Cost Accounting Systems :

Material Cost Management :

Material Costs

Material cost is the cost of material of any nature used for the purpose of production of a product or a service. It
includes cost of materials, freight inwards, taxes & duties, insurance ...etc directly attributable to acquisition, but
excluding the trade discounts, duty drawbacks and refunds on account of excise duty and vat.

Material management is an approach for planning, organizing, and controlling all those activities principally c The
scope of Materials Management varies greatly from company to company and may include material planning and
control, production planning, Purchasing, inventory control, in-plant materials movement, and waste management.

It is a business function for planning, purchasing, moving, storing material in a optimum way which help organisation
to minimise the various costs like inventory, purchasing, material handling and distribution costs. concerned with the
flow of materials into an organisation.

The fundamental objectives of the Materials Management function ,often called the famous 5 Rs of Materials
Management, are acquisition of materials and services:

• of the right quality

• in the right quantity
• at the right time
• from the right source
• at the right price

From the management point of view , the key objectives of MM are :

• To buy at the lowest price , consistent with desired quality and service

• To maintain a high inventory turnover , by reducing excess storage , carrying costs and inventory losses
occurring due to deteriorations , obsolescence and pilferage

• To maintain continuity of supply , preventing interruption of the flow of materials and services to users
• To maintain the specified material quality level and a consistency of quality which permits efficient and
effective operation

• To develop reliable alternate sources of supply to promote a competitive atmosphere in performance and
pricing

• To minimize the overall cost of acquisition by improving the efficiency of operations and procedures

• To hire, develop, motivate and train personnel and to provide a reservoir of talent

• To develop and maintain good supplier relationships in order to create a supplier attitude and desire furnish
the organisation with new ideas , products, and better prices and service

• To achieve a high degree of cooperation and coordination with user departments

• To maintain good records and controls that provide an audit trail and ensure efficiency and honesty

• To participate in Make or Buy decisions

Materials Management thus can be defined as that function of business that is responsible for the coordination of
planning, sourcing, purchasing, moving, storing and controlling materials in an optimum manner so as to provide
service to the customer, at a pre-decided level at a minimum cost.

The broad Materials function has the following as identified and interlinked sub functions:
Materials planning and control: Materials required for any operation are based on the sales forecasts and
production plans.

Planning and control is done for the materials taking into account the materials not available for the operation and
those in hand or in pipe line.

This involves estimating the individual requirements of parts, preparing materials budget, forecasting the levels of
inventories, scheduling the orders and monitoring the performance in relation to production and sales.

Purchasing: Basically, the job of a materials manager is to provide , to the user departments right material at the
right time in right quantity of right quality at right price from the right source.

To meet these objectives the activities undertaken include selection of sources of supply, finalisation of terms of
purchase, placement of purchase orders, follow up, maintenance of relations with vendors, approval of payments to
vendors, evaluating, rating and developing vendors.

Stores : Once the material is delivered , its physical control , preservation , minimisation of obsolescence and damage
through timely disposal and efficient handling, maintenance of records, proper locations and stocking is done in
Stores.

Inventory control : One of the powerful ways of controlling the materials is through Inventory control.

It covers aspects such as setting inventory levels, doing various analyses such as ABC , XYZ etc ,fixing
economic order quantities (EOQ), setting safety stock levels, lead time analysis and reporting.

Materials Management's scope:

The scope is vast. Its sub functions include Materials planning and control, Purchasing, Stores and Inventory
Management besides others.

Basically, under its scope are :

• emphasis on the acquisition aspect

• inventory control and stores management
• material logistics, movement control and handling aspect
• purchasing, supply , transportation , materials handling etc
• supply management or logistics management
• all the interrelated activities concerned with materials
Materials management can thus also be defined as a joint action of various materials activities directed towards a
common goal and that is to achieve an integrated management approach to planning, acquiring, processing and
distributing production materials from the raw material state to the finished product state.

In its process of managing , materials management has such sub fields as inventory management , value analysis,
receiving, stores and management of obsolete , slow moving and non moving items. The various activities represent
these four functions:

• Planning and control

• Purchasing
• Value analysis and
• Physical distribution
Valuing material issues and stock.
All receipts and issues of materials are the important aspects to continuous flow of production. A systematic.
procedure should be adopted for movement of materials from one place to another place. Materials received and
stored are issued on the basis of stores requisition, bills of materials, stock in balance, proper authorization and
pricing material issues etc. It is clear that ascertainment of accurate material cost, fixing of material issue and
effective cost control are the primary objective in order to fulfil the needs of management. For this reasons the
following aspects considered to be the subject matter of valuation of materials issues.
1. Valuation of total cost of materials purchased.
2. Material Issue Procedure.
3. Important methods of pricing of materials issued.

1. VALUATION OF TOTAL COST OF MATERIALS PURCHASED

Material costing is very important in terms of the valuation of the cost of materials consumed by the production
department as well as in terms of the estimation of the value of materials in stock. For costing purposes, the material
cost is worked out by the actual cost incurred by taking price quoted by supplier as the basis subtracting the discounts
and adding any other expenses not covered. In practice discounts may be allowed by the supplier in the following
ways such as :
(a) Trade Discount.
(b) Quantity Discount and
(c) Cash Discount.

(a) Trade Discount: Trade Discount is allowed by the seller to the buyer who has to resell the goods.
This allowance is to compensate the buyer for the cost of storage, breaking bulk, selling repacking the goods etc.
(b) Quantity Discount: This discount refers to the allowance which is allowed by the supplier to the buyer to
encourage large orders. Placing the large orders from the buyers gives savings in costs which arise from large-scale
production to the supplier. Part of the savings allowed by supplier to the buyer by means of a quantity discount.
(c) Cash Discount: Cash Discount is allowed by the supplier to a buyer to encourage prompt payment of cash within
the stipulated period.

