6000
@ 50% of direct
wages
10. Rent and taxes @ 75 125 25 25 25 275
0.50 per sq.yd
11. Service 8850 7165 6285 4515 6010 32825
Department D 2257 1355 903 -4515 --- ---
12. Service 1336 2003 2671 --- 6010
Department E
12443 10523 9859
* Rates of overhead absorption

Production Department A: 12,443/2000x100=622.15%

Production Department B: 10,523/3000x100=350.77%
Production Department C: 9,859/4000x100=246.47%

Re-apportionment of Service Department Costs to Production Departments

Service department costs are to be reapportioned to the production departments or the cost
centres where production is going on. This process of reapportionment of overhead expenses is
known as ‘Secondary Distribution’. The following is a list of the bases of apportionment which
may be accepted for the service departments noted against each:

Service Department Cost Basis of Apportionment

1. Maintenance department Hours worked for each department
2. payroll or time-keeping Total labour or machine hours or number of
employees in each department
3. employment or personnel department Rate of labour turnover or number of
employees in each department.
4. Store-keeping department No of requisitions or value of materials of each
department
 5. Purchase department No of purchase orders or value of materials for
each department
6. welfare, ambulance, canteen service, No of employees in each department
recreation room expenses
7. Building service department Relative area in each department
8. Internal transport service or overhead crane Weight, value graded product handled, weight
service and distance travelled.
9. Transport department Crane hours, truck hours, truck mileage, truck
tonnage, truck tonne-hours tonnage handled,
number of packages.
10. Power house (Electric power cost) Wattage horse power, horse power machine
hours, number of electric points etc.
11. Power house Floor area, cubic content

Methods of Re-apportionment (or Re-distribution)

The following chart depicts the methods of re-distribution of service department costs to
production departments:

Secondary Distribution of Overhead

Direct Re-distribution Step Distribution Method Reciprocal Services Method

Simultaneous Equation Method Repeated Distribution Method Trial and Error Method

(i) Direct Re-distribution Method. Under this method, the costs of service departments are
directly apportioned toe production departments without taking into consideration any service
from one service department to another service department. Thus, proper apportionment cannot be
done and the production departments may either be overcharged or undercharged. The share of
each service department cannot be ascertained accurately for control purposes. Budget for each
department cannot be prepared thoroughly. Therefore, Department Overhead rates cannot be
ascertained correctly.

ILLUSTRATION:
In a light engineering factory, the following particulars have been collected for the three months’
period ended on 31st March, 2004. You are required to re-apportion the service departments
expenses to production departments.

Production Departments Services Departments

Expenses as per Primary P1 P2 P3 S1 S2
Distribution Summary Rs. 8.850 Rs.7,165 Rs.6,285 Rs.4,515 Rs.6,010

Apportion the expenses of service department S2 in proportion of 3:3:4 and those of service
department S1 in the ratio of 3:1:1 to departments P1, P2 and P3 respectively.
Solution: PRODUCTION OVERHEADS DISTRIBUTION SUMMARY

Production Departments Services Departments

 P1 P2 P3 S1 S2
Rs Rs Rs Rs Rs
Total Expenses as per
Primary Distribution
Summary 8,850 7,165 6,285 4,515 6,010
Reapportionment of Dept. 1,803 2,404 (6,010)
1,803
S2 (3:3:4)
Reapportionment of Dept. 2,709 903 903 (4,515) ----
S1 (3:1:1) 13,362 9,871 9,592 ---
Total

(ii) Step Distribution Method. Under this method the cost of most serviceable department is first
apportioned to other service departments and production departments. The next service department
is taken up and its cost is apportioned and this process goes on till the cost of the last service
department is apportioned. Thus, the cost of last service department is apportioned only to the
production departments. The most important limitation of this method is that cost of one service
centre to other service cost centres is ignored and this the cost of individual cost centres are not
truly reflected.
(iii) Reciprocal Services Method. In order to avoid the limitation of Step Method, this method is
adopted. This method recognizes the fact that if a given department receives service from another
department, the department receiving such service should be charged. If two departments provide
service to each other, the department should be charged for the cost of services rendered by the
other. There are three methods available for dealing with inter-service departmental transfer:
(a) Simultaneous Equation Method, (b) repeated Distribution Method and (c) Trial and Error
Method.
ILLUSTRATION:
A Ltd has gen sets & produces its own power data for power costs are as follows:-

Horse Power Hours Production Service Department

Department
A B C D
Needed capacity 10,000 20,000 12,000 8,000
production

Used during the month 8,000 13,000 7,000 6,000

of May

During the month of May, costs for generating power amounted to Rs.9,300, of this Rs.2500 was
considered to be fixed cost. Service department C renders service to A,B,C & D in the rato of
13:6:1 while D renders services to A&B in the ratio of 31:3. Given that the direct labour hrs &
2,175 hrs respectively. Find the power cost per labour hours in each of these two departments.
Ans. O/H Distribution Summary

O/HS Basis of Total Production Department Service Department

Apportionment
A B C D
Fixed Cost H.P. Need 2500 500 1000 600 400
Variable Cost H.P.used 6800 1600 2600 1400 1200
 Total O/HS 9300 2100 3600 2000 1600
Cost & 1300 600 -2000 100
Service Deptt
Cost & 1550 150 --- 1700
Service Deptt
Total O/HS 9300 4950 4350 --- ---
Labour Hour 1650 2175
Work
Power cost 4950/1650 2:00
per Labour 3.00

(a) Simultaneous Equation Method. Under this method, the true cost of the service departments
ascertained first with the help of simultaneous equations; these are then redistributed to production
departments on the basis of given percentage. This method is preferable and is widely used even
if the number of service departments are more than two. Due to the availability of compute it is
not difficult to solve sets of simultaneous equations. The following illustration may be taken to
discuss the application of this method.
ILLUSTRATION

A company has three productions departments and two service departments, for a period the
departmental distribution summary has the following totals:
Rs.
Production Departments: P1-Rs.800; P2-Rs.700; P3-Rs.500; 2,000
Service Departments: S1-Rs.234 and S2-Rs.300 534
--------
2,534
The expenses of the service departments are charged out on a percentage basis as follows:

P1 P2 P3 S1 S2
Service Department S1 20% 40% 30% --- 10%
Service Department S2 40% 20% 20% 20% ---

Prepare a statement showing the apportionment of two service departments expenses to Production
Departments by Simultaneous Equation Method.

Solution:
Let x = Total overheads of department S1
y = Total overheads of department S2

Then,
X=Rs.234 + 2y and y=Rs.300 + 1x.
Rearranging and multiplying to eliminate decimals:
10x-2y=Rs.2340 (1)
-x+10y=Rs.3,000 (2)
Multiplying equation (1) by 5, and add result to (2), we get
49x=Rs.14700
x=Rs.300
Substituting this value in equation (1), we get
y=Rs.330
All that now remains to be done is to take these values x=300 and y=330 and apportion them on
the basis of the agreed percentage to the three production departments; thus:

Total P1 P2 P3
Per distribution summary Rs. Rs. Rs. Rs.
Service department S1 (90% 2000 800 700 500
of Rs.300) 270 60 120 90
Service department S2 (80% 264 132 66 66
of Rs.330) 2534 992 886 656

This method is recommended in more than two service departments if the data is processed with
computers and in two service departments only where the data is processed manually.

(b) Repeated Distribution Method. Under this method, the totals as shown in the departmental
distribution summary, are put out in a line, and then the service department totals are exhausted in
turn peatedly according to the agreed percentages until the figures become too small to matter.

By solving illustration 5 by Repeated Distribution Method, we get the Secondary Distribution

summary which is given as follows:

P1 P2 P3 S1 S2
As per summary Rs. Rs. Rs. Rs. Rs.
Service department S1 800 700 500 234 300
Service department S2 47 94 70 (234) 23
Service department S1 129 65 65 64 (323)
Service department S2 14 25 19 (64) 6
2 2 2 --- (6)
992 886 656 ---

(c) Trial and Error Method. Under this method, the cost of one service department is apportioned
to another centre. The cost of another centre plus the share received from the first centre is again
apportioned to the first cost centre and this process is repeated till the balancing the figure becomes
negligible.
By solving illustration 5 by Trial and Error Method, we get the following:

Service Departments
S1 S2
Original apportionment Rs Rs
234 300
(23) 23(10% of 234)
65(20% of 323) (323)
(65) 7(10% of 65)
1(20% of 7) (7)
300 330

BASIS FOR APPORTIONMENT OF DIFFERENT EXPENSES

Expenses Basis
 1. Rent and Rates According to the floor area occupied by each
machine including the surrounding space.
2. Heating and Lighting The number of points used plus cost of special
lighting or heating for any individual machine,
alternatively according to floor area occupied
by each machine.
3. Supervision Estimated time devoted by the supervisory
staff to each machine.
4. Lubricating Oil and Consumable Stores Capital values, machine hours, or past
experience
5. Insurance Insured value of each machine.
6. Miscellaneous expenses Equitable basis depending upon facts

Over & Under Absorption of O/HS

The predetermined rates are based on expected O/HS to be incurred.
Generally the O/HS absorbed into the product cost do not agree with the actual O/HS incurred for
the period.
If the O/HS absorbed are higher than the actual O/HS incurred it is called over absorption
If the O/HS absorbed is lower than the actual O/HS incurred during the accounting period, it is
called under absorption.

Reasons for Over & Under Absorption

The actual hours worked may be more or less than the estimated hours.
The actual O/H costs are different from budgeted O/HS
Both actual O/H costs & actual activity level are different from the budgeted costs & level.
The absorption level method used may not be correct.
Extra ordinary expenses might have been incurred.
Major changes might have taken place. For ex-replacement of manual labours with machines
increase in level of capacity etc.
Seasonal fluctuations in the overhead expenses from period to period.

PRACTICAL PROBLEMS

1. Kumaresh Ltd. has three production departments P1, P2, and P3, and two service departments S1,
and S2,. The following figures are extracted from the records of the company:

Rs
Rent and Rates 5000
Indirect Wages 1500
Depreciation of Machinery 10000
General Lighting 600
Power 1500
Sundries 10000

Following further details are available:

Total P1 P2 P3 S1 S2
Floor Space
(sq. meters) 10000 2000 2500 3000 2000 500
Light Points 60 10 15 20 10 5
Direct Wages (Rs) 10000 3000 2000 3000 1500 500
H.P. of Machines 150 60 30 50 10 ---
 Value of Machinery
(Rs) 250000 60000 80000 100000 5000 5000

Apportion the costs to various departments on the most equitable basis by preparing a Primary
Departmental Distribution Summary
Ans [P1-Rs.7550; P2-Rs.7200; P3-Rs.9650; S1-Rs.3125; S2-Rs.1075]

2. The following data were obtained from the books of Light Engineering Company for the half
year ended 31st March, 2002:

Item Production Department Office Stores Workshop Total

P1 P2 P3
Direct Wages 20,000 25,000 30,000 --- --- --- 75,000
Direct Material 30,000 35,000 45,000 --- --- --- 1,10,000
Indirect Material 2,000 3,000 3,000 1,000 2,000 2,000 13,000
Indirect Wages 3,000 3,000 4,000 10,000 10,000 5,000 35,000
Area in Square Ft 200 250 300 150 100 250 1,250
Book Value of
Machinery Rs 30,000 35,000 25,000 --- --- 15,000 1,05,000
Total H.P. of
Machinery 15 20 25 --- --- 5 65
Machine Hours 10,000 20,000 15,000 --- --- 5,000 50,000
Worked

General Expenses: Rent Rs.12,500; Insurance Rs.1050; Depreciation 15% of value of machinery;
Power Rs.3800; Light Rs.1250.

You are required to prepare an overhead analysis sheet for the departments showing clearly the
basis of apportionment where necessary.

Ans [P1-Rs.22268; P2-Rs.29780; P3-Rs.30302]

4. The following particulars relate to a manufacturing company which has three production
department P1 P2 andP3 and two service departments S1 S2.

Departments
P1 P2 P3 S1 S2
Total departmental overheads as per
primary distribution Rs. 6300 7400 2800 4500 2000
The company decided to charge the service departments cost on the basis of following percentages:

Service Departments Production Depts Service Depts

P1 P2 P3 S1 S2
S1 40% 30% 20% --- 10%
S2 30% 30% 20% 20 ---

Find the total overheads of production departments charging service departments costs to
production departments on (a) repeated distribution and (b) by simultaneous equation method.

Ans [P1-Rs.9050; P2-Rs.9650; P3-Rs.4300]

5. In a factory, there are two service departments S 1 andS2 and three production departments P1 P2
and P3. In April 2001, the departmental expenses were:

Departments
P1 P2 P3 S1 S2
Rs 650000 600000 500000 120000 10000
The service department expenses are allocated on a percentage basis as follows:

Service Departments Production Depts Service Depts

P1 P2 P3 S1 S2
S1 30 40 15 --- 15
S2 40 30 25 5 ---
Prepare a statement showing the distribution of the two service departments expenses to the three
departments by (a) Simultaneous Equation Method (b) Repeated Distribution Method.

Ans [P1-Rs.735340; P2-Rs.686045; P3-Rs.548615]

6. From the following information work out the production hour rate of recovery of overhead in
departments P1 P2 and P3.
Particulars Total Production Department Service Departments
P1 P2 P3 S1 S2

Rent 1000 200 400 150 150 100

Electricity 200 50 80 30 20 20
Fire Insurance 400 80 160 60 60 40
Plant Depreciation 4000 1000 1500 1000 300 200
Transport 400 50 50 50 100 150
Estimated Working Hours 1000 2500 1800
Expenses of Service Departments S1 S2 are apportioned as under:

P1 P2 P3 S1 S2
S1 30% 40% 20% --- 10%
S2 10% 20% 50% 20 ---

Ans [P1-Rs.1.66; P2-Rs.1.04; P3-Rs.0.96]

7. PH Ltd is a manufacturing company having three production departments P1 P2 and P3 and two
service departments S2 and S2. The following is the budget for December, 1998:

Total P1 P2 P3 S1 S2
Rs Rs Rs Rs Rs Rs
Direct Material 1000 2000 4000 2000 1000
Direct Wages 5000 2000 8000 1000 2000
Factory Rent 4000
Power 2500
Depreciation 1000
Other Overhead 9000
Additional Information 500 250 500 250 500
Area (sq. ft)
Capital value (Rs.lacs)
of assets 20 40 20 10 10
Machine hours 1000 2000 4000 1000 1000
Horse power of machines 50 40 20 15 25
A technical assessment for the apportionment of expenses of service department is as under:

P1 P2 P3 S1 S2
% % % % %
S1 45 15 30 --- 10
S2 60 35 --- 5 ---

Required:
(i) A statement showing distribution of overheads to various departments.
(ii) A statement showing redistribution of service departments expenses to production
departments.

Ans [P1-Rs.2700; P2-Rs.3700; P3-Rs.6000; S1-Rs.4750; S2-Rs.5350. (ii) P1-Rs.8482; P2-Rs.6505;

P3-Rs.7513]

8. Strongman Ltd has three production departments P1 P2 and P3 and two service departments S1
and S2. The following particulars are available for the month of March, 2002 concerning the
organisation: Rent 15000; Municipal Taxes 5000; Electricity 2400; Indirect Wages 6000; Power
6000; Depreciation on Machinery 40000; Canteen Expenses 30000; Other Labour Related Costs
10000. Following further details are also available:

Total P1 P2 P3 S1 S2
Floor Space (sq.mts) 5000 1000 1250 1500 1000 250
Light Point (Nos) 240 40 60 80 40 20
Direct Wages (Rs) 40000 12000 8000 12000 6000 2000
Factory Rent 4000
Horse power of
Machines (Nos) 150 60 30 50 10 ---
Cost of Machine (Rs) 200000 48000 64000 80000 4000 4000
Working Hours 2335 1510 1525
The expenses of service departments are to be allocated in the following manner:

P1 P2 P3 S1 S2
S1 20% 30% 40% --- 10%
S2 40% 20% 30% 10 ---

You are requested to calculate the overhead absorption rate per hour in respect of the three
production departments.

Ans [P1-Rs.16; P2-Rs.24; P3-Rs.32]

9. Modern Manufactures Ltd have three Production Departments P 1 P2 P3 and two Service
Departments S2 and S2, the details pertaining to which are as under:

P1 P2 P3 S1 S2
Direct Wages (Rs) 3000 2000 3000 1500 195
Working Hours 3070 4475 2419 --- ---
Value of Machine(Rs) 60000 80000 100000 5000 5000
H.P. of Machines 60 30 50 10 ---
Light Points 10 15 20 10 ---
Floor Space (sq ft) 2000 2500 3000 2000 500

The following figures extracted from the accounting records are relevant: Rent and Rates Rs.5000,
General Lighting Rs600 Indirect Wages Rs1939; Power Rs.1500; Depreciation on Machines
Rs.10000 and Sundries Rs9696. The expenses of the Service Departments are allocated as under:
P1 P2 P3 S1 S2
S1 20% 30% 40% --- 10%
S2 40% 20% 30% 10 ---

Find out the total cost of product ‘X’ which is processed for manufacture in Department P 1 P2
andP3 for 4,5 and 3 hours respectively, given that its Direct Material Cost is Rs.50 and Direct
Labour Cost Rs.30.
P1 P2 P3 S1 S2
Total as per P.D.S (Rs) 7700 7300 9800 4700 929
Overhead after re-distribution 9234 9035 12160
Overhead Rate per Working Hour (Rs) 3.01 2.02 5.03
Cost of Product X Rs.117.23]
 Unit-2
Costing Ascertainment
1. JOB COSTING
Job costing is that form of specific order costing which applies where the work is undertaken as
an identifiable unit such as:
(i) Manufacture of products to customers specific requirements.
(ii) Fabrication of certain materials where raw materials are supplied by the customers.
(iii) Repairs are done within a factory or at customers premises
(iv) Manufacturing goods are not for stock purposes but for immediate delivery once these are
completed in all respects.
(v) Internal capital expenditure jobs etc.

Job costing is a method of cost accounting whereby cost is completed for a specific quantity of
product, equipment repair or other service that moves through the production process as a
continuously identifiable unit, applicable material, direct labour, direct expenses and usually a
calculated portion of overheads being charged to a job order.

FEATURES OF JOB ORDER COSTING

Under this method costs are collected and accumulated for each job, work order or project
separately. Each job can be separately identified and hence it becomes essential to analyse the
costs according to each job. The industries, where this method of costing is applied must possess
the following features:

(i) The production is generally against customer’s order but not for stock
(ii) Each job has its own characteristics and needs special treatment.
(iii) There is no uniformity in the flow of production from department to department. The
nature of the job determines the departments through which the job has to be processed. The
production is intermittent and not continuous.
(iv) Each job is treated as a cost under this method of costing.
(v) Each job is distinctively identified by a production order throughout the production
stage.
(vi) The cost of production of every job is ascertained after the completion of the job.
(vii) The work in progress differs from period to period according to the number of jobs
in hand.
Thus, cost is ascertained for each job separately. This method is applicable to printers. Machine
tools manufactures, foundries and general engineering workshops.

OBJECTIVES OF JOB ORDER COSTING

Following are the main objectives of job order costing:
(i) It helps to find out the cost of production of every job or order and to know the profit or
loss made on its execution. The ultimately helps the management to judge the profitability of
each job and decide the future course of action.
(ii) It helps the management to make more accurate estimates for costs of similar jobs to be
executed in future on the basis of past records. Management can easily and accurately
determine and quote prices of jobs of a similar nature which are in prospect.
(iii) It helps the management to control the operational inefficiency by making a comparison
of actual costs with estimated ones.
 (iv) It helps the management to provide a valuation of work progress.

The following factors must be considered before adopting a system of job costing:
(a) Each job (or order) should be continuously identifiable from the stage of raw materials to
completion stage.
(b) This system should be adopted when it becomes absolutely necessary as it is very
expensive and requires a lot of clerical work in estimating costs, designing and scheduling
of production.

2 BATCH COSTING

Batch costing is a modification of job costing. It is used where articles are manufactured
in definite batches and help in stock for assembly of components to produce finished product
or for sales to customers. A batch, in fact, is a cost unit consisting of a group of identical items
which maintain their identity throughout one or more stages or production. Batch costing is
generally followed in toy making, aircraft manufacturing, bakeries, biscuit factories, radio-sets
and watches manufacturing factories, where manufacture of products or components can be
done more conveniently in batches of a definite number.

The costing procedure for batch costing is similar to that under job costing except with the
difference that a batch becomes the cost unit instead of a job. Separate job cost sheets are
maintained for each batch of products. Each batch is allotted a number. Material requisitions
are prepared batchwise. Cost per unit is ascertained by dividing the total cost of abatch by
number of items produced in that batch. Ordinary principles of inventory control are used.
Production orders are issued only when the stock of finished goods reaches the ordering level.
In case the batches are repetitive, the costing work is much simplified.

Determination of Economic Batch Quantity (EBQ)

One very important matter which is considered in batch costing is the determination of the
economic batch quantity. Since production is done in batches, and each batch can contain any
number of items, the determination of the optimum batch quantity is very significant. To determine
economic batch quantity, the general principles of inventory control with regard to economic order
quantity are followed. The determination of the economic (optimum) batch quantity or lot size
requires that the following factors be considered.

(a) The demand for the components in a given period, generally a year.
(b) The cost of setting up tools on the machines for each batch.
(c) The cost of manufacturing the components in each batch.
(d) The cost of capital blocked in the stock of components.
(e) The cost of storage.

The following formula may be used to determine the economic or optimum batch quantity
(EBQ):

EBQ =√2DS/C

Where, EBQ = Economic batch quantity

D= Demand of the component in a year
S= Setting up cost per batch
C=Cost of capital and storage (carrying cost) per unit per annum.
 3 CONTRACT COSTING

Contract or terminal costing is a variant of job costing and for this reason both contract and job
costing methods are based on the same costing principles. The difference between these two is that
in job costing a job is relatively small, whereas in contract costing contract is big. It has been well
said that a job is a small contract and contract is a big job. In contract costing each contract is a
cost unit. As the cost unit in contract costing is relatively large, it takes a considerable length of
time to complete and it may continue over more than one year. Moreover, whereas job work is
done in factory premises, contract work is done at site, away from the premises of the business.
Contract costing is employed in business undertakings engaged in building construction, road
construction, bridge construction and other civil engineering works.

The cost unit in contract costing is the contract itself. In contract costing, a separate account is
kept for each contract. Since a greater part of the work is carried out at the contract site itself all
the expenditures incurred on the contract including telephone installed at site, site vehicles,
transportation etc can be charged directly to the contract. Head Office expenses and the overheads
relating to central stores are however apportioned among the various contracts on some equitable
basis such as percentage of materials wages price cost or a percentage of total contract cost
depending on the circumstances. In the case of contract costing, direct costs account for a very
high proportion of the total cost of contract whereas indirect costs constitute only a small
proportion of it. One of the significant features of contract costing IS difficulty in cost control.
Because of the scale and the size of the contract and the site, there are frequently major problems
of cost control concerning material usage and losses, pilferages, labour supervision and utilization,
damage to and loss of plait and tools etc.

Special Terms used in contract costing

Work Certified (Certification of Work done)

It is generally agreed between the contractor and the conractee that on accounts payment
will be made by the contractee at stages of progress in the work. An architect or a surveyor is
appointed by the contractee to certify the extent of the work completed. He issues a certificate
from time to time to the effect stating how much work has been completed and the amount of
money due to the contractor in terms of the contract deed. The contractor credits the on account
payment received from the contractee in his account. On completion of the contract, the
contractee’s account will be debited with the contract price for receiving the final payment.

Retention money

The contractee generally does not make full payment of the work certified by the surveyor.
He retains some amount, (say 10% to 20% of the amount due) to be paid within a reasonable period
when it is ensured that there is no fault in the work done. The amount held back is called retained
money. If any defeat or deficiency is noticed in the work, it is to be certified before the release of
the retention money. Retention money provides a safeguard against the risk of loss due to faulty
workmanship.

Cash Received

Cash received is ascertained by deducting the retention money from the value of work
certified, i.e. Cash received=Value of work certified-Retention money.

Cost of work certified

 The cost of work certified represents the total expenditure incurred on the contract to date,
less cost of work uncertified, materials in hand plant at site etc. Thus Cost of work=Cost of work
(Cost of work uncertified + materials in hand + Plant at site)

Work uncertified

Work uncertified (or work not yet certified) represents the cost of the work which has been
carried out by the contractor but has not been certified by the contractee’s architect. It is always
shown at cost price. The cost of work uncertified may be ascertained as follows:

Rs
Total Cost to date --------- -------------
Less: Cost of work certified --------- -------------
Materials in hand plant --------- -------------
at site
cost of work uncertified --------- -------------

Work in progress

Incomplete contracts are referred to as work in progress. This should be shown on the assets side
of the balance sheet under the heading work in progress. Work in progress represents the net
expenditure on a contract is arrived at by addition the various expenses debited to the contract
account less materials in hand, returned lost or stolen etc the value of plant in hand returned lost
or destroyed etc. From the viewpoint of the contractor work in progress represents the net
expenditure incurred on the contract, irrespective of whether any cash for it has been received or
not. While showing the work in progress in the balance sheet any notional profit held back (profit
in reserve) and cash received are deducted:

Alternatively the work in progress account can be prepared by debiting to this account the amount
of work certified and work uncertified and crediting it with the profit in reserve i.e. the portion of
the profit not transferred to the profit and loss account. The difference between the debit and
crediting is work in progress. While showing it is in the balance sheet all cash received on account
of such uncompleted contracts is to be shown as a deduction. The value of plant and materials in
hand may be shown separately in the balance sheet under the heading plant at site and materials at
site, along with work in progress.

Notional Profit

Notional profit represents the difference between the value of work certified and cost of
work certified. It is determined in the following manner:

Illustration:

The following information is available:

Value of work certified Rs.500000
Cost of work to date Rs.400000
Cost of work not yet certified Rs.100000
Materials in hand and plant at site Nil
Calculate notional profit

Solution:
 Rs.
Value of work certified 500000
Less: Cost of work certified
Cost of work to date 400000
Cost of work not yet certified -10000 300000
Notional profit ------------- -------------
200000
However, if in any year the cost of work certified exceeds the value of work certified the resultant
figure will represent the notional loss.

Illustration: From the following information calculate the value of work in progress:
Rs
Total cost of contract to date 383000
Cost of contract not yet to certified 23000
Value of work certified 420000
Cash received to date 37800

Solution
Rs.
Value of work in progress 420000
Work certified 23000
Work uncertified 443000
Less: Reserve for Contingencies 24000
419000
Less: Cash Received 378000
----------
41000
Alternatively

Value of work in progress

Total cost of contract to date 383000
Add: Profit taken on the contract 36000
Less: Cash received 419000
Work in progress 378000

Working Note

Work in progress
Work Certified 420000
Work Uncertified 23000
--------------
Less: Cost of Contract to date 443000
Notional Profit 383000
-------------
Profit taken to Profit & Loss Account 60000
2/3 x 60000 x 378000/420000
=Rs.36000
Reserve for Contingencies = Rs.60000-36000
=Rs.24000

Estimated profit
Estimated profit represents the excess of the contract price over the estimated total cost of the
contract. Thus, Estimated profit =Contract price-Estimated total cost Estimated total cost is
determined by adding the cost to be incurred to complete the contract to the cost incurred to date
on a contract. Thus, Estimated total Cost = Cost incurred to date + Cost to be incurred to complete
the contract

Profit/loss on incomplete contracts

A contact usually extends over a number of years. If the profit on such contracts is recorded only
after their completion, wide fluctuations may be noted in the profit figures from year to year, as
there may be a year in which no contract is completed and another year in which no contract is
completed and another year in which a number of contracts are completed. To avoid wide
fluctuations in the reported profits and to reflect the revenue in the accounting period during which
the activity is undertaken, and also to comply with the matching principle, the profit and loss
accounting the year by calculating the notional profit. However, prudence requires that the total
notional profit should not be transferred to the profit and loss account but the total notional loss
should be written off to the profit and loss account of the year. The withholding of a portion of the
notional profit may be regarded as a provision for future unforeseen expenses and contingencies.
The portion of notional profit to be transferred to the profit and loss account depends on the state
of completion of the contract. It is always preferable to determine the stage of completion of a
contract with reference only to the certified work. For this purpose, as far as possible, uncertified
work should not be considered. To determine the profit, all the incomplete contracts are classified
into the following four categories:

(i) Contracts just started or contracts less than 25% complete.

(ii) Contracts between 25% and 50% complete.
(iii) Contracts between 50% and 90% complete.
(iv) Contracts nearing completion, say between 90% and 100% complete.

The transfer of profit to the profit and loss account:

(i) Contract less than 25% complete: No profit should be taken into account if the contract has
just started or is less than 1/4th complete.

(ii) Contract between 25% and 50% complete (i.e. it is ¼ or more complete but less than ½):
Onethird of the notional profit, reduced in the ratio of cash received to work certified, may be
transferred to the profit and loss account. Thus the amount of profit to be transferred to be profit
and loss account may be determined by using the following formula: 1/3x Notional Profit x Cash
received/Work certified

(iii) Contract between 50% and 90% complete (i.e. it is 500/0 or more complete but less than
90%): In this case two thirds of the notional profit reduced by the proportion of cash received to
work certified may be transferred to the profit and loss account. In this case, the formula will be :
2/3 x Notional Profit x Cash received/Work certified

(iv) Contract nearing completion: When 90% or more of the work has been done in a contract
the contract is considered to be nearing completion. In the case of such contracts, the amount of
notional profit to be transferred to the profit and loss account may be determined by taking into
account the estimated profit on such contracts. In that case the estimated profit is ascertained by
deducting the aggregate of costs to date and further expenditure to be incurred to complete the
contract from the contract price. An amount equivalent to a proportion of this estimated total profit
from the notional profit is credited to the profit and loss account and balance is kept in reserve.
This proportion is ascertained by anyone of the following formulas:

(a) Estimated profit x Work certified/Contract Price

(b) Estimated profit x Work certified/Contract price x Cash received/Work certified or
Estimated profit x work certified/contract price
(c) Estimated profit x work certified/contract price
(d) Estimated profit x Cost of work to done/Estimated total cost x Cash received/Work
certified

In the absence, of specific instructions, it is preferable to use formula estimated further.

However, if the estimated profit cannot be ascertained i.e. the estimated further expenditure is not
given, the amount of profit to be transferred to the profit and loss account may be ascertained on
the basis of notional profit by using the following formula:

(e) Notional profit x Work certified/Contract price

Types of Contracts:

Cost Plus Contracts

When it is not possible to estimate the cost of work with a reasonable degree of accuracy
at the time of entering into the contract, a cost plus contract is generally adopted. Under such a
contract the contractor receives his total costs plus a profit which may be fixed amount or it may
be a particular percentage or cost or capital employed. These types of contracts are undertaken for
production of special articles not usually manufactured e.g. construction work during war
production of newly designed ship or component parts of aircraft etc. Generally in such contract
contractors and contractee have clear agreement about the items of cost to be included, type of
materials to be sued labour rates for different grades, normal wastages to be permitted and the rate
or amount of profit.

Escalation Clause Contacts

This clause is often provided in contracts to cover any likely changes in the price of
utilization of materials and labour. Thus a contractor is entitled to suitably enhance the contract
price if the cost rise beyond a given percentage. The object of this clause is to safeguard the interest
of the contractor against unfavourable changes in cost. The escalation clause is of particular
importance where prices of materials and labour are anticipated to increase or where quantity of
materials and labour time cannot be accurately estimated.

Just as an escalation clause safeguards the interest of the contractor by upward revision of
the contract price, a de-escalation clause may be inserted to look after the interest of the contractee
by providing for down beyond an agreed level.

Illustration:

The following is the summary of the entries in a contract ledger as on 31 st December 1999 in
respect of contract No.87 which has a contract price of Rs.500000.
Rs
Materials purchased directly 175000
Materials supplied from stores 35000
Wages 90000
Direct Expenses 35000
Establishment Charges 40000
Plant 171000
Scrap sold 100000

The other information as follows:

(a) Accruals on 31st December 1999 were; wages Rs500 and direct expenses Rs.6000.
(b) The cost of work uncertified was Rs.25500
(c) Rs.10000 worth of plant and Rs.15000 worth of materials were destroyed by fire.
(d) Rs.20000 worth of plant was sold for Rs.15000 and materials costing Rs.25000 were sold
for Rs.30000.
(e) Depreciation on plant upto 31st December 1999 was Rs.50000
(f) Materials at site Rs.25000
(g) Cash received from contractee was Rs.300000 being 80% of work certified.

Show the Contract Account and Work in Progress Account. Also show the same in the Balance
Sheet.

Solution: Contract No.87 A/c

Particulars Rs Particulars Rs
To Materials purchased 175000 By sales of scrap 100000
To materials from stores 35000 By Profit & Loss A/c
To wages 90000 Loss of Plant 10000
Add outstanding 4500 94500 Loss of materials 15000 25000
-------- ---------
To Direct Expenses 35000 By Cash
Add outstanding 6000 41000 Sale of Plant 15000
To establishment charges 40000 Sale of Material 30000 45000
To plant 171000 By Profit & Loss A/c 5000
To profits & Loss A/c 5000 (Loss on sale of plant)
(Profit on sale of materials) By Materials at Site 25000
To Notional Profit c/d 39000 By Work in progress
600500 Work certified 375000
Work uncertified 25500 400500
To Profit & Loss A/c 20800 600500
(2/3 x 39000 X DOEOO) By Notional Profit bid 39000
To work in progress A/c 18200 39000
39000
Work in Progress A/c
Particulars Rs Particulars Rs
To Contract No 87 A/c By Contract No 87 A/c 18200
Work certified 375000 By Balance c/d 382300
Work uncerfied 25500 400500 400500
400500

Balance Sheet as on 31st December 1999

Work in progress
Work certified 375000
Work uncertified 25500
---------
 400500
Less Reserve 18200
Less Cash Received 300000 82300
Plant at Site 91000
Materials at Site 25000
Note: Calculation on Written Down Value of Plant

Rs.
Plant at cost
Less Lost 10000 171000
Plant sold 201000
Depreciation 50000 80000
Written Down Value of Plant
-----------
91000

Illustration:

Nikhil Limited undertook a contact for Rs.500000 on 1st April 1998. On 31st March 1999
when the accounts were closed, the following details about

Rs.
Materials purchased Wages paid 100000
General expenses 45000
Plant purchased 10000
Materials in hand 31.3.1999 50000
Wages accrued 31.3.1999 5000
Work certified 200000
Cash received 150000
Work uncertified 15000
Depreciation of plant 5000

The contract contained an escalation clause which read as In the event of increase(s) of
prices of materials and rates of wages by more than 5% the contract price would be increased
accordingly by 25% of the rise of the cost of materials and wages beyond 5% in each case.

It was found that since the date of signing the agreement, the prices of materials and wage
rates increased by 25%. The value of the work certified does not take into account the effect of the
above clause.

Prepare the contact account.

Solution: Nikhil Limited

Contract account for the year ended 31st March, 1999
Particulars Rs Particulars Rs
To materials purchased 100000 By Work in progress c/d
To wages paid 45000 Work certified 200000
Add: Wages accrued 5000 50000 Work uncertified 15000
To General expenses 10000 ---------
To Depreciation of plant 5000 Effect of escalation
To Notional profit c/d 80000 Clause 5000
245000 By Material in hand c/d 220000
 25000
To profit and Loss A/c 20000 245000
To work in progress c/d 60000 By Notional profit bid 80000
(profit in reserve) 80000

80000

Contract Account as on 1.4.1999

Particulars Rs Particulars Rs
To work in progress bid By Work in progress b/d 60000
Work certified 200000 (profit in reserve)
Work uncertified 15000
Effect of escalation 5000 220000
Clause
25000
To materials in hand b/d
Working Notes:

(i) Ascertainment of effect of escalation clause:

Total Increase upto 5% Rs Increase beyond 5%

increase Rs
25% Rs
Materials:
Effect of increased price
(Rs 100000 – Rs25000) x EOIO x 15000 3000 12000
Wages:
Effect of increased wage rates:
Rs.50000 x EOIO x 10000 2000 8000

Total 25000 5000 20000

Increase in value of work done (certified & uncertified) to date: 25% of Rs.20000=Rs.5000

(ii) Profit to be transferred to the profit and loss account:

Since the contract is between ¼ and ½ complete one third of the notional profit, reduced by the
proportion of cash received to work certified is to be transferred as below:

=1/3 x National profit Cash received/Work certified

=1/3 x Rs.80000 x Rs150000/Rs200000=Rs.20000

4 Process Costing
FEATURES OF PROCESS COSTING

Process costing is that form of operation costing which is used to ascertain the cost of the
production at each process or stage of manufacture, where processes are carried on having one or
more of the following features:
(i) Production is done having a continuous flow of identical products except where plant and
machinery is shut down for repairs etc.

(ii) Clear defined process cost centres and the accumulation of all costs (material, labour and
overheads) by the cost centre.

(iii) The maintenance of accurate records of the units and part units produced and cost incurred by
each process.

(iv) The finished product of one process becomes the raw material of the next process or operation
and so on until the final product is obtained.

(v) Avoidable and unavoidable losses usually arise at different stages of manufactured for various
reasons. Treatment of normal and abnormal losses or gains is to be studied in this method of
costing.

(vi) Sometimes goods are transferred from one process to another process not at cost price but
transfer price just to compare this with the market price and to have a check on the inefficiency
and losses occurring in a particular process.

(vii) In order to obtain accurate average costs, it is necessary to measure the production at various
stages of manufacture as all the input units may not be converted into finished goods; some may
be progress. Calculation of effective units is to be seen in this method of costing.

(viii) Different products with or without by products are simultaneously produced at one or more
stages or processes of manufacture. The valuation of by products and apportionment of joint cost
before point of separation is an important aspect of this method of costing. In certain industries by
products may require further processing before they can be sold. A main product of one firm may
be a by product of another firm and in certain circumstances, it may be available in the market at
prices which are low than the cost to be first mentioned firm. It is essential, therefore, that this cost
be known so the advantages can be taken of these market conditions.

(ix) Output is uniform and all units are exactly identical during one or more processes. Therefore
the cost per unit of production can be ascertained only by averaging the expenditure incurred
during particular period.

(x) It is not possible to trace the identify of any particular lot of output to any lot of input materials.
For example in the sugar industry, it is not possible to trace any lot of sugar bags to a particular lot
of sugarcane fed or vice versa.

APPLICATION OF PROCESS COSTING

The industries in which process costs may be used are many. In fact a process costing system can
usually be devised in all industries except where job batch or unit operation costing is necessary.
In particular the following are examples of industries where process costing is applied.

Chemical works textile, weaving spinning etc

Soap making Food products
Box making canning factory
Distillation process coke works
Paper mills paint, ink and varnishing etc
Biscuit works meat products factory
Oil refining milk dairy

COMPARISON BETWEEN JOB COSTING AND PROCESS COSTING

The main points of difference between job costing and process costing are given as under:
Basis of Distinction Job Costing Process Costing
1. Production Production is against specific Production is in continuous
orders. flow the products being
homogeneous.
2. Cost Determination Costs are determined for each Costs are complied for each
job separately process for department on
time basis i.e. for production
of a given accounting period
3. Entity Each job is separate and Products lose their individual
independent of others entity as they are
manufactured in a continuous
flow
4.Unit Cost Total cost of a job is divided The total cost of each process
by the number of units is divided by the total
produced in the job in order to production for the process to
calculate unit cost of a job calculate the average cost per
unit for the period
5. Cost Calculation Costs are compiled when a job Costs are calculated at the end
is completed of the cost period
6. Transfer There are usually no transfers Transfer of costs from one
from one job to another unless process to another is made as
there is a surplus work or the products moves from one
excess production process to another.
7. Work in Progress There may or may not be work There is always some work in
in progress at the beginning or process at the beginning as
end of the accounting period well as at the end of the
accounting period
8. Control Proper control is Proper control is
comparatively difficult as comparatively easier as the
each product unit is different production is standardised and
and the production is not is more stable
continuous
9. Forms and Details It requires more forms and It requires few forms and less
details regarding materials details but a closer analysis of
and labour due to the need for operations is needed.
the allocation of labour to so
many orders and material is
issued in bulk to departments
10. Suitability It is suitable where the goods It is suitably employed where
are made according to goods are made for stock and
customers orders production production is continuous or
is intermittent and customers goods although made to
orders can be identified in the customers order are owing to
value of production. the continuous nature of the
production lost sight in the
volume of production.
ADVANTAGES OF PROCESS COSTING

The following are the main advantages of process costing:

1. It is possible to determine process costs periodically at short intervals. Unit cost can be
computed weekly or even daily if overhead rates are used on predetermined basis.
2. It is simple and less expensive to find out the process cost.
3. It is possible to have managerial control by evaluating the performance of each process.
4. It is easy to allocate the expenses to processes in order to have accurate costs.
5. It is easy to quote the prices with standardisation of process. Standard costing can be
established easily in process type of manufacture.

DISADVANTAGES OF PROCESS COSTING

The following are the main disadvantages of process costing:

1. Costs obtained at the end of the accounting period are only of historical value and are
not very useful for effective control.
2. Work in progress is required to be ascertained at the end of an accounting period for
calculating the cost of continuous process. Valuation of work in progress is generally
done on estimated basis which introduces further inaccuracies in total cost.
3. Where different products arise in the same process and common costs are prorated to
various costs units. Such individual products costs may be taken as only approximation
and hence not reliable but may be taken as the best.
4. There is a wide scope of errors while calculating average costs. An error in one average
cost will be carried through all processes to the valuation of work in process and
finished goods.
5. The computation of average cost is more difficult in those cases where more than one
type of products are manufactured and a division of the cost elements is necessary.