2. MATERIALS ISSUE PROCEDURE

Issues of materials are based on production programme. Based on this and the bill of materials work orders are
printed, listing for each material quantity to be issued against each component requiring that material. The
storekeeper is very much concerned with the material control, as he is responsible for the issue of materials based on
the proper authorization of material requisition and bills of materials.
Materials Requisition: Purchase or Material Requisition is also known as Intent for Materials. This is a document
prepared by the production department for requisition of materials is known as Materials Requisition. The
storekeeper is authorized to issue the materials based on the proper authority to avoid the misappropriation of
material. The store keeper is responsible to maintained a record of serial number on requisition, issues and stock
balances are up to date are must be posted in stores ledger.
Bill of Materials: Bill of materials is a document which shows a complete listing for each material, quantity to be
issued against each component requiring that materials for a particular job order or process.
Bill of Materials is prepared by the production department before the quantity of the components to be manufactured.
This is helpful for the purpose of initiate material requisition and estimation of cost materials to collect quotations.

3. METHOD OF PRICING OF MATERIALS ISSUES

In the relation to the estimation of the cost of the product for pricing decisions, material issues assures a key role.
Material price usually refers to the price quoted and accepted in the purchase orders.
Materials are issued from the stores to work orders based on the material requisition. But stock of materials consists
of different consignment received at different dates and prices. There are different methods used for pricing the
materials issues may be summarized in the following categories :
(A) Actual Price Method (or) Cost Price Method
(1) First In First Out (FIFO).
(2) Last In First Out (LIFO).
(3) Specific Price Method.
(4) Base Stock Method.
(5) Highest In First Out (HIFO).
(B) Average Cost Method
(1) Simple Average Method.
(2) Weighted Average Method.
(3) Periodic Simple Average Method.
(4) Periodic Weighted Average Method.
(C) Standard Price Method.
(D) Inflated Price Method.
(E) Market Price Method (or) Replacement Price Method.
A. Actual Price Method
In this method, the materials issued are priced at their actual cost and this involves identification of each lot
purchased. This method is suitable only in the case of materials purchased for a specific job.
There are several methods frequently used under actual cost price method which will be discussed in details:
(1) First In First Out (FIFO): First In First Out is also known as FIFO. Under this method, the pricing of issue is
based on an assumption made that the oldest stock is issued first. Therefore at the time of issue, the rate pertaining to
that will be applied until the whole lots is exhausted.
Advantages
(1) It is simple and easy to adaptability.
(2) It is beneficial when the prices are falling.
(3) As actual prices are issued, it reflects on profit no loss in the pricing.
(4) This method is very useful for slow moving materials.
Disadvantages
(1) Calculation becomes complicated due to fluctuation of material prices.
(2) More chances of clerical errors due to complicated calculations.
(3) Under fluctuating prices, one requisition involves more than one price.
(4) In times of raising prices this method tends to show the production at low cost since the cost of replacing the
material will be higher.
(2) Last In First Out ( LIFO): This method is just opposite to First In First Out method. The basic assumption here is
that the most recent receipts are issued first. The price of the materials to be issued would be the cost price of the last
lots of materials purchased.
Advantages
(1) It is beneficial when the period of raising prices.
(2) Under this method, latest prices are issued thereby leading to lower reported profits hence savings in taxes.
(3) When there are wide fluctuations in price levels this methods tends to minimize unrealized
gains or losses in inventory.
Disadvantages
(1) This method involves more clerical work which leads to complicated calculations.
(2) Under this method more than one price is to be adopted for the same issue lot of material.
(3) Due to wide fluctuation of prices, comparison of cost of similar jobs is very difficult.
(3) Specific Price Method: Specific Price Method is one of the methods of actual price method.
In this method adopted where the materials are purchased for particular job or operation and the issue is charged with
the actual cost price. This method is suitable only in the case of special purpose materials are purchased for a
particular job. This method has been widely used in job order industries which carry out individual jobs or contract
against specific orders .
Advantages -
(1) This method is simple and easy to operate.
(2) This method is useful where the job costing is in operation.
(3) Under this method, the actual material cost can be easily identified.
(4) This method is desirable because actual cost of materials is charged to production and therefore no profit no loss.
Disadvantages
(1) This method involves considerable amount of clerical work.
(2) If the purchases and issues are numerous, it is difficult to identification of issues for a particular job.
(4) Base Stock Method: Under this method pricing is determined on the basis of assumption made here is that a
certain minimum quantity of materials maintained in stock. This minimum quantity is known as Base Stock or Safety
Stock. This quantity cannot be used unless an emergency arises. The minimum stock is in the nature of fixed assets
because it is created out of the first lot of the material purchased.
Therefore it always valued at the actual cost price of the first lot and is carried forward as fixed assets.
This method is usually applied with FIFO or LIFO.
(5) Highest In First Out (HIFO): This method is based on the assumption that the stock of materials should always be
valued at the lowest possible price. Accordingly materials purchased at the highest price should be used for making
the issue. This method is useful because issues are based on actual cost. It aims at recovering the highest cost of
materials when the market is constantly fluctuating. But at the same time this method involves too many complicated
calculations. And also this method has not been adopted widely.
B. Average Cost Method
In this method, the issues to the production department are split into equal batches from each shipment at stock. It is a
realistic method reflecting the price levels and stabilizing the cost price. The following various methods of averaging
issue prices may be used :
(1) Simple Average Method
(2) Weighted Average Method
(3) Periodic Simple· Average Method
(4) Periodic Weighted Average Method

(1) Simple Average Method: Under this method, price of issue materials is determined by dividing the total of the
prices of the materials in stock, i.e., adding of different prices by the number of different prices. Then, this average
price is applied to the issues to production. This method is simple and easy to operate. The value of closing stock
becomes unrealistic.

(2) Weighted Average Method: Under this method, the price of materials issue is determined by dividing the total
cost of materials in stock by the total quantity of material in stock. Here weighted average rate is calculated based on
both quantity and price of the materials in stock. As more issues are made, a new average rate is computed and this
average rate is applied to the subsequent issues.
(3) Periodic Simple Average Method: Under this method, the simple average rate is calculated for a particular
period ignoring the rate of opening stock. The issue price is calculated by totaling the unit price of all materials
purchased during a particular period by the total number of prices during that period.
Thus this rate is applied to the issue to production for a particular period say a month and not at the occasion of each
issue of materials.
(4) Periodic Weighted Average Method: This method is similar to the periodic simple average method. In this method
issue rate is calculated by total cost of materials purchased during a period by the total quantity of materials
purchased during that period. Here both quantity and prices of materials in stock during a particular period are taken
into account for calculation of periodic weighted average rate.
Under this method the issue rate is determined for a particular period ignoring the rate and quantity of opening stock.
A new average rate is computed at the end of each period say a month and this average rate is applied to subsequent
issues.
C. Standard Price Method
Under this method, standard price of material issues are calculated on the basis of detailed analysis of market prices
and trends. The standard price also referred to as predetermined price is fixed for a definite period of six months or
more. Accordingly the material issue is done on the basis of standard price irrespective of actual rate. The difference
between actual price and standard price is treated as material variance. At the end of the period, new standard price is
fixed for a further period.
D. Inflated Price Method
This method is used to cover material losses on account of obsolescence, deterioration, and materials handling
expenses. Under this method cost of materials issue, such losses and expenses are directly charged to material cost.
Therefore, when the issue of materials is made, the price is to inflated to cover all the losses and expenses.
E. Market Price Method
This method is also known as Replacement Rate Method. Under this method issue materials that are valued at the
market rate prevailing at the time issue. It therefore follows that when prices increase the stock on hand is
continuously under estimated because receipts are cost at actual and issued at higher rates.
Conversely Hand grossly over estimated. This method is most suitable when quotations or tenders have to be made
because they are to be quoted at competitive prices. Besides this system requires continuous monitoring of market
price for all materials and hence it is very unwieldy.

Labour Cost Management:

Definition of 'Cost Of Labor'

The sum of all wages paid to employees, as well as the cost of employee benefits and payroll taxes paid by an employer.
The cost of labor is broken into direct and indirect costs. Direct costs include wages for the employees physically making a
product, like workers on an assembly line. Indirect costs are associated with support labor, such as employees that
maintain factory equipment but don't operate the machines themselves.

When manufacturers set the price of a good they take the cost of labor into account. This is because they need to
charge more than that good's total cost of production. If demand for a good drops or the price consumers are willing
to pay for the good falls, companies must adjust their the cost of labor to remain profitable. They can reduce the
number of employees, cut back on production, require higher levels of productivity, reduce indirect labor costs or
reduce other factors in the cost of production

Objectives of an Ideal Wage System

An ideal wage system is required to achieve the following objectives:

(1) The wage system should establish a fair and equitable remuneration.
(2) A sound wage system helps to attract qualified and efficient worker by ensuring an adequate payment.
(3) It assists to improve the motivation and moral of employees which in turn lead to higher productivity.
(4) It enables effective control of labour cost.
(5) An Ideal wage system helps to improve union-management relations. It should reduce grievances arising out of
wage inequities.
(6) It should facilitate job sequences and lines of promotion wherever applicable.
(7) An ideal system seeks to project the image of a progressive employer and to comply with legal requirements
relating to wages and salaries.

Principles of an Ideal Wage System

The following principles should be adopted for an ideal wage system

(1) Differences in pay should be based on differences in job requirements.
(2) Follow the principle of equal pay for equal work.
(3) The scheme should be based on work study, and the work contents of various jobs should be stabilized.
(4) Recognize individual differences in ability and contributions.
(5) The scheme should not be very costly in operation.
(6) The scheme should be flexible.
(7) The scheme should encourage productivity.
. (8) The scheme should not undermine co-operation amongst the workers.
(9) The scheme should be sufficient to ensure for the worker and his family reasonable standard of living.
Method of Remuneration
There are two basic methods of wage payment: (1) Time Wage System and (2) Piece Wage System. Under time wage
system. wages are paid on the basis of time spent on the job irrespect of the amount of work done. This is known as
Time Rate or Day Wage System. The unit of time may be a day, a week, a fortnight or a month. Under piece wage
system, remuneration is based on the amount of work done or output of a worker. This is known as "Piece Rate
System" or "Payment by Result." Thus. a workman is paid in direct proportion to his output. A variety of bonus and
premium plans have been designed to overcome the drawbacks of two basic methods of wage payments. A system of
incentive plans also takes into consideration the primary principles of these two basic plans known as Incentive or
Bonus or Premium Plan.

The following are the important methods of remuneration which may be grouped into :
(1) Time Rate Systems
(2) Piece Rate Systems
(3) Bonus System (or) Incentives Schemes.
(4) Indirect Monetary Incentives.

These may be further classified as under:

(1) Time Rate Systems:

(a) At Ordinary Levels

(b) At High Wage Levels
(c) Guaranteed Time Rates.

(2) Piece Rate Systems:

(a) Straight Piece Rate

(b) Piece Rates with Guaranteed Time Rate
(c) Differential Piece Rates:

(i) Taylor's Differential Piece Rate System

(ii) Merrick Differential Piece Rate System
(iii) Gantt Task and Bonus Plan.