TYPES OF PROCESSING

Process costing is used in case of industries, which involve processing of a product through
different stages. The various types of processing are as follows:
(i) Continuous sequential processing: In case of this processing a product has to pass through
different cost centres or stages of manufacturing continuously and in succession one after the other
during a period. The processing being continuous and identical the costing units for each centre or
stage are identical during any period. Examples of this type of processing are cement making paper
making refining of crude petroleum etc.
(ii) Discontinuous Processing: In case of this processing a process is independently operated for
the individual product as such at frequent intervals. The costing unit in case of this processing
dependent upon the product may very even fort the same cost centre. Examples of this type of
processing are dye manufacturing fruit preservation, vegetable canning yam spinning etc.
(iii) Parallel Processing: In case of this processing the operations or stages through which the
product has to pass run parallel and separately. All these parallel processes ultimately join with the
end process. Examples of this type of processing are manufacturing different components which
ultimately join in the assembly process to make a product meat packing etc.
(iv) Selective Processing: In case of this processing the combination of the processes or stages of
operation depend upon the end product to be commercialised. Examples of this type of processing
are cooked meat chloride compounds like bleaching power of zinc chloride or hydrochloric acid
etc.

PROCESS LOSSES AND WASTAGES

 When materials are processed, they lose or gain volume or weight as a result of the process.
It is common that process loss or scrap or wastage occur in process industries. These process losses
may be of two types viz controllable and uncontrollable.

(a) Normal or uncontrollable loss: Because of the nature of the raw materials some loss is
inherent and is unavoidable. This is known as normal waste or normal loss. And this type of
loss is expected in normal condition for example stamping process evaporation etc. The
percentage of such losses is anticipated from past experience by the management. Loss of this
type should be absorbed by good units produced i.e. the cost of units lost in charged to the
good units output. Any value realisable on the normal loss will be credited to the process
amount.
(b) Abnormal Loss or Controllable Loss: In certain cases it can be seen that the loss exceeds the
predetermined normal loss. Any loss exceeding the normal is called abnormal loss. Abnormal
loss should not affect the normal cost of production. It is caused by accidents sub standard
materials, carelessness etc. Therefore abnormal loss is valued just like good units and
transferred to a separate account called Abnormal Loss Account. Value of Abnormal loss =
Normal cost of normal production/Normal output x Units of abnormal loss The loss on account
of abnormal loss or wastage is not borne by production, but by Profit and Loss Account.
Abnormal Wastage Account is debited and Process Account is credited with the cost of
abnormal wastage. If the wastage is sold in the market, Abnormal Wastage Account is credited
with the realised price and the balance is transferred to Profit and Loss Account.

Illustration: (Normal loss and abnormal loss with no scrap value).

Prepare Process Account from the following

Materials issued 1000 kg @ Rs.125
Wages Rs.28000
Overheads Rs8000
Normal loss 5% of input
Output 900 kgs

Solution: Process Account

Particulars Units Amount Rs Particulars Units Amount Rs
To Materials 1000 125000 By Normal 50 ---
Loss
To wages --- 28000 By Abnormal 50 8474
Wastage
To Overheads --- 8000 By next 900 152526
process @ Rs
1000 161000 169.47 161000
1000

Note: Normal output=1000 kgs 50 kgs = 950 kgs

Normal cost of Normal output Rs=161000
Cost per unit of normal output= Rs.161000
----------- =169.47
950
Abnormal Wastage amount=Rs169.47 x 50=Rs.8473.50 or Rs8474
Amount of good units = Rs.169.47 x 900 = Rs.152526 or 161000/950 x 900 = 152526

Illustration: (Normal loss and abnormal loss with scrap value)

 In process A, 100 units of raw materials were introduced at a cost of Rs.1000. The other
expenditure incurred by the process is Rs.600. Of the units introduced, 10% are normally scraped
in the course of manufacture and they possess a scrap value of Rs.7 per unit. The output of Process
A was only 75 units. Calculate the value of abnormal loss.

Solution: Process Account

Particulars Units Amount Rs Particulars Units Amount Rs
To Materials 100 1000 By Normal 10 70
To other 600 Loss
expenses By Abnormal 15 255
Loss
By Process B 75 1275
100 1600 A/C @ Rs17 1600
100

Value of abnormal wastage=Normal cost of normal output/Normal output x Abnormal Loss

Normal cost = Rs.1600-Rs.1530
Amount of abnormal Units=Rs.1530/90 x 15 = Rs.225
Amount of good units= Rs1530/90 x 75= Rs.1275

The unit rate of abnormal loss and the unit rate of good units are the same i.e. Rs.17

Note: Abnormal losses are valued as good units. The unit cost which is used to value good units is
also applied for valuation of abnormal loss units. The cost of abnormal loss units computed in this
manner is transferred to a separate account, called Abnormal Loss Account and credited to the
relevant Process Account. The amount of scrap which would otherwise have been realised, had
there been normal and no abnormal gain, is debited to the Abnormal Gain Account and the balance
is credited to Costing Profit and Loss Account.

Value of abnormal gain is calculated with the following formula:

Cost of Normal Output/Normal Output x Abnormal Gain (units)
=Total Process Cost-Reliable Value of Normal Wastage/Input (units) – Normal Wastage (units) x
Abnormal Gain (units)

Illustration:
In process A, 1000 units of raw materials were introduced at a cost of Rs.15000. direct wages
amounted to Rs7500 and manufacturing overheads to Rs.5000. 10% of the units introduced are
normally lost in the course of manufacture and these are sold @ Rs 5 per unit. The actual output of
the process was 940 units.

Prepare Process A Account and Abnormal Gain Account.

Solution: Process Account

Particulars Units Amount Rs Particulars Units Amount Rs
To Materials 100 15000 By Normal 100 500
To Direct 7500 Loss (10%)
Wages By Finished 940 28200
To Stock A/c
Manufacturing 1040 28700
overheads 5000
40 1200
 To Abnormal 1040 28700
Gain A/c

Note: Calculation of Value of Abnormal Gain

Normal Output=Units Introduced-Normal Loss

= 100-100
=900 units
Abnormal Gain=940-900
=40 units
Value of Abnormal Gam=Total Cost-Scarp Realised/Normal Output x Units of Abnormal Gain
=27500-500/900 x 40
= Rs.1200
Abnormal Gain A/c
To Normal 40 200 By Process A 40 1200
Loss A/c
(Loss of
income from
scrap)
To Cost Profit 1000
& Loss A/c
40 1200 40 1200

JOINT PRODUCTS

Joint products are products which by the very nature of the production process cannot be
produced separately and which have more or less equal economic importance. They represent two
or more products separated in the course of the same processing operation usually requiring further
processing each product being in such proportion that no single product can be designated as the
major product (Cost Accountants Hand book edited by T. Lang). For example gasoline diesel,
kerosene, lubricating oil, coal tar, paraffin and asphalt are the joint products obtained from crude
oil in a refinery. Different grades of lumber resulting from a lumbering operation are another
example.
Sometimes a disnction is made between joint product and co-products. Coproducts do not
always arise from the same operation or raw materials and the quantity of co-products is within
the control of the manufacturer. For example in the automobile manufacturing industry a number
of co-products such as cars, jeeps and trucks of various types may be produced in different
quantities according to the need of the concern while in the oil industry, the quantity of various
joint products remains almost the same and cannot be changed without changing the quantity of
the results of the items.

By-Products

By-products refer to secondary or subsidiary products having some saleable or usable value
produced incidentally in the course of manufacturing the main product. According to ICMA
terminology a by-product is a product which is recovered incidentally from the material used in
the manufacture of recognized main products such a by-product having either a net realizable value
or a usable value which is relatively low in comparison with the saleable value of the main
products. By-products may be further processed to increased their realizable value. For example
in sugar industries sugar is the main product and fibres from sugarcane for lining materials
molasses for the manufacture of alcohol are by products. Similarly in coke ovens gas and tar
produced along with the main product coke are by-products.

Distinction between Joint Products and By-products

The classification of various products from the same process into joint products and by-
products depends upon the relative importance of the products and their value. If the various end
products are almost equal in importance and their value is also more or less the same they may be
identified as joint products, but if one end-product has greater importance and higher value and
the other products are of less importance and rather of low value the hitter may be classified as by-
products. It may be noted that the value of some end-products may be so insignificant that they
may be classified as by-products. It may be noted that the value of some end-products may be so
insignificant that they may be classified suitable basis. This method is followed where by products
are processed (i) to dispose of waste material more profitably, or (ii) to utilize idle plant. In the
first case by products after separation are charged with overheads at full rates whereas in the second
case by product costs after separation will include variable costs only.

5. Operating Costing

Operating costing refers to a method which is designated to ascertain and control the costs
of the undertakings which do not produce products but which render services. Operating costing
is also known as service costing. It is that form of operation costing which is applied where
standardised services are provided either by an undertaking or by a service cost centre within an
undertaking.

Operating costing is the cost of rendering services. It is the cost of producing and
maintaining a service. Industries using operating costing do not produce tangible products but
render useful services e.g. transport services utility service like hospitals canteens etc distribution
service like supply of electricity gas etc.

Operating costing is just a variant of unit or output costing. The method of computing
operating cost is very simple. The expenses of operating a service for a particular period are
grouped under suitable headings and their total is divided by the number of service units for the
same period and thus cost per unit of service is obtained. The cost for a future period may be
estimated on the basis of estimated service units and the estimated costs. This will help in fixing
the price to be charged for the service. Thus the principle involved under operating costing is the
same as under unit costing but they differ in the manner in which costing is the same as under unit
costing but they differ in the manner in which costing information have to be collected and
allocated to cost units.

Characteristics

Operating costing has special application to undertakings which provide services to the
community as a whole rather than manufacture of products. Such undertakings where operating
costing is applied generally possess the following characteristics:

1. These undertakings render unique service to their customers

2. They invest a large proportion of the total capital in fixed assets.
3. The requirement of working capital is Comparatively less.
 4. The operating cost is divided into fixed cost and variable cost. This distinction is of
particular importance because the economies of scale of operations considerably affect the
cost per unit of service rendered.

Cost Unit

The selection of a suitable cost unit (unit of service) may sometime prove difficult. The
cost units may be of the following two types:

1. Simple cost Unit: In simple cost unit the unit is obvious for example, per student per bed
per mile etc. A few examples are given below:

Undertaking Cost Unit

(a) Transport Per kilometer or per passenger or per tonne
(b) School or College per student
(c) School or college per student
(d) Hospital per bed
(e) Canteen per cup of tea

2. Composite Cost Unit: In this type more than one units are combined together Examples are:

Undertaking Cost Unit

(a) Transport Per passenger kilometer or per tonne kilometer
(b) Hospital per bed per day
(c) Cinema per seat per show
(d) Electricity per kilowatt hour
(e) Canteen per meal per person
(f) Lodge per person per day

The operating costing procedure used in TRANSPORT undertaking is discussed below:

Transport Costing

It is very essential to differentiate the costs of different expense heads. In a broad way there
are two types-fixed (standing) costs and operating and running charges. Fixed costs are those
which are incurred irrespective of mileage run. These are the expenses for the vehicles. At the
same time maintenance repairs petrol oil etc which are directly proportional or related to the
mileage run are known as maintenance charges. For the sake of convenience the costs are classified
into the following categories:

1. Fixed or Standing Costing: These include salary of operating manager supervisor insurance
motor vehicle tax garage rent establishment expenses of workshop and head office, general
supervision interest on capital etc.
2. Maintenance Charges: These are semi-variable expenses which include the cost of tyres
and tubes, repairs and paints spares and accessories overheads etc.
3. Operating and Running Charges: These very in direct proportion to kilometers and include:
(a) Petrol, Oil, Grease etc (b) wages of driver, conductor, attendant, etc if payment is related
to time or distance of trips, (c) commission of undertakings, if any (d) depreciation if it is
allocated on the basis of mileage run and as such it is treated as variable expenses.

If the payment is made to drivers and conductors as a fixed sum without taking into account the
distance covered or the number of trips made then it is a fixed charge. Every month a vehicle
operating statement is prepared. Total fixed costs operating maintenance charges are collected.
This will be posted to respective vehicles. These are divided by the total units (tonne miles or
passenger miles) to arrive at average unit cost. A proforma of cost sheet is given below:

Monthly Cost Sheet

Vehicle No……….. For the month of…………………

Fixed Charges: Rs
Insurance
Road tax
Licence fees
Garage rent
Interest on capital

Maintenance Charges:
Repairs
Overhauling
Painting
Tyres and tubes
Garage charges

Running Charges:
Petrol
Oil
Grease
Wages of driver
Depreciation

Total

Illustration:
Work out in appropriate cost sheet form the unit cost per passenger km for the year 1994-95 for a
flet of passenger buses booked by a Transport Company from the following figures extracted from
its books: 5 passenger bussesd costing Rs.50000, Rs.120000, Rs.45000, Rs.55000 and Rs.80000
respectively. Yearly depreciation of vehicles-20% of the cost. Annual repairs, maintenance and
spare parts-80% of depreciation.

Wages of 10 drivers @ Rs.100 each per month

Wages of 20 cleaners @ Rs.50 each per month
Yearly rate of interest 4% on capital
Rent of six garages @ Rs.50 each per month
Directors fees @ Rs.400 per month
Office establishment @ Rs.1000 per month
Licence and taxes @ Rs.1000 every six months
Realisation by sale of old tyres and tubes @ Rs.3200 every six months. 900 passengers were
carried over 1600 kms, during the year.

Solution: OPERATING COST STATEMENT

Passenger kms-1440000
Particulars Rs Cost /passenger km
Annual fixed expenses: 14000 Rs
 Interest @ 4% on capital costs 3600
Rent for six garages @ Rs.50 pm 4800
Director’s fees 12000
Office establishment 2000
Licence and taxes 12000
Wages of drivers (10x12x100) 12000
Wages of clearners (20x12x50) 60400 .042

Annual Variable Expenses: 70000 .048

Depreciation @ 20% on Rs.3,50,000 56000 .039
Repairs and Maintenance Charges 80% of 0.129
Rs.70000

Less: Recovery from sale of tyre and tubes 6400 .004

Cost per passenger-km 0.125
(Total passenger Kms=1600x900=1440000)

Illustration:
The following were the expenses incurred by a company in operating two lorries (for the
conveyance of raw materials) and a bus (for the conveyance to staff) during a related month:
MONTHLY COST

Lorry A Rs Lorry B Rs Lorry C Rs

Driver Salary 110 115 120
Coolie’s wage 120 120 60
Petrol 170 240 110
Oil 18 25 20
Repairs 150 150 100
Depreciation 330 220 350
Supervision 70 70 70
Garage; Garage 130 100 75
Overhead
Road and other taxes 45 45 30
Other overhead 35 40 20
expenses

The above vehicles carried the following raw materials and passengers during the month:

Lorry A 100 tonnes of raw materials

Lorry B 120 tonnes of raw materials
Bus C 25 passengers daily 25 days

At the same time their respective kms covered during the same period were:

Lorry A 3000
Lorry B 4500
Bus C 2000
 From the above statistics you are required to prepare an operating cost sheet in summary
form for the three vehicles. In addition you should briefly explain the units of cost which you select
for the purpose of making your calculations.

Solution:
OPERATING COST SHEET FOR THE MONTH OF…….
Lorry A Amount Rs Lorry B Amount Rs Bus C Amount Rs
Driver Salaries 110 115 120
Coolie’s wage 120 120 60
General Garage 130 110 75
Overhead
Supervision 70 70 70
Road and other taxes 45 45 30
Other overhead 35 40 20
expenses
510 500 375
Variable expenses
Depreciation 330 220 350
Repairs 150 150 100
Petrol 170 240 110
Oil 18 25 20
Total cost 1178 1135 955
Tonne- 300000 540000 50000
kms/passenger-Kms
Per tonne-km .0039 .0021 .0191
Passenger-Km
Note: For lorry A and lorry B the unit of cost is tonne-km since the lorries carry tones of raw
materials for kms. Unit for bus C is passenger-km since it carries passenger for kms. The total no
of units have been calculated as under: Lorry A-100 tonnes x 3000 kms=300000 tonne-kms. Lorry
B-120 tonnesx4500kms=540000 tonne-kms. Bus C-25 passengersx200 kms=50000 passenger-
kms.

Illustration:
From the following data relating to two different vehicles A and B, compute the cost per running
km:
Vehicle A Vehicle B

Kms run (annual) 15000 6000

Cost of vehicle 25000 15000
Road licence (annual) 750 750
Insurance (annual) 700 400
Garage Rent (annual) 600 500
Supervision salaries 1200 1200
Driver’s wage per hour 3 3
Cost of fuel per hour 3 3
Kms run per gallon 20 kms 15 kms
Repairs & Maintenance per km 1.65 2.00
Tyre allocation per km 0.80 0.60
Estimated life of vehicles 100000 kms 75000kms
Charge interest at 5% per annum on cost of vehicles. The vehicles run 20 kms per hour on an
average.

Solution
STATEMENT OF COST PER RUNNING KM
Particulars Vehicle A Rs Vehicle B Rs
Fixed costs per annum
Road licence 750 750
Garage rent 700 400
Insurance 600 500
Supervision salaries 1200 1200
Interest 5% 1250 750
4500 3600
Kms run per annum 15000 6000
Fixed Cost per km 0.30 0.60
Running cost per km
Driver’s wage (Rs3 0.15 0.15
per hour for 20 kms)
Fuel cost per km 0.15 0.20
Repairs && 1.65 2.00
Maintenance
Tyre allocation 0.80 0.60
Depreciation 0.25 0.20
(cost÷estimated life)
Running cost per km 3.00 3.15
Total cost per running 3.30 3.75
km (A)+(B)

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

When cost accounts and financial accounts are maintained in two different sets of books there will
be prepared two profit and loss accounts-one for costing books and the other for financial books.
The profit or loss shown by costing books may not agree with that shown by financial books. Such
a system is termed as Non-Integral System whereas under the integral system of accounting there
are no separate cost and financial accounts. Consequently, the problem of reconciliation does not
arise under the integral system. However, where two sets of accounting systems namely financial
accounting and cost accounting are being maintained the profit shown by the two sets of account
may not agree with each other. Although both deal with the same basic transactions like purchases
consumption of materials wages and other expenses the difference of purpose leads to a difference
in approach in a collection analysis and presentation of data to meet the objective of the individual
system. Financial accounts are concerned with the ascertainment of profit or loss for the whole
operation of the organisation for a relatively long period usually a year without being too much
concerned with cost computation whereas cost accounts are concerned with the ascertainment of
profit or loss made by manufacturing divisions or products for cost comparisons and preparation
and use of a variety of cost statements. The difference in purpose and approach generally results
in a different profit figure from what is disclosed by the financial accounts and thus arises the need
for the reconciliation of profit figures given by the cost accounts and financial accounts. The
reconciliation of the profit figures of the two sets of books is necessary due to the following reasons
1. It helps to identity the reasons for the difference in the profit or loss shown by cost and financial
accounts.
2. It ensures the arithmetical accuracy and reliability of cost accounts.
3. It contributes to the standardization of policies regarding stock valuation, depreciation and
overheads.
4. Reconciliation helps the management in exercising a more effective internal control.

CAUSES OF DIFFERENCE

Difference in profit or loss between cost and financial accounts may arise due to following
reasons.

1. Items shown only in financial accounts: There are a number of items which are included
in financial accounts but find no place in cost accounts. These may be items of expenditure
or appropriation of profit or items of income. The former reduces the profit while the latter
have the reverse effect. The items may be classified as under:
(a) Pure financial charges: (i) Loss arising from the sale of fixed assets, Loss on investments
(Hi) Discount on debentures, (iv) Interest on bank loan mortgages and debentures (v)
Expenses of the company’s share transfer office.
(b) Appropriation of Profit: (i) Donations and Charities (ii) Income-tax 9iii) Dividend paid
(iv) Transfers to reserves and sinking funds.
(c) Purely financial incomes: (i) Rent receivable (ii) Profits on the sale to fixed assets (iii)
Transfer fees received (iv) Interest received on bank deposits (v) Dividend received.
(d) Writing off intangible and fictitious assets: (i) Goodwill, Patents and copyrights (ii)
Advertisement, preliminary expenses organisation expenses etc.

2. Items shown only in cost accounts: There are certain items which are included in cost accounts
but not in financial accounts. These items are very few and usually are notional charges. For
example interest may be calculated on capital employed in production to show the nominal cost of
employing the capital through in fact no interest has been paid. Similarly, production may be
charged with a nominal rent for premises owned to enable the concern to compare its cost
production with that of a rented factory.

3. Estimates and actual

Since cost accounts are meant for function as a control device it will be appropriate to adopt
estimated costing or preferably standard costing system while preparing cost accounts. Estimates
or standard can be nearer to the actual but in most cases they cannot be the same. This necessarily
means that the profit shown by the cost accounts is bound to be different from the profit shown by
the financial accounts.
Following are some of the important items the costs of which may be different in financial
books and costing books
(a) Direct materials: The estimated or standard cost of the direct materials purchased or
consumed in the production process may be different from the actual costs. This difference
will be due to change in price or quantity or both.

(b) Direct Labour: The estimated or standard cost of direct labour may be different from the
actual costs because of difference in wage rates or hours of work or both. Sometimes,
workers might have to be paid more due to increased dearness allowance pay revisions
bonus etc. This will cause difference between the profits shown by the two sets of books.
 (c) Overheads: In cost accounts the recovery of overheads is generally based on estimates
while in financial accounts the actual expenses incurred are recorded. This results in under
or over recovery of overheads.

The under recovery or over recovery of overhears may be carried forward to the next period or
may be charged by a supplementary rate (positive or negative) or transferred to Costing Profit and
Loss Account. In case the under recovery or over recovery of overheads has been carried forward
to the next period the profit as shown by the costing books will be different from the profit as
shown by the financial books. Such variation may be due to over or under charging of factory,
office or selling and distribution overheads.
(d) Depreciation: Different method of charging depreciation may be adopted in cost and financial
books. In financial books depreciation may be charged according to fixed installment method or
diminishing balance method etc while in cost accounts machine hour rate or any other method may
be used. This is also an item of overheads and may be one of the reasons of difference between the
overheads charged in financial accounts and overheads charged in cost accounts.
4. Valuation of stock
(a) Raw materials: In financial accounts stock of raw materials is valued at cost or market price
whichever is less while in cost accounts stock can be valued on the basis of FIFO or LIFO or any
other method. Thus the figure of stock may be inflated in cost of financial accounts.

(b) Work in progress: Difference may also exist regarding mode of valuation of work in progress.
It may be valued at price cost or factory cost or cost of production. The most appropriate mode of
valuing is at factory cost in cost accounts. In financial accounts; work in progress may be valued
after considering a part of administrative expenses also.
(c) Finished goods: Under financial accounts stock of finished goods is valued at cost or market
price whichever is lower. In cost accounts finished stock is generally valued at total cost of
production. If the circumstances warrant prime cost or factory cost may also be taken as the basis
for valuing the stock of finished goods.
Thus mode of valuation of stock gives rise to different results in the two sets of books.
Greater valuation of opening stocks in cost accounts means less profit as per cost accounts and
vice versa. Greater valuation of closing stocks in cost accounts means more profit as per cost
accounts and vice versa.
5. Abnormal gains and losses
Abnormal gains or losses may completely be excluded from cost accounts or may be taken
to costing profit and loss account. In financial accounts such gains and losses are taken to profit
and loss account. As such in the former case costing profit/loss will differ from financial profit
loss and adjustment will be required. In the latter case there will be no difference on this account
between costing profit or loss and financial profit or loss. Therefore, no adjustment will be required
on this account. Examples of such abnormal gains and losses are abnormal wastage of materials
e.g. by theft or fire etc. cost of abnormal idle time cost of abnormal idle facilities exceptional bad
debts abnormal gain in manufacturing through processes (when actual production exceeds normal
production).
The need for reconciliation will not arise in case of a business where Integral Accounting
System is in use as there will be only one set of books both for financial and costing records. But
where there are separate sets of books reconciliation is imperative.

Preparation of Reconciliation Statement

 When there is a difference between the profits disclosed by cost accounts and financial
accounts, the following steps shall be taken to prepare a Reconciliation Statement
1. Ascertain the various reasons of disagreement (as discussed above) between the profits
disclosed by two sets of books of accounts.
2. If profit as per cost accounts (or loss as per financial accounts) is taken as the base:
ADD:
(i) Items of income included in financial accounts but not in cost accounts.
(ii) Items of expenditures (as interest on capital rent on owned premises etc)

(iii) Amounts by which items of expenditure have been shown in excess in cost accounts as
compared to the corresponding entries in financial accounts.
(iv) Amounts by which items of income have been shown in excess in financial accounts as
compared to the corresponding entries in cost accounts.
(v) Over absorption of overheads in cost accounts.

(vi) The amount by which closing stock of inventory is under valued in cost accounts.
(vii) The amount by which the opening stock of inventory is over valued in cost accounts.
DEDUCT:
(i) Items of income included in cost accounts but not in financial accounts
(ii) Items of expenditure included in financial accounts but not in cost accounts.

(iii) Amounts by which item of income have been shown in excess in cost accounts over the
corresponding entries in financial accounts.
(iv) Amounts by which items of expenditure have been shown in excess in financial accounts over
the corresponding entries in cost accounts.
(v) Under absorption of overheads in cost accounts.
(vi) The amount by which closing stock of inventory is over-valued in cost accounts.
3. After making all the above additions and deductions the resulting figure will be profit as per
financial accounts.
Note: If profit as per financial accounts (or loss as per cost accounts) is taken as the base then
items added shall be deducted and items to be deducted shall be added i.e. the procedure shall be
reversed.

Illustration: Rs
Profit as per Cost Accounts 10000
Works overheads under recov ered in cost accounts 500
Interest on capital included in financial accounts 500
Dividends received 1000
Rent for owned building charged in cost accounts 300
Profit as per financial books 10300
 There is a difference of Rs.300 between the profit as shown by the financial books and the
profit as shown by the cost books. A reconciliation statement can be prepared to reconcile on the
following basis the profits shown by two sets of books.

1. Profit as per cost accounts may be taken as the base. In other words, the profit as shown by
the financial books can be found out if suitable adjustments are made in this figure of profit
and after taking it account the above causes of difference.
2. Works overheads have been charged more in financial accounts than those in cost accounts.
This means profit as shown by the financial accounts is less than the profit as shown by the
cost accounts by Rs500 (the amount of under recovery). Since profit as per cost accounts
has been taken as the base the amount of Rs.500 should be subtracted from this base profit
to arrive at the profit as shown by the financial accounts.
3. The inclusion of interest on capital; as an expense has resulted in decrease in profits as
shown by financial books. In other words the profit as shown by the cost books is more
than the profit as shown by the financial books by Rs.500 (the amount of interest). The
amount should therefore the subtracted from the base profit.
4. Dividend received has been credited in financial books. This means the profit as won by
the financial books is more than the profit as shown by the cost books by Rs 1000. The
amount should therefore be added to the profit as shown by the cost books.
5. No charge is made in financial books for rent on owned buildings. The amount has however
been charged in the cost books. It means the profit as shown by the financial books is higher
than the profit as shown by the cost books by this amount. The amount therefore should be
added to the profit as whom by the cost books.

The reconciliation statement may now be conveniently presented in the following form:

Reconciliation Statement
Particulars + -
Profit as per Cost Accounts 10000
Less Works overheads 500
under charged in cost
accounts
Interest on Capital included 500
in financial accounts
Add: Dividends received 1000 1
Rent on owned building 300
Profit as per Financial 10300
Accounts

In case in the above example the cost accounts show a loss of Rs 10000 in place of a profit
the amount of loss should be put in the minus column. The reconciliation statement should then be
prepared on the same pattern as if there is a profit in place to there being a loss.

Illustration:
The following figures are extracted from the financial accounts of a manufacturing firm for the
first year of its operation:

Rs
Direct material consumption 5000000
Direct wages 3000000
Factory overheads 1600000
Administration overheads 700000
Selling and Distribution overheads 960000
Bad debts 80000
Preliminary expenses 40000
Legal Charges 10000
Dividends received 100000
Interest Deposit received 20000
Sales -120000 units 120000
Closing stock:
Finished stock 4000 units 320000
Work in progress 240000

The cost accounts for the same period reveal that the direct material consumption was Rs.5600000;

Factory overhead is recovered is recovered at 20% on Prime Cost:

Administration overhead is recovered @ Rs.6 per unit of production;

Selling and Distribution overheads are recovered @ Rs.8 per unit sold.

You are required to prepare Costing and Financial Profit and Loss Accounts and reconcile the
difference in the profits as arrived at in the two sets of accounts.

Solution:
Costing Profit and Loss Account
Direct Materials 5600000
Direct wages 3000000
Prime cost 8600000
Factory overhead 20% on Prime cost 1720000
10320000
Less work in progress (Closing stock) 240000
Works cost 10080000
Administration overhead Rs6 per unit of 744000
production:120000+4000
Cost of production 10824000
Less closing stock 349161
Add selling and distribution expenses @ Rs8 960000
per unit i.e. 120000x8
Cost of goods sold 11434839
Profit 565161
Sales 12000000

Financial Profit and Loss Account

Rs Rs
To Direct materials 5000000 By sales 12000000
To direct wages 3000000 By closing stock
To factory overheads 1600000 Finished Stock 320000
To gross profit 2960000 WIP 240000
12560000 12560000
To administration By gross profit 290000
Overheads 700000 By dividends 100000
To selling and distribution 960000 By interest 2090000
 To bad debts 80000
To preliminary expenses 40000
To legal charges 10000
To net profit 1290000
308080 3080000

Financial Profit and Loss Account

Rs Rs
Profit as per cost accounts 5965161
Add Dividend not taken in 100000
costing.
Interest not take in costing 20000
Excess of Direct materials 600000
consumed
Over absorbed in costing
(a) Factory overheads 120000
(b) Administration 44000 884000
overheads 1449161
Less Bad debts taken in 80000
Financial Accounting but not
in costing
Preliminary expenses taken 40000
in Financial Accounting but
not in costing
Legal charges taken in 10000
financial but not in costing
Different in closing 29161 159161
stock(349161-320000)
Profit as per financial 1290006
accounts

Illustration:
From the following figures prepare a Reconciliation Statement:
Net loss as per financial records Rs216045
Net loss as per costing records 172400
Works overhead under recovered in costing 3120
Administrative overhead under recovered in excess 1700
Depreciation charged in financial records 11200
Depreciation recovered in costing 12500
Interest received but not included in costing 8000
Obsolescence loss charged in financial records 5700
Income tax provided in financial books 40300
Bank interest credited in financial books 750
Stores adjustments credit in financial books 475
Deprecation of stock charged in financial books 6750

Solution:
RECONCILATION STATEMENT
Particulars + -
Rs Rs
Net loss as per costing records 172400
 Less: works overhead under 3120
recovered
Obsolescence loss not charged 5700
Income tax not provided 40300
Depreciation in stock 6750
Add: Excess depreciation charged 1300
(12500-11200)
Excess administrative overhead 1700
Interest received not included 8000
Bank interest 750
Stores adjustments 475
Net loss as per financial records 12225 228270
216045

Illustration:
The financial Profit and Loss Account of a Manufacturing Company for the year ended 31 st March,
2020 is as follows

Rs Rs
To materials consumed 50000 By Sales 124000
To carriage inward 34000
To works expenses 12000
To direct wages 1000
To administration expenses 4500
To selling and distribution expenses 6500
To debenture interest 1000
To net profit 15000
124000 124000

The Net Profit shown by the cost accounts for the year is Rs 16270. On detailed comparison of the
two sets of accounts it is found that:
(a) The amounts charged in the cost accounts in respect of overhead charges are as follows: Works
overhead Rs.11500; Office overhead Rs 4590; Selling and distribution overhead Rs6640.
(b) No charge has been made in the csot accounts in respect of debenture interest. You are required
to reconcile the profits shown by the two sets of accouts.
Solution: RECONCILATION STATEMENT

Particulars Rs + -
Profit as per Cost Accounts 16270
Add: overhead overcharged in Cost
Accounts
(i) Office overheads
Cost Books 4590
Financial Books 4500 90
-------
(ii) Selling and Distribution
overheads
Cost Books 6640
Financial Books 6500 140
 Less: (i) Works overheads
undercharged in
Cost Accounts
Financial Accounts 12000
Cost Accounts 11500 500

(ii) Debenture Interest omitted 1000

from Cost Accounts
Profit as per profit & Loss a/c 16500 1500
(Financial Books) 15000

Illustration:
In a factory works overheads are absorbed at 60% of Works cost. Prepare (i) Cost Sheet (ii) Trading
and Profit & Loss Account and (iii) Reconciliation Statement if Total Expenditure consists of
Materials Rs.200000; Wages Rs150000, Factory Expenses Rs100000 and Office Expenses
Rs85000. 10% of the output is stock at the end and sales are Rs.520000.

Solution: COST SHEET FOR THE PERIOD

Materials 200000
Labour 150000
Prime cost 350000
Factory overhead 90000
Factory cost 440000
Office overhead 88000
Cost of production 528000
Less: Closing Stock (10% of 528000) 52800
475200
Profit 44800

Unit 3
 Analysis and Interpretation of Financial Statements
Financial statements refer to at least two statements which the accountant prepares at the end of
a given period of time for the business enterprise. These statements are:
1. Profit and Loss A/c which is prepared to ascertain the net results of a year’s working of the
business.

2. Balance Sheet which is prepared to ascertain the financial position of the business as on a
particular date.
In the case of a limited company financial statements also include profit and loss appropriation
account. Sometimes the statement of source and applications of funds also forms part of the
financial statements.

Financial statements are prepared primarily for decision making. They play a dominant role in
setting the framework of managerial decisions. But the information provided in the financial
statements is not an end in itself as no meaningful conclusions can be drawn from these statements
alone. However the information provided in the financial statements is of immense use in making
decision through analysis and interpretation of financial statements. Financial analysis is the
process of identifying the financial strengths and weaknesses of the firm by properly establishing
relationship between the items of the balance sheet and the profit and loss account. There are
various methods or techniques used in analyzing financial statements trend analysis schedule of
changes in working capital funds flow and cash flow analysis and ratio analysis.
Meaning of analysis of Financial Statements

An analysis is the process of critically examining in detail accounting information given in the
financial statements. For the purpose of analysis individual items are studied their
interrelatinsships with other related figures are established the data is sometimes rearranged to
have better understanding of the information with the help of different techniques or tools for the
purpose. Analysing financial statements is a process of evaluating relationship between component
parts of financial statement to obtain a better understanding of firm’s position and performance.
The analysis of financial statements thus refers to the treatment of the information contained in the
financial statements in a way so as to afford a full diagnosis of the profitability and financial
position of the firm concerned. For this purpose financial statements are classified methodically
analysed and compared with the figures of previous years or other similar firms.
Meaning of Interpretation

Analysis and interpretation are closely related. Interpretation is not possible without analysis and
without interpretation analysis has not value. Various account balances appear in the financial
statements. These account balances do not represent homogeneous data so it is difficult to interpret
them and draw some conclusions. This requires an analysis of the data in the financial statements
so as to bring some homogeneity to the figures shown in the financial statements. Interpretation is
thus drawing of inference and stating what the figures in the financial statements really means.
Interpretation is dependent on interpreter himself. Interpreter must have experience understanding
and intelligence to draw correct conclusions from the analysed data.
Objectives of Financial Analysis
Financial analysis is helpful in assessing the financial position and profitability of a concern. This
is done through comparison by rations for the same concern over a period of years or for one
concern against another or for one concern against the industry as a whole or for one concern
against the predetermined standards or for one department of a concern against other departments
of the same concern. Accounting ratios calculated for a number of years show the trend of the
change of position i.e. whether the trend is upward or downward or static. The ascertainment of
trend helps us in making estimates for the future. For example ratios of gross profit to sales for the
last five years indicate a rising trend. We can safely estimate that ratio of gross profit to sales for
the next years will also rise. Keeping in view the importance of accounting ratio the accountant
should calculate the ratio in appropriate form as early as possible for presentation to management
for managerial control.
In short the main objectives of analysis of financial statements are to access:

The present and future earning capacity or profitability of the concern

The operational efficiency of the concern as a whole and of its various parts or departments
The short term and long term solvency of the concern for the benefit of the debenture holders and
trade creditors.
The comparative study in regard to one firm with another firm or one department with another
department
The possibility of developments in the future by making forecasts and preparing budgets
The financial stability of a business concern and
The long term liquidity of its funds
Tools of Financial Statement Analysis

A variety of tools can be used by a financial analyst for the purposes of analysis and interpretation
of financial statements particularly with a view to suit the requirements of the specific enterprise.
The principal tools are as under:-
1. Comparative Statements
2. Common size statements
3. Trend Analysis

4. Cash Flow Statement

5. Ratio Analysis
6. Funds Flow Statements
Comparative Statements: Comparative Statement are the statements prepared to trace the
periodic changes in the financial performance of a company. Comparative statements will contain
items at least for two periods. Generally two separate statements (one for balance sheet and one
for profit and loss account) are prepared in comparative form for the purpose of financial analysis.
This changes in balance sheet and profit loss account over period can be shown in two ways.
Aggregate Changes
Proportionate Changes

Comparative statements can also be used to compare the performance of a firm with that of other
firms. However the financial data will comparable only when same accounting policies are used
in preparing these statements. In case of different accounting policies and frequent changes in them
both inter firm comparison and inter period comparison will be misleading.
Comparative Income Statement
The comparative income statement is the study of the trend of the same items/group of items in
two or more income statements of the firm for different periods. The changes in the income
statement items over the period would help in forming opinion about the performance of the
enterprise in its business operations.
Interpretation of comparative income statement
The changes in sales should be compared with the changes in cost of goods sold.
If increase in sales is more then the profitability will improve.

An increase in operating expenses or decrease in sales would imply decrease inoperating profit
and a decrease in operating expenses or increase in sales would imply increase in operating profit.
The increase or decrease in net profit will give an idea about the overallprofitability of the concern.
Illustration 1. The Income Statement of Nikhil Ltd are given for the years 1998 and 1999.
Rearrange the figures in a comparative form and study the profitability position of the firm.

Item 1998(Rs) 1999 (Rs)

Net sales 1500000 2000000

Less cost of goods sold 1200000 1500000
------------ ----------
Gross profit 300000 500000

Less operating expenses 75,000 100000

(Administration Selling Distribution --------- -----------
Expenses)
225000 400000
Operating profit
25000 40000
Add Other Incomes

Earnings before Interest & Tax

250000 440000
Less Interest
40000 40000

210000 400000
Earnings before Tax
84000 160000
Less Tax payable
126000 ----------
Profit after Tax
240000
Solution: Comparative Income Statement for the year ended 31st Dec 1998 and 1999

Items 31.12.98 31.12.99 Increase Percentage

(Decrease) (Rs) Increase
(Decrease)

Net Sales 1500000 2000000 500000 33.3

Less Cost of goods Sold 1200000 1500000 300000 25.0
Gross Profit ----------- ------------ ---------- -------
300000 500000 200000 66.7

Less Operating Expenses

(Administration Selling &
Distribution Expenses)
750000 100000 25000 33.3
Operating profit
225000 400000 175000 77.8
Add Other Incomes
25000 40000 15000 60.0
Earnings before Interest &
Tax 2500 440000 190000 76.0

Less Interest
Earning before Tax 40000 400000 ---

Less Tax 210000 190000 90.5

Earning after Tax 84000 160000 76000 90.5

126000 240000 114000 90.5

b) Comparative Balance Sheet

The comparative balance sheet analysis would highlight the trend of various items and groups of
items appearing in two or more Balance Sheets of a firm on different dates. The changes in periodic
balance sheet items would reflect the changes in the financial position at two or more periods.

Interpretation of Comparative Balance Sheet

(i) The increase in working capital would imply increase in the liquidity position of the firm over
the period and the decrease in working capital would imply deterioration in the liquidity position
of the firm.
(ii) An assessment about the long term financial position can be made by studying the changes in
fixed assets capital and long term liabilities. If the increase in capital and long term liabilities is
more than the increase in fixed assets it implies that a part of capital and long term liabilities has
been used for financing a part of working capital as well. This will be a reflection of the good
financial policy. The reverse situation will be a signal towards increasing degree of risk to which
the long term solvency of the concern would be exposed to
 (iii) The changes in retained earnings reserves and surpluses will give an indication about the trend
in profitability of the concern. An increase in reserve and surplus and the Profit and Loss Account
is an indication of improvement in profitability of the concern. The decrease in these accounts may
imply payment of dividends issue of bonus shares or deterioration in profitability of the concern.
Illustration 2: From the following balance sheets of Pal Ltd as on 31st December 1998 and 1999
prepare a comparative Balance Sheet for the concern
Balance Sheet of Pal Ltd

Liabilities 1998 (Rs) 1999 (Rs) Assets 1998 1999

(Rs) (Rs)

Equity share capital 300000 400000 Land & Building 200000 150000
Reserve & surpluses 160000 110000 Plant & Machinery 200000 300000
Debentures 100000 150000 Furniture 25000 30000
Mortgage loan 80000 100000 Bills receivables 75000 45000

Bills payable 30000 25000 S. Debtors 100000 125000

S. Creditors 50000 60000 Stock 113000 172000
Other Current Liabilities 5000 10000 Prepaid Expenses 2000 3000
Cash & Bank 10000 30000
Balance

725000 855000 725000 855000

Solution Comparative Balance Sheet of Pal Ltd

Item Year Ending Increase (Decrease) Increase (Decrease)

(Rs) (Percentage)

31.12.98 31.12.99

Fixed assets
Land & Building 200000 150000 (50000) (25.0)
Plant & Machinery 200000 300000 100000 50.0
Furniture 25000 30000 5000 20.0
12.9

Total Fixed Assets

425000 480000 55000

Current Assets
Bills receivable 75000 45000 (30000) (40.0)
S. Debtors 100000 125000 25000 25.0
Stock 113000 172000 59000 52.2
Prepaid expenses 2000 3000 1000 50.0

Cash & Bank Balance 10000 30000 20000 200.0

Total Current Assets 300000 375000 75000 25.0

725000 855000 130000 17.9

Shareholder’s Funds
Equity Share Capital 300000 400000 100000 33.3
Reserve & Surpluses 160000 110000 (50000) (31.3)

Total shareholders Funds 460000 510000 50000 10.9

Long term Loans

Debentures 100000 150000

Mortgage Loan 80000 100000
Total Long Term Loans 180000 250000
Current Liabilities
Bills Payable 30000 25000 (5000) (16.7)

S. Creditors 50000 60000 10000 20.0

Other current liabilities 5000 10000 5000 100.0
Total current Liabilities 85000 95000 10000 11.8
Total Liabilities 725000 855000 130000 17.9

2. Common size Statements

Financial statements when read with absolute figures are not easily understandable. It is therefore
necessary that figures reported in these statements should be converted into percentage to total
which is taken equivalent to hundred. This kind of analysis is also called as vertical analysis. It
depicts a static view of the qualitative relationship between the items of the balance sheet and
profit and loss account. But if it is studied over a period of time. Then it becomes a dynamic
analysis that is vertical analysis presented horizontally.
This technique throws light on the structure of the balance sheet and profit and loss account. The
trend depicted by common size analysis is more authentic as it reflects qualitative assessment as
against quantitative assessment depicted by absolute figures.
 Common Size Income Statement
In the case of income statement the sales figure is assumed to be equal to 100 and all other figures
are expressed as percentage of sales. The relationship between items of income statement and
volume of sales is quite significant since it would be helpful in evaluating operational activities of
the concern. The selling expenses will certainly go up with increase in sales. The administrative
and financial expenses may go up or may remain at the same level. In case of decline in sale selling
expenses should definitely decrease.
Illustration 3: From the following profit and loss account of Ram Ltd for the year ending 31st
December 1998 and 1999 prepare common size income Statement and give your interpretation.
Profit & Loss A/c of Ram Ltd for the year ending 31 st December

1998 (Rs) 1999 (Rs)

Net Sales 2230000 3185000

Less Cost of goods sold 1535000 2270000

Gross margin 695000 915000

Less operating expenses 402000 602000
Income before interest & tax 293000 313000
Less interest
Net income before tax 18000 30000

Less Tax @ 50% 275000 283000

Net income After Tax 137500 141500
137500 141500

Solution:
Common Size income statement of Ram Ltd for the year ending 31st December

Item 1998 1999

Rs %age Rs %age

Net sales 2230000 100.00 3185000 100.0

Less cost of goods sold 1535000 68.80 2270000 71.3
Gross margin 695000 31.20 915000 28.7

Less operating expense 402000 18.00 602000 18.9

Income before interest & 293000 13.20 313000 9.8
tax
Less interest
 Net income before tax 18000 0.80 30000 0.9
Less tax 275000 12.30 283000 8.9
Net income tax 137500 6.15 141500 4.45

137500 6.15 141500 4.45

Comments
The absolute figures reveal that sales cost of goods sold and gross margin all have increased over
the last year. But the common size statement reveals that cost of goods sold has increased hi 1999
in relation to sales. Consequently gross profit margin has decline during the current year. Similarly
net income after tax in terms of absolute figures shows an increase on the previous year but the
rate of net profit on sales in 1999 in 4.45 as against 6.15 in 1998. Thus the overall profitability has
decreased in 1999 due to rise in cost of sales.
Common Size Balance Sheet

For the purpose of common size balance sheet the total of assets or liabilities is taken as 100 and
all the figures are expressed as percentage of the total. In other words each asset is expressed as
percentage to total assets/liabilities and each liability is expressed as percentage to total
assets/liabilities. This statement will throw light on the solvency position of the concern by
providing an analysis of pattern of finding both long term and working capital heeds of the concern.

Illustration 4: The following are the Balance sheets of X Ltd and Y Ltd for the year ending 31 st
December 2000.
Balance Sheet of X Ltd and Y Ltd for the year ending 31st Dec 2000

Liabilities X Ltd Y Ltd Assets X Ltd Y Ltd

Equity share 300000 00000 Land & 60000 340000

capital building

Pref share capital Plant &

200000 320000 Machinery 660000 1000000

Investment
Reserve &
Surpluses 68000 136000 10000 80000

Long term loans S. Debtors

23000 350000 20000 50000

Bills Payable Stock

S. Creditors 4000 10000 Prepaid 16000 60000
Expenses
Expenses 24000 38000 2000 4000
outstanding Cash in hand
30000 42000
Proposed 8000 22000
Dividend
20000 60000

876000 1556000 876000 556000

Compare the financial position of two companies with the help of common size balance sheet.
Solution: Common Size balance sheet as on 31st December 2000

Item X Ltd Y Ltd

Rs %age Rs %age

Shareholder Funds
Equity Share Capital 300000 34.2 600000 38.6
Preference Share Capital 200000 22.8 320000 20.6
Reserve & Surplus 68000 7.8 136000 8.7
Total 568000 64.8 1056000 67.9

Long term loans 230000 26.3 35000 22.5

Total 230000 26.3 350000 22.5
Current Liabilities
Bills payable 4000 0.5 10000 0.6
S. Creditors 24000 2.7 38000 2.4

Expenses Outstanding 30000 3.4 42000 2.7

Proposed dividend 20000 2.3 60000 3.9
Total 78000 8.9 150000 9.6
Grand total 876000 100.0 1556000 100.0
Fixed assets
Land & Building 160000 18.3 340000 21.8

Plant & Machinery 660000 75.3 1000000 64.3

Total 820000 93.6 1340000 86.1
Investments 10000 1.2 80000 5.1
Total 10000
Current Assets

S. Debtors 20000 2.3 50000 3.2

Stock 16000 1.8 60000 3.9
Prepaid expenses 2000 0.2 4000 0.3
Cash in hand 8000 0.9 22000 1.4

Total 46000 5.2 136000 8.8

Grand total 876000 100.0 1556000 100.0

The statements show that both the companies depend more on shareholders funds for meeting their
long term requirements as the proportion of shareholders funds stands at 64.8% for X Ltd and
67.9% for Y Ltd. However the long term funds are not sufficient to finance the requirements of
foxed assets in case of X Ltd. X Ltd’s long term funds stand at 91.1% (64.8+26.3) against fixed
asset at 93.3% of the total of the balance sheet. Both the companies suffer from inadequacy of
working capital since the proportion of current liabilities is more than the proportion of current
assets. However X Ltd’s positions much wrose then Y Ltd in this regard.

3. Trend Analysis
Trend analysis is an important tool of horizontal financial analysis. This is immensely helpful in
making a comparative study of the financial statements of several years. Under this method trend
percentages are calculated for each items of the financial statement taking the figure of base year
as 100. The starting year is usually taken as the base year. The trend percentages show the
relationship of each item with its preceding year’s percentages show the relationship of each item
with its preceding year’s percentages. These percentages can also be presented in the form of index
numbers showing relative change in the financial data of certain period. This will exhibit the
direction (i.e. upward or downward trend) to which the concern is proceeding. These trend rations
may be compared with industry ratios in order to know the strong or weak points of a concern.
These are calculated only for major items instead of calculating for all items in the financial
statements.
While calculating trend percentages the following precautions may be taken

The accounting principles and practices must be followed constantly over the period for which the analysis
is made. This is necessary to maintain consistency and comparability.

The base year selected should be normal and representative year

Trend percentages should be calculated only for those items which have logical relationship with one
another.

Trend percentages should also be carefully studies after considering the absolute figures on which these are
based. Otherwise they may give misleading conclusions.

To make the comparison meaningful trend percentages of the current year should be adjusted in the light
to price level changes as compared to base year.

Illustration 5: Interpret the results of operations of a manufacturing concern using trend ratios on the
following information(Amount in 000 Rupees) For the year ended 31st March

Items 1999 1998 1997 1996

Sales (net) 13000 12000 9500 10000

Cost of goods 7280 6960 5890 6000
sold

Gross profit 5720 5040 3610 40000

Selling expenses 1200 1100 970 1000

Net operating 4520 3940 2640 3000

profit

Solution: Trend Ratios 31st March 1996=100

Items 1996 1997 1998 1999

Sales (net) 100 95 120 130

Cost of goods 100 98 116 121

sold

Gross profit 100 90 126 143

Selling expenses 100 97 110 120

Net operating 100 88 131 150

profit

Interpretation

From the above statement the following points are worth noting

The sales volume cost of goods sold and selling expenses all declined in 1997 as compared to 1996 but the
decrease in cost of goods sold and selling expenses was lesser to the decrease in sales volume.

The sales volume cost of goods sold and selling expenses in 1998 and 1999 have increased in comparison
to 1996 but the increase in cost of goods sold and selling expenses is lesser to the increase in sales volume.

In conclusion it can be said that a large proportion of cost of goods sold and selling expenses is foxed and
is not affected by changes in sales volume. This fact also becomes clear from this fact that in 1997 when
sales fell down the decrease in the company’s net operating profit was faster to sales volume and in 1999
when the sales volume increased the increase in company’s net profit was faster to sales volume.

4. Cash Flow Statement

A cash flow statement shows an entity’s cash receipts classified by major sources and its cash payments
classified by major uses during a period. It provides useful information about an entity’s activities in
generating cash from operations to repay debt distribute dividends or reinvest to maintain or expand its
operating capacity about its financing activities both debt and equity and about its investment in fixed assets
or current assets other than cash. In other words a cash flow statement lists down various items and their
respective magnitude which bring about changes in the cash balance between two balance sheet dates. All
the items whether current or non current which increase or decrease the balance of cash are included in the
cash flow statement. Therefore the effect of changes in the current assets and current liabilities during an
accounting period on cash position which is not shown in a fund flow statement is depicted in a cash flow
statement. The depiction of all possible sources and application of cash in the cash flow statement helps the
financial manager in short term financial planning in a significant manner because the short term business
obligations such as trade creditors bank loans interest on debentures and dividend to shareholders can be
met out of cash only.
The preparation of cash flow statement is also consistent with the basic objective of financial reporting
which is to provide information to investors creditors and others which would be useful in making rational
decisions. The basic objective is to enable the users of information to make prediction about cash flow in
an organization since the ultimate success or failure of the business depends upon the amount of cash
generated. This objective is sought to be met by preparing a cash flow statement.

5. Funds Flow Statement: Funds flow statement is a method by which we study changes in the financial
position of a business enterprise between the beginning and ending financial statement dates. It is a
statement showing sources and uses of funds for a period of time. Foulke defines this statement as A
statement of sources and applications of funds is a device designed to analyse the changes in the financial
condition of a business enterprise between two dates.

In the words of Anthony. The funds flow statements describes the sources from which additional funds
were derived and the use to which these sources were put.

I.C.W.A in the glossary of management accounting terms defines funds flow statement as a statement either
prospective or retrospective setting up of resources and application of the funds of an enterprise. The
purpose of the statement is to indicate clearly the requirements of funds and how they are proposed to be
raised and their efficient utlisation and application. Funds flow statement is called by various names such
as Sources and Application of funds Statement of changes in financial position Sources and uses of funds
summary of financial operations where came in and where gone out statement movement of working capital
statement and movement of funds statement funds received and disbursed statement funds generated and
expended statement funds statement etc.

Distinction between fund flow statement and cash flow statement

Both fund flow statement and cash flow statement are prepared to summarise the causes of changes in the
financial position of a business. A fund flow statement is prepared on the assumption that the changes in
the financial position of a business are effected through inflow or outflow of net working capital (excess of
total of current assets over total of current liabilities) whereas a cash flow statement assumes that the
financial position of a business changes through the inflow and outflow of cash. Some of the main difference
between a fund flow statement and a cash flow statement are described below:

Concept of funds: a fund flow statement is prepared on the basis of a wider concept of funds i.e. net
working capital (excess of current assets over current liabilities) whereas cash flow statement is based upon
narrower concept of funds i.e. cash only.

Basis of accounting: A fund flow statement can also be distinguished from a cash flow statement from the
point of view of the basis of accounting used for preparing these statements. A fund flow statement is
prepared on the basis of accrual basis of accounting whereas a cash flow statement is based upon cash basis
of accounting. Due to this reason adjustments for incomes received in advance incomes outstanding prepaid
expenses and outstanding expenses are made to compute cash earned from operations of the business (refer
to computation of cash from operations). No such adjustments are made while computing funds from
operations in the funds flow statement.

Mode of preparation: a fund flow statement depicts the sources and application of funds. If the total of
sources is more than that of applications then it represents increase in net working capital. A cash flow
statement depicts opening and closing balance of cash and inflows and outflows of cash. In a cash flow
statement to the opening balance of cash all the inflows of cash are added and from the resultant total all
the outflows of cash are deducted. The resultant balance is the closing balance of cash. A cash flow
statement is just like a cash account which starts with opening balance of cash on the debit side to which
receipts of cash are added and from the resultant total the total of all the payments of cash (shown on the
credit side) is deducted to find out the closing balance of cash.

Treatment of current assets and current liabilities: While preparing a funds flow statement the changes
in current assets and current liabilities are not disclosed in the funds flow statement rather these changes
are shown in a separate statement known as schedule of changes in working capital. In a cash flow statement
no distinction is made between current assets and fixed assets and current liabilities and long term liabilities.
All changes are summarized in the cash flow statements.

Usefulness in planning: A cash flow statement aims at helping the management in the process of short
term financial planning. A cash flow statement is useful to the management in assessing its ability to meet
its short term obligations such as trade creditors bank loans interest on debentures dividends to shareholders
and so on. A fund flow statement on the other hand is very helpful in intermediate and long term planning
because though it is difficult to plan cash resources for two three or more years ahead yet one can plan
adeaute working capital for future periods.

6. Ratio Analysis- Ratio is an arithmetical relation between the two related or inter dependent items. Ratio
analysis is the process of determining of interpreting numerical relationship between figures of the financial
statement.

Advantages & uses of Ratio Analysis-

Useful in analysis of financial statements.

Useful in simplifying accounting figures

Useful in Judging the operating efficiency of the business.

Useful for forecasting purpose

Useful in locating the weak sports of the business.

Types of Ratios
1. Liquidity Ratio (Short term solvency Ratio)
2. Turn over ratios or activity ratios
3. Profitability Ratios
4. Solvency Ratios (Long Term Solvency)

(i) Liquidity Ratios

a) Current Ratio or WC Ratio=Current Assets/Current Liabilities

Ques-

Balance Sheet

Liabilities Amount Assets Amount

Creditors-B/P 20000 Stock 60000

Tax payable 15000 Debtor 70000

O/S expenses 7000 Cash 20000

Bank OD 25000 Prepaid exp 10000

Debentures 175000 L&B 100000

Reserves 80000 Goodwill 50000

340000 340000

Calculate current ratio.

Ans. Current Assets=190000

Current Liabilities=85000

CA/CL=CR

190000/85000=2.23:1

Satisfactory ratio is 2:1

(b) Quick Ratios or Acid test Ratio or Liquid Ratio

=Quick Assets/Liquid Assets/ Current Liabilities

Satisfactory ratio is 1:1

Liquid assets=CA – Stock-Prepaid expenses

Ans. Q.A = 190000-60000-10000

= 120000

CL = 85000

QR = 120000/85000=1.41:1

(ii) Turnover Ratios

(a) Inventory turnover Ratio

Cost of goods sold/average stock

Average stock=(opening stock+ closing stock)/2

COGS=Opening stock+ net purchase + direct expenses-closing stock or sales – gross profit

Direct expenses = Expenses directly incurred on manufacturing like fuel power coal wages carriage inward
etc

Inventory conversion period –

Days in a year/inventory turnover ratio

(b) Debtors turnover ratio or debtors velocity ratio

=Net credit sales/Average debtors

Average debtors=opening debtor & B/R + closing debtors & B/R/2

Net credit sales=Credit sales-sales return

Or

Total sales-cash sales

Average collection period= No of days in a year/Month/Debtor turnover ratio

Ques. Total sales 700000

Cash sales 200000

Debtors in the beginning 80000

Debtors at the end 100000

Assuming that there are 360 days in a year OTR & Debtors collection period

Ans. DTR = 500000/90000=5.56 times

DCP=360/5.56=64.75 days & Creditors turnover

= credit purchase/average creditors

(c) Capital turnover Ratio

=Sales/Capital employed

(d) Fixed assets turnover Ratio

=Sales/Fixed assets

(e) Net working capital turnover Ratio

=Sales/Net working capital

Ques. The following is the B/S of K.Co Ltd

Liabilities Amount Assets Amount

Share capital 80000 Fixed assets 160000

General res 30000 Debtor 60000

P&LA/C 50000 B/R 20000

Loan @ 10% 80000 Cash at bank 50000

Creditors B/P 20000 Preliminary exp 10000

300000 300000

Sales during the year amounted to Rs 160000. Find out turnover ratios.

(iii) Profitability Ratios

(a) Gross profit Ratio=Gross profit/Net Sales x 100
(b) Net profit ratio=Net profit/Net sales x 100
(c) Operating profit ratio=Operating profit/Net sales x100 (OP=GP-Op Exps)
(d) Operating ratio=COGS+ operating expenses/Net Sales x 100
(e) Expenses Ratio=Particular Cost/Net Sales x100
(f) Return on investment or ROI=Earnings before interest but after taxes/capital employed x100
(g) Return on Assets (ROA) = PAT/Total Assets (Out of total assets fictitious assets may be excluded)
(h) Return on equity or ROE=Net profit (after interest tax & preference dividend)/Equity
shareholder’s fund
(i) Earning per share= Net profit – preference dividend/No of equity shares

Ques:The following is the trading & P& LA/C of W Ltd

Particulars Rs Particulars Rs
To stock 70000 By sales 500000

To purchase 300000 By stock 90000

To carriage 6000

To wages 14000

To gross profit 200000

590000 590000

To administrative 102000 By G/P 200000

expenses

To selling & 20000 By dividend received 5000

distribution exp

To interest 3000

To net profit 80000

205000 205000

Find out the profitability ratios.

(iv) Long term solvency Ratios

(a) Debt Equity Ratio= outsiders fund/external equity/shareholders fund/internal equity

DER = LT Loans/Shareholders fund

Debt = Long term loan + debentures + public deposits + mortgage

Equity=Equity Share + preference share + Reserves + P& LCCR Balance) + Accumulated profit - P&L (Dr
Balance) – Factious Assets (Like preliminary expenses or discount on issue of shares & debentures and
underwriting commission or goodwill written off)

(b) Debt to total capitalization=Debt/Total capitalization (Debt + Equity)

Total capitalization = External equity + internal equity

(c) Equity ratio or proprietary ratio=Eq shareholders fund/Total assets

Total assets = Fixed assets + current assets

(d) Solvency Ratio= Total Liabilities to outsiders / Total Assets

Total Liabilities = Loan debenture current liability

(e) Interest Coverage ratio=Net profit before interest & tax/interest on fixed (long term) loans or
debentures

Solution

Working Notes:

Funds from Operations

 Particulars Amount (Rs)

Profit earned and retained during the year 2004-05 (Rs 30000
50000-Rs20000)

Add: depreciation for 2004-05 185000

Loss on sale of fixed assets 5000

Dividends-interim 45000

Proposed for 2004-05 80000

Profit transferred to general reserve A/c 80000

Funds from operations 425000

Original Cost of Fixed Assets sold 75000

Less: Accumulated Depreciation on theseassets (65000)

Book value of Assets Sold 10000

Selling price 5000

Loss on sale of fixed assets 5000

Depreciation Provision Account

Dr Cr

Particulars Amount Rs Particulars Amount Rs

To fixed assets 65000 By balance b/d 760000

account (opening balance)

(Accumulated By profit & Loss A/c

depreciation on assets
sold) (b/figure) (Depreciation for the
year 2004-05)
To balance c/d(closing
balance) 880000 185000

945000 945000

Fixed Assets Account

Dr Cr

Particulars Amount Rs Particulars Amount Rs

To balance b/d(opening 1600000 By bank (Sale) 5000

balance)
By profit and Loss A/c 5000

(Loss on fixed assets sold)

To bank (Purchases)
(b/figure) 375000 By Depreciation provision A/c 65000
 By balance c/d (closing balance) 1900000

1975000 1975000

Fixed assets of original cost of Rs.75000 with book value of Rs.10000 were scrapped and sold for Rs5000

Included in current liabilities are proposed dividend figures: 31.3.2004: Rs 60000 31.3.2005 Rs.80000

During the year interim dividend for Rs.45000 was paid besides the outstanding as on 31.3.2005.

From the above you are required to prepare a funds flow statement for 2004-05.

Solution:

Schedule of Changes in Working Capital

Particulars At the end of March 31 Effect on working capital (Rs)

2004 2005 Increase (+) Decrease (-)

Current assets

Stock 320000 260000 --- 60000

Cash & bank balance 180000 220000 40000 ---

Other current Assets 72000 96000 24000 ---

Sundry debtors 200000 200000 --- ---

Total current Assets (A) 772000 776000

Less: Current Liabilities

Provision against debtors 20000 50000 --- 30000

Current liabilities (excluding proposed 72000 96000 --- 24000

dividends)

Total C.L. (B)

146000
Working capital (A-B)
92000 630000 --- ---
Net Decrease in Working Capital
680000 ---- 50000

50000 680000 114000 114000

680000

Funds Flow Statement for the year ending 31st March, 2005

Sources Amount (Rs) Applications Amount (Rs)

Funds from operations 425000 Purchase of fixed 375000

assets
Sale of fixed assets 5000
Redemption of 15%
Amount realized from issue of 200000 debentures (A 400000
equity shares Series)
Issue of 14% debentures (B) Payment of
series investment
500000 300000
Decrease in working capital Payment of interim
50000 dividend

Payment of proposed 45000

dividend for 03-04
---------------- 60000

1180000 1180000

4. Investment

Dr Cr

Particulars Amount Rs Particulars Amount Rs

To balance b/d 20000 By Cash (dividend received out of pre 1000

acquisition profit)
To Purchase (b/figure) 11000
By balance c/d
30000

31000 31000

5. Provision for Taxation Account

Dr Cr

Particulars Amount Rs Particulars Amount Rs

To Bank A/c 40000 By balance b/d 40000

To Balance c/d 50000 By adjusted P & L A/c 50000

(provision for the year) (b/figure)

90000 90000

Assume that the provision for tax for the previous year of Rs.40000 was paid during the year.

Illustration:

The summarized balance sheet of Kuldeep Ltd as on 31st March 2004 and 31st March 2005 were asfollows:

Sources of Funds 2004 (Rs) 2005 (Rs)

Share capital 700000 900000

General Reserve 340000 420000

Profit and loss account 20000 50000

15% debentures- A 40000 ---
series
14% debenture-B --- 500000
series
Total 1460000 1870000

Application of funds 1600000 1900000

Fixed assets at cost 760000 880000

Less: accumulated 1020000

depreciation
Net fixed assets (A) 840000

- 300000

Investments 200000 200000

Sundry debtors 20000 50000

Less: provision for 180000 150000

doubtful debts
Stock 320000 260000

Cash and Bank 180000 220000

Balance
Other current assets 72000 96000

Total current assets 652000 626000

Less: current liabilities 132000 176000

Net current assets (C) 520000 450000

Total (A+B) 1460000 1870000

While going through the accounts the following are noticed:

Fund flow statement of ABC Ltd for the year ended December 31, 2005

Sources Amount Rs Application Amount Rs

Funds from 185000 Redemption 50000

operation of preference
shares
Equity share 100000 Payment of 42000
capital (last year’s
proposed
dividend)
Sale of land 50000 Payment of 40000
tax (provision
of the last
year)
Dividend on 1000 Purchase of 142000
investment plant
(credited to Purchase of 11000
investment investment
account)
 346000 Payment of 20000
interim
dividend
Increase in 41000
working
capital

Working notes:

Calculation of funds from operations

Particulars Amount (Rs) Amount (Rs)

Closing balance of 50000

profit and loss account
Less: Opening balance 30000
of profit & loss ---------
account
profit earned during 20000
the year 2005
Add: Goodwill written 10000 48000
off 30000
Preliminary expenses 50000 18000
written off
Depreciation 50000
Provision for taxation 2000
Proposed final 10000
dividend
Loss on sale of plant
Transfer to general
reserve
Interim dividend 20000 167000
----------
Therefore funds from
operations 185000

Dr. Land Account Cr.

Particulars Amount Rs Particulars Amount Rs

To balance 300000 By cash (sale 50000

b/d 20000 of land bal 270000
To capital 320000 figure) 320000
reserve (profit By balance
on sale) c/d

Dr. Plant Account Cr.

Particulars Amount Particulars Amount Rs

Rs
To balance b/d 80000 By cash (sale of plant) 10000
To purchases (b/figure) 142000 By profit & loss A/c 2000
(loss)
By Profit & Loss A/c 10000
(Depreciation)
By Balance c/d 200000
222000 (Closing balance) 222000

Illustration:

2004 2005
Investment 20000 30000
Sundry debtors 140000 170000
Stock 77000 109000
Bills receive able 20000 30000
Cash in hand 315000 310000
Cash at bank 10000 8000
Preliminary expenses 25000 20000
1187000 1227000

A piece of land has been sold out in 2005 and the profit on sale was credited to capital reserve.
A machine was sold for Rs.10000. The written down value of the machine was Rs.12000.
depreciation of Rs.10000 was charged on plant account in 2005.
The investments are trade investments. Rs.3000 is received by way of dividends which included
Rs.1000 from pre acquisition profit. It has been credited to investment account;
An interim dividend of Rs.20,000 has been paid in 2005.

Solution:
Statement of Changes in Working Capital
Particulars At the end of December Effect on working capital
31 (Rs)

2004 2005 Increase Decrease

Rs Rs Rs Rs

Current Assets:
Sundry debtors 140000 170000 30000 --
Stock 77000 109000 32000 --
Bills receivable 20000 30000 10000 --
Cash in hand 315000 310000 -- 5000
Cash at Bank 10000 8000 -- 2000
Total Current Assets 562000 627000
(A)
Current Liabilities 25000 47000 -- 22000
Sundry creditors 20000 16000 4000 --
Bills payable 30000 36000 -- 6000
Liability for expanse 75000 99000
Total current liabilities 487000 528000
(B)
Working capital (A-B) 41000 41000
Changes in working 528000 528000 76000 76000
capital
Increase in working
capital
Total
Working Notes: Funds from operations
 Rs Rs

Net profit for 2004-05

Add depreciation 40000 58000
Preliminary expenses written off 7200
Provision for taxation 32000 79200
137200
Less: profit on sale of machine funds from 2000
operations 2000 ---------
--------- 135200
135200
2. Cost price of the machine sold 9000
Cost price of the machine sold 8000
Less Accumulated deprecation
Written down value of machine sold 1000
Selling price 3000
Profit on sale of machine 2000

Fixed assets at Cost on 31.3.2005 480000

Less Cost price of machine sold 9000
Cost price of rest of the assets 471000
Cost price of assets on 31.3.2005 520000
Purchases made during the year 49000

Illustration:

From the following balance sheets of ABC Ltd prepare a statement of changes in working capital and funds
flow statement.

Particulars 2004 2005 Rs

Rs
Capital and Liabilities:

Equity share capital 700000 800000

8% redeemable preference shares 250000 200000

Capital reserve -- 20000

General reserve 50000 60000

Profit and loss account 30000 48000

Proposed dividends 42000 50000

Sundry creditors 20000 16000

Bills payable

Liability for expenses

Provision for taxation

Assets 2004 2005 Rs

Rs
Goodwill 100000 80000
 Land and building 300000 270000

Plant and machinery 80000 200000

Sundry creditors 175350 183650

Proposed dividend 15000 28800

Provision for taxation 32000 --

The net profit for the year 2004-05 (after providing for depreciation Rs.40000 writing off
preliminary expenses Rs.7200 and making provision for taxation Rs.32000 amounted to
Rs.580000. The company sold during the year 2004-05 old machinery costing Rs 92000 for
Rs.3000. The accumulated depreciation on the said machinery was Rs.8000. A portion of the
company investments became worthless and was written off to General Reserve during 2004-05.
The cost of such investment was Rs.5000. During the year 2004-05 the company paid interim
dividend of Rs.10000 and the Directors have recommended a final dividend of Rs.15000 for the
year 2004-05.

Prepare (a) Funds flow statement for the year ended 31st March 2005 and (b) A schedule of working
capital changes.

Solution:

Schedule of working capital changes

Particulars Amount Rs as on March Effect on working capital

31 (Rs)

2004 2005 Increase Decrease

Rs Rs Rs Rs

Current assets 55600 90500 34900

Sundry debtors 118300 167800 49500
Cash and Bank 49800 47500 2300
Balances 223700 305800
Total current Assets
(A) 183650 175350 8300
Current Liabilities 183650 175350
Sundry creditors 40050 130450
Total current liabilities 92700 2300
(B) 90400 90400
Working capital (A-B)
Changes in working 130450 130450 92700 92700
capital
Net increase in
working capital
(Rs.92700-Rs.2300)
Total
Funds flow statement for the year ending 31st March 2005

Sources Amount Applications Amount Rs

Rs
Funds from 135200 Purchases of fixed 49000
operations 3000 assets 10000
Realization 40000 Payment of dividends 28800
from sale of 178200 Interim (2004-05) 90400
machine Final (2004-05)
 Issue of equity Increase in working 178200
shares capital

*15% of (Rs.298000-Rs20000-Rs3000)=15% of Rs.275000=41250

+15% on cost of purchase made=15% of Rs.230000= 34500
---------------
75750

Closing balance Rs.429250

Less: WDV of existing machine 233750
(275000-41250) 195500

WDV of new machine. This represents 85% of cost of new machine purchase. Therefore cost of
new machines = Rs.1.95500/85% = Rs.230000
Selling price of investments = Rs.50000
Premium on redemption of debenture = Rs.2500 and total cash outflow = Rs.52500

Calculation of funds from operation

Particulars Amount Amount

Rs Rs

Profit earned during the year and

retained in the company
(differences between closing and
opening balance of P & L A/c)
Add: Transfer to Reserve 20000
Premium on redemption of debentures 2500
Provision for tax for 2005 35000
Proposed dividend for 2005 40000
Goodwill w/off 10000
Depreciation 75750
WDV of machine sold 3000
Discount on debentures w/off 3000 189250
209250
Less: profit on sale of machine 15000
Profit on sale of investment 10000 25000
Funds from operations 184250

Illustration:

The comparative balance of Sudhir Ltd are indicated in a condensed form as under:

Particulars As on 31.3.2004 As on 31.3.2005

Fixed assets 520000 480000

Less: depreciation to (140000) 108000
date 380000 372000
50000 100000
Investment 90500 55660
Stocks 167800 118300
Sundry debtors 47500 49800
Cash and Bank -- 7200
Balance 735800 702900
Preliminary expenses 400000 360000
 Share capital: Equity
shares of Rs.100 each 600000 110000
issued for cash 53450 20450
General Reserve
Surplus in profit and
loss account

Solution:

Schedule of changes in working capital

Particulars Amount Rs as on Effect on working Capital

December 31 (Rs)

2005 2005 Increase Decrease

(1) Rs (1) Rs

Current assets
Prepaid expenses 4000 5750 1750 --
Sundry debtors 160000 110000 -- 50000
Stock 50000 80000 30000
Cash and Bank 410000 420000 10000
Total current assets 624000 615750
(A)
Current liabilities 90000 70000 20000
Trade creditors 90000 70000
Total current liabilities 534000 545750
(B) 461750 450000
Therefore working 11750
capital A-B
Total increase and
Decrease in working 71750
capital 545750 545750 461750 461750
Therefore net increase
in working capital
Total

Funds flow statement of XYZ Co Ltd for the year ended December 31, 2005

Sources of funds Amount Application of funds Amount Rs

Rs
Funds from operations 184250 Redemption of 52500
Issue of shares 100000 debentures 45000
Amount realized from 50000 Payment of tax 30000
sale of investment 35000 Payment of dividend 230000
Amount realized from for 2004 11750
sale of machine 369250 Payment of plant & 369250
machinery
Increase in working
capital

Working Notes

Provision for Taxation Account

Dr Cr

To Bank A/c 45000 By balance b/d (opening 50000

By Balance c/d 40000 balance) 35000
(Closing balance) 85000 By adjusted P&L 85000
(provision for the year)
(b/figure)

Dr Cr
To Balance b/d 298000 By Bank (Sale of machine) 35000
To P&L A/c (Profit 15000 BY P&L (WDV of 3000
on sale of machinery) 230000 machine sold) 75750
To Bank (purchase of 543000 By P&L A/c 429250
asset) (b figure) (depreciation)
By balance c/d 543000

(4)

Provision for taxation account

Dr Cr
To Cash A/c (tax 10000 By balance b/d (opening 15000
paid) (b/figure) 20000 balance) 15000
To Balance c/d 30000 By P&L A/c 30000
(closing balance)

Illustration:

From the following details relating to the accounts of XYZ Co Ltd prepare statement of source
and application of funds

Liabilities 31.12.04 Rs 31.12.05 Rs

Share capital 800000 700000

Reserve 100000 80000
Profit & Loss Account 50000 30000
Debenture 100000 150000
IT provision 40000 50000
Trade creditors 70000 90000
Proposed dividend 40000 30000
1200000 1130000
Assets
Good will 90000 100000
Plant & machinery 829250 698000
Funds flow statement 429250 298000
Debenture discount 5000 8000
Prepaid expenses 5750 4000
Investments 60000 100000
Sundry debtors 110000 160000
Stock 80000 50000
Cash and bank 420000 410000
1200000 1130000

15% depreciation was charged in the account on plant & cachinery

Old machines costing Rs.50000 (WDV Rs.20000) was been sold for Rs35000
A machine costing Rs 10000 (WDV Rs.3000) has been discharged
 Rs.10000 profit has been earned by sale of investments
Debentures have been redeemed at 5% premium
Rs.45000 income tax has been paid and changed against income Tax provision account

Sundry 10000 12000 2000

creditors 10500 13000 2000
Total (B) 35000 46000
Working 11000 11000
capital 46000 46000 17000
(A-B) 17000
Net
increase
in
working
capital
Funds flow statement for the year ending 31st December 05

Source of Amount Application of funds Amount Rs

funds Rs
Funds from 47000 Purchase of plant 15000
operations 50000 Purchase of building 49000
Issue of share Purchase of 2000
capital investment 10000
97000 Tax paid 10000
Interim dividend paid 11000
Net increase in 97000
working capital

Working notes
Funds from operations

Loss suffered during the year (3000)

(Rs15000-Rs.12000)
Add: non funds & Non operating items
Depreciation on plant
Depreciation on building 10000
Transfer to general reserve 7000
Provision for taxation 5000
Interim dividend paid 15000
Good will w/off 10000
3000 50000
47000

Plant Account

Particulars Amount Particulars Amount Rs

Rs
To balance 35000 By depreciation 10000
b/d 49000 (charged during the
To cash A/c 50000 year) 40000
Purchase of By balance c/d 50000
plant b/f (closing balance)

Buildings Account
Particulars Amount Particulars Amount Rs
Rs
To balance b/d 100000 By depreciation (for 7000
To cash A/c 49000 the year)
Purchases (b) 149000 By balance c/d 142000
(closing balance) 149000

Illustration:
Prepare the following statements from the balance sheet of Y Ltd as on 31st December 2004 &
2005. You are required to prepareSchedule of changes in working capital and Funds flow statement

Liabilitie 2004 2005R Assets 2004 2005

s Rs s Rs Rs

Share 15000 200000 Goodwill 15000 12000

capital 15000 20000 Building 10000 14200
General 15000 12000 Plant 0 0
reserve 10000 12000 Non trading 35000 40000
Profit & 15000 20000 Investment 10000 12000
loss A/c 1000 s
Sundry 500 265000 Stock 15000 12000
debtors 20550 Bills 5000 7000
Provision 0 receivable 20000 25000
for Debtors 50000 15000
taxation Cash 20550 26500
Provision 0 0
for
doubtful
Doubts

Additional information:

1) Depreciation charged on plant was Rs.10000 and on building Rs.7000

2) Provision for taxation of Rs.15000 was made during the year 2005
3) Interim dividend of Rs.10000 was paid during the year 2005

Solution

Schedule of changes in working capital for the period ending 31 st December 05

Particulars 2004 2005 Effecti

amount amount on
Rs Rs working
capital
Increase Decrease
(+) Rs (-) Rs

Current 5000 15000 10000

assets 20000 25000 5000
Cash 50000 7000 2000
Debtors 15500 12000 3500
Bills 45500 59000
receivable
Stock
Total (A)
Current 500 1000 500
liabilities
Provision
for
doubtful
debts

Additional Information:

(i) Depreciation is charged on building at 3% of cost of Rs.900000 on plant and machinery at 8%

of cost Rs.400000 fixtures and fitting at 5% of cost Rs.8000

(ii) Investments were purchased and interest received Rs.3000 was used in writing down the book
value of investments

(iii) The declared dividend for 2004 was paid and interim dividend for Rs.20000 paid out of profit
and loss appropriation account.

Solution:
Cash flow Statement (AS-3 (Revised) Method

Cash flow from operating

activities
Net profit before tax and extra 143700
ordinary items
(30000+50000+20000+43700)
Adjustments
Dep on furniture and fixtures 400
Dep on plant and machinery 32000
Depreciation on building 27000
Preliminary expenses 8000
Operating profit before 211100
working
Capital changes
Decrease in debtors 55000
Decrease in stock 56300
decrease in creditors 5000
increase in accounts receivable 1000
decrease in bills payable 1000
increase in prepaid expenses 100
net cash flow from operating
activities 315300
cash flow from investment
activities
interest on investments
purchase of investments 3000
purchase of building 9000
purchase of machinery 227000
purchase of furniture of 152000
fixtures 1400
purchase of goodwill
net cash from investment 43700
activities 430100
cash flow from financing
activities
 proceeds from issue of share
capital 135000
loan on mortgage 60000
dividend paid for 2004 70000
interim dividend paid 20000
net cash from financing
activities 105000
net decrease in cash and cash
equivalent 9800
cash and cash equivalents at
the beginning of the period 6000
cash and cash equivalents at 15800
the end of the period

Working notes:
Income tax paid
Income tax liability at the commencement of the year 5000
Income tax expense for the year 5000
Income tax liability at the end of the year 10000
Income tax paid during the year 6000
Purchase of equipment 4000
Balance at the commencement of the year 500000
Sold during the year 20000
Purchased during the year (balancing figure) 480000
Balance at the end of the year 220000
No adjustment is required for equipment received in 700000
exchange for issue of bond
In effect the transaction results in receipts and payment 15000
of cash
Sale of equipment 2000
Written down value of the equipment (20000-5000) 13000
Loss on sale of equipment 125000
Proceeds from sale of equipment 100000
Sale of investment 100000
Balance at the commencement of the year 125000
Purchase during the year 12000
Balance at the close of the year 137000
Cost of investments sold during the year 265
Gain on sale of investments 85
-----

Issue of bonds 350

Balance at the commencement of the year issued during
the year
Balance at the end of the year
Illustration:

Prepare cash flow statement from the following balance sheet of XL Engineering Ltd

Liabilities Rs2004 Rs.2005 Assets Rs.2004 Rs.2005

Share 1700000 1835000 Building 800000 1000000

capital
Reserve 40000 83700 Plant & 250000 370000
Machinery
 Profit and 100000 130000 Fixtures 5000 6000
Loss and fittings
appropriati
on account
Provision 70000 50000 Cash 2000 2200
for
dividends
Creditors 100000 95000 Debtors 100000 45000

Bank 8000 18000 Account 8000 9000

overdraft receivable
Bills 14000 13000 Stock 400000 343700
payable
Loans on 10000 70000 Prepaid 3000 3100
mortgage expenses
2642000 2294700 Investment 164000 170000

Goodwill 300000 343700

Preliminary 10000 2000

Expenses 2642000 2294700

The following additional information on transactions for the year 2005 is provided by Sudhir Ltd

Purchased investments for Rs.100000

Sold equipment that cost Rs.20000 with accumulated depreciation of Rs.5000

Issued Rs.85000 of bonds at face value in exchange for an equipment on 31st December 2005.