(3) Bonus System or Incentive Schemes:

(1) Halsey Premium Plan

(2) Halsey-Weir Premium Plan
(3) Rowan Plan
(4) Barth Variable Sharing Plan
(5) Emerson Efficiency Plan
(4) Indirect Monetary Incentives:
(5) Non-Monetary Incentives:

(1) Time Wage System

(a) Time Rate at Ordinary Levels: This is also termed as "Day Wage System" or "Flat Rate System." Under this
system, wages are paid to the workers on the basis of time spent on the job irrespective of the quantity of work
produced by the workers. Payment can be made at a rate per day or a week, a fortnight or a month. The formula for
calculation of payment of time rate of ordinary levels is as follows:

Remuneration or Earnings = Hours Worked X Rate Per Hour

Time wage system is suitable under the following conditions:

(1) Where the units of output are difficult to measurable, e.g., watchman.
(2) Where the quality of work is more important, e.g., artistic furniture, fine jewellery, carving etc.
(3) Where machinery and materials used are very sophisticated and expensive.
(4) Where supervision is effective and close supervision is possible.
(5) Where the workers are new and learning the job.
(6) Where the work is of a highly varied nature and standard of performance cannot be established.

Advantages
(1) It is simple and easy to calculate.
(2) Earning of workers are regular and fixed.
(3) Time rate system is accepted by trade unions.
(4) Quality of the work is not affected.
(5) This method also avoids inefficient handling of materials and tools.

Disadvantages
(1) No distinction between efficient and inefficient worker is made and hence they get the same remuneration.
(2) Cost of supervision are high due to strict supervision used for high productivity of labour.
(3) Labour cost is difficult to control due to more payment may be made for the lesser amount of work.
(4) No incentive is given to efficient workers. It will depress the efficient workers.
(5) There is no specific standards for evaluating the merit of different employees for promotions.

(b) Time Rate at High Levels: Under this system, efficient workers are paid higher wages in order to increase
production. The main object of this method designed to remove the drawbacks of time rate at ordinary levels. This
system is simple and easily understandable. When higher rate of wages are paid, it not only reduces labour turnover
but also increases production and efficiency.
(c) Guaranteed Time Rates: Under this method, the wage rate is calculated by considering to changes in cost of
living index. Accordingly, the wage rate is varied for each worker according to the change in cost of living index.
This system is suitable during the period of raising prices.

(2) Piece Rate System

This is also known as "Piece Wage System" or "Payment By Result." Under this system, wages of a worker are
calculated on the basis of amount of work done or output of a worker. Accordingly, a worker is paid in direct
proportion to his output.

Advantages
(I) It facilitates direct relation between efforts and reward.
(2) This system encourages the efficient workers to increase production.
(3) Under this system efficient workers are recognized and rewarded.
(4) It helps to reduce the cost of supervision and idle time.
(5) Tenders or quotations can be prepared confidently and accurately.
Disadvantages
(1) Where a concern is producing large quantities, it is difficult to fix a piece rate.
(2) In order to maximize their earnings, workers working with high speed may affect their health.
(3) The quality of output cannot be maintained.
(4) This system is not encouraging to the inefficient workers.
(5) Temporary delays or difficulties may affect the earnings of the workers.

Piece Rate System is Suitable Where

(l) Quality and workmanship are not important.
(2) Work can be measured accurately.
(3) Quantity of output directly depends upon the efforts of the worker.
(4) Production of standardized goods in a factory.
(5) Job is of a repetitive nature.
There are three important methods of paying labour remuneration falling under this type: (a) Straight Piece Rate (2)
Piece Rates with Guaranteed Time Rates and (c) Differential Piece Rates.
(a) Straight Piece Rate: Under this system, workers are paid according to the number of units produced at a given
rate per unit. Thus, total earnings of each worker is calculated on the basis of his output irrespective of the time taken
by him. The following formula is used for measuring piece work earning:
Straight Piece Work Earnings = Units Produced x Rate Per Hour
(b) Piece Rates with Guaranteed Time Rates: Under this method, the worker earning from piece work less than the
guaranteed minimum wage, will get the fixed amount of guaranteed time rate. A guaranteed rate would be paid per
hour rate or day rate or week rate.
(c) Differential Piece Rates: This system is designed to provide for variation of piece rates at different levels of
output. Accordingly increase in wages is proportionate to increase in output. Under this system, efficient workers get
ample reward and at the same time inefficient workers are motivated to earn more. The following are the three
important types of differential piece rates :
(a) Taylor's Differential Piece Rates System.
(b) Merrick's Differential Piece Rates System.
(c) Gantt Task Bonus Plan.

(a) Taylor's Differential Piece Rates System

EW. Taylor, who is the father of scientific management introduced this plan. Under this system, two piece rates are
applicable on the basis of standard of performance established. Accordingly one is high rate and the other one is
lower rate. Thus high piece rate is applicable for standard and above the standard performance. Lower piece rate for
those workers with below the standard performance.