Issued 500 shares of Rs100 each at face value

Paid cash dividend of Rs.10000

Prepare a cash flow statement using the indirect method

Solution: Cash flow statement of Sudhir Ltd for the year 2005

Cash flow from operating Rs Rs

activities

Net profit before taxation 25

Adjustment for

Depreciation 55

Gains on sale of investments 12

Loss on sale of equipment 2

Interest expense 20

Interest income 5

Operating profit before 85

working capital changes
Decrease in accounts 10
receivable
15
Increase in inventory
4
Decrease in prepaid expenses
5
Increase in accounts payable
10
Decrease in accured liabilities

Cash generated from

operations 79

Income tax paid 4

Net cash from operating 75

activities

Cash flow from investing

activities

Purchase of equipment 220

Sale of equipment 13

Purchase of investments 100

Sale of investments 137

Interest received 5

Net cash from investing 165

activities

Cash flow from financing

activities

Proceeds from issue of share 50

capital

Issue of bonds 85

Interest paid 20

Dividend paid 10

Net cash from financing 105

activities

Net increase in cash (and cash 15

equivalents)

Cash (and cash equivalents) at 25

beginning of period

Cash (and cash equivalents) at 40

the end of the period
 Illustration:

The following is the profit and loss account of Sudhir Ltd for the year 2005 and its balance sheets as on 31
December 2005 and 31 December 2004

Profit and Loss Account for the year 2005

Sales 830

Cost of goods sold 650

Gross margin 180

Operating expenses (including 150

depreciation of Rs.55)

Interest expenses 20

Interest income 5

Gain on sale of investment 12

Loss on sale of equipment 2 5

Net profit before taxation 25

Income tax 5

Net profit 20

Balance sheet as on December 31, 2005 and as on December 31, 2004

Assets 31 Dec 2005 (Rs) 31 Dec 2004 (Rs)

Plant and equipment 700 500

Accumulated depreciation 100 50

600 450

Long term investments 100 125

Current assets

Inventory 150 135

Account receivables 40 50

Cash 40 25

Prepaid expenses 1 5

Total 931 790

Liabilities

Share capital 350

Reserves and surplus 150 140

Bonds 350 265

Current liabilities

Account payable 55 50

Accrued liabilities 20 30

Income tax payable 6 5

931 790

Solution:

Cash flow from operating Rs Rs

activities

Net profit before tax 60000 --

+Depreciation on machinery 15000

+stock obtained on acquisition 20000

Increase in current assets 17500

Tax paid 25000

Cash from operating activities 52500

Cash flow from investment

activities

Purchase of machinery 5000

Cash flow from financing

activities

Issue of share capital 40000

Repayment of bank loan 60000

Payment of dividends 25000 45000

Net increase in cash during the 2500

year

Opening cash balance 7500

Closing cash balance 10000

The company issued share capital of Rs.60000 for acquiring assets of another company. It is anon cash
items hence it has not been shown in Cash flow statement.

Working notes:

Depreciation on machinery has been ascertained as follows

Opening balance Rs. 100000

+acquired from another company 20000

+purchased during the year 5000

 -closing balance 110000

Depreciation for the year 15000

Prepare a cash flow statement given that the company has paid divided of Rs.50000 during the year.

Solution: Cash flow statement for the year ending March 31, 2005

Cash flows from operating Amount Rs Amount Rs

activities:

Current year profit before tax 55000 50000

50000(100000-95000)

+depreciation 10000

65000

+ increase in current liabilities 10000

-increase in stock 10000

-increase in debtors 18000

Cash from operating activities 73000

Cash flow from investment

activities:

Purchase of land and building 130000

Purchase of machinery 30000

Cash from investment 160000

activities

Cash flows from financing

activities:

Issue of share capital 100000

Increase in loans 40000

Payment of dividends 50000

Cash from financing activities 90000

Net decrease in cash during the 3000

year

Opening cash balance 10000

Closing cash balance 7000

Illustration:
Following are comparative balance sheets of Surjeet Ltd for the year ending Dec 31 2004 and Dec 31, 2005.
Prepare a cash flow statement as per AS-3 (Revised)

Liabilities As on Dec As on 31.5 Assets As on Dec As on 31.5

31.4 31.4

Share capital 200000 300000 Land & 200000 200000

Building
Reserves 50000 50000
Machinery
P&LA/c 35000 35000 100000 110000
Goodwill
Bank loan 60000 -- -- 20000
Current
Current 75000 75000 Assets 152500 170000
liabilities
Cash
Prov for tax
40000 50000 7500 10000

460000 510000 460000 510000

Additional information:

(i) During the year 2005 the company paid tax of Rs.25000

(ii) A dividend of Rs.25000 was paid during the year 2005

(iii) Profit before tax for the year is Rs.60000

(iv) During the year the company purchased machinery for Rs.5000. it also acquired another company
(Stock Rs.20000 and machinery Rs.20000 and paid Rs 60000 in share capital for the acquisition)

+prem on red of deb 6000

+ proposed Dividend 72000

+preliminary exp written off 20000

+loss on sale of fixed assets 8000

Operating profit 544000

-increasing in current assets 88000

+increase in creditors 20000

Cash before tax 476000

-tax paid during the year 180000

Cash from operating activities 296000

Cash from investment

activities

Purchase of fixed assets 428000

Sale of investments 60000

 Sale of fixed assets 50000

Cash from financing activities 318000

Issue of share capital 200000

Redemption of deb 126000

Dividend paid 52000 22000

Increase/Decrease in cash NIL

Working notes:

1. There is no opening or closing cash balance given in the question therefore there is no change in cash
balance during the year. The current assets (of Rs. 560000 and Rs.660000) have been considered as other
current assets.

2. The opening balance of profit and loss account has been taken at Rs.132000 (i.e. Rs.120000+12000 profit
on revaluation of opening stock.

3. The opening balance of current assets has been taken at Rs.572000 (i.e. Rs.560000+12000 profit on
revaluation of opening stock.

4. Fixed assets written off (cost Rs.28000 and accumulated depreciation Rs.20000) during the year does
not involve any cash flow. Hence it has been shown in the cash flow statement.

5. The dividend paid during the year is Rs.52000 (i.e. 60000-Rs.8000)

Illustration:

Following are the balance of Hari Ltd as on March 31, 2004 and March 31, 2005.

Liabilities As on As on Assets As on As on
31.3.2004 31.3.2005 31.3.2004 31.3.2005

Capital 200000 300000 land & 140000 270000

Building

Reserve 95000 100000 Machinery 210000 250000

Loans 60000 100000 360000 520000

Current 75000 85000 Depreciation 60000 70000

liabilities

30000 450000

Cash 10000 7000

Debtors 70000 68000

Stock 50000 68000

430000 585000 430000 585000

Illustration:
The balance sheet of Hari Ltd as on Dec 31, 2004 and 2005 are given below:

Balance sheet of Hari Ltd

Liabilities 31.12.04 31.12.05 Assets 31.12.04 312.12.05

Shree capital 600000 800000 Fixed assets 1600000 1900000

Capital -- 20000 Less Dep 460000 580000

reserve

General 340000 400000 1140000 1320000

reserve

Profit & Loss 120000 150000 Investment 200000 160000

A/c

Debenture 400000 280000 Current assets 560000 660000

Current 240000 2600000 Preliminary 40000 20000

liabilities Exp

Proposed 60000 72000

dividend

Provision for 180000 170000

tax

Unpaid -- 8000
dividends

1940000 2160000 1940000 2160000

Additional information:

During the year 2005 the companySold one machine for Rs.50000 the cost of which was Rs.100000 and
the depreciation provided on it was Rs.40000.

Charged Rs.180000 as depreciation

Sold some investments at a profit of Rs.20000 which was credited to capital reserve

Redeemed 30% of the debenture @ Rs.15

Stock has been valued at cost whereas previously the practice was to value stock at cost less 10%. The stock
according to books on 31.12.2004 was Rs.108000. the stock on 31.12.05 was correctly valued at Rs.150000
and

Fixed assets has been written off as costing Rs.28000 on which depreciation amounting to Rs.20000 has
been provided.

Prepare the cash flow statement for the year 2005.

Solution: Cash flow statement for the year ending 31.12.05

Cash from operating activities Amount Rs Amount Rs

Increase in P& L A/c 18000

 Increase in General Reserve 60000

+depreciation 180000

+provision for tax 170000

+Loss on sale of machine 10000

1 month = Closing inventory x 12 months/Rs.3200000 therefore closing inventory = Rs. 266667

Fixed assets

Fixed assets/Net worth x 100 = 40%

Fixed assets/Rs.1280000 x 100 = 40% therefore fixed assets = Rs.704000

Balance sheet of a Textile company

Liabilities Amount Rs Assets Amount Rs

Current debt 576000 Current assets

Long term debt 384000 Cash 750222

Net worth 1280000 Stock 711111

Fixed assets 512000 Inventory 266667

Fixed assets 512000

2240000 2240000

Solution:

Net worth: Sales to net worth = 2.5 times

Sales to net worth = sales/net worth

2.5 times = Rs.3200000/Net worth

Therefore net worth = Rs.3200000/2.5 = Rs.1280000

Current Debt:

Current debt to Net worth = Current Debt/Net Worth x 100

45% = Current Debt/Rs.1280000 x 100

Therefore Current debt = Rs. 576000

Total Debt: Total Debt/Net worth x 100 = 75%

Total Debt/Rs.1280000x 100=75%

Therefore total Debt = Rs.960000.

Current Assets: Current Ratio = Current Assets/Current Liabilities = 3 = Current Assets/Rs.576000
therefore current assets = Rs. 1728000

Inventory

Net sales/Inventory = 4.5 times

Rs.3200000/Inventory = 4.5 times therefore inventory = Rs. 711111

Debtors:

Average Collection Period = 1 month

Average collection period = closing inventory x 12 months/sales

The Liquidity of the Firm

The current ratio of the firm is slightly higher than the industry standard which indicates short term solvency
from the point of creditors. However, the current assets may be higher because of piling up of excessive
stock as reflected in the low stock turnover ratio. The firm has debtors turnover ratio of 12 time (i.e. the
collection period is 1 month) as against the industry average of 10 times (i.e. the collection period is 1.2
months). It also indicates the satisfactory position. However, there is a scope for making the credit policy
slightly more liberal.

The Activity Ratios of the Firm

The review of the activity ratios of the firm indicates that the debtors turnover ratio is high as compared to
industry average. However, the stock turnover ratio indicates that the firm is maintaining higher level of
stock of 4 months (i.e. 12/3) as against the stock of 1.5 months (i.e. 12÷8) in comparison with industry
standard which is excessively high. The assets turnover ratio of the company is 3.5 against the industry
average of 3 which does not present a good picture about utilization of assets.

The profitability of the Firm

All the three ratios i.e. Net profit ratio ROI and Net profit on net worth is lower than the industry standard
which does not present a good picture about the company. Net profit ratio of the firm is lower than the
industry standard and thus indicates the presence of higher cost of production/higher operating expenses in
proportionate to the sales of the firm. Even the investment of the firm is proportionately higher that the
industry standard because of low ROI. NPNW ratio of the firm being lower than the industry standard
indicates that the company is not a highly leveraged firm and there is a scope for trading on equity.

Solvency of the Firm

The company is solvent from the point of view of long term creditors of the firm. Interest coverage ratio of
the firm is higher than the industry standard which presents a satisfactory cushion for the interest coverage.
Lower debt to equity ratio in comparison with the industry average presents that the company is having
lower debt content in the capital structure of the firm. Thus there is a scope for trading on equity. But before
increasing the debt content it is particularly relevant to ensure that the firm has profitable investment
opportunities and the debt is available at relatively cheaper rates.

Illustration:

From the following information of a textile company complete the proforma balance sheet if its sales are
Rs.3200000.

Sales to net worth 2.5 times

Current debt to net worth 45%

Total debt to net worth 75%

Current Ratio 3 times

Net sales to inventory 4.5 times

Average collection period 1 month

Fixed assets to net worth 40%

(i) Shareholder’s Net Worth:

Fixed assets to Shareholders net worth = 0.80

0.80= Fixed assets/shareholder’s net worth

0.80= Rs.900000/shareholder net worth therefore shareholder net worth = Rs.1125000

Share capital and reserves and surplus

Shareholders net worth = Share capital + reserve and surplus

Rs.1125000= Share Capital+ Reserve and Surplus given reserves and surpluses to capital = Rs. 750000

Therefore reserves and surpluses to capital = 0.50

Therefore share capital = Rs.750000

Reserves and Surplus= Rs.375000

Balance sheet

Liabilities Amount Rs Assets Amount Rs

Share capital 750000 Fixed assets 900000

Reserves and surplus 375000 Stock 300000

Long term borrowings 225000 Debtors 375000

(balancing figure)

Current liabilities 300000 Bank 75000

1650000 1650000

Illustration:

The following table provides the standard ratios for the industry and the ratios of Company X Ltd. Indicate
the strength and weaknesses of the firm

Industry standard Company X Ltd

1 Current Ratio 2.8 3.5

2 Debtors turnover ratio 10.0 12.0

3 Stock turnover ratio 8.0 3.0

4 Assets turnover ratio 3.0 1.5

5 Net profit ratio 5% 2%

 6 Net ROI 7% 3%

7 Net profit on net worth 11% 5%

8 Total debts on total assets 65% 38%

9 Debt to equity ratio 1.85 times 62 times

10 Interest coverage ratio 10 times 12 times

= Liquid Assets/Rs.300000 therefore the liquid assets= Rs.450000

Stock Current Assets-Stock-Prepaid Expenses + Liquid Assets

Therefore stock = Current Assets – Liquid Assets

= Rs. 750000-Rs.450000

=Rs.300000 (Prepaid expenses are assumed to be zero)

cost of sales:

Stock Turnover Ratio = Cost of Sales/Closing Stock

6 = cost of sales/Rs.300000 therefore cost of sales = Rs.1800000

Sales:

Gross profit ratio = Gross Profit/Sales

Gross profit= Sales-Cost of sales.

If gross profit = Rs.20 the cost of sales Rs.80 and the sale is Rs.100. as cost of sales= Rs.1800000. therefore
sales = Rs. 1800000x100/80= Rs.2250000

Fixed Assets: Fixed Assets turnover ratio = 2 times

Fixed assets turnover ratio = cost of sales/fixed assets

Therefore fixed assets = Rs.1800000/2 = Rs.900000

Trade Debtors

Debt collection period=2 months

Debt collection period=Trade Debtors x 12 months/credit sales

2 = Trade Debtors x 12/Rs.2250000 therefore Trade debtors = Rs.375000.

Notes (1) Debtors turnover ratio assumed to be based on year end debtors

(2) Sales are assumed to be on credit

(3) Assumed to be based on year end creditors

(4) Creditors average payment period

(5) All purchases assumed to be on credit

(6) Debt collection period

(7) Average payment period

Illustration:

With the help of the following ratios regarding Indu Films draw the Balance sheet of the company for the
year 1998.

Current ratio 2.5

Liquidity ratio 1.5

New working capital Rs.450000

Stock turnover ratio (cost of sales/closing stock) 6 times

Gross profit ratio 20%

Fixed assets turnover ratio (on cost of sales) 2 times

Debt collection period 2 months

Fixed assets to shareholder net worth 0.80

Reserve and surplus to capital 0.50

Solution:

Current assets

If current liabilities = 1

Then current assets = 2.5

Therefore the difference of working capital = 1.5

Networking capital = Rs.450000

Therefore the current assets = net working capital x 2.5/1.5 = Rs.750000

(b) Current liabilities

Thus current liabilities

Current ratio = Current Assets/current liabilities

2.5 = Rs.750000/current liabilities

current liabilities = Rs.300000

(c) Liquid Assets:

Liquid Ratio = 1.5

Liquid Ratio = liquid Assets/current liabilities

We know that average inventory = opening stock + closing stock/2

Thus opening stock + closing stock = 2 x average inventory

=(opening stock + (opening stock + Rs.5000) = 2x Rs.30000 = Rs.60000 2 opening stock = Rs.55000
opening stock = Rs.27500 and closing stock = Rs.32500
(c) Fixed Assets Fixed Assets turnover ratio = Sales Revenue/fixed Assets thus 5= Rs.250000/Fixed assets
Fixed assets = Rs.50000

(d) Capital:

Capital turnover ratio = Sales Revenue/Capital

2= Rs.250000/Capital

Capital = Rs.125000

(e) Debtors

Debt Collection period= Trade Debtor’s x Months/Credit Sales

months= Trade Debtors x 12 months/250000= Therefore trade debtors= Rs.31250

Creditors

Average payment period = Trade Creditors/Credit x Days/Purchases

60 days = Trade Creditors x 360 days/155000 = Rs.25000

Notes Credit purchases = Cost of Goods sold-opening stock+ closing stock)

*Purchases = Rs. 150000-27500+32500 = 155000

Balance sheet of a company as on March 31, 2005

Capital and Amount Rs Assets Amount Rs

liabilities

Capital 125000 Fixed assets 50000

Creditors 25000 Debtors 31250

Inventory 32500

Cash (balancing figure) 36250

150000

Illustration:

From the following information prepare a summarized balance sheet as at 31st March 2005.

Stock velocity 5

Fixed assets turnover ratio 5

Capital turnover ratio 2

Gross profit 40%

Debt collection period 1.5 months

Creditors payment period 60 days

The gross profit was Rs.100000

 Closing stock was Rs.5000 in excess of opening stock. All working should form part of your answer.
Assume 360 days in a year

Solution:

(a) Sales Revenue & Cost of Sales

Gross profit = Rs.100000 and GP Ratio=40%

GP Ratio = Gross Profit/Sales revenue x 100 therefore sales revenue = Gross profit/GP Ratio =
Rs.100000/40% therefore cost of goods sold = Rs. 250000-Rs.100000 = Rs.150000

(b) Inventory

Stock Velocity = Cost of goods sold/average inventory

Therefore average inventory = Cost of goods sold/stock velocity = Rs.150000/5 = Rs.30000

Practical Problems
1. The Balance Sheet of X & Co as on 31.12.2005 shows as follows

Liabilities Amount Rs Assets Amount Rs

Equity capital 100000 Fixed assets 180000

8% preference shares 50000 Stores 25000

8% debentures 50000 Debtors 55000

Retained earnings 20000 B/R 3000

Creditors 45000 Bank 2000

265000 265000

Comment on the financial position of the company

Ans Debt equity Ratio-Rs.95000/17000=0.56 times

Proprietary fixed ratio-Rs.170000/265000=0.64 times

Current ratio-85000/45000=1.9 times

Liquidity ratio-60000/45000=1.33 times The financial position is quite satisfactory

2. Light and sound manufacture furnish the following information

2001 2002 2001 2002

Cash at bank 25 37 Building (net) 192 208

Bills 121 137 Land 32 32

receivable

Stock in trade 178 160 Current 138 114

liabilities
Prepaid 8 12 Equity share 380 380
expenses

Furniture and 38 60 General 76 152

fixtures reserve

Profit and loss

Net sales 640 658 General and 54 64

Adm
Expenses

Cost of goods 460 464 Income tax 14 10

sold

You are required to compute the following ratios:

Current ratio

Inventory turnover ratio

Net sales to receivable ratio

Net income per share

Ans (a) CR = 24 and 3.04

ITR = 2.58 and 2.9 times

5.29 and 480 times

Rs.2.95 and rs.3.16 (face value of share Rs.10)

3.The Net sales of Apex Co are Rs 15 crores. The EBIT of the company as a percentage of sale is 12%.
The capital employed of the company comprises of Rs.5 crores of equity Rs.1 crore of 13%. Preference
shares and Rs.3 crores of 15% Debt capital.

The company’s profit is subject to a tax at 50%. Calculate the return on equity for the company.

Ans. 10.9%

4. Company is capitalized as follows:

Rs.600000 7% preference shares Rs.1 each

Rs1600000 ordinary share Rs.1 each

Rs.220000 The following information is relevant as to its financial year just ended

Profit after taxation at 50 per cent Rs.542000

Ordinary dividend paid 20%

Depreciation Rs.120000

Market price of ordinary shares Rs.4

Capital commitments Rs240000 your are required to state the following showing the necessary workings
 (i) the dividend yield on the ordinary shares

(ii) the cover for the preference and ordinary dividends

(iii) The earnings yield

(iv) the price earning ratio and

(v) the net cash flow

Ans (i) 5% (ii) 12.9% and 1.56 times (iii) 78% (iv) 12.9 (v) Rs.300000

5. With the help of the following information complete the balance sheet of XYZ Ltd

Owners equity Rs.200000

Current debt to Total debt 40

Total debt to owner equity 60

Fixed assets to owners equity 60

Total assets turnover 2 times

Inventory turnover 8 times

Sales 640000

Ans Balance sheet of XYZ Ltd

Liabilities Rs Assets Rs

Owners equity 200000 Fixed assets 120000

Current debt 48000 Cash 120000

Long term debt 7200 Inventory 80000

320000 320000

6. From the following information pertaining to M/s Sukanya & Co Ltd prepare Trading and profit and loss
account for the year ended March 31, 1992 and a summarized balance sheet as that date.

Current Ratio: 2.5

Quick ratio 1.3

Proprietary Ratio 0.6 (Fixed assets/propreitory funds)

Gross profit to sales ratio 10%

Debtors velocity 40 days

Sales Rs 73000

Working capital Rs 120000

Bank overdraft Rs15000

Share capital Rs.250000

 Net profit 10% of proprietary funds

Ans Gross Profit Rs73000 Net profit Rs.30000 and balance sheet total Rs.380000

7. From the following ratios worked out from financial statements of a company and standard ratios make
comments

Actual Standard

1 Current ratio 4 2

2 Liquid ratio 2 1

3 Proprietary ratio fixed 4 6.7

assets /proprietor’s funds

4 Debtors velocity 40 days 60 days

5 Stock velocity 7 12

6 Net profit to net worth 5 12

7 Fixed assets to turnover 4 6

8 Net worth/turnover 10 15

9 Creditors velocity 30 days 40 days

10 G.P. Ratio 20% 25%

11 Net profit to sales 8% 12%

Ans The company has a lot of idle funds lying. This is the reason for less profitability. Moreover gross
profit needs to be improved.

8.Following is the profit & loss account of X limited for the year ended 31 st December 2005 and balance
sheet as on that date. Calculate the different ratios and comment on the financial position of the company.

Profit and loss account for the year ended 31st December 2005

Particulars Rs Rs

Net sales 600000

Less cost of goods sold 516000

Gross profit 84000

Operating expenses

Selling 4400

General and administration 8000

Rent of office 5600 18000

Gross operating profit 66000

Depreciation 20000
 46000

Other income 3000

Interest on Govt securities 49000

Gross income

Other expenses

Interest on bank overdraft 600

Interest on debentures 8400 9000

Net income before tax 40000

Tax @ 50 percent on net income 20000

Net income after tax 20000

Balance Sheet as on 31st December 2005

Liabilities Rs Assets Rs

Sundry Creditors 12000 cash 10000

Bills payable 20000 Investments 30000

(Govt securities)

Outstanding 2000 Sundry debtors 40000

expenses

Provision for 26000 Stock 60000

taxation

140000

Total current 60000 Fixed Assets 360000

liabilities

6% Mortgage 140000 Less: Provision 100000 260000

debentures for depreciation

7% preference 20000
share

Equity share 100000

Reserve & 80000

surplus

Total claim on 400000

assets

Ans. Gross profit Ratio 14% Net profit ratio (after considering interest on bank overdraft) 7.56% ROI
13.53% stock turnover ratio 8.6 Debt collection period 24 days. Fixed assets turnover 2.3 fixed assets ratio
0.76 debt equity ratio 70/1000=0.7 current ratio 2.3.
9. The following position statement has been prepared by a new recruit. You are required to rearrange the
same in the right form:

Madurai & Co condensed balance sheet as at March 31 2005

Current assets

Cash 6.9

Short term investment 8.7

Inventories 79.65

Accounts receivable (gross) 59.2

Prepaid expenses 7.8

Total current assets 7.8 162.25

Add:

Fixed assets (gross) 554.75

Investments in affiliated companies 14.0

Other long term investments 3.35

Total of tangible assets 57.21

734.35

Less: long term liabilities 133.3

Mortgage debt 33.5

Debenture debt 8.3

Reserve for provident fund 175.1/559.25

Net working capital

Less: current liabilities 20.65

Long term debt (current) 3.85

Notes payable 3.50

Dividend payable 41.25

Accounts payable 4.25 (55.5)

Accrued taxes 503.75

Add: Preliminary expenses 4.7

Excess of assets over liabilities 508.45

Represented by

Retained income 21.6.2

Reserve for bad debts 1.1

 Depreciation 222.5

Equity share capital 58.15

Preference share capital 10.00

508.45

Prepare a rearranged position statement. Compute the following

Debt to equity ratio

(ii) Equity to net fixed assets ratio

Acid Test Ratio

Tangible net worth

Ans. Liquid Assets Rs.73.7

Current assets Rs 161.15

Current liabilities & provisions 63.8

Fixed assets Rs.346.25

Net worth Rs.280.2

Equity shareholders funds 270.15

Ratio (i) 0.60 (ii) 0.78 (iii) 1.16 (iv) 280.15

10. The financial position of M/s A&B on Jan 1 and Dec 31, 2005 was as follows

Liabilities Amount Rs Amount Rs 31 Assets Amount Rs Amount Rs 31

Jan 1 Dec Jan 1 Dec

Current 36000 40600 Cash 4000 3600

liabilities

Nos Loan -- 20000 Debtors 35000 38000

Loan from 30000 25000 Stock 25000 22000

bank

Hire purchase -- 20000 Land 20000 30000

vendor

Capital 148000 154000 Building 50000 55000

Machinery 50000 86000

Delivery van -- 25000

214000 259600

The delivery van was purchased in December 2005 on hire purchase basis a payment of Rs.5000 was made
immediately and the balance of the amount is to be paid in 20 monthly installments of Rs.1000 each together
with interest @ 12% p.a. during the year the partners with drew Rs 26000 for domestic expenditure. The
provision for depreciation against machinery on 31.12.2004 was Rs.27000 and on 31.12.2005 Rs.36000.
you are required to prepare the cash flow statement.

Ans

Cash inflow from operation activities Rs.48000

Cash from investment activities Rs.35000

Cash outflow for financing activities Rs.11000

11. The financial position of XYZ company as it stood on the 31st December 2005 is set out below:

Liabilities Amount Rs Assets Amount Rs

Accounts payable 8000 Cash 500

Loan from bankers 12500 Accounts receival 1500

Capital 5500 Inventories 18000

26000 Equipments 6000

26000

The company adopted the following goals and forecasts as a basis for planning its activities for the year
2005.

(i) At the end of the year current ratio of 2:1

(ii) At the end of the year cash balance of Rs.1500

(iii) At the end of the year receivable balance equivalent to a 30-day collection period assuming 360 selling
days in a year

(iv) The reduction of the bank loans consistent with the other plan s and the liquidation in full of the accounts
payable

(v) Drawing or additional investment to account for the resulting fund balance

(vi) A sales forecast of Rs.20000 with a gross margin of 50%

(vii) Expenses estimated at Rs.5000 excluding depreciation. No other purchases or manufacture during the
year will occur. Draw up a proforma. Balance Sheet at the end of 31.02.05. Prepare a cash flow statement

Ans.

Current asset (2005)

Inventories Rs10000

Accounts receivable 1667

Cash 1500

Equipment 6000

Capital 7583
P&L A/c 5000

Loan from Banker 6584

12. Given below are the condensed balance sheet of Kishan Ltd for two years and statement of profit and
loss for one year

Balance Sheet as at 31st March 2005

2004 Rs 2005 Rs

Equity share capital 150 110

10% redeemable preference 10 40

shares

Capital redemption reserve 10 --

General reserve 15 10

Profit and loss A/c balance 30 20

8% debentures with 20 40
convertible option

Other term loans 15 30

Fixed assets less deprecation 130 100

Long term investment 40 50

Working capital 80 100

250 250

Statement of profit and loss for the year ended 31st March 2005

Rs Rs

Sales 600

Less cost of sales 400

Gross profit 200

Establishment charges 30

Selling and distribution 60

expenses

Loss on sale of equipment 15

Interest expenses 5 110

+interest income 4

+foreign exchange gain 10

+dividend income 2
 +damages received for loss of 14
reputation

Depreciation 30/120

50/70

Taxes 30

Dividends 40-15

Net profit carried to balance 25

sheet

You are informed by the accountant that ledgers relating to debtors creditors and stock for both the years
were seized by the income tax authorities and it would take at least two months to obtain copies of the same.
However he is able to furnish the following data:

2005 2004

Dividend receivable 2 4

Interest receivable 3 2

Cash on hand and with 7 10

bank

Investment maturing 3 2
within two months

15 18

Interest payable 4 5

Taxes payable 6 3

Current ratio 1.5 1.4

Acid test ratio 1.1 0.8

It is also gathered that debenture holder owning 50% of the debentures outstanding as on 31.3.04 exercised
the option for conversation into equity shares during the financial year and the same was put through.

You are required to prepare a direct method cash flow statement for the financial year 2005 in accordance
with para 18(a) of accounting standard (AS) 3 revised.

Ans Cash inflow from operating activities Rs.122

Cash outflow from investing activities Rs.78

Cash outflow from financing activities Rs 46

13. The balance sheet of C & B on 1.0.05 and 31.12.05 were as follows:
Balance Sheet

Liabilities 31.12.04 Amt 31.12.05 Amt Assets 31.12.04 Amt 31.12.05 Amt
(Rs) (Rs) (Rs) (Rs)

Creditors 45000 50000 Cash 20000 25000

Mrs Loan 20000 -- Debtors 20000 35000

Loan from 40000 60000 Stock 10000 20000

Bank

Capital 125000 150000 Machinery 100000 80000

Land 50000 60000

Building 30000 40000

230000 260000 230000 260000

During the year a machine costing Rs.15000 was sold for Rs.15000. Net profit for the year amounted to
Rs.25000

Dep charge on machinery Rs.5000

Dep charge on building Rs.10000

No dep was charged on loan

Prepare a cash flow statement

14. Prepare a funds flow statement for ABC Co Ltd from the following information for the year ended
30.9.95

Compative Balance sheet of ABC company limited

Liabilities As on 30.9.95 Amt Rs As on 30.9.94 Amt Rs

Share capital 6000000 5000000

Reserve & surplus 1500000 500000

Secured loans 3500000 4000000

Current liabilities 5000000 6000000

Assets

Fixed assets 4100000 400000

Investment 150000 --

Cash and bank balances 250000 125000

Inventory 7500000 7875000

Sundry debtors 4000000 3500000

16000000 15500000
(i) The net profit after adjustment in respect of provision for dividends taxation was Rs 100000 for the year

(ii) There was an addition to fixed assets during the year amounting to Rs 400000 and depreciation provided
for year was Rs.300000

Ans Increase in working capital Rs.1250000 sources Rs2300000 application Rs 1050000

15. The fixed assets and equities of Castern Manufacturing Co Ltd is supplied to you both at the beginning
and at the end of the year 2004-05 as follow

Particulars 1.04.04 amount Rs 31.3.05 Amt Rs

Plants less depreciation 163500 242500

Investment in share of S Ltd 132000 290000

Bonds payable 250000 70000

Capital stock 500000 500000

Retained earnings 238000 410500

You are not in a position to have complete income statement or balance sheet. The following information
is available.

Dividend of Rs. 37000 were paid

The net income included Rs.13000 as profit on the sale of equipment. There has been an increase of
Rs.93000 in the value of gross plant assets though equipment worth Rs 29000 with a net book value of
Rs.19000 was disposed off.

Prepare a funds flow statement

Ans decrease in working capital Rs.244500

Funds from operations Rs.122000

Source and application of funds Rs.497500

16. From the following balance sheet of a company you are required to prepare (i) schedule of changes in
working capital (ii) Statement of sources and Application of funds:

January 2004 December 2004

Cash 140000 144000

Account receivable 10000 20700

Inventory 15000 15000

Land 4000 4000

Building 20000 16000

Equipment 15000 17000

Accumulated Depreciation 5000 28000

Patents 1000 900

 Current liabilities 30000 32000

Bonds payable 22000 22000

Bonds payable discount 2000 1800

Capital stock 135000 143500

Retained earnings 15000 19500

200000 200000

Additional information:

income for the period Rs.10000

A building that cost Rs.4000 which had a book value of Rs.1000 was sold for Rs 1400

The depreciation charge for the period was Rs 800

There was Rs 5000 issue of common stock

Cash dividend of Rs 2000 and a stock dividend of Rs.3500 were declared

Ans Increase in working capital Rs 13100 sources and application of Funds Rs 17100

17. The summarized balance sheet of XYZ limited as at 31st Dec 2004 and 31st Dec 2005 are given below:

Liabilities 31.12.04 Amt 31.12.05 Amt Assets 31.12.04 Amt 31.12.05 Amt
Rs Rs Rs Rs

Share capital 750000 750000 Fixed assets 700000 620000

General 400000 410000 Investment 150000 160000

reserve

Profit & Loss 56000 68000 Stock 240000 210000

A/c

Creditors 168000 134000 Debtors 210000 455000

Provision for 75000 10000 Bank 149000 197000

taxation

-- 270000

1449000 1642000 1449000 1642000

Additional Information:

(i) Investments costing Rs 8000 were sold during the year 2005 for Rs 8500

(ii) Provision for tax made during the year was Rs.9000
(iii) During the year part of the fixed assets costing Rs.10000 were sold for Rs 12000 and the profit was
included in profit and loss account and

(iv) Dividend paid during the year amounted to Rs.40000

Prepare a statement of sources and uses of funds.

Ans. Increase in working capital Rs.297000. funds from operations Rs.138500 Total of FFS (Rs) 429000.

18. The Balance sheets of A Ltd as at March 31 2004 and 2005 are given below

31.3.04 Rs 31.3.05 Rs

Share capital 600000 700000

Capital reserve -- 20000

General reserve 280000 310000

Profit and loss account 70000 90000

Debentures 300000 200000

Current liabilities 130000 120000

Provision for income tax 80000 60000

Proposed dividend 40000 50000

1500000 15500000

Fixed assets at cost 1000000 1000000

Less: Depreciation 260000 310000

740000 690000

Trade investment 110000 90000

Current Assets 520000 650000

Preliminary expense 130000 120000

1500000 1550000

During the year ended 31st March 2005 the company

1. Sold one machine for Rs.40000 the cost of which was Rs.80000 and the depreciation provided on it was
Rs.30000.

2. Provided Rs.100000 as depreciation.

3. Redeemed the Debenture at Rs.105

4. Sold some trade investment at a profit which was credited to Capital Reserve

5. Decided to write off fixed assets (fully depreciated) costing Rs.20000

6. Decided to value opening stock at cost which was valued. Previously at cost less 10%. The opening stock
according to books of account was Rs.63000. The closing stock was correctly valued at cost.
Prepare a funds Flow statement for correctly the year ended 31 st March 2005 showing the changes in
working capital.

Ans. Net increase in working capital Rs.133000 funds from operations Rs 278000. Total sources and
Application of Funds Rs. 458000

Unit 4
Management Accounting, Marginal costing and its Application

Management Accounting

Meaning: The terms management accounting refers to accounting for the management i.e.
accounting which provides necessary information to the management for discharging its functions.
The functions of the management are planning organizing directing and controlling. Thus
management provides information to the management so that planning organizing directing and
controlling of business operations can be done in an orderly manner.

The Chartered Institute of Management Accountants London defines Management Accounting as

follows. The application of professional knowledge and skill in the preparation of accounting
information in such a way to assist management in the information of policies and in the planning
and control of the operations of the undertaking.

The definition given by the American Accounting Association is as follows:

Management Accounting is the application of appropriate techniques and concepts in processing

historical and projected economic data of an entity to assist management in establishing plans for
reasonable economic objectives in the making of rational decisions with a view towards achieving
these objectives.

The above definitions clearly indicate that management accounting is concerned with accounting
information which is useful to the management.

Efficiency of the various phase of management is as a matter of fact the common thread which
underlies all these definitions. However it should be clearly understood that it does not supplant
financial accounting but rather it supplements it in order to serve the diverse requirements of
modern management.

Management accounting covers all rearrangement combination or adjustment of the orthodox

accounting figures which may be required the Chief Executive with the information from which
he can control the business. It comprises accounting methods systems and techniques which
coupled with special knowledge and ability assist management in its task of maximizing profits or
minimizing losses.

Functions of Management Accounting

The basic function of management accounting is to assist the management in performing in its
function effective the functions of the management are planning organizing directing and
controlling. Management accounting helps in the performance of each of these functions in the
following ways

Provides Data:

Management accounting serves as a vital source of data for management planning. The accounts
and documents are a repository of a vast quantity of data about the past progress of the enterprise
which are a must for making forecasts for the future.

Modifies Data:

The accounting data required for managerial decisions are properly compiled and classified. For
example purchase figures or different months may be classified to know total purchases made
during each period product wise supplier wise and territory wise.

Analysis and Interprets Data: The accounting data is analysed meaningfully for effective
planning and decision making. For this purpose the data is presented in a comparative form. Ratios
are calculated and likely trends are projected.

Serves as a means of communicating: Management accounting provides a means of

communicating management plans upward downward and outward through the organization.
Initially it means identifying the feasibility and consistency of the various segments of the plan.
At later stages it keeps all parties informed about the plans that have been agreed upon and their
roles in these plans.
Facilitates Control: Management accounting helps in translating given objectives and strategy
into specified goals for attainment by a specified time and secures effective accomplishment of
these goals in a efficient manner. All this is made possible through budgetary control and standard
costing which are in integral part of management accounting.

Uses also qualitative information: Management accounting is concerned with presentation of

accounting information in the most useful way for the management. Its scopes is therefore quite
vast. It includes within its fold almost all aspects of business operations.

Scope of management accounting

The following areas can rightly be identified as falling within the ambit of management
accounting:

Financial Accounting: Management accounting is mainly concerned with the rearrangement of

the information provided by financial accounting. Hence management cannot obtain full control
and coordination of operations without a properly designed financial accounting system.

Cost Accounting: Standard costing: Standard Costing marginal costing opportunity cost analysis
differential costing and other cost techniques plan a useful role in operation and control of the
business undertaking.

Revaluation Accounting: This is concerned with the ensuring that capital is maintained intact in
real terms and profit is calculated with this fact in mind.

Budgetary Control: This includes framing of budgets comparison of actual performance with the
budgeted performance computation of variances finding of their causes etc.

Inventory Control: It includes control over inventory from the time it is acquired till its final
disposal.

Statistical Method: Graphs charts pictorial presentation index numbers and other statistical
methods make the information more impressive intelligible.

Interim Reporting: This includes preparation of monthly quarterly half yearly income statements
and other related reports cash flow and funds statements scrap and reports etc

Taxation: This includes computation of income in accordance with the tax laws filing of returns
and making tax payments.

Office Services: This includes maintenance of proper data processing and other office
management services reporting on the best use of mechanical and electronic devices.

Internal Audit: Development of a suitable internal audit system for internal control.

Characteristics of Management Accounting

Management accounting is the furnishing of accounting information to the management for taking
diverse decisions controlling and coordinating the operations of an undertaking. The following are
the main characteristics of management accounting:
 a) It is the combination of two words: Management +Accounting that it is an accounting for
the use of management to cater to its diverse requirements.
b) It involves the preparation and presentation of information in such a way to suit the needs
of management.
c) It is concerned with forecasting and planning the future course of action.
d) It helps to establish the cause and effect relationship between various factors affecting the
decision.
e) It does not follow any prescribed format. Though the tools of management accounting are
the same but its use and interpretation varies from concern to concern.
f) It uses only selective data which is useful and relevant to management and presents it in a
form suitable for them.
g) It is the provision of information to the management which is helpful in decision making.
It does not mean decision. The date are presented in the manner in which it is required by
the management. It depends on the efficiency of the management for utilizing the
information in taking the decisions.
h) The purpose of management accounting is to increase and improve the efficiency of the
concern.

Role and Functions of Management Accountant

The management Accountant has significant role to play. He helps in the installation development
and operation of management accounting system. The position of management accounting has
been very beautifully explained by P.L.Tandon (1965). Management Accountant is exactly like
the spokes in a wheel connecting the rim of the wheel and the hub receiving the information. He
processes the information and then returns the processed information back to where it came from.
Management accountant is also designated as the chief controller who performs the following
diverse functions:

Planning: Management accountant lays in adequate plan regarding diverse activities and
operations of business enterprise. Standards and targets are laid down regarding capital investment
financial structure profitability sales costs expenses etc by the management accountant.

Controlling: He has to compare actual performance with operating plans and standards and to
report and interpret the result of operations to all levels of management and the owners of the
businesses. This is done through the compilation of appropriate accounting and statistical records
and reports.

Coordinating: He consult all segments of management responsible for policy or action. Such
consultation might concern any phase of the operation of the business having to do with attainment
of the objectives and the effectiveness of the organization structure and policies.

Other functions:

a) He administers tax policies and procedures

b) He supervises ad coordinates the preparation of reports to government agencies
c) He ensures fiscal protection for the assets of the business through adequate internal control
and proper insurance coverage.
d) He carried out continuous appraisal of economic and social forces and the government
influences and interprets their effect on the business.

It should be noted that the functions of a Management Accountant are more of those of a staff
official. He in addition to processing historical data supplies a good deal of information concerning
the future operations in line with the management’s heads. Besides serving top management with
information concerning the company as a whole he supplies detailed information to the line
officers regarding alternative plans and their profitability which help them in decision making.

Requisites for Successful Management Accountants

The following are the basic requisites for a management Accountant to be successful in his job.

Direct Contact with the top management: The goal of the management accountant is to channel
for use in the process data that will have a vital influence on company policy. Technicalities and
redtape cause delay which may prove very costly to the business. He should therefore report
directly to the President or the Chief Executive of the company.

Freedom From Detail: The most likely title of the management accountant is that of the
controller. He is the principal officer incharge of accounts and performs such additional duties
which the Board of Directors the executive committee or the President of the company may assign
to him from time to time. He cannot possibly measure up to this status if he is immersed in
accounting routine or is a slage to the operation of balancing.

Personal Qualities: The Management Accountant has perhaps the maximum changes of going up
high in the management hierarchy. He can make best use of the opportunities if he possesses the
following personal qualities:

a) A personality acceptable to all types of individuals that may make up the management
group in company.
b) The ability to receive the views of management with comprehension and to appreciate the
type of information management requires.
c) An understanding of how to fill the role of specialist and adviser
d) A knowledge of theory as well as practice of management
e) A balanced outlook on functioning of the business.
f) The capacity to think and confer with top management about matters central to the
profitability and progress of the company.