(b) Merrick Differential Piece Rate System

This is also termed as Multiple Piece Rate system. This plan is 'designed to overcome the drawback of Taylor's
Differential Piece Rate System. Under this method, three piece rates are applied with different levels of performance.
Accordingly

Performance Differential Piece Rate

(1) Less than 83% Normal Piece Rate (or) Basic Piece
(2) From 83% to 100% Rate
(3) More than 100% 110% of Normal Piece Rate
120% of Normal Piece Rate

(c) Gantt's Task Bonus Plan

This system is designed by Henry L. Gantt. Under this system, standard time for every task is fixed through time and
motion study. The main feature of this system is a good combination of time rate, differential piece rate and bonus. In
this system day wages are guaranteed to all workers. Wages under this system are calculated as follows :'
Performance Earnings
(Output) Time Rate (Guaranteed)
(1) Output Below Standard Wages of Time Rate plus Bonus of
(2) Output at Standard 20% of the
(3) Output at Above Standard Time Rate
High Piece Rate on worker's output

Bonus or Incentives Schemes

Incentive schemes of wage payment are also known as Premium Bonus Plans. introduced in order to increase
production with ensuring proper industrial climate. Wage incentive plans may be of two types :
(1) Individual Incentive Plans and (2) Group Incentive Plans. Under individual incentive plans, remuneration can be
measured on the performance of the individual worker. In the case of the group incentive scheme earnings can be
measured on the basis of the productivity of the group of workers or entire work force of the organization. Various
types of incentive schemes are combinations of time and piece rate systems. The following are the important
individual incentive plans discussed below:
(1) Halsey Premium Plan: This Plan was developed by F. A. Halsey. This system also termed as Split Bonus Plan or
Fifty-Fifty Plan. Under this plan, standard time is fixed for each job or operation on the basis of past performance. If
a worker completes his job within or more than the standard time then the worker is paid a guaranteed time wage. If a
worker completes his job within or less than the standard time, then he gets a bonus of 50% of the time saved plus
normal earnings.

Merits
(1) It is simple to understand.
(2) Total earnings of each worker can be easy to calculate.
(3) Both employer and employee get equal benefit of time saved.
(4) This system not only benefits efficient worker but also provides average worker to get guaranteed minimum
wages.
(5) This system is based on time saved and it can reduce the labour cost.
Demerits
(1) Lack of co-operation among the employees.
(2) Under this system establishment of standard is very difficult.
(3) Earning are reduced at high level of efficiency.

(2) The Halsey-Weir Scheme: Under this system, the worker gets the bonus of 30% of the time saved instead of
50% of time saved under Halsey Plan. Except for this, Halsey Plan and Halsey-Weir Systems are similar in all other
respects.

(3) Rowan Plan: This plan was introduced by James Rowan of England. It was similar to the Halsey Plan in many
respects except that it differs in calculation of bonus. Under this system. bonus is determined as the proportion of the
time taken which the time saved bears to the standard time allowed.

(4) Emerson's Efficiency Sharing Plan: Under this plan, earning of a worker is by combining guaranteed day wages
with a differential piece rate. Accordingly the level of efficiency is determined on the basis of establishment of
standard task for a unit of time. If the level of worker's efficiency reaches 67% the bonus is paid to him at a normal
rate. The rate of bonus increases in a given rate as the output increases from 67% to 100% efficiency. Above 100%
efficiency, the bonus increases to 20% of the wage earned plus additional bonus of 1 % is added for each increase of
1 % in efficiency.

Group or Collective Bonus Plan

The incentive schemes explained so far are applicable to individual performance depending directly on production.
However. it is not the individual worker who produce the goods or services (operation) alone but group of several
other workers are required to jointly perform a single operation. It is, therefore, essential that a group incentive
scheme be introduced. Bonus is calculated for a group incentive scheme.
The bonus is calculated for a group of workers and the total amount is distributed among the group of workers on
anyone of the following basis :
(a) Equally by all the workers of the group.
(b) Pro rata on the time rate basis.
(c) Pre determined percentage basis.
(d) Specified proportion basis.

Types of Group Incentive Plans

The following are the important types of group incentive bonus plans:
(1) Budgeted Expenses Bonus Plan
(2) Priest Man Bonus Plan
(3) Towne's Gain-sharing Plan
(4) Scanlon Plan
(1) Budgeted Expenses Bonus Plan: Under this method, bonus is determined on the basis of savings in actual
expenditure compared with total budgeted expenditure.
(2) Priest Man Bonus Plan: Under this plan, standard performance is fixed by the management and committee of
workers. The group of workers get bonus when actual performance exceeds the standard performance irrespective of
individual's efficiency or inefficiency.
(3) Towne's Gain-sharing Plan: Under this plan, bonus is calculated on the basis of savings in labour cost. The
group of workers get bonus when actual costs is less than the standard costs, one-half of the savings is distributed
among workers including foremen in proportion with the wages earned.
(4) Scanlon Plan: Scanlon Plan is designed with the chief aim of reducing the cost of operations in order to increase
the production efficiency. This plan is generally applicable in industries where the operation cost is high. Under this
scheme, bonus is determined on the basis of standard costs or wastages and percentage of the reduction in operation
cost.

Indirect Monetary Incentives

Incentive schemes are regarded beneficial to both employers and workers. In this regard, under indirect monetary
incentives by giving them a share of profit and introducing co-partnership schemes or as they have become partners
in the business in order to make a very profitable enterprise.
Profit Sharing: Profit sharing and bonus is also known as Profit sharing bonus. Under this scheme, there is an
agreement between the employer and employee by which employee receives a share, fixed in advance of the profits.
Accordingly profit sharing bonus refers to the distribution of profit on the basis of a certain percentage of one's
monthly earnings. The amount to be distributed depends on the profits earned by an enterprise. The proportion of the
profits to be distributed among the employees is determined in advance.
Co-partnership: This system provides not only a worker to become partner in the business but also to share in the
profits of the concern. There are different degrees of partnership and share of responsibilities allowed to the workers
to take part in its control.
Non-Monetary Incentive Schemes: Under this system, employees are provided better facilities, instead of additional
monetary payments. Some of the examples of non-monetary incentives are free education for children, rent free
accommodation, medical facilities, canteen facilities, welfare facilities, and entertainment facilities etc.

Labour Turnover

Labour turnover refers to the movement of employees in and out of a business. However, the term is commonly used
to refer only to ‘wastage’ or the number of employees leaving.

High labour turnover causes problems for business. It is costly, lowers productivity and morale and tends to get worse
if not dealt with.

Effect and costof Labour Turnover.

Measuring labour turnover

The simplest measure involves calculating the number of leavers in a period (usually a year) as a percentage of the
number employed during the same period. This is known as the "separation rate" or "crude wastage rate" and is
calculated as follows:

Number of leavers / average no employed x 100

For example, if a business has 150 leavers during the year and, on average, it employed 2,000 people during the year,
the labour turnover figure would be 7.5%

An alternative calculation of labour turnover is known as the "Stability Index" . This illustrates the extent to which
the experienced workforce is being retained and is calculated as follows:
Number of employees with one or more years’ service now / Number employed one year ago x 100

Labour turnover will vary between different groups of employees and measurement is more useful if broken down by
department or section or according to such factors as length of service, age or occupation.

Patterns of labour turnover

The highest rate of labour turnover tends to be among those who have recently joined an business.

Longer-serving employees are more likely to stay, mainly because they become used to the work and the business
and have an established relationship with those around them.

Causes of labour turnover

A high level of labour turnover could be caused by many factors:

• Inadequate wage levels leading to employees moving to competitors

• Poor morale and low levels of motivation within the workforce

• Recruiting and selecting the wrong employees in the first place, meaning they leave to seek more suitable
employment

• A buoyant local labour market offering more (and perhaps more attractive) opportunities to employees

Costs of labour turnover

High rates of labour turnover are expensive in terms of:

- Additional recruitment costs

- Lost production costs

- Increased costs of training replacement employees

- Loss of know-how and customer goodwill

- Potential loss of sales (e.g. if there is high turnover amongst the sales force)

- Damage that may be done to morale and productivity (an intangible cost)

Benefits of labour turnover

Labour turnover does not just create costs. Some level of labour turnover is important to bring new ideas, skills and
enthusiasm to the labour force.

A "natural" level of labour turnover can be a way in which a business can slowly reduce its workforce without having
to resort to redundancies (this is often referred to as "natural wastage".)
Overheads:
An accounting term that refers to all ongoing business expenses not including or related to direct labor, direct
materials or third-party expenses that are billed directly to customers. Overhead must be paid for on an ongoing basis,
regardless of whether a company is doing a high or low volume of business. It is important not just for budgeting
purposes, but for determining how much a company must charge for its products or services to make a profit.
For example, a service-based business that operates in a traditional white-collar office setting would have overhead
expenses such as rent, utilities and insurance.

Overhead expenses can be fixed, meaning they are the same from month to month, or variable, meaning they increase
or decrease depending on the business's activity level. They can also be semi-variable, meaning that some portion of
the expense will be incurred no matter what, and some portion depends on the level of business activity. Overhead
can also be general, meaning that it applies to the company's operations as a whole, or applied, meaning that it can be
allocated to a specific project or department. These expenses are typically found on a company's income statement.

Objective of Overhead

o To compute budgeted factory overhead rates and apply factory overhead to production.
o To determine and use appropriate cost drivers for overhead application.
o To identify the meaning and purpose of normalized overhead rates.
o To construct an income statement using the variable-costing approach.
o To construct an income statement using the absorption-costing approach.

Measuring and importance

1. Calculate the full cost of outputs or activities
Overheads are used to calculate the full cost of outputs or activities. This information is needed to manage the
cost and mix of products, services, location and customers. In commercial terms, information on overheads
can help with distinguishing between profitable and unprofitable activities; setting prices; and judging
whether, e.g., to contract out a service or keep it in-house. In the broadcasting sector specifically, full cost
information is needed to inform comparisons between in-house and independent productions.
2. Manages and controls costs
Identifying overheads help organizations by developing responsibility and holding people responsible for the
costs incurred within their sphere of influence. This may involve pre-specifying costs or setting standard
costs, and subsequently analyzing variances from these.
3. Reports to internal and external stakeholders
It gives reports to internal and external stakeholders on how resources have been used at an aggregate level,
and provides assurance about the level of resources which have been spent on an organization’s core products
or services.
Production overheads
Production overhead is also known as factory overhead or manufacturing overhead, or works overhead. It is the
aggregate or total of indirect material cost, indirect wages and indirect expenses incurred in respect of manufacturing
activity. The manufacturing activity in an organization is said to begin with the supply of materials and end with the
primary packing of products. Examples of production overhead are,
1. Indirect material cost
▪ Cost of consumable stores and supplies like cotton waste, lubricating oil, etc.
▪ Cost of printing, postage and stationary used in production department.
2. Indirect labor costs
i. Salary of supervisors, works manager and departmental superintendents.
ii. Contribution to ESI, P.F., leave pay etc.
3. Indirect expenses
i. Rent, rates and taxes of factory building.
 ii. Repairs, insurance and depreciation of factory building, plant and machines and furniture.
iii. Factory telephone expenses.
iv. Lighting, heating and cleaning of factory.

Primary Distribution and Secondary distribution

Primary Distribution
It is defined as the allotment of proportions of items of cost to cost centers or cost units. The apportionment should be
done on some rational and equitable bases.
Format of statement showing the allocation of overheads
Production Service
Department Department
Items of overheads allocated P1 P2 S1 S2
Direct material
Direct wages
Direct expenses
Indirect material
Indirect wages
Total overhead allocated

Basis of Apportionment
Overhead apportionment depends upon matching with principles. Accordingly the basis for apportionment should be
related to the basis on which the expenditure is incurred. The following are the usual basis adopted for apportionment
of overhead,

Overhead cost Bases of apportionment

(1)Lighting No. of light points, floor space or meter reading
(2) Rent, Rates and Taxes Floor Area
(3)Insurance of building Area of floor
Depreciation of building,
Heating
(4) Depreciation of plant Book value
and Machinery and
Equipments
(5) E S I, Canteen, Safety, No. of employees
compensation, supervision
welfare, fringe benefits
(6) Delivery Van, Weight, volume ton
Internal Transport
(7)Audit fees Sales or Total Cost
(8) Storekeeper's expenses Weight, value of materials or Number of
requisitions
(9) Power H. P. Hours or K. W. Hours

Secondary Distribution
Re-distribution of overhead from various service departments to production departments is known as Re-
apportionment or Secondary distribution. Accordingly, allocation and apportionment of overheads from service
departments or centres to production centres or departments.