Management Accounting Principles

Besides the basic accounting principles which are accepted generally throughtout the accounting
profession the following are the additional conventions/principles which are now generally
regarded as essential part of management accounting:

Designing and Compiling:

Accounting information records reports statements and other evidence of past present or future
results should be designed and compiled to meet the needs of the particular business and or specific
problem.

This implies a certain flexibility of system. When a particular problem is to be solve the system
should be capable of producing the relevant data. If necessary there must be departure from double
entry principles. Accounting and operational research principles should be linked together.
Information should be modified and adapted to meet each need whenever possible. However it is
important to remember that if this principle is carried to far the cost of the management
accountancy system may become excessive. It is partly for the reason that a systematic rather than
an adhoc method is used for accumulating costing data.
Management by exception:

The principle of management by exception is followed when presenting information to

management.
This assumes that plans are predetermined and then actual results are compared with expected
results. If there are no deviations there is no necessary to report. When there are variations from
predetermined plans management is informed precisely of what is going wrong. In this way the
information presented to management is kept to the minimum yet at the same time all important
facts are being revealed. What is more management has less to read and study and therefore should
have more time to take action.

Control at source accounting:

Costs are best controlled at the points at which they are incurred. Control at source accounting.
Recognition of this convention is acknowledge through the preparation of departmental operating
statements and the design of costing system which control individual workers materials issues and
the usage of services.

Accounting for inflation:

A profit can not be said to be earned unless capital is maintained intact in real terms. This
convention recognizes that the monetary unit is not stable. Attempts to overcome the effects of
changes in the value of money have been made via revaluation accounting bus as yet there is not
general acceptance of the theory. However there is strong evidence that more and more accountants
are modifying their views to meet the dynamic state of business and the economy.

Use of ROI

Return on capital employed is used as the criterion for measuring the efficiency of the business.
For this purpose the capital employed should be calculated by reference to current replacement
values.

Integration

There should be integration of all management information so that fullest use is made of the facts
available and at the same time the accounting service should be provided minimum cost.

Absorption of overhead costs

Overhead cost should be apportioned to cost centres and absorbed to products on the basis of
benefits received for fixed costs or responsibilities incurred for variable costs. The methods or
methods selected should bring about the desired results of recovering the overheads in the most
equitable manner. However this is subject to what is stated on this matter later in the chapter on
Marginal Costing and Profit Planning.

Utilisation of resources

Management accountancy should endeavour to show whether or not the resources of the business
are being utilized in the most effective manner.

Forwarded looking approach

Management accountancy should seek to anticipate problems and prevent them. There should be
a forward looking approach and actual costs should be employed only as measures of achievements
realized. The principle recognizes the importance of budgetary control and standard costing.

Appropriate means

The most appropriate means of accumulating recording the presenting the accountancy
information should be selected.

This normally implies that mechanisation should be adopted as much as possible. It does not mean
that every business should employ computer. The machines selected should be of a size and type
that can economically be employed by the particular concern to deal with its own problems. If
there is insufficient work for a computer then clearly this should not be acquired.

Personal Contacts

Personal contact with departmental managers foremen and others can not be replaced entirely by
reports and statements.

The above list of conventions is not exhaustive on account of the subject of management
accounting being a growing own. It may be possible that in the times to come many more suitable
conventions may be developed by the management accountants all over the world which may be
developed by the management accountants all over the world which may take the form of
universally acceptable management accounting principles.

Benefits of Management Accounting

Management accounting provides invaluable services to management in the performance of its

functions effectively as explained below:

1. Planning: It involves formulation of policies setting up of goals and initiating necessary

programmes for achievement of the goals. Management accounting makes an important
contribution in performance of this function. It makes available the relevant data after pruning and
analyzing them suitably by effective planning and decision-making.

2. Controlling: It involves evaluation of performance keeping in view that the actual performance
coincides with the planned one and remedial measures are taken in the event of variation between
the two. The techniques of budgetary control standard costing and departmental operating
statements greatly help in performing this function. As a matter of fact the entire system of control
is designed and operated by the management accountant designated as controller.

3. Coordinating: It involves interlinking of different divisions of the business enterprise in a way

so as to achieve the objectives of the organization as a whole. Thus perfect coordination is required
among production purchase finance personnel sales departments etc. Effective coordination is
achieved through departmental budgets and reports which from the nucleus of management
accounting.

4. Organising: It involves grouping of operative action in a way as to identify the authority and
responsibility within the organization. Management accounting here also plays a prominent role.
The whole organisation is divided into suitable profit or cost centres. A sound system of internal
control and internal audit for each of the cost or profit centers helps in organising and establishing
a sound business structure.

5. Motivating: It involves maintenance of a high degree of morale in the organization. Conditions

should be such that each person gives his best to realize the goals of the enterprise. The superiors
should be in a position to find out whom to demote or promote and to reward or penalize. Periodical
department profit and loss accounts budgets and reports go a long way in achieving this objective.

6. Communicating: It involves transmission of data result etc both to the insiders as well
outsiders. The orders of the supervisors should be communicated to the subordinates while the
results achieved by the subordinates should be reported to the supervisors. Moreover the
management owes a duty to the creditors prospective investors shareholders etc to communicate
to them about the progress financial position etc of the enterprise, Management accounting helps
the management in performance of this function by developing a suitable system of reporting
which emphasis and highlights the relevant facts.

Limitations of Management Accounting

Management accounting being comparatively a new discipline it suffers from the following
limitations:

1. Limitations of basis records: Management accounting derives its information from financial
accounting and other records. The strength and weaknesses of the management accounting
limitations are also the limitations of the management accounting.

2. Persistent efforts: The conclusions drawn by the management accountant are not executed
automatically. He has to conscience people at all levels. In other words he must be an efficient
sales man in selling his ideas.

3. Management Accounting is only a tool: Management accounting cannot replace the

management. Management accountant is only an advisor to the management. The decision
regarding implementing his advice is to be taken by the management. There is always a temptation
to take an easy course of arriving at decision by intutin rather than going by the advice of the
management accountant.

4. Wide Scope: Management accounting has a very wide scope incorporating many disciplines. It
considers both monetary as well as non monetary factors. This all brings inexactness and
subjectivity in the conclusions obtained through it.

5. Top heavy structure: The installation of management accounting system requires heavy costs
on account of an elaborate organizations and numerous rules and regulations. It can therefore be
adopted only by big concerns.

6. Oppositions to change: Management accounts demand a breakway from tradition accounting

practices. It practices. It called for a rearrangement of the personnel and their activities which is
generally not like by the people involved.

Difference between Financial and & Cost Accounting

Basis of Financial Accounting Cost Accounting

distinction
 Statutory These accounts have to be prepared pared Maintenance of these
Requirements according to the level requirements of accounts is voluntary except
Companies Act and Income Tax Act in certain industries where it
has been made obligatory to
keep cost records under the
Companies Act
Purpose The main purpose of financial accounting The main purpose of cost
is to prepare profit and loss account and accounting is to provide
balance sheet for reporting to owners and detailed cost information to
outside agencies i.e. external users management i.e. internal
users
Analysis of Financial accounts reveal the profit or loss Cost accounts show the
cost and of the business as a whole during a detailed cost and profit data
profit particular period. It does not show the for each product line
figures of cost and profit for individual department process etc
products departments and processes etc
Periodicity of Profit and loss account and balance sheet Cost reporting is a
Reporting are prepared periodically usually on an continuous process and may
annual basis be daily weekly monthly etc
Control It keeps records of financial transactions It is used as a detailed
aspect and does not attach any importance to system of controls. It takes
control aspect. the help of certain special
techniques like standard
costing and budgetary
control
Nature It is concerned with historical records. The Cost accounting does not
historical nature of financial accounting end with what has happened
can be easily understood in the context of in the past. It extends to
the purpose for which it was designed plans and policies to
improve performance in the
future.
Nature of General purpose statements like profit and It generates special purpose
statements loss account and balance sheet are prepared statements and records like
prepared by it. That is to say that financial Reports of Loss of Materials
accounting must produce information that Idle Times Report Variance
is used by many classes of people none of Report etc Cost accounting
whom have explicitly defined information identifies the user discuses
needs. his problems and needs and
provides tailored
information.
Classification Financial accounting classifies records and Cost accounting records and
of Records analysis transactions in subjective manner classifies expenditure
purpose i.e. according to nature of expenditure according to the purpose for
which cost is incurred.

Cost Accounting Vs Management Accounting

Cost accounting and management accounting are both internal to an organization. Both have more
or less the same objective of assisting management in it planning decision making etc. It is not
worthwhile to distinguish the two inter related disciplines as two branches of accounting. Consider
what experts opine in this regard.
Dobson: Management accounting is so broad and comprehensive that it includes both financial
and cost accounting.

C.T. Horngren: Cost accounting is management accounting plus a small part of financial
accounting.

It is because of the overlapping nature of the two in many areas that everyone talks of cost and
management accounting as a single discipline. However some distinctions can be drawn thus:
Distinction between Cost Accounting and Management Accounting

Point of distinction Cost accounting Management accounting

Coverage It deals with ascertainment It is concerned with the impact and
allocation distribution and effect aspects of cost
accounting aspects of costs
Position in the Cost accountant is generally Management accountant assumes a
hierarcy placed at a lower level of hierarcy superior level in the management
than a management accountant hierarcy
Approach Narrow as the focus is primarily Wider as one may have to use
on cost data certain economic and statistical
data along with costing data to
assist managerial decision making
Emphasis It lays emphasis on cost It is used as a decision making
ascertainment and cost control technique
Scope The scope of cost accounting is It makes use of other techniques
limited to important techniques like funds flow ratio analysis cash
like variable costing break even flow etc in addition to variable
analysis and standard costing costing break even analysis and
standard costing. This includes
financial accounting tax planning
and tax accounting
Focus It focuses on short term planning. It focuses on sort range and long
Sophisticated tools not employed range planning and uses
for forecasting purposes sopmsticated technique in the
planning and control process.
Orientation It deals with data supplied by Futuristic in orientation is more
financial accounting orientation is predictive in nature than cost
not futuristic accounting
Evolution The evolution of cot accounting is It draws heavily on cost data and
mainly due to the limitations of other information derived from cost
financial accounting accounting. It is merely an
extension of the managerial aspects
of cost accounting.
Purpose Its main purpose is to report Its main objective is to provide all
current and prospective costs of accounting information relevant for
product service department job or use in formulation of policies
process planning controlling decision
making etc to ensure maximum
profits.

Tools and Techniques of Management Accounting

1. Analysis of Financial HSH
2. Budgetary Control
3. Decision Accounting
(i) Make/Buy
(ii) Do’s or Dont’s to do any business activity
(iii) To choose best alternative
4. Calculation of price of product

5. MIS
6. Financial Policy
7. Working Capital Management
8. Variance Analysis
9. CVP Analysis
10. Cost Behaviour Analysis
11.ROI Analysis
12. EOQ
13. Safe Stock/Lead Time Analysis/Inventory Management
14. ABC

Marginal Costing And Profit Planning

Marginal costing is not a method of costing on the lines of job or process costing but is a special
technique which presents information to management enabling it to measure the profitability of an
undertaking by considering the behavior of costs. Marginal costing may be used in conjunction
with other costing methods like job or process costing or with other techniques such as standard
costing or budgetary control.

Fixed and Variable Costs

The classification of costs into fixed and variable is of special interest and importance in marginal
costing. The concepts of fixed and variable costs have been described earlier. These two types of
cost behave differently with changes in the volume of output fixed costs remain largely constant
regardless of the actual level of production. Variable costs on the other hand change in proportion
to the volume of output. Semi fixed or semi variable costs are separated into fixed and variable
elements and added to their respective categories.

Under marginal costing fixed and variable costs are kept separate for all purposes. Only variable
costs are taken into account for computing the costs of products and thus are treated as product
costs. Fixed costs do not find place in the cost of products or in inventory valuation. Such costs
are treated as period costs and are written of in the costing profit and loss account of the period in
which they incurred. The following entry is passed through cost journal after analysing production
administration and selling and distribution overheads into fixed and variable components.

Dr variable overhead incurred A/C

Dr Fixed overhead incurred A/C
Cr Production overhead incurred A/C
Cr Administration overhead incurred A/C
Cr Selling and Distribution overhead incurred A/c

What is Marginal Cost

Marginal cost is nothing but variable cost. It is clearly composed of all direct costs and variable
overheads. The ICMA London has defined marginal costs as the amount at any given volume of
output by which aggregate costs are changed if volume of output is increased or decreased by one
unit. In simple words marginal cost is the additional cost of producting additional units. An
important point is that marginal cost per unit remains unchanged irrespective of the level of
activity. The following example would further clarify the concept of marginal costs.

Example: A company manufactures 100 radios per month. Total fixed cost per month is Rs 5000
and marginal cost per radio is Rs.150. The total cost per month will be

Rs
Marginal (variable) cost of 100 radios 15000
Fixed cost 5000
---------
Total cost 20000

If output is increased by one radio the cost will appear as follows:

Rs
Marginal cost (101x150) 15150
Fixed cost 5000
-----------
20150
Thus the additional costs of producing one additional radio is Rs.150 which is its marginal costs.
However where fixed costs also increase with the increase in the volume of output this may be the
result of increase in production capacity.

Such increases in fixed costs are dealt with as a part of what is known differential cost analysis
discussed separately in this chapter.

What is Marginal Costing

Marginal costing is defined by ICMA London as the ascertainment of marginal costs by

differentiating between fixed and variable costs and of the effect on profit of changes in volume
or type of output. This definition makes it clear that marginal costing goes beyond the
ascertainment of costs. It is a technique concerned with the effect on profit when the volume or
type of output changes. In particular marginal costing studies the effect which fixed cost has on
the running of a business.

Characteristics of Marginal Costing

The essential characteristic 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 costs are also segregated into fixed and variable elements.

2. Marginal costs as products costs. Only marginal (variable) costs are charged to products costs.

3. Fixed costs as period costs. Fixed costs are treated as period costs are changed to 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 costs
only.

5. Contribution. Contribution is the difference between sales value and marginal costs 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.

7. Marginal costing and profit In marginal costing profit is calculated by a two stage approach.
First of all contribution is determined for each product or departments. The contributions of various
products or departments are pooled together and such a total contributions from all products is
called Fund. Then from this fund is deducted the total fixed cost to arrive at a profit or less. This
is illustrated below

Sales of Sales of Sales of

Product A Product B Product C
Less Less
Less Marginal Cost Marginal
Marginal Cost of B Cost of C
of A
Contributio Contributio Contributio
n of A n of B n of C

Total Contribution Pool

(Fund)
Less
Total Fixed Cost

Profit
Usefulness of Marginal Costing Or Variable Costing Or Direct Costing

(A) Profit planning: With the rising cost and shrinkage in profit margin attention is now directed
more and more by management towards a better and fuller understanding of the relationship
between profit and the major factors affecting it like sales volume production selling price sales
mix production and selling costs etc. This is simply because all these factors are variable in nature.
Unless these relationships are known there can be no assurance that the plans and subsequent
actions to control activity will lead to the anticipated profited. Marginal or variable costing as a
method of evaluation the result of operation is designed to specify the need for a simple
presentation of operating results which clearly show the cost volume profit relationship. It attempts
to improve the procedure for collecting and presenting information regarding these relationships.
This type of information is not necessary for the determination of net income or for the
measurement of production cost but it is important to have such information for purposes of
budgeting and profit planning in selecting product lines and in deciding upon the relative
importance to be given to each line of activity in appraising the performance of sales personnel in
establishing price policy and as a basis for decisions involving choice amongst alternatives.

(B) Decision Making: The technique of marginal costing is a valuable aid to management for
decision making under changing conditions. Business policies which form the basis of budgeting
and which must be followed to secure desired results are formulated with the help of marginal cost
analysis. Thus one of the important duties of the cost accountant is
to advise management on business policies arising out of marginal costing. Some of the important
areas of decision making where marginal cost analysis becomes unseful are mentioned below:

(i) Determination of selling price and volume of output: If the total revenue can be projected on
the basis of anticipated prices and volumes of production the increase in revenue at different levels
of production and at different prices can be compared with the marginal costs at those levels of
activity. Then the selling price which will maximize profits can be determined easily by comparing
the marginal costs and incremental revenue. Production should be increased as long as the
increment in revenue is more than the marginal cost of producing the additional output. It will not
be profitable any more to increase production when marginal revenue is equal to the marginal cost.

(ii) Determining optimum product or sales mix Business firms producing and selling two or more
products often face the problems of determining the ratio in which the different items should be
produced and sold so as to maximize profits or minimize costs. As the fixed overheads are constant
whatever be the mix the most profitable mix is that which would give the highest amount of gross
margin (excess of selling price over the variable costs). Application of the marginal costing
technique is very appropriate in this connection. The decision will naturally depend on the effect
of alternative combinations on the use of labour materials machine time selling technique storage
space etc.

(iii) Make or buy decision: Manufactures have sometimes to decided whether components or parts
should be bought from the market or produced in the factory. The marginal cost of producing the
parts compared with the market price gives an accurate basis for taking the decision to make or
buy.

(iv) Replacement of machinery: Whether it would be more profitable to replace existing machinery
by new and improved ones is a question which management in every concern has to face from
time to time. The differential cost of keeping the old machine in use and using new machinery is
the proper basis for making decisions of this nature.

(v) Acceptance of special order: If a special order is proposed and the price offered is less than the
average total cost a comparison of the additional revenue and marginal cost is necessary to decided
whether the order is worthwhile to accept. Assuming that the order executed at the offered price
will not affect the selling price in the market it will be profitable to accept the offer so long as the
additional revenue and marginal cost is necessary to decide whether the order is worthwhile to
accept. Assuming that the order executed at the offered price will not affect the selling price in the
market it will be profitable to accept the offer so long as the additional revenue exceeds the
marginal cost of supplying the order.
(vi) Submitting tenders and quotations: When a tender is submitted the additional production
involved will mean an increase in total cost. To make a competitive bid the minimum price has to
be quoted. The marginal cost indicates the floor below which the quotation will be unprofitable.
This implies that any price above the marginal cost may be quoted price does not lower the normal
price for the rest of the market.

(vii) Alternative use of plant facility: If the manufacture of a particular product or component is
possible by different methods techniques it needs to be decided whether one machine should be
used instead of another or how many operators should be used with a machine or whether the
processing should be carried out by manual or machine work. Marginal costing may be used in
comparing the effect of alternative technique on profit. The variable cost affected by alternative
techniques on profit. The variable cost affected by alternative technique will lead to varying gross
margins and this can be on the basis of deciding upon the best alternative.

(C) Cost Control: The importance of cost control for accomplishing the objective of profit
maximization is widely recognized in business houses. But neither all costs are controllable by any
individual nor are all costs controllable by management at all times. Therefore it is appropriate and
logical that a clear distinction should be made between controllable costs.

However it is also necessary for effective cost control that the responsibility of control must lie
with those who make the cost incurring decisions. This is possible to ensure through the marginal
cost technique where variable and fixed costs are normally separated.

As marginal costing recognizes the behavior of costs in relation to volume and or time only
variable costs are charged to product processes or functions per unit basis while the fixed expenses
incurred to keep capacity and sell in readiness for use are not charged to products and can be
controlled by functional responsibility centres. Hence the foreman is no longer accountable for
depreciation and rent over which he has no control. Fixed costs are referred to the controlling
authority involved. Thus marginal costing ensures reporting only such costs to individual managers
which are relevant and appropriate.

Further under marginal costing it is possible to accumulate costs by cost centres the smallest area
of responsibility like for instance a department. Thus reports to foremen include only those costs
which are subject to his control. Reports to higher managers include costs items in either detailed
or summary form because ore costs are controllable as the scope of management responsibility
enlarges. For instance the production superintendent is responsible for all costs of the production
department and own office costs. The production manager is responsible for costs of the production
and service departments. The repots sent to management thus summarise the controllable costs at
each stage.

Fixed costs are collected and reported in the income statement as separate deductions from
marginal income i.e. contribution margin instead of being merged with the cost of goods sold and
inventory. This helps management to clearly understand the expense behavior and not to loose
sight of individual items of fixed expenses.

In short the most important requirement of cost control that costs within the functional area of
responsibility be identified and controlled by people who make the cost incurring decisions is
fulfilled in marginal costing. It follows a logical principle that costs which are not controlled by
the responsible individual should be omitted or separated from the costs which the individual is
expected to control. This is technically referred to as Responsibility Accounting.
Marginal costing facilitates management by exception by focusing attention of the management
towards results which are moving out of line and prompt them to initiate timely action for
correction. Moreover it helps higher level management personnel in evaluating the performance
of men responsible to them. The impact of fixed expenses over specific functions and in the firm
as a whole is conveyed to management in a more meaningful form under marginal costing. This
helps management to ensure better utilisation of existing facilities and personnel.

To sum up as a tool of management the marginal costing technique highlights relationships

between profits and the major factors affecting profits. The significance of marginal costing is
particularly established in multi product companies and situations in which there is under utilized
capacity and in connection with cost reporting to managers at different approaches for phrposes of
control. From this point of view marginal costing followes a logical principle that costs which are
not controllable by operating managers should be separated from costs which are expected to be
controlled by them. It also facilitates management by exception.

Limitations of Direct Costing/Marginal Costing/Variable Costing

Under certain conditions some of the advantages listed in the previous section can be considered
disadvantages. If for example the management of a company were prone to make all decisions
both short and long term on the basis of contribution it might be a disadvantage to have the monthly
accounting statements reflect contribution. In addition to these disadvantages that may apply in
particular cases there are five disadvantages to direct costing.

(A) Inventories are undervalued. The first disadvantage of direct costing is that inventories are
undervalued. There is no question that inventories will have a lower value under a direct costing
system than under a full absorption system and in this respect could be considered undervalued.
Whether this disadvantage applies to any situation will depend on what effect this lower inventory
value has. (The same disadvantage applies to the LIFO methods of inventory valuation). To the
extent that in direct costing inventories are smaller than in full absorption costing internal
statements will show a lower profit (in the year of the change over).

(B) Internal Financial Statements Differ from Published Reports. The second disadvantage is that
the internal financial statements will differ from the published reports. This results because most
direct costing methods are not considered acceptable by the public accounting profession for
external financial statements. Consequently when a company uses direct costing it is necessary to
increase the value of the inventory to reflect full accounted costs. This adjustment may cause
confusion because the internal profit figure will be different from that included in the annual
report.

The seriousness of this disadvantage depends on the ability of management to understand the
situation. If management understands and agrees that a direct costing system is more useful there
should be little problem. If however management is not able (or willing) to understand why internal
and external statements are different this factor could be an important consideration in deciding
whether to adopt a direct costing system.
The calculation to adjust the inventories to full cost is usually not an involved problem with respect
to either the public accountant or the internal revenue service. Acceptable methods are available
that can be applied to the entire inventory value so that it is not necessary to recalculate the cost of
each item. The clerical cost of making this calculation is relatively small.

(C) Monthly profits tend to fluctuate more widely. The third disadvantage of direct costing is that
monthly profits will tend to fluctuate widely where the demand is seasonal. Under a full absorption
system if production is relatively constant the effects of seasonal changes in sales will be
considerably mitigated. With direct costing however the same amount of fixed costs will be
reflected in the income statement each month regardless of the sales volume therefore profits will
be higher in above average months and lower in below average months.

The seriousness of this disadvantage will depend upon several things first upon whether seasonal
demand exists if it does exist upon whether production is more constant than sales (if it is not the
monthly profit fluctuations will not be mitigated) third upon whether management understands the
limitations of the monthly profit estimates. As in the other situations this is considering the
adoption of direct costing system.

(D) It is difficult to Calculate Variable Costs. The fourth disadvantage offered by proponents of
full costing is the inability of some companies to calculate variable costs or even to agree on a
definition. Management must make decisions based on differential costs and consequently these
costs must be estimated. No matter how inexact the estimate it is generally better than no estimate
at all. The objection refers to having these variable costs reflected on the books of account. Since
the variability of costs will differ under different circumstances the usefulness of a single
calculation of the variability of overhead costs is questioned. The answer to this question must also
be decided in the context of a specific situation. If management must take many decision where
variable cost may be very widely a separate study will be required for each decision. Under these
circumstances little would be gained in having a single arbitrarily defined variable cost reflected
on the books of account. If however the variability of overhead costs does not differ much for
different types of decisions the fourth objection to direct costing is not valid.

(E) Direct Costing Requires a Change in the present system. The fifth disadvantage of direct
costing is that for most companies it entails a departure from accounting methods that have been
in effect for some period of time. Any change causes a certain amount of trouble and confusion.
A change to a direct costing system therefore should not be made unless there are positive
advantages for doing so. A company should not change its internal accounting system simply
because it appears to be the thing to do. Direct costing (or any other costing) is not a panacea for
management ills. A direct costing system may aid management to make better decisions but it will
not compensate for inadequate management.

Break Even Analysis/CVP Analysis

The narrower interpretation of the term break even analysis refers to a system of determination of
that level of activity where total cost equals total selling price. The broader interpretation refers to
that system of analysis which determines the probably profit at any level of activity. The
relationship among cost of production volume of production the profit and the sales value is
established by break even analysis. Hence this analysis is also designated as Cost volume profit
analysis.

Such an analysis is useful to the management accountant in the following respects

(a) It helps in determining the amount of overhead cost to be charged at various levels of operations
since overhead rates are generally pre determined on the basis of a selected volume of production.

(b) It helps in formulating price policy by projecting the effect which different price structures will
have on cost and profits.

(c) It also assists him in performance evaluation for purposes of management control.
(d) It is helpful in setting up flexible budgets since on the basis of this relationship he can ascertain
the costs sale and profits at different levels of activity.

(e) It helps him in forecasting the profit fairly accurately.

Thus cost volume profit analysis is an important media through which the management can have
an insight into effects on profit on account of variations in costs (both fixed and variable) and sales
(both volume and value) and take appropriate decisions.

The most important point about break even analysis is that costs must be capable of being resolved
into their fixed and variable components so much so that its accuracy depends upon the precision
with which cost variability is determined. Thus a careful study of each cost or group of costs has
to be made.

(A) Fixed Overheads. Preliminary analysis cost will readily indicate certain costs to be fixed for
all practical purposes. Therefore theoretically costs may be shown by means of a straight line
extended fully across the graph though from the practical point of view they will represented by a
straight line within certain limits only. Beyond these limits increased expenditure on fixed charges
will be incurred e.g. to cater for additional plant or building. Changes in fixed costs will normally
take the graphical form of definite steps rather than a gradual curve.

(B) Variable Overheads- There are certain other elements of costs which are more or less variable
in nature. This means that they would vary direct by with the volume of business. For plotting each
pint on the break even chart the variable overheads will be aggregated with the fixed and semi
variable overheads.

(C) Break even point- The point at which the total cost line and the turnover line interest on the
graph is the break even point. The spread to the right of this point between these two lines
represents the profit potential while the spread to the left would represent the loss potential. Thus
the probable profit or loss for any volume of business can be assessed by measuring the vertical
gap between the sales line and the total cost line at that particular volume.

(D) Sales Turnover- The sales turnover for the respective quantities is plotted on the graph.

(E) Semi Variable Overheads- There is a large group of costs possessing the characteristic of both
fixed and variable costs i.e. semi variable costs. These are the costs that require special analysis
the objective being toe separate the fixed and variable components. Generally the most logical
basis on which to attempt such separation is an analysis of historical data. These overheads must
be computed for several volumes of business as under flexible budgeting the appropriate amounts
have to be added to fixed charges to plot each point on the chart. Thus in effect semi variable
charges are plotted using he fixed charges line as the horizontal axis.

(F) Margin of Safety- This represents the amount by which the actual volume of sales exceeds
those at the break even point. It is important that there should be reasonable margin of safety
otherwise a reduced level of activity may prove disastrous. A low margin usually indicates high
fixed overheads so that profits are not made until ther is a high level of activity to absorb fixed
costs.

(F) Angle of Incidence- This is the angle at which sales line cuts the total cost line. The
management’s aim would be to have as large an angle as possible because this indicates a high
quantum of profit once the fixed overheads are absorbed. A narrow angle would show that even
when fixed overheads are absorbed profit accrues at a relatively low rate of return indicating that
variable costs form a large part of cost of sales.

Limitations of break even Analysis

Though break even analysis has gradually become a very serviceable tool for modern financial
management its detractors raise a number of points against its use. The objections which have been
commonly raised are the following:

a. The break even analysis does not depend on the assumption of a straight line representing total
experiences it does need information regarding expenses at different levels of sales. Therefore if
the total expenses does not possess the characteristics of a straight line and the fact is known total
expenses curve should be drawn differently.

b. In a number of cases it is a straight line particularly where the individual seller cannot influence
the price. However if the seller has the capacity to affect the price. However if the seller has the
capacity of affect the price a number of break even charts would depict the situation satisfactorily.

c. Break even analysis is based on the assumption that income is influence only by changes in sales
so that changes in inventory would not directly affect income. If marginal costing is used this
assumption would hold good but in other cases changes in inventory will affect income since the
absorption of fixed costs will depend on production rather than sales.

d. This is undoubtedly true in actual practice. Though the horizontal axis cannot measure the
number of unit sold in case there are unlike products being sold the fact remains that measuring of
units sold on X axis is useful either where the plant is manufacturing only one product or break
even analysis is being made for only one product.

e. The objection can be met by preparing a sales of break even charts to show the result of sales of
different product mixes. The argument is valid but when break even analysis is used in the
preparation of budgets there is nothing improper in assuming that the cost of finished goods
inventory would remain unchanged.

Assumptions of Break Even Analysis

The important assumptions are discussed as follows:

(i) The costs can be accurately segregated into fixed and variable elements
(ii) The fixed cost remain constant at all levels of output and the variable cost varies in direct
proportion to the level of output.
(iii) The selling price remain unchanged.
(iv) There is no opening or closing inventory. The volume of production and sales coincides.
(v) Only a single product is being produced and in case of multi products the sales mix remains
constant.
(vi) All other variables such as the general price level and the productivity of each worker remains
constant.
(vii) It is applicable only to a short term time horizon
(viii) There exists linear relationship between output on the one hand and costs and revenue on the
other hand

The study of break even analysis is based on the following equation:

Sales – Variable Cost= Fixed Cost+Profit
The break even analysis facilitates the computation of:
• Contribution
• Profit-volume (P/V) Ratio
• Break Even Point
• Margin of safety

Contribution

Contribution is the difference between the total sales revenue and the total variable cost. Per unit
contribution is the excess of selling price over the variable cost per unit. It can be expressed by the
following formula

Contribution = Sales –Variable Cost

Contribution Per Unit = Selling Price- Variable Cost per unit
Contribution = Fixed Cost

Illustration 1

Variable cost = Rs 20000@ Rs 2 per unit

Fixed cost = Rs10000
Sales= Rs 50000 @ Rs5 per unit
Compute contribution and the profit at level of 10000 units of output

Solution

Contribution = Sales-Variable Cost

=Rs 50000-Rs.20000
= Rs.30000
Profit=Contribution-Fixed Cost
=Rs.30000-Rs.10000
=Rs.20000
Contribution Per Unit=Selling Price-Variable Cost Per Unit
=Rs.5-2
=Rs.3 per unit
Profit Volume Ratio (P/V Ratio)
It establishes the relationship between the contribution and sales ratio. Therefore this ratio may
also be called as Contribution to Sales Ratio. The ratio can also be expressed as in terms of
percentage. The ratio is computed by using the following formula:

P/V Ratio = Total Contribution/Total Sales Revenue = Sales-Variable Cost/Sales

Or
P/V Ratio= Unit Contribution/Unit Selling Price
Since the contribution is equivalent to aggregate of fixed cost and profit.
Thus
P/V Ratio = Fixed Cost+Profit/Sales Revenue
In case of loss it will be as follows:
P/V Ratio= Fixed Cost-Less/Sales Revenue
It can also be computed by the following formula:
P/V Ratio= Change in Contribution/Change in Sales
Or
P/V Ratio = Change in profit/change in sales
It is so because it is assumed that variable cost per unit and selling price per unit remain constant.
Since fixed costs are assumed to remain constant at all levels of output therefore any increase in
contribution would mean increase in profit only. This ratio can be used for calculation of variable
cost at any volume of sales.
Variable Cost=Sales (1-P/V Ratio)

Illustration 2

P/V Ratio = Contribution/Sales

= Rs100000/250000=0.4 or 40%
Or
P/V Ratio=Fixed Cost+ Profit/Sales
=Rs.40000+Rs60000/250000=0.4 or 40%

Variable cost can be ascertained at any volume of sales as follows:

Variable cost=Sales (1-P/V Ratio)
= Rs 200000(1-40)
Rs120000

Multi-Product P/V Ratio

In case of multi-product companies the P/V ratio is computed in the same manner as described
below
Composite or company’s P/V Ratio = Campany’s Total Contribution/Campany’s Total Sales
Revenue
One can also compute the P/V Ratio for each product using the following formula:
P/V ratio of Product A = Contribution from product A/Sales of Product A

P/V ratio is very useful for taking a number of marginal decisions. It helps in the computation of
break even point planning for desired levels of profit deciding the most profitable mix of
company’s product etc

Improvement in P/V Ratio

The P/V Ratio can be improved in the following ways:

(i) Increase the selling price without allowing for an increase in unit variable cost.
(ii) Reduce the unit variable cost without allowing for a decrease in the selling price
(iii) Increase the selling price at a higher rate than the rate of increase in the unit variable cost.
(iv) Decrease the variable cost at a higher rate than the rate of reduction in the selling price
(v) Increase the selling price and reduce the variable cost simultaneously.

Break Even Point

Break even point is the level of sales at which there shall neither be profit nor loss. It is point at
which total cost is equal to the total sales. At this point the total sales revenue is equal to the total
cost and the firm incur neither profit nor loss. If the sales volume is increased beyond the break
even sales the profit shall be earned by the business. If sales volume is decreased beyond the break
even sales the loss shall be suffered by the business. It is computed as follows:

Break even point (Units) = Fixed Costs/Contribution per unit

Break even point (Rs) = Fixed Costs/P/V Ratio= Fixed Costs/Contribution x Sales Revenue
= Fixed Costs/Contribution per unit x Selling price per unit
Break even point (units) x selling price per unit
Or
Break Even Point (Rs) = Fixed Costs/1-Variable Cost per unit/Selling price per unit

If the company wants to determine the required sales to earn the desired profit it can be computed
as follows:

Required sales units for a desired profit=Fixed cost+ desired profit/contribution per unit
Required sales revenue for a desired profit = Fixed cost + Desired Profit/P/V Ratio
Illustration 3

A company’s turnover in a year was Rs.5000000. Its profit was Rs 500000 and its P/V ratio was
40%. What is the break even point?

Solution:

Computation of Fixed Cost

Contribution =Fixed Cost + Profit
(Rs.5000000x40%) = Fixed Cost + Rs 500000
=Rs.1500000
Computation of Break Even Point:
Break Even Point = Fixed cost/P/V Ratio = Rs.1500000/40%
=Rs.3750000

Composite Break Even Point

In case of multi product firms a composite break even point is computed according to the following
formula
Composite break even point (Sales Amount) = Total Fixed Cost/Composite P/V Ratio
Or
Total Fixed Cost/Total Contribution x Total Sales
Composite P/V Ratio = Total Contribution/Total Sales x 100
Composite break even point (Units) = Total Fixed Cost/Composite Contribution Per Unit

Illustration 4

A company with 5x+60000 cost structure and with the objective of earning a profit of Rs.5 per
unit sells its product at Rs.20 per unit. Find out the number of units that it has to sell to achieve the
desired profit.

Solution:

Let x be the required sales volume to earn a profit of Rs.5 each on units sold. Therefore

x=FC + Desired Profit/Contribution per unit

x= Rs60000 + Rs 5 x/15
Therefore 15x= 60000+5x
10x = 60000
X=60000 units

Illustration 5
Sales of XYZ company were Rs 20000 producing a profit of Rs.8000 in a week. In the next week
sales amounted to Rs28000 producing a profit of Rs 2400. Find out the break even point.

Solution

Week Sales Rs Profit Rs Contribution Rs Fixed Cost Rs

I 20000 800 4000 3200
II 28000 2400 5600 3200

P/V Ratio = Change in Profit/Change in Sales x 100

=Rs 1600 x 100/Rs8000 = 20%
Therefore contribution will be 20% of sales and
Fixed cost = Contribution-Profit
=Rs.4000-800
=3200
Weekly fixed cost = Rs3200
Monthly fixed Cost = Rs.12800 (Rs 3200x4)
Yearly fixed cost = Rs.166400 (Rs3200x52)

Break even point (Weekly) = Fixed cost/P/V Ratio = Rs.3200/20% = Rs.16000

Break even point (Monthly) = Fixed Cost/P/V Ratio = Rs.12800/20% = Rs.64000
Break even point (Yearly) = Fixed cost/P/V Ratio = Rs.166400/20% = Rs.832000

Illustration 6

A factory has the capacity to produce 1000 per machines per annum
Variable cost Rs.250 per unit
Selling price Rs.300 per unit
Fixed overheads are Rs.15000 per annum. Calculate the break even point (in units) and (in amount)

Solution:

Break even point (units) = Fixed Costs/contribution per unit

=Rs.15000/50 = 300 machines
P/V Ratio = Contribution /Sales = Rs.50/300 x 100=16.6%
Break even point (Amount) = Fixed Cost/P/V Ratio
=Rs.15000/16.6% = Rs.90000
Alternatively
Break even point (For Sales)=Output x Selling Price Per Unit
300 machines x Rs 300 per unit
=90000
The break even point for sales can also be calculated with the help of any of the following formula
(i) Break Even Point (Amount) = Total Fixed Cost/1-Variable Cost Per Unit/Sales price per unit

= Rs 15000/1-Rs.250/300
=90000

Illustration 7

From the following data Calculate

(i) P/V Ratio
(ii) Profit when sales is Rs30000 and
(iii) New Break Even Point if selling price is reduced by 20%
Fixed Expenses Rs.5000
Break even point Rs.10000

Solution
(i) Break Even Point = Fixed Expenses/P/V Ratio
P/V Ratio = Fixed Expenses/Break Even Point
=Rs.5000/10000=50%
(ii) Profit when sales is Rs 30000
Profit = Sales x P/V Ratio – Fixed Expenses
=Rs.30000 x 50%-Rs.5000
=15000-5000
=10000

(iii) New Break Even Point if selling price is reduced by 20%

If sales Price at present is Rs 100
New sales price = Rs80
Variable cost per unit is Rs 50 (P/V ratio is 50%)
Hence
New P/V Ratio = Rs.30/80=37.5%
Break even point = 5000/37.5= 13,333

Margin of Safety

Margin of safety is the excess of actual sales over break even sales. Thus the formula is as follows
Margin of safety = Actual sales – Break Even Sales
It can also be computed according to the following formula
Margin of safety (Ratio) = Break Even Sales/Actual Sales x 100
Margin of safety (Rs) =Net Profit/P/V Ratio
The company with high margin of safety is able to earn more profit than the companies with low
margin of safety.

Illustration 8

Total sales Rs.200000

Variable cost Rs 100000
Fixed cost Rs50000

Compute margin of safety

Solution
Break even Sales = Fixed Cost/P/V Ratio
50000/50%
100000
Net profit = Contribution – Fixed Cost
=100000-50000
=50000
Margin of safety = Actual sales – Break Even Sales
=200000-100000
=100000
Or
Margin of safety = Net Profit/P/V Ratio
50000/50%
Rs.10000

Illustration 9

The P/V Ratio of Hans Ltd is 50% and margin of safety is 40%. You are required to work out the
Net profit and break even point if sales volume is Rs.2000000.
Solution

Net profit = Margin of Safety x P/V Ratio

=800000 x 50%
=400000
Break even point = Actual Sales-Margin of Safety
=2000000-800000
1200000

Working notes:

Margin of safety Ratio = 40%

Therefore Margin of safety would be Rs.800000 (Rs 2000000 x 40%)

Illustration 10

The following figures relate to a company manufacturing a varied range of products

Year ended Total Sales Rs Total Cost Rs

31.12.04 3223000 2983600
31.12.05 3451000 3143200

Calculate (a) P/V Ratio to reflect the rate of growth for profit and sales (b) Fixed Cost (c) Fixed
Cost % to Sales (d) Break Even Point and (e) Margin of Safety for the year 2004 and year 2005.

Solution
Particulars 2004 Rs 2005 Rs Difference Rs
Sales 3223000 3451000 228000
Total cost 2983000 3143200 159600
Profit 239400 307800 68400

(a) P/V Ratio = Change in Profit/Change in Sales x 100

= Rs.68400/228000x100
30%

(b) Fixed Costs

2004 2005
Contribution (30%) of Sales 966900 1035300
Less: Profit 239400 307800
----------- -----------
727500 727500
Therefore annual fixed cost= Rs.727500

(c) Fixed Cost as % of Sales

2004 2005
Fixed Cost/Sales x 100 727500/3223000 x 100 727500/3451000x100
22.6% 21%

(d) Break Even Point (Rs) Fixed Cost/P/V Ratio= Rs.727500/30%

2425000

(e) Margin of Safety

2004 2005
Sales –Break Even Sales 3223000-2425000 3451000-2425000
798000 1026000

Margin Safety of Ratio Margin of Safety/Sales x 100 798000/3223000x100

1026000/3451000 x 100
=2476% 29.7%
Limiting or Key Factor

The aim of a business is to achieve maximum profitability. Unfortunately it is not always easy to
achieve because profit earning is affected by a variety of factors. For example an undertaking may
have sufficient orders on hand ample skilled labour and production capacity but may be unable to
obtain all the quantity of material it needs over a period for the manufacture of maximum quantities
which could be sold. Thus material is the factor which limits the size of output and prevents and
undertaking from maximum its profit. Similarly sometimes a business is not able to sell that it can
produce. In such a case sales is the limiting factor.