The following are the important bases adopted for apportionment of secondary distribution
 Service Department Basis of Apportionment
(1) Purchase Department Number of Purchase Orders or Number of
(2) Maintenance and Repairs Department Purchase Requision or Value of Materials
(3) Stores Department Hours worked
(4) Personnel Department (Canteen, Welfare, No. of Requisition or Value of Materials
Medical, Employer's liability)
(5) Time Keeping Department No. of Employees or Direct wages
(6) Pay roll Department No. of Employee or Labour Hours or Direct
Wages
(7) Accounts Department No. of Employees or Direct Wages
(8) Tool Room No. of Employees
(9) Transport Department Car hours, Truck hours, Tonnage handled
(10) Power House K.W. Hours
(11) Fire Insurance Stock Value

Methods or Re-apportionment or Re-distribution

The following are the important methods of re-distribution of service department overheads to production department
(1) Direct Re-distribution Method
(2) Step Distribution Method
(3) Reciprocal Service Method - this method further grouped into:
(a) Repeated Distribution Method
(b) Simultaneous Equiation Method
(c) Trial and Error Method

(1) Direct Re-distribution Method: Under this method, the cost of service department is directed to re-distribution
to the production departments without considering the services rendered by one service department to another service
department.
(2) Step Method: Under this method the cost of most serviceable department is first distributed to production
departments and other service departments. Thereafter, the next service department is distributed and later the last
service department until the cost of all the service departments are redistributed to the production department.
(3) Reciprocal Service Method : This method recognizes the fact that if a service department receives services from
other department, the services should be charged in the receiving department. Thus, the cost of inter departmental
services is taken into account on reciprocal basis. The following are the three important methods available for dealing
with reciprocal distribution :
(a) Simultaneous Equation Method.
(b) Repeated Distribution Method.
(c) Trail and Error Method.
(a) Simultaneous Equation Method: Under this method, the true cost of total overhead of each service department is
ascertained with the help of Simultaneous or Algebraic Equation. The obtained result reapportioned to production
department on the basis of given percentage.
(b) Repeated Distribution Method: Under this method, the total overhead costs of the service departments are
distributed to service and production departments according to given percentage of the service departments are
exhausted, in turn repeatedly until the figures become too small to matter.
(c) Trail and Error Method: In this method, the cost of a service centre is apportioned to another service centre.
Then, the cost of another service centre along with the apportioned cost from the first centre is again apportioned
back to the first service centre. This process is repeated till the amount to be apportioned becomes zero or negligible.
Allocation and apportionment of cost
The first step of overhead analysis is distribution of overhead to production department and service department.
Before analysing overhead, we should know the concept of Allocation, Absorption and Apportionment.
Allocation: Cost allocation refers to the allotment of whole item of cost to cost centres. The technique of charging
the entire overhead expenses to a cost centre is known as cost allocation.
Absorption: Cost absorption refers to the process of absorbing all overhead costs allocated to apportioned over
particular cost centre or production department by the unit produced.
Apportionment: Apportionment is the process of distribution factory overheads to cost centres or cost units on an
equitable basis. The term apportionment refers to the allotment of expenses which cannot be identified wholly with a
particular department. Such expenses require division and apportionment over two or more cost centres in proportion
to estimated benefits received.
Allocation Vs Apportionment
(1) Allocation deals with whole amount of factory overheads while apportionment deals with proportion of item of
cost or proportion to cost centres.
(2) The item of factory overhead directly allocated and identified with specific cost centers. Whereas apportionment
requires suitable and equitable basis. For example, factory rent may be allocated to the factory and has to be
apportioned among the producing and service departments on an equitable basis.

Absorption by production units

It means charging of overheads to individual products or jobs. It is defined as “ The process of absorbing all overhead
costs allocated or apportioned over a particular cost center or production department by the units produced”. A fair
proportion of the total factory overhead should be assigned to each unit of production. This requires the identification
of the main factor which causes the overhead to be incurred and then measuring the production in terms of that factor.
Overhead absorption rate are applied for the absorption of overhead to individual jobs, processes or products.
Overhead absorption is also known as Levy, Recovery or Application of overheads.

Overhead absorption rate = Total overhead of the cost center ÷ Total quantity or value

Common base for absorption of production overhead

Bases of denominator Applicability

Units of production When single product is produced or various
products are similar in specification
Direct labor cost When conversion process is labor intensive and
wage rates are substantially uniform.
Direct labor hour When conversion process is labor intensive.
Machine hour or vessel occupancy or reaction When production mainly depends on performance
hour or crushing hour, etc of the base.