A limiting or key factor may thus be defined as the factor in the activities of an undertaking which
at a particular point in time or ever a period will limit the volume of output examples of limiting
factors include

(i) Sales
(ii) Materials
(iii) Labour (particulars skill)
(iv) Production capacity and
(v) Financial resources

The purpose of the limiting factor technique is to indicate the most profitable course of action in
all such cases where alternatives are possible.

Contribution per unit of key factor

When no factor in short supply the choice will lie with accepting an order which yields the highest
contribution if however a factor of production for instance materials is in short supply the order
which yields the largest contribution per unit of material consumed should be accepted. In other
words when a key factor is operating the best position is reached when contribution per unit of key
factor is maximum.

For example in case of sales being the key factor P/V Ratio should be considered. In case of
shortage of labour the contribution per labour hour is to be considered. In case of shortage of
material the contribution per unit of materials should be considered. Thus the decision would be
guided by the contribution per unit of key factor.

Profitability of key factor=Contribution/Key factor

Illustration 11

A company manufactures and markets three products XY and Z. all three products are made from
the same of machines. Production is limited by the capacity of machine. From data given below
indicate priorities for product X and Y and Z with a view to maximize profits.

Product X Rs Product Y Rs Product Z Rs

Raw materials cost 2.25 3.25 4.25
per unit
Direct labour cost 0.50 0.50 0.50
per unit
Other variable cost 0.30 0.45 0.71
per unit
Selling price unit 5.00 6.00 7.00
Standard machine 30 mts 20 mts 28 mtrs
hours required per
unit
In the following year the company faces extreme shortage of raw materials. It is noted that 3 kg, 4
kg and 5 kg of raw material are required to produce one unit of X, Y and Z respectively. How
would product priorities change?

Solution
Comparative Statement of Profitability
Particulars Product X Product Y Product Z
Selling price unit 5.00 6.00 7.00
Direct materials 2.25 0.50 4.25
Direct labour 0.50 0.50 0.50
Other variable costs 0.30 0.45 0.71
Total variable cost 3.05 4.20 5.46
Contribution per unit 1.95 1.80 1.54
(Sales-Variable Costs)
P/V Ratio 39% 30% 22%
Contribution per minute 0.05 .09 .055
of standard machine time
Contribution per kg of 0.65 0.45 0.31
raw materials

In case of limited machine capacity the product B is the most profitable followed by product C and
product A is the least profitable.

In case of limited raw materials product A is the most profitable product B comes next and product
C is the least profitable.

Marginal Costing and Decision Making

The most important contribution of marginal costing is its aid to the management for taking a
number of marginal decisions. It is an effective took in the hands of the management for taking a
number of decisions related to the following:

1. Determination of Sales Mix

2. Maintaining a Desired Level of Profits
3. Pricing Decision
4. Discontinuation of a Product Line
5. Make of Buy Decision
6. Temporary Shut Down
7. Resource Allocation Problems
8. Optimum Level of Activity
1. Determination of Sales Mix

The sales mix means the composition of various products to be produced and sold by the enterprise.
The sales mix is decided on the basis of contribution per unit of each product. The product with
the highest contribution per unit should be given the first priority and vice versa. The products
with the negative contribution should not be produced unless there are other qualitative factors
justifying to continue its production. The contribution of a number of sales mix should be
compared and the sales mix with the highest contribution should be taken up.

Illustration 12
The following information is available regarding the cost records of M/s Surekha Fibres Ltd
Direct materials Per unit
A Rs.10
B Rs.5
Direct wages
A 15 hours @ 50 paisa per hour
B 16 hours @ 50 paisa per hour
Variable overheads 100% of direct wages
Fixed overheads 100
Selling price
A 50
B 40

The direction has the choice of the following alternative sales mix.
250 units of A and 250 units of B
500 units of B only
400 units of A and 100 units of B
350 units of A and 150 units of B
State which of the alternative sales mix you would recommend to the management.

Solution
Contribution Statement (per unit)
Particulars A B
Selling price 50 40
Direct materials 10 5
Direct wages 7.5 8
Variable overheads 7.5 8
Total variable cost 25 21
Contribution (S.P-V.C) (1)-(2) 25 19
Per unit

Profit statement under alternative sales mix

Particulars Alternative 1 Alternative 2 Alternative 3 Alternative 4
(250 units of A 500 units of B 400 units of A& 350 units of
100 units of B
 & 250 units of A&150 units of
B) B
Total 250x25=Rs6250 500x19=9500 400x25=10000 350x125=8750
contribution 250x19=Rs4750 Rs9500 100x19=1900 160x19=2850
Less: Fixed 11000 9500 11900 11600
Cost (1000) (1000) (1000) (1000)
Profit 10000 8500 10900 10600
Priority 3rd 4th 1st 2nd

Thus the alternative 3 is the most profitable since it gives the maximum profit of Rs10900.

2. Maintaining a Desired Level of Profits

Thus marginal costing technique helps to answer the quanties of various products to be produced
during a period of time to maintain the desired level of profit. The management may face a number
of critical situations. The price of the product may have to reduced on account of competition or
restrictions of the government. Similarly the sales of the particular product may go down because
of unfavourable market tends. Under such situations the management is confronted with the
maintenance of desired level of profits. The marginal costing technique provides an effective
answer to these kinds of situations.

3. Pricing Decision

The determination of the price of the product is one of the most important decision of the
management. The price of the product is generally influenced by the market prices government
restrictions nature of competition etc. But it can not be denied that price is related with the cost of
the product. The majority of the companies base their prices on cost to earn a reasonable level of
profit. Marginal costing techniques helps in determination of the price under normal and special
circumstances.

Illustration 13
A company follows the flexible budgeting system and position at 70% level of production is as
follows

Production 40000 units

Direct wages 60000
Direct materials 80000
Overheads Fixed 84000
Variable 42000
---------------
266000

The selling price per unit is Rs.8.65. In the present market conditions there is hardly any chance
for selling more locally. A special export order for 8000 units @ Rs.6.50 per unit is received.

Would it be wide for the company to accept the order at this point?
What is the price beyond which it would be profitable to accept this order.

Solution
Particulars Present market Proposed market Incremental costs/
Revenue
Output 40000 units 48000 units 8000 units
 Sales 346000 398000 52000
(40000x8.65+8000xRs6.5)
Less Costs 80000 96000 16000
Variable costs direct
materials (@ Rs.2)
Direct labour (@ Rs.1.5) 60000 72000 12000
Direct expenses (@ 42000 50400 8400
Rs1.05)
Fixed costs 84000 84000 36000
Total costs (2) 260000 302400 36400
Profit (1)-(2) 80000 95600 15600

From the above analysis it can be seen that the export order ensures an additional profit of Rs
15600. Hence the offer should be accepted.

(b) Incremental Cost Statement

Particulars Per unit Total 8000 units Rs
Direct materials 2.60 16000
Direct wages 1.50 12000
Direct expenses 1.05 8400
4.55 36400
From the above it can be concluded that any price in excess of Rs.4.55 would be a profitable price.

4. Discontinuation of a Product Line

In case of multi product concern the management may think of discontinuing the product line
which has been incurring losses for quite a long time. However the following factors should be
kept in mind about the discontinuation of a product line

(i) The trend of the market: The product which is not profitable in the short run but having
reasonably good long term prospects should not be discontinued.

(ii) The capacity to influence the sale of other products: In some cases the discontinuance of one
product may adversely affect affect the sale of the other products then the discontinuation is not
justified.

(iii) The contribution earned by the product

(iv) The level of utilization of existing capacity: In case a firm is having surplus capacity the
production of any product which contributes towards recovery of fixed costs is beneficial

Illustration 14

X company limited manufactures three products A B and C. The directors of the company are
worried about the profits of the organization and propose to discontinue product A which is
incurring losses. The following information is available regarding the three products A B and C.

Particulars A B C
Sales (units) 2000 5000 12000
Price per unit (Rs) 500 5 2.5
Direct materials per 5.0 0.6 0.75
unit (Rs)
 Direct labour per 1.00 0.6 0.25
unit (Rs)
Variable overhead 300 200 300
(%age of direct
labour)
Direct fixed cost per 0.50 0.5 0.375
unit (Rs)
Profit/loss (Rs) -3000 3500 1500
Fixed costs Rs6000

Fixed costs are apportioned to the products A B and C in the ratio of 1:2:3 respectively.
What suggestions would you give if you find that direct fixed costs are directly involved with each
product line and that they would be avoided if a particular product line is dropped?
If direct fixed costs are such that no portion of this expenditure can be saved by dropping a product
what would be your advice?

Solution
Comparative Income Statement
Particulars Products Rs Total
Selling price per unit 5.00 5.00 2.50
Direct materials cost per unit 1.50 0.60 0.75
Direct labour costs per unit 1.00 0.60 0.25
VOHEs (300% 200% and 3.00 1.20 0.75
300% of DLC respectively)
Total VC per unit 5.50 2.40 1.75
Contribution per unit -0.50 2.60 0.75
Sales Volume (units) 2000 5000 12000 19000
Total contribution -1000 13000 9000 21000
Direct FCs per unit (Rs) 0.50 0.50 0.375
Total direct FCs 1000 2500 4500 8000
Contribution towards -2000 10500 4500 13000
common FCs (3-4)

From the above it is clear that product A is not at all profitable as its VCs themselves exceed its
SP. Therefore product A is to be discontinued. This is evident from the following calculations:

If all the three products are If A is discontinued (i.e.

continued Rs only B and C are continued)
Rs
Contribution towards
common FCs and profits
Product
Product A -2000 0
B 10500 10500
C 4500 4500
Total 13000 15000
Less Common FCs (i.e. 6000 6000
unavoidable)
Profits 7000 9000
(b) Even if the direct FCs are unavoidable it is better to discontinue A as its MCs exceed the
revenue from it. By doing so profit can be increased by Rs.2000.

1. Make or Buy Decision

A firm may manufacture a component itself or may buy it from outside. The decision in such case
will be made by comparing the marginal cost of a component and other additional costs if any with
the cost of buying the concerned part. In a make or buy decision only the marginal cost of
manufacturing or special additional cost if any are relevant. Fixed costs are sunk costs and hence
irrelevant for the purpose. The following additional factors should be taken into account in a make
or buy decisions

The possibility of using the released capacity for any other purpose.
The reliability of the supplier in terms of quality of the component and regularity in delivery of
the component.

Illustration 15

The managing director of X Pvt Ltd asks for your assistance in arriving at a decision as to whether
to continue manufacturing a component A or to buy it from an outside supplier. The component A
is used in the finished products of the company. The following data are supplied.

1. The annual requirement of component A is 10000 units. The lowest quotation from an outside
supplier is Rs.7.00 per unit
2. The component A is manufactured in the machine shop. If the component A is bought out certain
machinery will be sold at its book value and the residual capacity of the machine shop will remain
idle.
3. The total expenses of the machine shop for the year ending 31.3.2005 are as follows: During
that year the machine shop manufactured 10000 units of A.
Materials 135000
Direct labour 100000
Indirect labour 40000
Power and fuel 6000
Repairs and maintenance 11000
Rate Taxes and insurance 16000
Depreciation 20000
Other overhead expenses 29600

4. The following expenses of the machine shop apply to manufacturing of component A

Materials Rs35000
Direct labour 50000
Indirect labour 12000
Power and fuel 600
Repair and maintenance 1000

The sale of machinery used for the manufacture of component X would reduce

Depreciation by Rs 4000
and insurance by Rs 2000
5. If the component A is bought out the following additional expenses would be incurred Freight
Rs.1.00 per unit inspection Rs 10000 per annum.

You are required to prepare a report to the managing Director showing the comparison of expenses
of machine shop (i) when the component X is made and (ii) when bought out.

Solution:
Comparative Statement of Cost
Particular To make component A To buy component A Rs
Direct material 35000
Direct labour 50000
Indirect labour 12000
Power and fuel 600
Repair and Maintenance 1000
Depreciation 4000
Insurance 2000
Total variable cost 104600
Variable cost per unit 10.46
Purchase price per unit 7.00
Freight charge per unit 1.00
Inspection charge per unit 1.00
Cost per unit 10.46 9.00

It is better to buy component A than to make it in the shop because the variable cost per unit is less
by Rs 1.46. Only variable cost is to be considered since fixed costs would remain the same under
both the circumstances. The capacity which would be saved on account of buying this component
from the market may be used for some other purpose.

6. Temporary Shut Down

In some cases due to trade recession a firm may be compelled to operate below the satisfactory
level. There may be overall reduction in the demand for the product of the industry or for the
company only. In such cases the management is confronted with the problem of whether to
continue or to shut down. A firm should continue as long as it sales revenue is sufficient to cover
the variable costs plus a part of fixed overheads i.e. excess of fixed costs over shut down costs.
Shut down costs are those costs which will be incurred by the firm even if a plant is closed down.
The shut down point is determined by the following formula

Shut down point (Sales Volume) Rs = Fixed costs – shut down costs
P/V Ratio
Shut down point (sales units) = Fixed costs-shut down costs
Contribution per unit

Illustration 16

Sameer Ltd operates at normal capacity it produces 100000 units of a product and sells them @
Rs 150 per unit. The unit cost of manufacturing at normal capacity is as follows
Direct materials 35.00
Direct labour 15.00
Variable overhead 20.00
Fixed overhead 20.00
Total 90.00

Each unit of product is sold with variable selling and administrative expenses of Rs.5 per unit. Due
to recession the company feels that during the next year only 10000 units can be sold and that too
@ Rs.120 per unit. Management is thinking of shuting down the plant during the next year
estimating that in case of closure the fixed manufacturing overhead can be reduced to Rs 1500000
for the next year. Additional costs of plant shut down are estimated at Rs.350000.

You are required (i) to advise whether the plant should be shut down (ii) Indicate the shut down
point in sales value in sales units.

Solution
Profit (loss) from plant during recession
Rs
Sales (10000 units @ Rs 150 each) 1500000
Variable costs (10000 @ Rs 75 each) 750000
Contribution 750000
Fixed costs 2000000
(* Rs 35.0 + Rs.15 + Rs.20.0 + Rs.5 = Rs.75)
Computation of shut down costs
Unavoidable fixed cost 1500000
Additional shut down costs 350000
Total shut down costs 1850000

Since the shut down costs exceed operating loss by Rs 600000 (Rs 1850000-Rs1250000) it is in
advantage not to shut down the plant.

(ii) Computation of shut down points

Shut down point = Fixed cost-shut down costs/P/V Ratio
= Rs2000000-Rs1850000/50%
= Rs.300000
* P/V Ratio = Contribution/Sales x 100 = Rs750000/1500000 x 100=50%

7. Resource Allocation Problems

A large number of industrial undertaking are engaged in the production of more than one goods.
In such cases the management needs to decided the proportion in which their products are to be
produced or sold. Similarly resources available with the companies is not unlimited and the
companies have to plan properly for the utilization of these scare resources so that maximum
possible profits are generated. Under such situations decision making is guided by the following
considerations:

(a) In the absence of the Limiting Factor

Decision is to be taken on the basis of P/V ratio of the products or contribution. The products with
the highest contribution should be produced first of all and vice versa.
(b) In the presence of the Limiting Factor
Limiting factor as already discussed is one which restricts the volume of output. The decision
making is guided by the following criterion Profitability = Contribution per unit/key factor The
product which earns the highest contribution per unit is the most profitable product.

8. Optimum Level of Activity

The optimum level of the activity of the firm is decided on the basis of contribution towards profit.
It is done by comparing the differential revenue with the differential costs of various operating
levels.

Practical Problems

1. The sale of a product amounts to 200 units per month at Rs.10 per unit. The fixed overhead is
Rs.40 per month and the variable cost is Rs6 per unit. This is a proposal to reduce the price by 10
percent.
Calculate present and future P/V Ratio. How many units must be sold to earn the present total
profit?

Ans. Present P/V Ratio 40%

Future Ratio 33.33%
Units to be sold 267 units

2. Calculate
(i) the amount of fixed expenses
(ii) the number of units to break even
(iii) the number of units to earn a profit of Rs 40000
The selling price per unit can be assumed at Rs 100

The company sold 7000 units and 9000 units in two successive periods and has incurred a loss of
Rs.10000 and earned a profit of Rs 10000 respectively.

Ans (i) 80000 (ii) 8000 units (iii) 12000 units

3. Merry manufacturing limited has supplied you the following information in respect of one of its
products:

Total fixed cost Rs.18000 variable cost Rs.30000

Total sales Rs 60000 units sold 20000

Find out
(a) Contribution per unit (b) Break even point (c) Margin of safety (d) Profit (e) Volumes of sales
to earn a profit of rs.24000

Ans (a) 1.50 (b) 12000 units as Rs 36000 (c) 8000 units or Rs.24000 or 40% (d) Rs 12000 (e)
Rs.12000 (e) 28000 units or Rs.84000.

4. From the following data prepare statements of cost according to both absorption costing and
marginal costing system
Product A Product B Product C
Sales 50000 75000 100000
Direct Materials 15000 3000 35000
Direct labour 10000 20000 15000
Factory overheads
Fixed 7000 10000 15000
Variable 3000 3000 5000
 Administration
Overheads
Fixed 2000 2000 5000
Selling overheads
Fixed 2000 2000 2000
Variable 1000 3000 3000
Ans. Absorption costing profit Product A Rs 10000 product B Rs 5000 product C Rs 20000.
Marginal costing contribution product A Rs21000 product B Rs 19000 product C Rs.42000.

5. The budget manager of XYZ electrical Ltd is preparing a flexible budget for the accounting year
starting from 1st July 2005.

The company produce one product A direct material costs Rs.7 per unit. Direct labour averages
Rs.2.50 per hour and requires 1.6 hours to produce one unit of A salesman are paid a commission
of Rs.1 per unit sold. Fixed selling and administration expenses amount to Rs.85000 per year.

Manufacturing overhead is estimated in the following amounts under specified conditions of

volume:
Volume of Production (in units) 120000 150000
Expenses Rs Rs
Indirect materials 264000 330000
Indirect labour 150000 187500
Inspection 90000 112500
Maintenance 84000 102000
Supervision 198000 234000
Depreciation-Plant and Equipment 90000 90000
Engineering services 94000 94000
Total manufacturing overhead 970000 1150000
Normal capacity is 125000 units. Prepare a budget of total cost at 140000 units of production.

Ans Total cost Rs 2855000 Hint Maintenance Cost Fixed Rs 12000 variable Rs 0.60 per unit
supervision Cost Fixed Rs 54000 variable Rs.1.20 per unit

6. A company is at present working at 90% of its capacity and produces 13500 units per annum. It
operates a flexible budgetary control system. The following figures are obtained from its budget

Expenses 90% Rs 100% Rs

Sales 1500000 1600000
Fixed expenses 300500 300500
Semi variable expenses 97500 100500
Variable expenses (other than material and labour) 145000 149500

Labour and material cost per unit remain the same under present conditions. Profit margin has
been 10% on sales.

(ii) You are required to determine the differential cost of producing 1500 units by increasing
capacity to 100%
(ii) What would you suggest for an export price for these 1500 units taking into account that the
overseas prices are lower than those of the home market.

Ans (i) Rs. 97170 (ii) Cost per unit comes to Rs64.78. The selling price should not be less than
this price.
{Hint. Cost of materials and labour of 13500 units comes to Rs807000 by working backward.}

7. A firm has two factories the product being the same in both cases. The following is the relevant
information about the two factories.
I II
Capacity p.a 10000 units 15000 units
Variable cost per unit 70 55
Fixed cost p.a 400000 900000
The demand is only 20000 units. State how the capacity in two factories should be utilized

Ans. Both factories have to be operated for meeting demand in full. However factory II has a lower
variable cost per unit. Hence Factory II should produce 15000 units and Factory I 50000 units)

8. A company shows the trading results for two periods

Period Sales Profit

I Period 30000 1000
II Period 20000 400
Calculate P/V Ratio

9. The following data are obtained from the records of a company

First Year Second Year
Sales 100000 110000
Profit 10000 14000

Calculate the break even point.

P/V Ratio = 40%

Cont=40000
Fixed Cost = 30000

Ans: Rs.75000
 UNIT 5
Budgetary Control & Variance Analysis
What is Budget

A budget is a plant relating to a period of time expressed in quantitative terms. It has been defined
by ICMA London as financial and/ or quantitative statement prepared prior to a defined period of
time of the policy to be pursued during that period for the purpose of attaining a given objective.
This definition reveals the following characteristics of a budget:-

(i) A budget may be expressed in terms of quantity of money or both.

(ii) A budget is prepared for definite future period. In other words a budget is prepared in advance
of the period during which it is to operate.
(iii) The purpose of a budget is to implement the policies formulated by the management for
attaining the given objective.

What is Budgetary Control

Budgetary control is a system of controlling costs through budgets. Budgeting is thus only a part
of the budgetary control. ICMA London defined budgetary control as the establishment of budgets
relating to the responsibilities of executives of a policy and the continuous comparison of the actual
with the budgeted results either to secure by individual action the objective of the policy or to
provide a basis for its revision.

The following characteristics of budgetary control are important:

(i) Establish a budget or target of performance for each department or function or the organization.
(ii) Compare actual performance with the budget
(iii) Ascertain the reason for the difference between actual and budget performance.
(iv) Take suitable remedial action so that budgeted performance may be achieved.

Budgetary control is one of the very important tools of organizational planning and control. It
involves a constant comparisons of actual performance with the budgeted goals of the business.
Many businesses fail because o lack of planning. By planning many problems and dangers are
anticipated which the business has to face.

Objectives/Motive of Budgetary Control

The objective of budgetary control may be explained under three heads planning. Co-ordination
and Control. These three objectives are so much interrelated that it is not possible to discuss one
without the other.

(i) Planning-A budget provides a detailed plan of action for a business over a definite period of
time. Detailed plans relating to production sales raw material requirements labour needs
advertising and sales promotion performance research and development activities capital additions
etc are drawn up. By planning many problems are anticipated long before they arise and solutions
can be sought through careful study. Thus most business emergencies can be avoided by planning.
In brief budgeting forces management to think ahead to anticipate and prepare for the anticipated
conditions.
(ii) Co-Ordination-Budgeting aids managers in co-ordinating their efforts so that objectives of the
organisation as a whole harmonise with the objective of its parts. Effective planning and
organisation contributes a lot in achieving co-ordination. There should be co-ordination in the
budgets of various department. For example budget of sales should be in co-ordination with the
budget of production. Similarly production budget should be prepared in co-ordination with the
purchase budget and so on.

(iii) Control- Control is necessary to ensure that plans and objectives as laid down in the budgets
are being achieved. Control as applied to budgeting is a systematized effort to keep management
informed of whether planned performance is being achieved or not. For this purpose a comparison
is made between plans and actual performance. The difference between the two is reported to
management for taking corrective action. Thus control is not possible without planning.

Advantages of Budgetary Control

Budgetary control provided the following advantages

1. Budgeting compels managers to think ahead to anticipate and prepare changing conditions.
2. Budgeting co-ordinates the activities of various departments and functions of the business.
3. It increases production efficiency eliminates waste and controls the costs.
4. It pinpoints efficiency or lack of it
5. Budgetary control aims at maximisatin of profits through careful planning and control.
6. It provides a yardstick against which actual results can be compared.
7. It shows management where action is needed to remedy the situation
8. It ensures that working capital is available for the efficiency operation of the business
9. It directs capital expenditure in the most profitable direction
10. It instills into all levels of management a timely careful and adequate consideration of all
factors before reaching important decisions.
11. A budget motivates executives to attain the given goals.

Budgetary Control
Advantages Limitations
Maximisation of profit Uncertain future
Proper co-ordination Revision required
Provided specific aims Discourages efficient persons
Tool for measuring performance Problem of co-ordination
Economy Conflict among different departments
Corrective action Depentds upon support of top management
Creates budget consciounsness
Reduced costs
Determines weaknesses
Introduction of incentive scheme

Limitations of Budgetary Control

Despite many good points of budgetary control there are some limitations of this system. Some of
the limitations are discussed as follows:
1. Uncertain Future. The budgets are prepared for the future period. Despite best estimates made
for the future the predictions may not always come true. The future is always uncertain and the
situation which is presumed to prevail in future may change. The change in future conditions upsets
the budgets which have to be prepared on the basis of certain assumptions. The future uncertainties
reduce the utility of budgetary control system.

2. Budgetary Revision Required. Budgets are prepared on the assumptions that certain conditions
will prevail. Because of future uncertainties assumed conditions may not prevail necessitating the
revision of budgetary targets. The frequent revision of targets will reduce the value of budgets and
revisions involve huge expenditures too.

3. Discourages Efficient Persons. Under budgetary control system the targets are given to every
person in the organisation. The common tendency of people is to achieve the targets only. There
may be some efficient persons who can exceed the targets but they will also feel contented by
reaching the targets. So budgets may serve as constraints on managerial initiatives.

4. Problem of Co-ordination. The success of budgetary control depends upon the co-ordination
among different departments. The performance of one department affects the results of other
departments. To overcome the problem of co-ordination a budgetary officer is needed. Every
concern cannot afford to appoint a budgetary officer. The lack of co-ordination among different
departments results in poor performance.

5. Conflict among Different Departments. Budgetary control may lead to conflicts among
functional departments. Every departmental head worries for his department goals without
thinking of business goal. Every department tries to get maximum allocations of funds and this
raises a conflict among different departments.

6. Depends upon Support of Top Management. Budgetary control system depends upon the
support of top management. The management should be enthusiastic for the success of this system
and should give full support for it. If at any time there is a lack of support from top management
then this system will collapse.

Classification and Types of Budgets

The budgets are usually classified according to their nature. The following are the types of budgets
which are commonly used.

(A) Classification According to Time

1. Long term budgets
2. Short term budgets
3. Current Budgets

(B) Classification on the Basis of Functions

1. Operating Budgets
2. Financial Budgets
3. Master Budget

(C) Classification on the Basis of Flexibility

1. Fixed Budget
2. Flexible budget

(A) Classification According to Time

1. Long Term Budgets. The budgets are prepared to depict long term planning of the business. The
period of long term budgets varies between five to ten years. The long term planning is done by
the top level management it is not generally known to lower levels of management. Long time
budgets are prepared for some sectors of the concern such as capital expenditure research and
development long term finances etc. These budgets are useful for those industries where gestation
period is long i.e. machinery electricity engineering etc.

2. Short Term Budgets. These budgets are generally for one or two years and are in the form of
monetary terms. The consumers good industries like sugar cotton textile etc use short term budgets.

3. Current Budgets. The period of current budgets is generally of months and weeks. These budgets
relate to the current activities of the business. According to ICWA London Current budget is a
budget which is established for use over a short period of time and is related to current conditions.

(B) Classification on the Basis of Functions

1. Operating Budgets. These budgets relate to the different activities or operations of a firm. The
number of such budgets depends upon the size and nature of business. The commonly used
operating budgets are

• Sales Budget
• Production Budget
• Production Cost Budget
• Purchase Budget
• Raw Material Budget
• Labour Budget
• Plant Utilisation Budget
• Manufacturing Expenses or Works Overhead Budget
• Administrative and Selling Expenses Budget etc

The operating budget for a firm may be constructed in terms of programmes or responsibility areas
and hence may consist of

(i) Programme budget and

(ii) Responsibility Budget

(i) Programme Budget: It consists of expected revenues and costs of various products or project
that are termed as the major programmes of the firm. Such a budget can be prepared for each
product line or project showing revenues costs and the relative profitability of the various
programmes. Programme budgets are thus useful in locating areas where efforts may be required
to reduce costs and increase revenues. They are also useful in determining imbalances and
inadequacies in programmes so that corrective action may be taken in future.

(ii) Responsibility Budget: When the operating budget of a firm is constructed in terms of
responsibility areas it is called the responsibility budget. Such a budget shows the plan in terms of
persons responsible for achieving them. It is used by the management as a control device to
evaluate the performance of executives who are incharge of various cost centres. This performance
is compared to the targets (budgets) set for them and proper action is taken for adverse results if
any. The kinds of responsibility areas depend upon the size and nature of business activities and
the organizational structure. However responsibility areas depend upon the size and nature of
business activities and the organizational structure. However responsibility areas may be classified
under three broad categories:
Cost/Expense Centre
Profit Centre
Investment Centre

We have discussed the concept and technique of responsibility budgeting in detail under a separate
chapter on Responsibility Accounting latter in this book.

2. Financial Budgets. Financial budgets are concerned with cash receipts and disbursements
working capital capital expenditure financial position and results of business operations. The
commonly used financial budgets are

• Cash Budget
• Working Capital Budget
• Capital Expenditure Budget
• Income Statement Budget
• Statement of Retained Earnings Budget
• Budgeted Balance Sheet or position statement budget

3. Master Budget. Various functional budgets are integrated into master budget. This budget is
prepared by the ultimate integration of separate functional budgets. According to ICWA London
The Master Budget is the summary budget incorporating its functional budgets. Master budget is
prepared by the budget officer and it remains with the top level management. This budget is used
to co-ordinate the activities of various functional departments and also to help as a control device.

(C) Classification on the Basis of Flexibility

1. Fixed Budget. The fixed budgets are prepared for a given level of activity the budget is prepared
before the beginning of the financial year. If the financial year starts in January then the budget
will be prepared a month or two earlier i.e. November or December. The changes in expenditure
arising out of the anticipated changes will not be adjusted in the budget. There is a difference of
about twelve months in the budgeted and actual figures. According to ICWA London Fixed budget
is a budget which is designed to remain unchanged irrespective of the level of activity actually
attained. Fixed budgets are suitable under static conditions. If sales expenses and costs can e
forecasted with greater accuracy then this budget can be advantageously used.

2. Flexible Budgets. A flexible budget consists of a series of budgets for different level of activity.
It therefore varies with the level of activity attained. A flexible is prepared after taking into
consideration unforeseen changes in the conditions of the business. A flexible budget is defined as
a budget which by recognizing the difference between fixed semi fixed and variable cost is
designed to change in relation to the level of activity.

The flexible budgets will be useful where level of activity changes from time to time. When the
forecasting of demand is uncertain and the undertaking operates under conditions of shortage of
materials labour etc then this budget will be more suited.
Essential for the Installation of Budget System/Steps in B.Control

Essentials for the Installation of Budget System/ Steps in Budgetary Control

Pre-requisites for the successful implementation of a budgetary control system are as follows:
1. Creation of budget Centres
A budget centre is a section of the organisation of an undertaking created for the purpose of
budgetary control. Budget centre must be clearly defined because a separate budget has to be set
for each such centre with the help of the head of the departmental concerned. For example in the
preparation of purchase budget the purchase manager has to be consulted. Similarly while
preparing labour cost budget the personnel manager will be of great help.

2. Introduction of adequate accounting records

The accounting system should be designed as to be able to record and analysis the information
required. The budget procedures must also comply the same classification of revenues and
expenses as the accounting department. Comparisons cannot be made if the classifications do not
coincide. A chart of accounts corresponding with the budget centres should be maintained.

3. Preparation of an organisation chart

Proper organisation is essential for successful budget system. An organisation chart should be
prepared which clearly shows the plan of the organisation. Each member of management should
know the exact scope of this authority and responsibility and his relationship to other members.
For this purpose copies of the organisation chart and written supplements should be distributed to
all concerned.

Managing Director

Budget Committee

Budget Director

Sales Purchase Production Personnel Chief

Manager Manager Manager Manager Accountant

1. Sales Budget Purchase 1. Production 1. Cash Budget

2. Selling Cost Budget Budget 2. Capital Ex Budg
3. Distribution 2. Plant Utilisation Budget 3. Master Budget
4. Advertising Budget

The organisation chart will depend upon the nature and size of the company. A specimen budget
of the organisation chart is given above.

4. Establishment of budget committee

In large concerns generally the direction and execution of the budget committee which report
directly to the top management. The financial controller is usually appointed to serve as the budget
director. He is in charge of preparing budget manual of instructions and accumulates the budget
the actual figures for reporting. Other members of the budget committee usually comprise of
various heads of functional departments like sales manager purchase manager production manager
chief accountant etc as shown in the above organisation chart. Each member prepares his own
departmental budget(s) which will be then considered by the committee for co-ordination.
5. Preparation of Budget manual

A budget manual has been defined by ICWA London as a document which sets out the
responsibilities of the persons engaged in the routine of and the forms and records required for
budgetary control. A budget manual is thus a statement of budget policies and lays down the details
of the organsational set up with duties and responsibilities of executives including the budget
committee and budget director and the procedures and programmes to be followed for developing
budgets for various activities.

The contents of a budget manual are summarized as follows

• Description of the budget system and its objectives.

• Procedure arid forms to be used in budget preparation
• Responsibilities of operational executives budget committee and budget director.
• Budget calendar specifying definite dates for the completion of each part of the budget and
submission of the reports.
• Method of accounting and account codes in use.
• Procedure to be adopted in operating the system
• Follow up procedures

6. Budget Period

Budget period is a length of time for which a budget is prepared and operated. Budget periods very
between short term and long term and to specific period can be laid down for budgets. It varies
among concerns and industries as a result of several factors.

A budget is usually prepared for one year which corresponds to the accounting year. It is then sub
divided into quarters and in turn each quarter is broken down into three separate months. When a
business experiences seasonal fluctuations the budget period may be fixed to cover one seasonal
cycle covers (say) two or three years a long term budget should be prepared to cover that period
by preparing short term budgets.

Budgets for capital expenditures are usually prepared on long term basis. For example in electricity
companies which incur very heavy capital expenditure the need for new proper stations is possibly
forecast five to ten years in advance. Such long term budgets are supplemented by short term ones.

An important point to note is that short term budgets will be much more detailed and are costly to
prepare and operate while long term budgeting is considerably affected by unforeseen conditions.

7. Determination of the key factor

Also know as limiting factor governing factor and principal budget factor the key factor means the
factor which limits the size of output. It is defined as the factor the extent of whose influence must
first be assessed in order to ensure that functional budgets are capable of fulfillment. Such a factor
is of vital importance and affects all budgets to a large extent.

Thus a key factor determines priorities in functional budgets. Among the various key factors which
affect budgeting are the following

a) Sales
• Low market demand
• Shortage of experienced salemen
 • Inadequate advertising due to shortage of funds

b) Materials
• Availability
• Restrictions imposed by licenses quota etc

c) Labour
• General Shortage
• Shortage of specialized labour in a particular process

d) Plant
• Limited plant capacity
• Bottleneck in certain key processes

It is possible that more than one key factor is operating the same time under such conditions the
relative impact of such factors is considered in budget preparation.

Moreover key factor is not necessarily a permanent factor. The management may be provided with
the opportunities to overcome the limitations imposed by key factors. For example plant and
machinery which may be financed by the issue of new shares.

Cash Budget

The cash budget is one of the most important and one of the last to be prepared. It is a detailed
estimate of cash receipts from all sources and cash payments for all purposes and the resultant cash
balances during the budget period. It makes certain that the business has sufficient cash available
to meet its needs as and when these arise. It is a device for co-ordinating and controlling the
financial side of the business to ensure solvency in cash. Cash budget thus play an important role
in the financial management of a business undertaking.

The main purposes of cash budget are outlined below

• It ensures that sufficient cash is available when required
• It indicates cash excesses and shortage so that action may be taken in time to invest any
excess cash or to borrow funds to meet any shortage.
• It establishes a sound basis for credit
• It shows whether capital expenditures may be financed internally
• It establishes a sound basis for control of cash position.

Construction of Cash Budget

There are three methods of preparing cash budget

1. Receipts and payments method
2. Adjusted profit and loss method
3. Balance sheet method

1. Receipts and Payments Method

This method is usually used for short term cash forecast and is much more detailed than the other
two methods.
 The cash budget begins with the opening balance of cash in hand and at bank. To this will be added
the cash receipts from various sources and against this will point of sales and realization of cash.

Cash payments are made for raw material purchases direct labour out of pocket expenses capital
expenditure projects dividends etc. The period of credit appropriate to the payment concerned
should be taken into account.

A cash budget may be presented in the following form:

Cash Budget for the period ending

Jan Feb March April
Opening
balance
Receipts
Cash sales
Receipt from
debtors
Dividend
income
Issue of shares
etc
Total
Payments
Cash purchases
Trade creditors
Wages and
salaries
Dividend
payable
Capital
expenditure
Taxes
Total payments
Cash available
(Closing
Balance)

2. Adjusted Profit and Loss Method

This method is suitable for long term cash forecast. It is based on the view that it is the profit that
is the source of cash in the business. The profit as per Profit and Loss Account. All those items of
income and expenditure (like depreciation provisions etc) which do not involve an inflow or
outflow of cash are adjusted in the forecasted profit figure to arrive at the figure of cash made
available by profit.

Given below is a cash budget performa under this method showing the various items that require
adjustment in the profit figure for finding out the cash position at the end of a particular period.
The adjusted profit profit and loss method is often termed as cash flow statement because it
converts the profit and loss account into a cash forecast. The main difference between this method
and the receipts and payment method is that whereas the former considers non cash items for
adjustment in the profit figure the latter takes into account only cash transactions.
 It will be appreciated that under the adjusted profit and loss method the equation that PROFIT =
CASH will hold good if there were no credit transactions accruals capital transactions stock
fluctuations or appropriations of profit. But such a situation can not exist in practice.

Cash Budget for the period………

Jan Rs Feb Rs March Rs April Rs
Opening balance of cash
Additions
Budgeted Net Profit
Depreciation
Provisions
Sale of plant
Issue of capital and debentures
Reduction in debtors
Reduction in stocks
Accured expenses
Increase in liabilities
Total additions
Total cash available
Deductions
Dividends
Prepayments
Capitals
Increase in stock
Increase in debtors
Decrease in liabilities
Total deductions
Closing balance of cash

3. Balance Sheet Method

This method is also used for forecasting cash requirements for long periods and is rather similar
to adjusted profit and loss account method discussed above. Under this method a budgeted balance
sheet is prepared with all items of assets and liabilities excepting cash or bank balance. The two
sides of the balance sheet are then balanced and the balancing figure is taken as cash. If the
liabilities are more than assets this revels a balance of cash and or/bank and if assets exceed
liabilities this reveals a bank overdraft.

Thus under the adjusted profit and loss method cash figure is computed by preparing a cash flow
statement and the figure is computed as a balancing figure under the balance sheet method.

Master Budget

When all the subsidiary budgets have been prepared these are summarized into what is known as
a Master Budget. The master budget shows the overall plan of the business for the next period. It
is commonly prepared in the form of a forecasted profit and loss account and balance sheet and is
variously known summary budget planning budget operating plan etc.

The master budget is prepared by the budget director (or budget officer) and is presented to the
budget committee for approval. If approved it is submitted to the Board of Directors for final
approval. The Board may make amendments/alternations before it is finally approved.
Standard Costing Vs Budgetary Control

Budgetary control is another important technique of cost control. In budgetary control budgets are
used as a means of planning and control. The targets of various segments are set in advance and
actual performance is compared with pre determined objects. In this way management can assess
the performance of efficiency on the basis of standards set and actual performance. The question
arises as to whether both the systems are used to serve the same purpose? If both standard costing
and budgetary control serve the same purpose then which one should be used. There are two
opinions about the use of these systems. One opinion is that budgetary control is essential to
determine standard costs. The other opinion is that standard costing system is necessary for
planning budgets. In fact the systems operate in two different fields and both are complimentary
in nature. The question is whether a concern can afford to sue both the methods at the same time
or not. If it is possible then both systems will be beneficial in planning and controlling costs and
expenditures. Both are similar in their nature in determining the results. Besides similarities
standards costing and budgetary control have points of difference too. The points of distinction
between the two systems are discussed as follows:

Concept: In budgetary control the budgets are prepared for the concern as a whole whereas in
standard costing the standards are set for producing a product or for providing a service. In standard
costing unit concept is used while in budgetary control total concept is used. The whole concern
is taken as one unit for budgets. The actual figures for the whole concern are compared with the
predetermined budgeted figures. In the case of Government the budgets are fixed for the whole
country or the whole state. The standard cost is fixed for one product and different standards are
used for different products.

Basis: The budgets are fixed on the basis of past records and future expectations. Standards costs
are fixed on the basis of technical information. Standard costs are planned costs and these are
expected in future.

Scope: The scope of budgetary control is much wider than the scope of standard costing. Budgets
are prepared for income expenditures and other activities etc. Budgets are prepared for different
functional departments such as purchase sale production finance and personal department. One
budget knows as Master Budget is prepared for the whole concern. On the other hand standards
are set up for expenditures only and therefore for manufacturing departments standards are set for
different elements of cost i.e material labour and overheads.

Emphasis: In budgetary control the targets of expenditure are set and these targets cannot be
exceeded. In this system the emphasis is on keeping the expenditures within the budgeted figures.
In standard costing the standards are set and an attempt is made to achieve these standards. The
emphasis is on achieving the standards. Actual costs may be more than the standard costs and
there can be no such thing in budgetary control.

Objective: Budgets are set on the basis of present level of efficiency while standard costs are based
on the basis of standards set by the management. The standards are related to what management
wants to achieve.

Relationship: Budgetary Control is related to financial accounts while standard costing is related
to the cost accounts.
Use: Budgets are used for forecasting purpose. The forecasts about incomes expenditures and costs
are based on historical figures and expected changes in nature. Standard costing control be sued
for forecasting purpose.

Variance Analysis: Budgetary control deals with total variance only. The variances may be
calculated for different departments or for the concern as a whole. In standard costing variances
are calculated for different elements of cost i.e. materials labour and overheads. In standard costing
variances are studied according to the course.

Zero Based Budgeting (ZBB)

Zero Base Budgeting (ZBB) was introduced at Texas Instruments in the United States in 1969 by
Peter Peter Pyrrh who is known as the father of ZBB.

It is a modern management tool for planning and controlling expenditure. However ZBB is not
conceptually new because every company might have experienced this approach once in its life
time e.g. when the company had prepared its first budget or when a re-organisation of a company
calls for a budget revision.

ZBB may be defined as operating planning and budgeting process which requires each manager
to justify his entire budget request in details from scratch (hence zero base). Each manager states
why he should spend any money at all. This approach requires that all activities be identified as
decision packages which will be evaluated by systematic analysis ranked in order of importance.
It is also defined as a system whereby each budget item regardless or whether it is new or existing
must be justified in its entirely each time a new budget is prepared. The novel part of the ZBB is
the requirement that the budgeting process starts at zero with all expenditures completely justified.
This contracts with the usual approach in which a certain level of expenditure is allowed as a
starting point and the budgeting process focuses on request for incremental expenditures.

Traditionally most firms prepare their budget on the basis of their previous year’s budget perhaps
with some adjustment for price level changes. Additional items requested are scrutinized but the
portion of a budget request representing a continuation of the previous year’s level of activity is to
generally challenged. As a result many organizations found that wasteful and unnecessary
activities were continued year after year simply because nobody was ever asked to explain their
need. ZBB attempts to correct this problem. ZBB requires every item of the budget to be justified
every year. Under ZBB there is a continuous re-evaluation of the activities of the organisation to
ascertain that activities are absolutely necessary for the organisation. Those of the activities which
are of no value find no place in the forthcoming budget even though these might have been an
integral part of the past budget prepared under traditional approach ZBB in a way tries to locate
activities which are not essential.

Advantages and Limitations of ZBB

The advantages are:

• In ZBB all activities included in the budget are justified on cost benefit considerations
which promotes more effective allocation of resources.
• ZBB discards the attitude of accepting the current position in favour of an attitude of
questioning and challenging each item of budget.
• It is an educational process and can promote a management team of talented and skilful
people which tends to promptly respond to changes in the business environments.
 • It facilitates identification of inefficient and unnecessary activities and avoid wasteful
expenditure.
• Cost behavior patterns are more closely examined.

The disadvantages are:

• ZBB involves high cost of preparing budgets every year
• It also requires high volume of paper work
• In ZBB there is danger of emphasising short term gains at the expense of long term ones
• It has a tendency to regard any activity not foreseen and sanctioned in the most recent ZBB
as illegitimate.

Traditional Budgeting Vs Zero Bases Budgeting

Emphasis: Traditional budgeting is more accounting oriented. It depends upon past data and
allowances are made for inflation and other foreseeable changes. ZBB is decision oriented. It is
rational in nature and each activity or programme has to be justified in its entity and has to compete
for resources.

Approach: T.B is monitoring towards expenditure while the approach in ZBB is for the
contribution of an activity towards the achievement of objectives of an enterprise.

Focus: TBB is focused on the increase or decrease in expenditure over the past while ZBB is
focused on the rigorous analysis of proposed cost and benefits.

Decision: In TBB it is generally the top management who decides the amount to be spent on
particular decision unit or programme. In ZBB it is manager of the programme or activity who has
to prove the justification for the amount to be spent on an activity or programme.

Alternatives: In TBB the mangers are generally not encouraged to consider and evaluate
alternatives while in ZBB alternative budget levels of alternative ways of performing job are
considered and evaluated.

Thus traditional base budgeting is not as dynamic and rational as ZBB where by each activity is
evaluated afresh and in the light of changed circumstances.

Responsibility accounting

“Responsibility accounting is that type of management accounting that collects and reports both
planned actual accounting information in terms of responsibility centres.”
-Anthony and Reece
The emphasis in this definition is on setting the objectives of responsibility centers and then
recording the actual performance so that the persons in charge of various activities are able to
assess their performance.

Responsibility accounting is “a system of management accounting under which accountability is

established according to the responsibility delegated to various levels of management and a
management information and reporting system instituted to give adequate feedback in terms of the
delegated responsibility. Under this system divisions or units of an organisation under a specific
authority in a person are developed as responsibility centers and evaluated individually for their
performance.”
-Institute of Cost and Works Accountants of India
According to this definition the organisation is divided into different cost centrs. There cost centres
are put under certain persons and adequate authority is delegated to them for completing the work
assigned to them. A system of management reporting is used to assess the performance of cost
centers.

“It is the classification management maintenance review and appraisal of accounts serving the
purpose of providing information on the quality quantity and standards of performance attained by
persons to whom authority has been assigned.”
-Kohler EL
Responsibility accounting according to Kohler is the maintaining of accounts in such a way that
the performance and level of achievement of various persons responsible for different works is
studied.

“Responsibility accounting is the name given to that aspect of the managerial process dealing with
the reporting of information to facilitate control of operations and evaluation of performance.”
-Louderback and Dominiak

“Responsibility accounting is a system of accounting that recognizes various decision centers

throughtout an organisation and traces costs to the individual managers who are primarily
responsible for making decisions about the costs in question.”
-Charles T Horngren

“Responsibility accounting is a system of accounting in which costs and revenues are accumulated
and reported to managers on the basis of the manager’s control over these costs and revenues. The
managerial accounting system that ties budgeting and performance reporting to a decentralized
organisation is called responsibility accounting.”
-Schaltke R.W & Jonson H.G

This is a system of accounting in which cost data are reported to managers who are in charge of
various cost centres. In this system budgets are prepared and actual performance is recorded and
reported.

“Responsibility accounting is a system or mechanism for controlling the wider freedom of action
that executives decision centre manages in other words are given by senior management and for
holding those executives responsible for the consequences of their decisions.”
-David Fanning

Types of Responsibility Centres/Classification of Responsibility Centres

For the purposes of evaluating financial performance and control the responsibility centers are
generally classified into three categories

1. Cost or Expenses Centre

2. Profit Centre
3. Revenue Centre
4. Investment Centre

1. Cost or Expenses Centre

Cost centres are segments in which the managers are responsible for costs incurred but have no
revenue responsibilities. As observed earlier responsibility accounting is used to measure both
inputs and outputs. However when we can measure only the expenses or costs incurred and not
the revenue earned from a responsibility centre it is known as cost or expense centre.

The contribution of accounting department to the company cannot be measured in monetary terms
so we will call it an expense centre. Generally a company has product and service departments.
The output of production departments can be measured whereas service departments incur only
expenses ad their output is not measured. It may not be either feasible or necessary to measure the
output of some service departments. Such centres are therefore called expense cost centres.

The performance of a cost centre is measured in terms of quantity of inputs used in producing a
given output. A comparison between the actual input used and the predetermined budgeted inputs
is made to determine the variances which represents the efficiency of the cost centre.

Types of Cost/Expense Centres

There can be two general types of expense centres:

a. Engineered expense centres

b. Discretionary expense centres

The above classification of expense centres is based upon the two types of cost i.e. engineered and
discretionary. Engineered costs are those costs which can be estimated with reasonable reliability
for example factory costs for direct materials direct labour and direct overheads. An engineered
cost has a definite physical relationship with output. Discretionary costs are those for which no
such engineered estimate is feasible. In discretionary expense centres the costs incurred depend
upon the manager’s decisions. Discretionary expense centres include administrative and support
cost centres.

Cost centres can also be classified on functional basis as

i) Production cost centre
ii) Service cost centre
iii) Ancillary cost centre
iv) Administrative and support centre
v) Research and development centre
vi) Marketing Centre

2. Profit Centre

Responsibility centres may have both inputs and outputs. The inputs are taken as costs and outputs
are revenues. The difference between the revenue earned and costs incurred will be profit. When
a responsibility centre gets revenue from output it will be called a profit centre. The output of a
centre may be undertaken either for outside consumers or for other centres in the same
organisation. When the output is meant for outsiders then the revenue will be measured from the
price charged from customers. If the output is meant for other responsibility centre then
management takes a decision whether to treat the centre as profit centre or not. For example if a
business has a number of processes and the output of one process is transferred to the next process.
When the transfer from one process to another is only on cost then these processes will not be
profit centres. On the other hand if management decided to transfer the output from one process to
the other at a profit (or at a price at which the output is available in the market) then the process
will become profit centre. Internal transfers at profit do not increase company’s assets whereas
sales to outsiders will increase assets of the company (in the shape of cash debtors bills receivables
etc). The income statement of a profit centre is used as a control device. The profits of a
responsibility centre will enable in evaluating the performance of the manager of that centre.

The performance of the manager of a profit cente may be evaluated by the following measures of
profitability.

i) Contribution margin
ii) Direct profit
iii) Controllable profit
iv) Profit/income before tax
v) Profit/income after tax/net income

Suitability of Profit Centres

Establishment of profit centers may be suitable if the following conditions are satisfied
a) There exists a decentralized form of organisation
b) The divisional manager has access to all relevant information needed for decision making
c) The divisional manager is sufficiently independent
d) Internal transfer of output from one division/centre to another division are not significant
e) A definite measure of performance is available

Advantages of Profit Centre

Establishing of profit centers offers the following advantages

i) It encourages initiative as a manager of a profit cente is subject to a lesser degree of control of

the top management
ii) It may improve the quality of decisions of these are made by managers responsible for their
execution
iii) It may quicken the decision making process as these need not be referred to top management
iv) It saves time of top management by allowing them management by exception
v) It enhances profit consciousness in the entire division/organisation
vi) It promotes competition amongst managers of various profit centres and improves their
performance.
vii) It helps in training divisional managers for top management responsibilities.

Disadvantages of Profit Centres

Inspite of many advantages of establishing profit centres there are many limitations or
disadvantages

i) Loss of top management control over different divisions

ii) Faculty decision at divisional level which might have been avoided at top management level
iii) Conflict amongst individual interest of divisions and the organisation as a whole
iv) Too much emphasis on short term profitability
v) Increased cost due to multiple requirements of facilities and personnel at each profit centre.
vi) Trasfer pricing problems amongst profit centres.

3. Investment Centre

An investment centre is an entity segment in which a manager can control not only revenues and
costs but also investments.
The manager of a responsibility centre is made responsible for properly utilizing the assets used in
his centers. He is expected to earn a fair return on the amount employed in assets in his centre.
Measurement of assets employed poses many problems. It becomes difficult to determine the
amount of assets employed in a particular responsibility centre. Some assets may be used in a
responsibility center but their actual possession may be with some other department. Some assets
may be used by two or more responsibility centes and it becomes difficult to apportion the amount
of those assets to various centres. Investment centres may be used for big responsibility centers
where assets will be in exclusive possession becomes difficult to apportion the amount of those
assets to various centres. Investment centres may be used for big responsibility centres where
assets will be in exclusive possession of that centre.

The performance of an investment centre can be measured by relating profit to the investment
base. The two methods which are generally used to evaluate the performance of an investment
centre are
a. Return on investment/Capital Employed (ROI)
b. Economic Value Added (EVA) or Residual Income Approach (RI)

a. Return on investment/Capital Employed

Return on capital employed establishes the relationship between profits and the capital employed.
The term capital employed refers to the total investment made in the investment centre/businesses.
However net capital employed comprises the total assets used less its current liabilities. The profits
for the purpose of calculating return on capital employed should be computed according to the
concept of capital employed i.e. gross capital employed or net capital employed. Further net profits
should be taken before tax because tax is paid after profits have been earned and has no relation to
the earning capacity of a centre. Return on investment can be computed as follows:

Return on investment/capital employed = Net Profit/Capital Employed x 100

Or ROI = Net Profit/Sales x Sales/Capital Employed x 100
Or ROI = Net Profit Ratio x Capital Turnover Ratio

b. Economic Value Added/Residual Income Approach

Economic value added is a measure of performance evaluation that was originally employed by
Stern Stewart and Co. It is also referred to as residual income (RI) approach of performance
evaluation. It is a very popular method used to measure the surplus value created by an investment
or a portfolio of investments. EVA has been considered as a better measure of divisional
performance as compared to the return on assets ROA or ROI. It is also being used to determine
whether an investment positively contributes to the shareholders wealth. The economic value
added of an investment is simply equal to the after tax operating profits generated by the
investment minus the cost of funds used to finance the investment. EVA can be calculated as
below:

EVA=(Net operating profit after tax)-(Cost of capital x Capital invested)

Or EVA = Capital employed (Return on investment –Cost of capital)
Or EVA = Capital employed (ROI-Cost of capital)

According to this approach an investment can be accepted only if the surplus (EVA) is positive. It
is only the positive EVA that will add value and enhance the wealth of shareholders. However to
calculate the economic value added we need to estimate the net operating profit after tax and cost
of funds invested. Suppose an investment generates net operating profit after tax of Rs.20 lakhs
and the cost of financing investment is Rs 16 lakhs. The economic value added by the investment
shall be Rs 4 lakhs and it should be accepted.

Illustration 1: Prepare a Cash budget for the 3 months ending 30th June, 2005 from the information
given below:
(a)
Monthly Sales Materials Wages Overheads
February 14000 9600 3000 1700
March 15000 9000 3000 1900
April 16000 9200 3200 2000
May 17000 10000 3600 2200
June 18000 10400 4000 2300

(b) Credit terms are:

Sales /Debtor-10% sales are on cash 50% of the credit sales are collected next month and the
balance in the following month.

Creditors Materials 2 months

Wages ¼ Month
Overhead ½ month
(c) Cash and Bank balance on1st April, 2005 is expected to be Rs.6000
(d) Other relevant information is:
(i) Plant and Machinery will be installed in February 2005 at a cost of Rs 96000. The monthly
installments of Rs.2000 is payable from April onwards
(ii) Dividend @ 5% on preference share capital of Rs.200000 will be paid on 1 st June
(iii) Advance to be received for sale of vehicles Rs 9000 in June
(iv) Dividend from investments amounting to Rs 1000 are expected to received in June
(v) Income Tax (advance) to be paid in June is Rs.2000

Solution:
Cash Budget April-June 206
Particulars April Rs May Rs June Rs Total Rs
Opening 6000 3950 3000 6000
balance
Add Estimated
Cash receipts:
Sales 14650 15650 16650 46950
Dividend -- -- 1000 1000
Advance -- -- 9000 9000-
against vehicle
Total 20650 19600 29650 62950
Estimated Cash
payments
Creditors 9600 9000 9200 27800
Wages 3150 3500 3900 10550
Overhead 1950 2100 2250 6300
Capital 2000 2000 2000 6000
expenditure
Dividend on -- -- 10000 10000
preference
Shares
-- -- 2000 2000
 Income tax
advance 16700 16600 29350 62650
Total 3950 3000 300 300
Closing balance
(A)-(B)

Working Notes
Collection from Sales/Debtors
Months Calculation April Rs May Rs June Rs
Feb (14000-10%of 14000)x50% 6300
March 6750 6750
April (15000-10%of 15000)x50% 1600
May 7200 7200
10% of 16000(16000-10%of -- 1700 7650
June 16000)x50% -- 1800
14650 15650 16650
10% of 17000(17000-10%of
17000)x50%

10% of 18000

Please note that payment for creditors wages & overhead have also been computed on the same
pattern.

Illustration 2

Based on the following information prepare a cash budget for ABC Ltd
Particulars 1st Quarter Rs 2nd Quarter Rs 3rd Quarter Rs 4th Quarter Rs
Opening cash 40000 45000 45000 33500
balance
Collection from 155000 150000 160000 221000
customers
Total cash 195000 195000 205000 254500
available (A)
Payments
Purchase of 30000 35000 35000 54200
materials
Other expenses 35000 20000 20000 17000
Salary and 90000 95000 95000 109200
wages
Income tax 5000 -- -- --
Purchase of -- -- -- 20000
machinery
Total cash 170000 150000 150000 200400
payments (B)
Minimum cash 15000 15000 15000 15000
balance
required (C)
Total cash 185000 165000 165000 215400
required (D) +
(C) = (D)
 Excess (deficit) 10000 30000 40000 39100
(A)-(D)
Financing
Borrowing 20000 -- -- --
Repayment -- -- 20000
Interest -- -- 150
payment
Total effect of 20000 -- 21500
financing (E)
Cash balancing 45000 45000 33500 54100
at the end of
quarters (A)+
(E)-(B)
20000x0.10x9/12=Rs.1500

Illustration 3

Prepare a cash budget for the 6 month ending 31st December, 2005 from the monthly budgeted
operating results of the company and other additional information given below:
(In Lakhs of Rupees)

Sales Materials Wages Product Admini Selling Distribu Researc

purchased ion stration tion h and
and Develop
consumed ment
March 8.00 3.60 0.80 0.48 0.40 0.20 0.10 0.11
April 12.00 6.00 1.28 0.64 0.56 0.29 0.14 0.16
May 9.60 5.20 1.20 0.62 0.48 0.25 0.10 0.12
June 6.40 3.36 0.56 0.30 0.20 0.11 0.06 0.06
July 8.00 3.84 0.80 0.44 0.32 0.16 0.08 0.10
August 8.80 4.00 0.96 0.49 0.40 0.21 0.10 0.12
September 11.20 4.96 1.20 0.62 0.52 0.26 0.12 0.13
October 12.80 6.00 1.04 0.54 0.40 0.20 0.10 0.12
November 14.40 6.40 1.36 0.72 0.56 0.29 0.15 0.16
December 16.00 8.00 1.52 0.74 0.58 0.30 0.16 0.17

New machinery which was installed in April at a cost of Rs.1.20 lakhs is to be paid for on 1 st
August Extension to the Research Development amounting to Rs 8.00 lakhs in total was
contemplated from September at the rate of Rs 1.60 lakhs per months. 2.40 lakhs per month is to
be paid under a hire purchase scheme agreement.

The sales commission of 4 per cent on sales not included in selling overheads is to be paid within
the month following actual sales.

The period of credit allowed by suppliers is 4 months and that allowed to customers is 3 months.
The delay in the payment of overheads is 2 months and that in payment of wages is one fourth of
a month.

Preference share dividend of 8 percent on the capital of Rs.160.00 lakhs is payable in1st December.
8 percent calls on equity shares at the rate of Rs.9.60 lakhs is due on 1st July 1st September and 1st
November.
Taxation of Rs.8.00 lakhs is paid on 1st November. Dividends on investment amounting to Rs 2.40
lakhs is expected on 1st July and 1st December cash sales of Rs.0.80 lakhs per month is expected
on which no commission is payable. This cash sales is not included in the details for sales given
in the table above. Cash balance on 1 st July was expected to be Rs.2.00 lakhs.
Solution:
Cash budget for the 6 months ending 31st December 2005

July August Sept October November December

Opening cash 2.00 18.23 17.06 22.07 20.66 20.58
balance
Add: Receipts
Debtors 12.00 9.60 6.40 8.00 8.80 11.20
collected
Cash sales 0.80 0.80 0.80 0.80 0.80 0.80
Capital 9.60 -- 9.60 -- 9.60 --
Dividend 2.40 -- -- -- -- 2.40
received
Total receipts 26.80 28.63 33.86 30.87 39.86 34.98
(A)
Payments
Materials 3.60 6.00 5.20 3.36 3.84 4.00
purchased
Wages 0.74 0.92 1.14 1.08 1.28 1.48
Production 0.62 0.30 0.44 0.49 0.62 0.54
overhead
Administration 0.48 0.20 0.32 0.40 0.52 0.40
overhead
Selling 0.25 0.11 0.16 0.21 0.26 0.20
overhead
Distribution 0.10 0.06 0.08 0.10 0.12 0.10
overhead
R&D 0.12 0.06 0.10 0.12 0.13 0.12
Overhead
Commission 0.26 0.32 0.35 0.45 0.51 0.58
Capital 2.40 3.60 4.00 4.00 4.00 4.00
Payments
Taxation -- -- -- -- 8.00 --
Dividend -- -- -- -- -- 12.80
Total 8.57 11.57 11.79 10.21 19.28 24.22
payments (B)
Closing 18.23 17.06 22.07 20.66 20.58 10.76
balance of
Cash/Bank
(A)-(B)

Difference between fixed and Flexible Budget

Sl No Basis Fixed Budget Flexible Budget

1 Definition It is known as rigid or inflexible budget It is not rigid
 2 Level of It operates on one level of activity and It consists of various budgets
activity under one set of conditions. It assumes that for different level of activity
there will be no change in the prevailing
conditions which is unrealistic
3 Analysis of All cost life Fixed cost V.C and S.V.C are
Here analysis of information
variance related to only one level of activity so
provide useful information
variance analysis does not give useful
as each cost is analysed as to
information its behaviour
4 Cost If the budgeted and actual activity level
Flexible budget at different
ascertainment differ significantly than the aspects like
level of activity facilitate
and price cost statement and price fixation do not
ascertainment of cost
fixation reveal a correct picture fixation of S.P and tendering
of quotations
5 Basis of Comparison of actual performance with It provides a meaningful
comparison budgeted target will be meaning less basis of comparison of the
specially where there is difference actual performance with the
between the two activity levels budgeted targets.

Illustration 4

XYZ Ltd manufactures a single product for which market demand exists for additional quantity.
Present sales of Rs.60000 per month is at 60% capacity of the plant.

The following data are available

i) Selling price Rs 20 per unit
ii) variable cost Rs.13 per unit
iii) semi variable cost Rs.6000 fixed +50 paisa per unit
iv) Fixed Cost Rs.20000 at present level estimated to be Rs.24000 at 80%
output.

You are required to prepare the following statements

1. The operating profit at 60% 70% and 80% level at current selling price and
2. The operating profit at proposed selling price at the above levels.

Solution

Statement showing operating profit at Current as well as at Proposed selling prices

Capacity utilization 60% 70% 80%

Production/Sales 6000 units 7000 units 8000 units
Volume (units)
A sales at present 120000 140000 160000
S.P. (Rs 20 per unit)
B costs
Variable @ Rs.3 per 78000 91000 104000
unit
Semi variable cost
Variable portion @ 3000 3500 4000
Rs 0.50 per unit
Fixed portion 6000 6000 6000
Fixed cost 20000 20000 24000
 Total cost 107000 120500 138000
C. profit at existing 13000 19500 22000
S.P (A-B)

Illustration 5

Preparing flexible budget at different capacity levels). The following data are available in a
manufacturing company for an yearly period.
Fixed expenses
Wages and salaries 19.5
Rent rates and taxes 16.6
Depreciation 17.4
Sunday administrative expenses 16.5
Semi variable expenses
Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries etc 3.8
Sunday administrative expenses 2.8
Variable expenses (at 50% of capacity)
Materials 21.7
Labour 20.4
Other expenses 7.9
138.0

Assume that the fixed expenses remain constant for all levels of production. Semi variable
expenses remain constant between 45% and 65% of capacity increasing by 10% between 65% and
80% capacity and by 20% between 80% and 100% capacity.

Sales at various levels are Rs (Lakhs)

50% capacity 200
60% capacity 220
75% capacity 250
90% capacity 280
100% capacity 300

Prepare flexible budget for the year and forecast the profit at 60% 75% 90% and 100% of capacity.

Solution:
Capacity utilization 50% 60% 75% 90% 100%
Sales 200 220 250 280 300
Total costs
Variable costs
Materials 21.70 26.04 32.55 39.06 43.40
Labour 20.40 24.48 30.60 36.72 40.80
Other expenses 7.90 9.48 11.85 14.22 15.80
Semi variable costs
Maintenance and repairs 3.50 3.50 3.85 4.20 4.20
Indirect labour 7.90 7.90 8.69 9.48 9.48
Sales dept salaries 3.80 3.80 4.18 4.56 4.56
S. Admn expenses 2.80 2.80 3.08 3.36 3.36
Fixed costs
 Wages and Salaries 19.50 9.50 9.50 9.50 9.50
Rent rates and taxes 16.60 6.60 6.60 6.60 6.60
Depreciation 17.40 7.40 7.40 7.40 7.40
S. Admn expenses 16.50 6.50 6.50 6.50 6.50
Total costs 138.00 148.00 164.80 181.60 181.60
Profit (1-2) 62.00 72.00 85.20 98.40 108.40

Illustration 6
(Preparation of budget and cost per unit at a specified capacity). The monthly budgets for
manufacturing overhead of a concern for two levels of activity were as follows:

Capacity 50% 100%

Budgeted Production 1600 2000
Wages 3200 4000
Consumable stores 2400 3000
Maintenance 2100 2500
Power and fuel 2600 3000
Depreciation 4000 4000
Insurance 1000 1000
---------- --------
15300 17500

You are required to

(i) Indicate which of items are fixed variable and semi variable
(ii) Prepare a budget for 80% capacity and
(iii) Find the total cost both fixed and variable per unit of output at 60% 80% and 100% capacity.

Solution (a) Fixed

Depreciation Since it remains constant at both the given levels
Insurance same as above
Variable
Wages Because it is Rs.2 per unit at both the given level
Consumable Stores Because it is Rs.1.50 per unit at both the given levels
Semi Variable
Maintenance Since it is neither fixed not the quantum of increase is
proportionate to the increase in volume

Power and fuel Same as above

(b) First of all find out the variable portion of semi variable overheads

Solution:

Cost of Production Budget for 50% Capacity Level

Particulars Amount Rs
Budgeted production (80% capacity) 1800 units
Wages @ Rs 2 per unit 3600
Consumable stores @ Rs 1.5 per unit 2700
Maintenance (working note) 2300
Power and fuel (do) 2800
Depreciation (fixed in nature) 4000
Insurance (fixed in nature) 1000
 Total 16400

(iii) variable cost per unit = Rs 5.50

=Wages (Rs 2.00) + consumable Stores (Rs.1.50) + Maintenance (Rs.1.00) + Power and Fuel
(Rs.1.00) + power and Fuel (Rs 1.00)= Rs 5.50

Total fixed cost

Depreciation (Rs4000)+Insurance (Rs.1000)+
Maintenance (Rs500) + Power and Fuel (Rs.1000)= Rs.6500

Total Cost Per Unit

Particulars 60% capacity 80% capacity 100% capacity
Production (units) 1600 1800 2000
Variable cost 5.50 5.50 5.50
Fixed cost (Rs6500 0.25 3.61 3.25
÷production)
Total 9.5625 9.11 8.75

Working Notes
Maintenance variable portion = Change in overhead/change in activity = Rs.400 ÷ 400 = Rs.1 per
unit
Fixed portion Rs2100-(1600 units x Rs.1) = Rs.500
At 80% capacity level =(1800 units x Rs 1) + Rs.500=Rs.2300
Power and fuel
Variable portion =Rs400÷400=Rs.1 per unit
Fixed portion =Rs2600-(1600 units x Rs.1) = Rs.1000
At 80% capacity by level =(1800 unit x Rs.1) +Rs.1000=Rs2800

Illustration 7

The expenses for the budgeted production of 10000 units in a factory are furnished below

Per unit Rs
Materials 70.0
Labour 25.0
Variable overhead 20.0
Fixed overhead (Rs 100000) 10.0
Variable expenses (Direct) 5.0
Selling expenses (10% fixed) 13.0
Distribution expenses (20% fixed) 7.0
Administration Expenses (Rs 50000) 5.0
Total cost per unit 155.0

Prepare a budget for production of 8000 units (b) 6000 units and (c) indicate cost per unit at both
the levels. Assume that the administration expenses are fixed for all levels of production.

Solution
Flexible Budget

Particulars 10000 units 8000 units 6000 units

Production cost
Materials 70.0 700000 70.0 560000 70.0 420000
 Labour 25.0 250000 25.0 200000 25.0 150000
Overhead 20.0 200000 20.0 160000 20.0 120000
Direct variable 5.0 50000 5.0 40000 5.0 30000
expenses
Fixed overhead (Rs 10.0 100000 12.5 100000 16.67 100000
100000)
Selling expenses
Fixed 1.3 13000 1.625 13000 2.167 13000
Variable 11.7 117000 11.70 93600 11.70 70200
Distribution
expenses
Fixed 1.4 14000 1.750 14000 2.33 14000
Variable 5.6 56000 5.60 44800 5.60 33600
Administration 5.0 50000 6.25 50000 8.33 50000
expenses
Total cost 155.0 1550000 159.43 1275400 166.8 1000800

Practical Questions

1. ABC Co. Wishes to arrange overdraft facilities with its bankers during the period April to June
when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from
the following data including the extent of bank facilities the company will require at the end of
each month:

(a) Sales Purchases Wages

Rs Rs Rs
February 180000 124800 12000
March 192000 144000 14000
April 108000 243000 11000
May 174000 246000 10000
June 126000 268000 15000

(b) 50 percent of credit sales is realized in the month following the sales and the remaining 50
percent in the second month. Creditors are paid in the month following the month of purchase.

(c) Cash bank on 1st April (Estimated) Rs.25000

Ans Closing balance (overdraft) April May June
56000 47000 167000

2. Texas Manufacturing Company Ltd is to start production on 1st January 1998. The prime cost
of a unit is expected to be Rs 40 out of which Rs.16 is for materials and Rs.24 for labour. In
addition variable expenses per unit expected to be Rs.8 and fixed expenses per month Rs.30000.
payment for materials is to be made in the month following the purchase. One third of sales will
be for cash and the rest on credit for settlement in the following month. Expenses are payable in
the month in which they are incurred.

The selling price is fixed at Rs80 per unit. The number of units manufactured and sold are expected
to be as under:

January 900 April 2100

February 1200 May 2100
March 1800 June 2400

Draw up a statement showing requirements of working capital from month to month ignoring the
question of stocks.

Ans Cumulative Jan Feb March April May June

Surplus Rs Rs Rs Rs Rs Rs
Cash required 34800 37600 32400 6400 30800 66400
(Hint Prepare a Cash Budget)

3. A glass manufacturing company requires you to calculate and present the budget for the next
year from the following information:

Sales
Toughened Glass Rs3000000
Bent toughened Glass Rs5000000
Direct materials cost 40% of sales
Direct wages 120 workers @ Rs 1500 per month
Fixed
Works Manager Rs5000 per month
Foreman Rs4000 per month
Factory rent Rs 10500 month
Variable
Stares and Spares 2 ½ on sales
Depreciation of machinery Rs126000
Light and power Rs50000
Repairs and maintenance Rs 80000
Other sundries 10% on direct wages
Administration selling and Rs140000 per year
Distribution expenses

(Ans Budgeted Net Profit Rs1534000)

4. For production of 10000 electrical automatic irons the following are budgeted expenses
Per unit Rs
Direct materials 60
Direct labour 30
Variable overhead 25
Fixed overhead (Rs150000) 15
Variable expenses (Direct) 5
Selling expenses (10% fixed) 15
Administration expenses (Rs50000 5
Rigid for all levels of production)
Distribution Expenses (20% fixed) 6
Total cost of sales per unit 160

Prepare a budget for production of 6000, 7000 and 8000 Irons showing distinctively per unit and
total marginal cost and total cost.

Answer: unit M. Cost per unit Total per unit cost Total cost
6000 units 137.50 175.00 1050000
 7000 units 137.50 169.64 1187500
8000 units 137.50 165.63 1325000

1. Prepare a cash budget for M/s Alpha Manufacturing Company on the basis of the following
information for the first six months of 2001.

1. Costs and price remain unchanged

2. Cash sales are 25% and credit sales are 75% of total sales
3. 60% of credit sales are collected in the month after sales 30% in the second month and 10% in
the third no bad debts are anticipated.
4. Sales forecasts are as follows:

October 2000 1200000 March 2001 800000

November 2000 1400000 April 2001 1200000
December 2000 1600000 May 2001 1000000
January 2000 600000 June 2001 800000
February 2000 800000 July 2001 1200000
(5) Gross
profit margin
20%
(6)
Anticipated
purchases
January 2000 640000 April 2001 800000
February 2000 640000 May 2001 640000
March 2000 960000 June 2001 960000
(7) Wages
and Salaries
to be paid for
1991
January 12000 April 200000
February 160000 May 160000
March 200000 June 140000

(8) Interest on Rs 2000000 @ 6% on debentures is due by end of March and June.

(9) Excise deposit due in April Rs 200000
(10) Capital expenditure on plant and machinery planned for June Rs 120000
(11) Company has a cash balance of Rs400000 at 31.12.2000
(12) Company can borrow on monthly basis
(13) Rent is Rs 8000 per month

Ans Cash balance at the close of the month Jan Rs 907000 Feb Rs 1034000 March Rs 651000
April Rs 400000 May Rs 550000 June Rs 400000

5. Sakshi Pvt Ltd ended with the following profit and loss during the year 2005

Sales 50.50
Less Expenses
Raw materials 12.00
Stores 4.00
Expenses 20.50
Interest 2.50
Depreciation 3.00 42.00
Profit for the year 8.50
The concern had been working at 50% capacity during 2005. Of the expenses of Rs.20.50 lakhs
50% is variable.

In 2006 production/sales volume at 75% of capacity is expected to be achieved. Fixed cost is

however expected to increase by Rs.1.50 lakhs

Draw the 2006 budget

Ans Budgeted profit Rs 1912500

6. Draw up a flexible budget for overhead expenses on the basis of the following data and
determine the overhead rate at 70% 80% and 90% plan capacity

Capacity levels
Variable overheads 70% 80% 90%
Indirect labour Rs Rs Rs
Stores including spares -- 12000 --
Semi variable overheads -- 4000 --
Power (30% fixed 70% variable) -- 20000 --
Repair and maintenance -- 20000 --
(60% fixed 40% variable) -- 2000 --
Fixed overheads:
Depreciation -- 11000 --
Insurance -- 3000 --
Salaries -- 10000
Total overheads -- 62000 --
Estimated direct labour hours -- 124000 hrs --

Ans. Total overheads at 70% capacity Rs58150 at 80% capacity Rs.62000 at 90% capacity Rs.
65850 Direct labour Rate Rs 0.536 Rs 0.500 and Rs 0.472 respectively

Variance Analysis
The standard costing is incomplete without variances analysis. Variance is the difference between
the actual and standards. In relation to cost variance refers to the difference between actual cost
and standard cost in relation to each element of cost viz direct material direct labour and factory
overhead. If the actual cost is less than the standard cost it is called favourable variance. however
if the actual cost is more than the standard cost it will be an unfavorable variance. In case of sales
things are different. If the actual sales are more than the budgeted sales the variance will be
favourable variance and if vice-versa is the case the variance will be unfavourble. Standard costing
through variance analyses attempts at elimination of unproductive cost and control over costs for
reduction of costs and achieving maximum efficiency.

All variances are summarized below:

I. Direct Material Cost Variances

1. Material Cost Variance (total)

i) Material Price Variance
ii) Material Quantity or Usage Variance
Material Mix Variance
Material Yield Variance or Material Sub Usage Variance

II. Labour Cost Variances

1. Labour Cost Variance
(i) Labour Rate Variance
(ii) Labour Efficiency Variance

Labour Gang Variance or Mix Variance

Labour Yield Variance or Sub Efficiency Variance

(iii) Idle Time Variance

III. Overheads Cost Variances

1. Variance Overhead Cost Variance
2. Fixed Overhead Cost Variance

Variable Overhead Cost Variance

1. Variable Overhead Expenditure Variance
2. Variable Overhead Efficiency Variance

Fixed Overhead Cost Variance

i) Fixed Overhead Expenditure Variance
ii) Fixed Overhead Expenditure Variance
Fixed Overhead Efficiency Variance
Fixed Overhead Capacity Variance
Fixed Overhead Calender Variance

IV. Sales Variances

1. Sales Value Variance
(i) Sales Price Variance
(ii) Sales Volume Variance

Sales Mix Variance

Sales Quantity Variance

Computation of Cost Variances

The computation of cost variance refer to finding difference between actual cost and standard cost.
Standard cost always refers to the standard cost of actual output. Therefore one needs to ascertain
the standard cost of actual output in respect of each element of cost viz materials labour overheads.
The calculation of variances are discussed as below:

Direct Material Cost Variance

Material cost variance refer to the difference between the standard cost of direct materials for
actual output and actual cost of direct material used Hence Material Cost Variance = Standard
Material Cost for Actual Output-Actual Material Cost

= Standard x Standard Actual x Actual

Price per Quantity for Price per Quantity
 Unit of Actual - unit of of
Materials Output materials Materials

Materials cost variance depends on two important variances i.e. the price paid and quantity of
materials used in the production. Therefore material cost variance (MCV) is divided into two
elements viz materials price variance (MPV) and material quantity or usage variance (MUV)
Hence MCV=MPV + MUV

If actual materials cost is less than the standard material costs the variance will be unfavourble and
if standard material cost is more than the actual material cost the variance will be favorable one.

Material Price Variance (MPV)/ Material Rate Variance

It is the part of MCV which arises because of difference between standard price determined and
the actual price paid for the materials used.

Material Price Variance = Standard Price for Actual Quantity – Actual Price for Actual Quantity
of Materials Used Quantity of Materials Used

Therefore

MPV/MRV = Actual Quantity (Standard Price-Actual Price)

If the actual price of materials is less than the standard price the variance will be facourble and if
reverse is the case (i.e. SP<AP) the variance will be an unfavourable variance.

Material Usage or Quantity Variance (MUV/MQV)

CIMA London It is that portion of material cost variance which is due to the difference between
standard quantity specified (for the output achieved) and the actual quantity used.

It is computed as follows:
Standard - Actual
Material Usage Variance = Standard Prize Quantity Quantity of materials
Of materials
For actual output

Direct Material Usage Variance may further be classified as

-Material Mix Variance
-Material Yield Variance
Illustration 1

A manufacturing concern which has adopted standard costing furnishes the following information

Standard Materials for price of materials 70 kg of finished goods: 100 kgs

Price of Material: Rs 1.1 per kg
Actual Price (AP) = Rs 0.9 per kg
Standard quantity (SQ) = 10/7 kgs
Actual Quantity (AQ)=4/3 kgs
Actual Output (AO) = 210000 units
Quantity of Material Used = 280000kgs

Material Cost Variance

MCV =(Standard Prize x Standard Quantity for Actual Output)- (Actual Price x Actual Quantity)

= (Rs 1.1x10/7x210000)- (Rs 0.9 x 280000)

=Rs 330000-Rs 252000=Rs 78000(F)

Material Price Variance

MPV=Actual Quantity (Standard Price-Actual Price)
=280000 (Rs 1.1-Rs 0.9) = Rs 56000(F)

Material Usage Variance

MUV= Standard Price x (Standard Quantity of Material Used for Actual Output-Actual quantity
of Materials)

= Rs 1.1 (10/7 kgs x 210000 units – 280000 kgs)

=Rs 1.1 (300000 kgs – 280000 kgs)
=Rs 22000 (F)

Hence MCV=MPV+MUV Rs 78000 (F) = Rs 56000 (F) + Rs 22000 (F)

Material Mix Variance (MMV)

The combination of materials used in the process of production of a product is called materials
mix. Mix variance arises when there is a difference between actual mix of materials used and the
predetermined standard mix.
CIMA London defined materials mix variance as that portion of the direct materials usage variance
which is due to the difference between the standard and actual composition of mixture. This
variance arises only when more than one type of materials are required to produce a commodity.
It may arise due to number of reasons such as non availability of material temporary shortage of
one or more type of materials rising prices etc. It can be computed as follows

Material Mix Variance=Standard Price x (Revised Standard Quantity-Actual Quantity)

(a) Where the actual weight of mix does not differ from the standard mix:

Revised Standard Quantity = Total Weight of Actual Mix/Total Weight of Standard Mix x
Standard Quantity

Here Total weight of Actual Mix = Total weight of standard mix therefore MMV = Standard Price
x (Standard Quantity – Actual Quantity)

The formula can be used even when the weight of standard mix is equal to the weight of actual
mix although the actual or standard may be revised due to shortage of a specific type of material
or any other reason. If actual quantity is lower than the standard quantity the variance will be
favourable and if vice-versa is the case the variable will be unfavourable.

Illustration 2

From the following compute MMV

Materials Standard Actual
Quantity Kg Rate Rs Amount Rs Quantity Rate Rs Amount
Kg Rs
 A 200 10 2000 250 10 2500
B 300 15 4500 250 15 3750
500 6500 500 6250

Solution
MMV= Standard Price x (Standard Quantity – Actual Quantity)
For material A MMV = Rs 10 (200-250)
=Rs.500 (A)
For material B MMV = Rs 15(300-250)
= Rs.750(F)
Hence MMV = Rs 500 (A) + Rs.750 (F)
=250 (F)

(b) When the standard weight of mix is different from the actual weight of mix

The variance shall be due to mix as well as reasons other than mix hence the revised standard
quantity is to be calculated:

Material mix variance= Standard Price x (Revised Standard Quantity-Actual Quantity)

Where Revised Standard Quantity = Total Weight of Actual Mix/Total Weight of Standard Mix x
Standard Quantity It is to be noted that here total weight of actual mix # total weight of standard
mix
If actual quantity is lower than revised standard quantity the variance will be termed as favourble.
If RSQ<AQ the variable will be termed as unfavourble.

Illustration 3
From the information presented below compute the material mix variance
Materials Standard Mix Actual Mix
Quantity Kg Rate Rs Amount Rs Quantity Rate Rs Amount
Kg Rs
A 60 5 300 80 5 400
B 50 10 500 60 10 600
110 800 140 1000

Solution:
Revised Standard Quantity = Total Weight of Actual Mix/Total Weight of Standard Mix x
Standard Quantity
For material A: 140/110x60=76.36 kgs
For material B: 140/110x50=63.64 kgs

Material mix variance=Standard Price x (Revised standard quantity-Actual Quantity)

For A: Rs 5(76.36-80) = Rs18.2 (A)

For B: Rs 10(63.64-60) = Rs364 (F)
Total 18.2 (F)

There is another formula which is used for the computation of material mix variance
Material Mix Variance=Total Actual Mix x (Standard Rate of Standard Mix –Standard Rate of
Actual Mix

Taking the figures of illustration 3

Standard Rate of Standard Mix = Total standard cost of standard mix/total standard mix
=Rs 800/110=Rs 7.27 per kg
Standard Rate of Actual Mix = Total Standard cost of actual mix/total actual mix
=Rs 400+600/140 kg = Rs 7.14 per kg

Thus MMV= Total actual mix x (standard rate of standard mix-standard rate of actual mix)
=140 kg x (Rs 7.27-Rs 7.14)
=Rs 18.2(F)

Material Yield Variance

It is another sub variance of materials usage variance CIMA London It is that portion of direct
material usage variance which is due to the difference between the standard yield specified and the
actual yield obtained.

Some loss in process of production is evitable. The term standard yield means the production which
will be because of putting in standard quantity of materials. Actual output mostly differs from the
standard output and therefore the calculation of yield variance is required. The formula for
calculating yield variance is:
Material Yield Variance =Standard cost per unit (Actual output-standard output for actual mix)
Standard cost per unit=Total Cost of Standard Mix at Standard Price/Net Standard Output
Or where total cost of standard mix at Standard price
=standard price x standard quantity
If the actual production is more than the standard production the variance will be termed as
favourbale. If standard production is more than the actual production the variance will be termed
as unfavourble (or adverse variance).

Illustration 4
Standard price of materials =Rs 5 per unit
Standard quantity = 15 kgs of materials per unit of output
Standard production = 100 units
Actual production=80 units
Standard cost per unit = Total cost of standard mix at standard price/net standard output
=Rs 5x15=75
Or
Standard price x standard quantity = Rs 5x15=75
Material yield variance=Standard Cost per unit x (Actual output standard output)
Rs 75 (80 units-100 units)
Rs 1500 (A)

Illustration 5
The standard material cost for a normal mix of one tone of chemical X is based on
Chemical A B C
Usage Kg 240 400 640
Price per kg 7 10 10

During a month 6.25 tonnes of X were produced from

Chemical A B C
Consumption (tons) 1.6 2.4 4.5
Cost (Rs) 11200 3000 47250

Calculate the material variances

Solution
Standard mix
A:1500 kgs @ Rs.7 = Rs10500
B:2500 kgs @ Rs.10 = Rs25000
C:4000 kgs @ Rs.10 = Rs40000
Rs 75500

Actual mix
A:1600 kgs @ Rs.7 = Rs11200
B:2400 kgs @ Rs.12.5 = Rs30000
C:4500 kgs @ Rs.10.5 = Rs47250
Rs 88450

Material cost variance=Standard material cost-actual material cost

= Rs75500-88450=Rs12950 (A)
Material price variance=Actual Quantity (Standard Price-Actual price)
A:1600 (Rs7 Rs7) = Nil (A)
B: 2400 (Rs 10-Rs 12.5) = Rs 6000 (A)
C:4500 (Rs10-Rs10.5) = Rs 2250 (A)
MPV Rs8250 (A)

Material usage variance = Standard price (Standard quantity of materials used for actual output-
Actual quantity of materials)

A:Rs 7 (1500 kg-1600 kg) = Rs700 (A)

B:Rs 10 (2500 kg-2400 kg) = Rs1000 (F)
C:Rs 10 (4000 kg-4500 kg) = Rs5000 (A)
Check MUV = Rs4700 (A)

MCV=MPV+MUV
Rs12950 (A) = Rs8250 (A) + Rs 4700 (A)

Material mix variance=standard price (Revised standard quantity-Actual quantity)

RSQ=Total Weight of Actual mix/Total weight of standard mix

A Rs7 (8500/800x1500)-1600)=43.75 (A)
B Rs12 (8500/8000x2500)-2400)=2562.5 (F)
C Rs6 (8500/8000x4000)=Rs 2500 (A)
MMV = Rs 18.75 (F)

(e) Material Yield Variance=

Standard Material Cost per unit x (Actual output-standard output)
Actual output=6250 kgs
Standard output for actual mix = 1000kg(output)/1280 kg (input)x8500 kgs of input
=6640.625 kgs

Standard material cost per unit= Standard cost/standard output=Rs75500/6250 kgs of output
=Rs 12.08
=12.08 (6250 kgs-6640.625 kgs)
=Rs 4718.75 (A)
Check
MUV=MMV+MUV
Rs 4700 (A)=Rs 18.75 (F) + Rs 4718.75 (A)

Illustration 6
From the following information regarding a standard product (i) Price (ii) Usage and (iii) Mix
variances
Materials Standard Mix Actual Mix
Quantity Unit Total Quantity Unit Total
Kilos Price Kilos Price
A 4 1.50 6.00 2 3.50 7.00
B 2 2.00 4.00 1 2.00 2.00
C 2 4.00 8.00 3 3.00 9.00
Total 8 2.25 18.00 6 3.00 18.00

Solution
Material price variance=actual quantity x (standard price –actual price)
Material A = 2 x (Rs 1.50-Rs 3.50) = Rs.4 (Adverse)
Material B = 1 x (Rs 2-Rs 2) = -
Material C = 3 x (Rs 4-Rs 3) = Rs.3 (Favourable)
Total Rs 1 (Adverse)

(ii) Material usage variance= standard price x (Standard Qty-Actual Qty)

Material A = 1.50 x (4.2) = Rs.3 (Favourble)
Material B = 2 x (2-1) = Rs 2 (Favourble)
Material C = 4 x (2-3) = Rs.4 (Adverse)
Total = Rs 1 (Favourable)

(iii) Material mix variance = Standard Price x (Standard Qty – Actual Qty)
Revised Std Quantity = Total weight of actual mix/total weight of standard mix x standard qty
Material A: 6/8x4 = 3.0
Material B: 6/8x2 = 1.5
Material C: 6/8x2 = 1.5

Mix material
Material A: Rs 1.50x (3-2) = Rs.1.50 (Favourble)
Material B: Rs 2x (1.5-2) = Rs.1 (Favourble)
Material C: Rs 4x 1.5-3 = Rs.6 (Adverse)
= Rs3.50 (Adverse)

The usage variance after segregating the mix variance shall be

Standard price x (Standard quantity-Revised Std Quantity)

Material A: Rs 1.50x (4-3) = Rs.1.50 (Favourble)

Material B: Rs 2x (2-1.5) = Rs.1 (Favourble)
Material C: Rs 4x (2-1.5) = Rs.2 (Favourable)
= Rs4.50 (Favourable)

Verification
MCV = MPV+MUV
Nil=Rs 1 (A) + Rs 1 (F)
MUV=MMU+MYV
Rs 1 (F) = 3.50 (A) + Rs 4.50 (F)
Illustration 7
Sanya Ltd produces an article by mixing two basic raw materials. It operates a standard costing
system and the following standards have been set for raw materials:

Materials Standard Mix Standard price per kg

X 40% Rs 5.00
Y 60% Rs3.00

The standard loss in processing is 15%

During April 2005 the company produced 1700 kg of finished output.
The position of stock and purchases for the month of April 2005 are as under

Material stock on 1.4.05 Stock on 30.4.05 purchased during April 05 cost per kg

X 35 5 800 3400
Y 40 50 1200 3000

Calculate the following variances:

(i) Material price variance
(ii) Material usage variance
(iii) Material yield variance
(iv) Material mixture variance
(v) Total material cost variance

Solution
Types of Standard Actual
Materials
Quantity Kg Rate Rs Amount Rs Quantity Rate Rs Amount
Kg Rs
X 800 5 4000 35 5 175.00
Y 1200 3 3600 795 4.25 3378.75
2000 40 3 120.00
1150 2.50 2875.00
2020 6548.75

(i) Material Price Variance

=Actual quantity x (Standard Rate-Actual Rate)
Material A: 795 kg (Rs 5-Rs 4.25) = Rs596.25(F)
Material B: 1150 kg (Rs 3-Rs 2.50) = Rs575(Favourble)
MPV=Material A+ Material B
=Rs 596.25 (F) + Rs 575 (F) = Rs1171.25 (Favourble)

(ii) Material Usage Variance = Standard Rate x (Std Quantity for actual output-actual quantity)
Material A=Rs 5 x (800-830) = Rs 150 (A)
Material B=Rs 3 x (1200-1190) = Rs 30 (F)
MUV = Rs120 (A)

(iii) Material Mix Variance= Standard rate (Revised Std Quantity-Actual quantity)
Material A = 2020/2000x 800=808 kgs
Material B = 2020/2000x 1200=1212 kgs
Material A: Rs5 x (808-830) = Rs 110 (A)
Material B: Rs3 x (1212-1190) = Rs 66 (F)
MMV = Rs 44 (A)

(iv) Material yield variance=Standard Cost Per unit x (Standard output for actual mix – actual
output)

= Rs 4.48 x (1700/2000x2020)-(1700)
=Rs 4.48 x (1717-1700)= Rs76(A)

(v) Material cost variance= Standard cost for actual output-actual cost
=Rs 7600-6548.75
=Rs 1051.25(F)

Verification
Material cost variance + material usage variance
=Rs 1171.25 (F) + Rs 120 (A) = Rs 1051.25 (F)
Material usage variance = Material mix variance+ Material yield variance
=Rs 44 (A) + Rs 76 (A) = Rs 120 (A)

Working notes:
1. Standard loss 15%. Thus to produce 1700 kg of the output standard quantity of material is
100/85x1700kg=2000 kg type A: 40% and type B:60% This means standard quantity of raw
materials of type A will be 800 kgs and of type B 1200 kg in the total mix of 2000 kgs

2. Standard cost per unit = Total Standard Cost/Total Standard Output = Rs 7600/1700 = Rs 4:48

Labour Variances

Labour variances are very much similar to material variances and can be calculated in the same
way as material variances. The various labour variances may be put as follows:

Labour Cost Variance

Labour cost variance is also known as labour variances or wages variance. CIMA London defined
LC variances as It is the difference between the standard direct wages specified for the activity
achieved and the actual direct wages paid. The formula for its calculation may be put as follows
Labour Cost Variance=Standard Labour Cost for Actual Output-Actual Labour Cost= (Standard
Rate x Standard time for Actual Output)- (Actual Rate x Actual time for actual output)

Illustration 8
Calculate labour cost variance from the following information
Standard output 120 units
Standard time per unit 2 hours
Standard rate per hour Rs5
Actual output 100 units
Total actual time taken 220 hours
Actual rate per hour Rs5.50

Solution
Labour cost variance = (Standard rate per hour x standard time for actual output)- (Actual Rate per
hour x Actual time for actual output)
Standard time for actual output = (Standard time per unit x actual outputs)
2 hours x 100 units =200 hours
LCV = (Rs 5x200)-(Rs 5.50x220)
LCV = Rs 1000-1210=Rs210 (A)

Labour Cost Variance is subdivided into Three Elements

(i) Labour Rate Variance

(ii) Labour Efficiency (Time Variance)
(iii) Idle Time Variance

Labour (Wage) Rate Variance (LRV)

It is a part of labour cost variance which arises due to the difference between the actual wage rate
and standard wage rate. CIMA London defined it is as It is that portion of direct labour (wage)
variance which is due to the difference between the standard rate of pay specified and the actual
rate paid.

The formula is: Labour Rate Variance = Actual time x (Standard Rate-Actual Rate)
If the standard rate is more than the actual rate the variance is favourable and if vice versa is the
case the variance will be unfavourble.

Illustration 9
Taking the figures from illustration 8 the labour rate variance may be computed as follows:
Labour Rate Variance=Actual time x (Standard Rate-Actual Rate)
=220 hours x (Rs5-5.5)
= Rs 110 (A)

Labour Efficiency (Time) Variance

CIMa London defined it as that portion of labour cost variance which is due to the difference
between standard labour hours specified for the activity achieved and the actual hours expended.
It is computed as follows:

Labour efficiency Variance=Standard Rate (Standard Time for Actual Output-Actual Time)

If the actual labour hours worked are lower than the standard labour hours the variance will be
termed as favourable and if reverse is the case the variance will be termed as unfavourble. It should
be noted that it does not include the idle time because of factors such as strike lockouts etc.
Example
Taking the figures from illustration 8 the labour efficiency variance may be computed as follows:
LEV=SR (Std time for actual output-actual time)
Rs 5 (200 hours-220 hours)= Rs100 (A)
LCV= Labour Wage (Rate) Variance + Labour Efficiency Variance
Rs 210 (A) = Rs 110 (A) + Rs.100 (A)

Idle Time Variance

Due to abnormal wastage of time or on account of non availability of materials breakdown of

machines strike lockouts etc the actual numbers of hours worked may be less than the standard
hours fixed. It is separate from labour efficiency variance and is always unfavourble or adverse
variance. It is computed as follows:
Idle Time Variance = Standard Hourly Rate x Abnormal Idle Time (in hours)

Illustration 10

As citied from illustration 8 if the Idle time is 5 hours

Idle time Variance= 5 hours x Rs 5 = Rs25 (A)
The efficiency variance shall now be calculated on the basis of 215 hours which is the actual time
worked.
Labour Efficiency Variance= Standard Rate x (Standard Time for actual output-actual time
worked)
Rs5 (200 hours-215 hours)
=Rs.75 (A) therefore LCV=LRV+LEV+LTV
= Rs 110 (A) + Rs 75 (A) + Rs.25 (A) = 210 (A)

Labour efficiency variance is sub divided into two elements:

(i) Labour Mix (Gang Composition) Variance

(ii) Labour Yield Variance

Labour Mix Variance

Labour mix is similar to the material mix variance and arises because of difference in the grades
of labour used in actual production are different from standard labour mix. It arises because of
change in the composition of labour force.
(i) Labour Mix (Gang Composition) Variance

It is calculated as follows:
Where total standard labour hours are different from total actual hours Labour mix
variance=Standard Rate x (Revised Standard time-Actual time)

Where Revised Standard Time=Total Actual Time/Total Standard Time x Standard Time
It is computed separately for each grade of labour
Where total standard labour hours are the same as total actual hours.
LMV = Standard Rate x (Standard Time- Actual Time for Actual Output)

Illustration 11
Calculate labour mix variance from the following standard

Standard
For 100 hours grade A: 50 workers @ Rs 5 per hour
Grade B: 100 workers @ Rs 2 per hour

For 120 hours Actual

Grade A: 60 workers @ Rs 5 per hour
Grade B: 90 workers @ Rs 2 per hour

Solution
Labour Mix Variance = Standard Rate x (Revised Standard Time-Actual Time)

Revised Standard Time

Grade A: 18000 hours/15000 hours x 5000 hours = 6000 hours

Grade B: 18000 hours/15000 hours x 10000 hours = 12000 hours

Hence labour Mix Variance= Standard Rate (Revised Standard time-Actual time)
Grade A: Rs 5 per hour (6000 hours-7200 hours) = Rs 6000 (A)
Grade B: Rs 2 per hour (12000 hours-10800 hours) = Rs 2400 (F)
LMV = Rs3600 (A)

Illustration 12
Actual Production: 100 units
Standard Production=120 units
Standard Rate= Rs 10 per unit
Standard time=2 hours per unit
Calculate Labour Yield Variance

Solution
Labour Yield Variance = Standard Rate (Actual Output-Standard Output)
Standard Rate= Rs 10 x Rs.2 = Rs 20
Therefore LYV = Rs 20 (100 units -120 units)
= Rs400 (A)

Labour Yield Variance

It is similar to material yield variance. It is the variance in labour cost on account of difference
between the actual yield (or output) and the standard yield (or output) it is calculated as follows:

Labour yield variance = Standard Cost per unit x (Actual output standard output from Actual hour
worked)

If actual production is more than the standard production, it would be a favourble and if vice versa
Rs the case it would be unfavourble variance.

Illustration 13

The standard cost sheet revels the following information:

Standard Labour Rate = Rs 1 per hour
Standard hour required per unit = 15 hours
Units produced=500
Actual hours worked: 8000 hours
Actual labour cost=Rs 9000
Calculate labour variances

Solution
Standard time for actual output= 15 hours x 500 units
=7500 hours
Standard labour cost=Standard Rate x Standard Time
= Rs 1x7500 hours = Rs 7500
(i) Labour Cost Variance = Standard Labour Cost-Actual Labour Cost
=7500-9600=Rs.2100 (A)

(ii) Labour Rate Variance= Actual time (Standard Rate-Actual Rate)

Where actual rate = Actual Cost/Actual Hours Worked = Rs 9600/8000 hours Rs.1.2 per hour
Labour Rate Variance=8000 hours (Rs 1-Rs 1.20)
=Rs1600 (A)

(iii) Labour Efficiency Variance = Standard Rate x (Standard Time-Actual Time)

Rs 1(7500 hours -8000 hours)
Rs500 (A)

Labour cost variance = Labour Rate Variance + Labour Efficiency Variance

Rs 2100 (A) = Rs1600 (A) + Rs500 (A)

Illustration 14
A group of workers normally consist of 10 men 5 women and 5 boys. They are paid at standard
rates as under:
Men : Rs 1.25
Women: Rs0.80
Boys: Rs 0.70

In a normal working week of 40 hours the gang is expected to produce 1000 units. During the
week ended 31st June 2005 the gang consisted of 13 men 4 women and 3 boys. Actual wage rates
are as under:
Men : Rs 1.20
Women: Rs0.85
Boys: Rs 0.65

2 hours were lost due to abnormal time and 960 units were produced. Calcualte (i) Labour Cost
Variance (ii) Labour Rate Variance (iii) Labour Efficiency Variance (iv) Labour Mix Variance (v)
Labour Idle Time Variance

Solution
Labour Cost Variance = Standard Labour Cost for Actual Output-Actual Labour Cost
Actual Labour Cost
Men : 13x40 hours x Rs 120 = Rs 624
Women : 4x40 hours x Rs 0.85 = Rs 136
Boys : 3x40 hours x Rs 0.65 = Rs 78
Rs 838

Standard Labour Cost For Standard Output

Men : 10x40 hours x Rs 1.25 = Rs 500
Women: 4x40 hours x Rs 0.85 = Rs 160
Boys: 5x40 hours x Rs 0.70 = Rs140
Rs 800

Standard Labour Cost for 960 units = Rs 800/100 units x 960 units = Rs 768
Hence LCV = Rs 768-838=70(A)

Labour Rate Variance = Actual time x (Standard Rate-Actual Rate)

Men : 13x40 hours x Rs 1.25-1.20 = Rs 26 (F)
Women 4x40 hours x (Rs 0.80-0.85) = Rs 8 (A)
Boys 3x40 hours x (Rs 70-0.65) Rs 6 (F)
= 24 (F)

Labour Efficiency Variance = Standard Rate (Standard Time for Actual Output-Actual Time)
Men : Rs 1.25 (384 hours) – (13x38 hours) = Rs137.5(A)
Women: 0.80 (192 hours-(4x38 hours) = Rs 32 (F)
Boys: Rs 0.70 (192 hours) –(3x38 hours) = Rs54.6 (F)
Total Rs 50.90 (A)

Where Standard Time for Actual Output is calculated as follows

Men: 10x40 hours = 400 hours x 960/1000=384 hours
Women: 5x40 hours = 200 hours x 960/1000=192 hours
Boys: 5x40 hours =200 hours x 960/1000=192 hours

Labour Group Variance

Here Revised Standard Time will be:
Actual time = 760 hours Men = 760/800 x 400=380
Standard time = 800 hours Women= 760/800x200=190
Boys=760/800x200=190
Therefore LMV=Standard Rate hours x (Revised Standard Time-Actual Time)

Men: Rs1.25 x (380-494 hours) = Rs 142.50 (A)

Women: Rs0.80 x (190 hours-152 hours)=Rs30.40 (F)
Boys: Rs.0.70 x (190 hours -114 hours) = Rs 53.20 (F)
Rs 58.90 (A)

Labour Yield Variance

LYV=Standard Cost Per unit x (Actual Output-Standard Output from Actual hours worked)
= Rs 0.80 (960-950) = Rs 8(F)
Where Standard Cost per unit = Total Standard Cost/Standard Output
Rs 800/1000 units = Rs 0.80 per unit
Standard output for actual hours worked
=1000 units/standard hours x actual hours=1000 units/800 hours x 760 hours

Labour Idle Time Variance

=Standard hourly rate x abnormally idle time (in hours) 38+3 revised

Men : Rs 1.25 x 26 hours = Rs32.5(A)

Women: 0.80 x 8 hours = Rs 6.40 (A)
Boys: Rs 0.70 x 6 hours = Rs4.20 (A)
Total Rs 43.10 (A)
Verification
LCV= Labour Wage Variance +Labour Efficiency Variance + Labour Idle Time Variance Rs
70(A) = Rs.24 (F) + Rs 50.90 (A) + Rs 43.10 (A)
Labour Efficiency Variance =Labour Mix Variance+Labour Yield Variance
Rs 50.90=Rs 58.90 (A) + 8 (F)
Illustration 15
The standard labour component and the actual labour component engaged in a week for a job are
as under:

Particulars Skilled workers Semi skilled workers Unskilled workers

Standard number of 32 12 6
workers in the gang
Standard wage rate 3 2 1
per hour (Rs)
Actual number of 28 18 4
workers employed in
 the gang during the
week
Actual wage rate per 4 3 2
hour (Rs)

During the 40-hours working week the gang produced 1800 standard labour hours of work.
Calculate the different labour variances.

Solution
Category of workers Standard Actual
Hrs Rate Amount Hrs Rate Amount
Skilled 1280 3 3840 1120 4 4480
Semi skilled 480 2 960 720 3 2160
Unskilled 240 1 240 160 2 320
2000 5040 2000 6960

Labour Cost Variance= Standard Cost for Actual Output-Actual Cost

= Rs 4536-6960=Rs 2424 (Adverse)
Labour Rate Variance= Actual Time x (Standard Rate- Actual Rate)

Skilled = 1120 x (3-4) = Rs 1120 (A)

Semi Skilled = 720 x (2-3) = Rs 720 (A)
Unskilled = 160 x (1-2) = Rs 160 (A)
Total = Rs1120 (A)+720 (A) + Rs160 (A) = Rs2000 (Adverse)

Labour Efficiency Variance= Standard Rate x (Standard Time for actual output-actual time)
Skilled Rs3x(1152-1120) = Rs96(F)
Semi Skilled Rs 2(432-720)= Rs576(A)
Unskilled Rs 1 x (216-160) = Rs 56(F)
Total = Rs96(F) +576(A)+56(F)=Rs424(A)

Labour Mix Variance = Standard Rate x (Revised Standard time-Actual time)

Skilled Rs3x(1280-1120) = Rs480(F)
Semi Skilled Rs 2(240-720)= Rs480(A)
Unskilled Rs 1 x (240-160) = Rs 80(F)
Total = Rs480(F) +480(A)+80(F)=Rs80(F)

Labour Yield Variance = Standard Cost Per x (Actual Output-Standard Output hour of work for
actual mixture)
=2.52x (1800-2000)= Rs504 (Adverse)
Verification:
=LCV=LRV+LEV
=2000(A) + 424 (A) = Rs 2424 (Adverse)
LEV=LMV+LYV
=80(F) + Rs.504(A) = Rs.424 (Adverse)

Working Notes

1. Standard Cost for Actual Output = Rs 5040/2000x1800=4536

2. Standard time for Actual Output
Skilled = 1800/2000 1280=1152 hours
Semi Skilled = 1800/2000x480=432 hours
Unskilled =1800/2000x240=216 hours
3. Revised Standard Time = Total Actual Time/Total Standard Time x Standard Time
Since standard mix and actual mix are the same the standard time will also be the revised standard
time
Standard cost per hour of standard work= total standard cost/total standard hours of work
= Rs5040/2000 hours = Rs 2.52 per hour

Illustration 16
100 skilled workmen 40 semi skilled workmen and 60 unskilled workmen were to work for 30
weeks to get a contract job completed. The standard weekly wages was 60 Rs 30 and Rs 24
respectively. The job was actually completed in 32 weeks by 80 skilled 50 semi skilled and 70
unskilled workmen who were paid Rs65 Rs40 and Rs20 respectively as weekly wages.
Find out the labour cost variance labour rate variance labour mix variance and labour efficiency
variance.

Solution:
Type of No of Standard Actual
employees employees
Standard Standard SLC No of Actual AR ALC
no of Rs amount employees of Rs Amount Rs
man Rs man
weeks weeks
Skilled 100 3000 60 180000 80 2560 65 166400
Semi 40 1200 36 43200 70 1600 40 64000
skilled 60 1800 24 43200 70 2240 20 44800
Unskilled
Total 6000 266400 6400 275200

(a) Labour Cost Variance = Standard Labour Cost – Actual Labour Cost
=Rs 266400-275200=Rs8800(A)

(b) Labour Rate Variance= Actual Time (Standard Rate-Actual Rate)

Skilled =2560(60-65)=2560xRs.5=Rs12800 (A)
Semi skilled = 1600(36-40)=1600x Rs.4 = Rs6400 (F)
Unskilled =2240 (24-20) = 2240x Rs.4 = Rs8960
Total LRV = Rs 10240(A)

(c) Labour Usage Mix Variance = Standard Rate (Revised Standard Mix-Actual Time) therefore
LMV of:

Skilled = Rs 60(3000/6000x6400)-2500) = Rs 60 (3200-2560) = Rs 38400 (F)

Semi skilled = Rs 36 (1200/6000x6400)-1600) = Rs36 (1280-1600) = Rs 11520(A)
Unskilled = Rs 24(1800/6000x6400)-2240) = Rs 24 (1920-2240) = Rs7680 (A)

Total LMV = 19200(F)

(d) Labour Effiency = Standard Rate x (Standard time for actual Output-Actual Time)
Variance
Skilled = Rs 60(3000-2560)= 26400(F)
Semi skilled= Rs36 (1200-1600) Rs 14400(A)
Unskilled = Rs 24 (1800-2240)= Rs 10560(A)
LEV = Rs 1440(F)

Please note that there is no difference between actual output and standard output.
Verification: LCV=LRV+LEV
Rs8800(A) = Rs 10240(A) +Rs 1440(F)

Overheads variances

There are 2 types of overhead variances

1. Fixed OHS variance
2. Variable OHS variances

(I) Fixed OHS Variances

1 Cost variance/recovered OHS-Actual OHS
(RO)-(AO)

2 Expenditure Variance-
Budgeted OHS-Actual OHS
(BO)-(AO)

3 Volume Variance-
Recovered OHS-Budgeted OHS
(RO)-(BO)
Verification- (1) = (2) + (3)
RO-AO = BO-AO+RO-BO
RO-AO = RO-AO

(II) Variable OHS Variances

(1) Cost Variance-Recovered OHS-Actual OHS

(2) Expenditure Variance-

Standard OHS-Actual OHS

(3) Efficiency Variance

Recovered OHS-Standard OHS

Verification- (1) = (2) + (3)

(4) Capacity Variance

Standard OHS-Budgeted OHS
(5) Volume Variance
Recovered OHS-Budgeted OHS
Verification:
(3)+(4)=(5)

(I) Standard OHS

Output Basis: Standard Rate/Unit x Standard Output for actual time
OR
Input Basis: Standard Rate/Hour x Actual Hours

(II) Actual OHS

Actual rate/Unit x actual output
Or
Actual rate/Hour x actual hours

(III) Budgeted OHS

Standard Rate/Unit x Budgeted output
Or
Standard rate/Hour x Budgeted Hours

(iv) Recovered OHS

Standard Rate/Unit x actual Output
Or
Standard rate/hour x standard hour of actual output

Illustration17
Standard rate of fixed OHS Rs 15 per unit. Budgeted production 300 units. Actual production 250
units. Actual fixed OHS Rs 4000 calculate OHS variances.

Ans Actual fixed OHS = Rs 4000

RO=15x250=3750
BO=15x300=4500
(1) Cost Variance= 3750-4000 = Rs 250 (U)
(2) Expenditure variance Rs 4500-4000=500(F)
(3) Volume Variance = 3750-4500=750(U)
(1)= (2)+(3)
250(U) = 250 (U)

Illustration 18
Calculate overhead variance from the following data
Budget Actual
No of working days 20 22
Man Hour per day 8000 8400
Output per man hour in units 1 0.9
Fixed overhead cost (Rs) 16000 168000

(a) Fixed overhead cost variance = (Standard fixed x Actual overhead rate output per unit) x (actual
fixed overhead expenses)
= (Rs 160000/20x8000x1) (22x8400x0.9)-(168000)
=Rs 166320-168000= Rs 1680(A)

(b) Fixed Overhead = Budgeted Fixed overheads – Actual overheads

= Rs 160000-168000=8000

(c) Fixed Overhead Volume Variance = (Standard fixed overheads for actual output) – (Budgeted
fixed overheads) = Rs 160000/20x8000 x (22x8400x0.9) – Rs 16000
=Rs 166320-160000 = Rs 6230(F)

Verification: Fixed overhead = Fixed overhead+ fixed overhead

Cost variance Expenditure Variance Volume variance
Rs 1680(A) = Rs 8000(A) + Rs 6320 (F)

(d) Fixed overhead efficiency variance

(Standard fixed overhead rate per hour) x (Standard hour for action production-Actual Hours)
= Rs 160000/160000 hours x Rs 166320-184800= Rs 18480 (A)

(e) Fixed overhead capacity variance with calendar variance=

(Standard fixed overhead rate per unit) x (Standard output for actual hours-standard output for
actual working days)
=(1) x (22x8400)-(1x8000x22)
=Rs 1(184800-176000) = Rs 8800 (F)

(f) Fixed overhead calendar = standard fixed overhead Rate per day x No of excess days worked
= Rs 160000/20 x (22-20) = 8000x2= 16000(F)

Verification:
Fixed overhead = Fixed overhead + fixed overhead + fixed overhead volume variance efficiency
variance capacity variance calendar variance
Rs 6320(F) = 18480(A) + Rs 8800(F) + Rs 16000 (F)

Illustration 19
From the following compute the variable overhead variance
Standard Actual
Labour hours 1200 1500
Output (units) 500 400
Variable overhead 400 500

Solution
Standard variable overhead Rate:
Per hour = Rs 400/1200=Rs 0.33
Per unit = Rs 400/500= Rs 0.80
Standard variable overhead for actual production = Standard variable x actual output (Units)
= Rs 0.80x 400 units= Rs320

Standard variable overhead for actual time = standard variable x actual overhead Rate hours per
hour
=Rs0.33 x 1500 hours = Rs495

Variable overhead expenditure variance=(Standard variable overheads for actual time) – (actual
variable overheads expenses incurred)
= Rs 495-500= Rs.5(A)

Variable overhead Efficiency Variance = (Standard Variable overheads for actual production) –
(Standard variable overheads expenses incurred)
Variable overhead cost variance = (Standard variable overheads for actual production) – (actual
variable overheads)
= Rs 320-500=180(A)

Verification
V.O Cost Variance = VO Exp Variance + VO Eff Variance
Rs180 (A) = Rs 5(A) + Rs 175A (A)

Sales Variances

The sales are affected by two important factors:

 (A) the selling price and
(B) the volume of sales

The variations in the standard set and the actual causes variances. If selling price goes high it will
be favourable and vice-versa. If selling price goes down it will be unfavourable variance and vice
versa. The amount of profit earned by the business is influenced by both the cost and the revenue.
The variance related to the cost has already been discussed. The variance related to the revenue
(sales variance) can be understood with the help of the following chart:

With reference to
turnover Price
Variance
Quantity
Sales Value Variance
Variance Sales Value
Variance Volume
Variance
Sales Value
Variance Mix Variance

Price Quantity
Variance
Variance

With reference to
Profit Mix Variance
Volume
Variance

Value Variance (with Reference to Turnover)

This variance is based on the sales revenue or turnover and therefore this revenue is called value
variance or sales revenue variance. It is calculated by finding out the difference between the
budgeted sales revenue and the actual sales revenue. Therefore

Sales Revenue = Actual sales – Budgeted

Variance Revenue Sales Revenue
(Value Variance)

If the actual sales revenues is more than the budgeted sales revenue it will be favourbale variance
and the vice versa.

The difference in sales revenue variance may be on account of difference in price and volume of
sales. Therefore Sales Revenue Variance = Sales Price Variance + Sales Volume Variance

(i) Sales Price Variance

The variance which is a part of sales revenue variance which arises due to the difference between
the actual selling price and the budgeted selling price. Therefore this variance is computed as
shown below:

Sales Price Variance= Actual Sales Quantity (Actual Selling Price-Standard Selling Price)
If actual selling price is more as compared to standard selling price it will be a favourable variance
and vice versa.

(ii) Sales Volume Variance

It is also a part of sales revenue variance. It represents the difference between the budgeted quantity
of sales at standard prices and the actual quantity of sales at the standard price. The formula is:
Sales Volume Variance = (Actual Sales Quantity-Standard Sales Quantity) x Standard Selling
price

If the actual sales volume is higher than that of standard sales volume the variance will be favourble
otherwise (if ASQ<SSQ) it will be an unfavourable variance.

The sales volume variance is sub divided into two sub variances viz sales quantity variance and
the sales mix variance. The break up of sales volume variance arises in case of multi product
concern engaged in the sales of two or more products.

Therefore sales volume variance= Sales Quantity Variance + Sales Mix Variance

(A) Sales Quantity Variance

The variance is a sub variance of sales volume variance. It is the difference between the budgeted
sales and the revised standard sales. It is calculated as follows:

Sales quantity = Revised Standard – Budgeted

Variance Sales Revenue Sales Revenue

If budgeted sales revenue > Revised Standard Sales Revenue the variance will be unfavourble
where Budgeted = Standard Sales x Standard Selling Price
Sales Revenue Quantity

Revised Standard = Revised Standard Sales Quantity x Standard selling price. Revised Standard
Sales Quantity= Total Quantity of Actual Mix/total quantity of standard mix x Standard Quantity
therefore SQV=(RSSQ-SSQ) x SSP

(b) Sales Mix Variance

It represents the difference between the standard value of standard mix of sales and the revised
standards value of actual mix. It arises when the proportion of actual sales quantity of different
products are not in the same proportion as budgeted.

Therefore sales mix variance= Standard Selling Price x (actual quantity-Revised Standard Sales
Quantity) if actual sales quantity exceeds the revised standard sales quantity it will be a favourable
variance and vice versa. A summary of sales variance on the basis of turnover is presented as
below:
 Sales Revenue Variance SRV=ASR-
BSR

Sales Price Variance SPV=ASQ- Sales Volume Variance SSV=SSP

ASP-SSP (ASQ-SSQ)

Sales Mix Variance SMV=SSP- Sales Quantity Variance SQV=SSP

ASQ-RSSQ RSSQ-SSQ

Illustration 20
Arena Manufacturers operate budgetary control and standard costing system. The following
information is available from their books:

Budget Actual
Product Std cost of sales Std selling price Units Sales Units Sales
per unit Rs per unit Rs to be value sold value
sales Rs Rs
E 100 120 100 12000 100 11000
F 94 120 50 6000 50 6000
G 75 90 100 9000 200 17000
H 40 60 75 31500 400 37000
325

From the above calculate:

(a) Sales Variance
(b) Sales Volume variance and
(c) Sales price variance

Solution

Sales Revenue / Sales Value = Actual Sales Revenue –Budgeted Sales Revenue
Variance Variance

SVV = AS - BS
SVV of E = Rs 11000-12000 = 1000 (A)
F = Rs6000-6000 = Nil
G = 17000-9000 = 8000 (F)
H = 3000-4500 = 1500 (A)
Total = 31500-37000 =5500 (F)

Sales price variance=Actual Sales quantity (Actual Selling Price-Standard Selling Price)
SPV = AQ(AP – BP)
SPV of E = 100 (11000/100-120) = 100 (110-120) = Rs 1000 (A)

F=50 (6000/50-120) = 50(120-120) =Nil

G= 200 (17000/200-90) = 200(85-90) = Rs 1000 (A)
H=50 (3000/50-60) = 50(60-60) = Nil
Total Rs 2000 (A)

Sales Volume Variance

SVolV = BP (AQ-BQ)
SVolV of E = (100-100) x 120 =Nil
F = 120(50-50) = Nil
G= 90 (200-100) = Rs 9000(F)
H = 60 (50-75) = Rs 1500(A)

SVV = Rs 7500(F)

Verification:

SVV = SPV+SolV
Rs 5500(F) = Rs 2000 (A) + Rs 7500 (F)
=5500(F)

Sales Mix Variance

Sales Mix Variance= Budgeted Price (Actual Sales/Quantity-Revised Standard/Sales Quantity)
SMV = BP (AQ – RBQ)
SMV of E = Rs 120 (100-(400/325x100)) = 120(100-123) Rs2760 (F)
F = Rs 120 (50-(400/325x50)) = 120(50-62) Rs1440 (A)
G = Rs 90 (200-(400/325x75)) = 90(200-123) Rs6930 (F)
H = Rs 60 (50-(400/325x75)) = 60(50-92) Rs2520 (H)
---------------
Total SMV 210(F)

Practical Problems

1. The standard mix of product A2 is as follows:

Kg Material Price per kg

45 X 6.00
25 Y 4.50
30 Z 9.75

The standard loss in production is 10% of input. There is no scrap value. Actual production for the
materials was 7425 kg of A2 from 80 mixes. Actual purchases and consumption during the month
were:

Kg Material Price per kg

4200 X 6.50
1700 Y 4.25
2600 Z 9.75

You are required to calculate the following variances for presentation to the management
(i) Material cost variance (ii) Material price variance (iii) Material Mix Variance (iv) Material
Yield Variance

Ans. Rs 4806.25 (A) (ii) Rs2325(A) (iii) Rs 812.50 (A) (v) Rs1668.75(A)
2. Find out variable overhead variances from the following
Budgeted variable overhead for January Rs 8000
Budgeted production for the month 500 units
Standard time for one unit of production 10 hours
Actual variable overhead Rs 6600
Actual production for the month 400 units
Actual hours worked 3800

Ans. Cost Rs 200(A) Expenditure Rs520 (A) Efficiency Rs 320(F)

3. Following details are available from the records of ABC Ltd engaged in manufacturing article
A for the week ended 28th September. The standard labour hour and rates of payment per article A
were as follows

Particulars Hours Rate per hour Rs Total Rs

Skilled 10 3.00 30
Semi skilled 8 1.50 12
Unskilled 16 1.00 16
58
The actual production was 1000 articles A for which the actual hours worked and rates are given
below:

Particulars Hours Rate per hour Rs Total Rs

Skilled 9000 4.00 36000
Semi skilled 8400 1.50 12600
Unskilled 20000 0.50 18000
66000
From the above set of data calculate the following
(a) Labour cost variance
(b) Labour Rate variance
(c) Labour efficiency variance
(d) Labour mix variance

Ans. LAC=Rs 8600(A) LRV Rs7000(A) LEV Rs 1600(A) LMV= 4200(F)

4.The standard mix of product P is shown below

Raw material X: 30 units @ Rs 2 each
Raw material Y: 70 units @ Rs 3 each
Standard loss is 10% of input. Actual mix is 34 units of X and 66 units of Y. Rates are the same.
The actual loss is 15% of input. Calculate the variances.

Ans. DMPV Rs 11 (A) DMPV (Ni)l; DMUV Rs 11(A) DMMV Rs 4 (F) DMYV Rs 15(A)

5. The standard cost of a chemical mixture is as under

8 tonnes of materials X at Rs 40 per tonne
12 tonnes of materials Y at Rs 60 per tonne
Actual cost for a period is as under
10 tonnes of material X at Rs 30 per tonne
20 tonnes of material Y at Rs 68 per tonne
Actual yield is 26.5 tonnes
Compute
 (A) Materials cost variance
(B) Material usage variance
(C) Material price variance
(D) Material mix variance
(E) Material yield variance

Ans. (A) Rs 129 (b) Rs69(A) (c) Rs60(A) (d) Rs40 (A) (e) Rs 29(A)

6. From the data given below calculate labour variances for the two departments

Deptt X Deptt Y
Actual gross wages (Direct) 2000 1800
Standard hours produced 8000 6000
Standard rate per hour 30 paisa 35 paisa
Actual hours worked 8200 5800

Ans. Particulars Deptt X Deptt Y

DLCV 400(F) 300(F)
DLRV 460(F) 230(F)
DLEV 60(A) 70(F)

7. A gang of workers normally consist of 30 men. 15 women and 10 boys. They are paid at standard
hourly rate as under:

Men 0.80
Women 0.60
Boys 0.40
In a normal working week of 40 hours the Gang is expected to produced 2000 units of output.
During the week ended 31st December 1998 the Gang consisted of 40 men 10 women & 5 boys.
The actual wages paid were Rs 0.70 0.65 and 0.30 respectively. 4 hours were lost due to abnormal
idle time and 1600 units were produced.

Calculate (i) wage variance (ii) wage rate variance (iii) labour efficiency variance (iv) gang
composition variance (labour mix variance) and (v) labour idle time variance

Ans. 256(A) (ii) 160(F) (iii) 416 (A) (iv) 108 (A) (v) Rs160(A)

8. A manufacturing company operating a standard costing system had the following data in respect
of February 2005

Budgeted Actuals
No of working days 20 22
Man hours per month 8000 8600
Units produced std man hours 850
10 per units produced
Overheads Std rate per man hour 3600
Rs 0.50

Calculate the fixed overhead variances

Ans. FOCV=Rs650(F) FOVV Rs 250(F) FOEV= Rs 400(F) FO Eff Variance = Rs 50(A)

FO Capacity Variance without calendar variance Rs 300(F)
9. XYZ Ltd Furnishes the following information for April 1998:

Budgeted sales Product Sales quantity sales Selling price per

units Rs
A 1200 15
B 800 20
C 2000 40
Actual Sales A 880 18
B 880 20
C 2640 38

Calculate sales variance

Ans (i) SQV = Rs 22400(F) (ii) SMV Rs 11000(F) (iii) SPV= Rs 2640(A) (iv) Sales Variance =
Rs 19780(F)