A suitable example is production unit, direct wages, machine hour, direct labor hour, etc., is to be selected after
careful consideration of all relevant factors.
Methods
(1) Direct Material Cost Method: Under this method, the rate of absorption is calculated on the basis of direct
material cost method. The rate of manufacturing overhead absorption is determined by dividing the manufacturing
overhead by the direct material cost. The result obtained the rate of absorption is expressed as percentage. Thus, the
overhead rate is calculated by the following formula:
Factory Overheads x 100
Direct Material Percentage Rate = Direct Material Cost
(2) Direct Labour Cost Method: Direct Labour Cost Method is also termed as Direct Wages Method.
Under this method direct wage rate can be determined by dividing the estimated factory overhead cost apportioned by
the predetermined direct wages, and the result obtained is expressed as a percentage. The following formula for
calculating the percentage rate is :

Percentage of Direct Labour Rate =Factory Overhead x 100

Direct Wages
(3) Direct Labour Hours Method: Under this method the rate is determined by dividing the production overheads
by direct labour hours of each department. This method is designed to overcome the objections of direct labour cost
method. This method is most suitable in such industries where the production is carried out manually or by skilled
labours. Thus, the direct labour hour rate will be calculated by applying the following formula:

Direct Labour Hour Rate =Factory Overhead

Direct Labour Hours
(4) Prime Cost Method: Under this method, both direct material cost and direct labour cost are taken into account
for determination of recovery rate. The actual or predetermined rate of factory absorption is computed by dividing
actual or budgeted overhead expenses by the aggregate of direct material or direct labour cost of the department. The
following formula is used for calculation of overhead recovery rate:
Overhead Recovery Rate = Factory Overhead x 100
Prime Cost
(5) Unit of Output Method: This method is also termed as Production Unit Method or Cost Unit Rate Method.
Under this method absorption rate is determined on the basis of number of units produced is known as Cost Unit
Rate. The recovery rate is calculated by dividing the actual or budgeted factory overheads by the number of cost units
produced. The formula is :
Cost Unit Rate = Factory Overhead
No. of Units Produced
This method is most suitable in such industries where the production of same grade is carried out.
(6) Machine Hour Rate: Machine hour rate means the cost or expenses incurred in running a machine for one hour.
It is one of the scientific methods of absorbing factory expenses where the process of manufacturing are carried out
by machines. Under this method overhead costs are allocated on the basis of the number of hours a machine or
machines are used for a particular job. According to the Institute of Cost and Management Accountants, England a
machine hour rate is "an actual or predetermined rate of cost apportionment or overhead absorption, which is
calculated by dividing the cost to be apportioned or absorbed by the number of machine hours expended or to be
expended."
The machine hour rate is determined by dividing the amount of overhead cost to be apportioned or absorbed by the
number of machine hours. Machine hour rate can be calculated as below :

Machine Hour Rate = Factory Overhead

Machine Hours
Calculation Machine Hour Rate: The following steps are required for computing the machine hour
(1) Identify the overhead expenses relating to a specific machine or group of machine in order to require for
computing machine hour rate.
(2) Each machine or group of machine treated as a cost centre.
(3) Manufacturing overhead or machine expenses are grouped into two types:
(a) Fixed or Standing Charges (b) Variable Machine Expenses.
(a) Fixed or Standing Charges: Fixed or Standing Charges which remain constant irrespective of the use of machine.
For example, rent, insurance charges, rates, supervision etc.
(b) Variable Machine Expenses: These expenses are variable with use of the machine. For example, power,
depreciation, repairs etc.
(4) An hourly rate of fixed or standing charges will be calculated by totalling of fixed charges and dividing by the
number of normal hours worked by machine.
(5) Normal working hours are calculated by adding the cost relating to non-productive time, i.e., normal ideal time
for maintenance and setting up etc.
(6) Separate hourly rate for each machine expenses will be calculated.
(7) The total of the standing charges rate and the machine expenses rates per hour will give the machine hour rate.

Activity Based Costing

Activity-Based Costing (ABC) is that costing in which costs begin with tracing of activities and then to producing the
product. In other words, it is the process of costing system which focuses on activities performed to produce products.
This system assumes that activities are responsible for the incurrence of costs and products creates the demand for
activities. Costs are charged to products based on individual product's use of each activity.
ABC aims at identifying as many costs as possible to be subsequently accounted as direct cost of production. Any
cost that is traced to a particular product via its consumption of activity becomes direct of the product. For instance,
in conventional costing system, cost of setup and adjustment time is considered as factory overhead and subsequently
assigned to different products on the basis of direct labour hours.
But in Activity-Based Costing, setup and adjustment time is determined for each product and its costs are directly
charged to each product. Thus. by emphasing activities, ABC tries to ascertain the factors that cause each major
activity, cost of such activities and the relationship between activities and products produced.
According to professor Vipul "Activity-Based Costing had it genesis in the increasing importance of indirect costs in
the manufacturing operations. The direct processing costs which are easier to handle are being relegated to the
background with each passing day due to automation. In this changing scenario where indirect costs far outweigh the
direct processing costs in many a situation, one cannot be content with rough and ready methods of yester years in
dealing with indirect costs."
Different Stages in Activity-Based Costing
There are different activities in ABC costing. The following are the important stages of Activity-
Based Costing :
(1) Identify the different activities within the organisation.
(2) Relate the overhead cost to the activities.
(3) Support activities are then spread across the primary activities.

(4) Determine the activity cost drivers.

(5) Calculate the activity cost drivers rate, i.e., the quantity of cost driver used by each product.

Advantages of Activity-Based Costing

ABC system is a very valuable tool of control. It offers a number of advantages to the management and the following
are the main advantages :
(I) It brings accuracy and reliability of the costing data in determination of the cost of the products_
(2) It facilitates cause and effect relationship to exercise effective cost control.
(3) It provides necessary cost information to the management to take decisions on any matter, relating to the
business_
(4) It is much helpful in fixing the cost and selling price of a product.
(5) It facilitates overhead costs allocate directly to the specific product.
(6) It enables to manage the activities rather than costs.
(7) It helps to remove all types of wastages and inefficiencies.
(8) It provides valuable information to evaluate on the relative efficiencies of various plants and machinery.
(9) Cost Driver Rates will help in significant impact on the development of new products or modification of existing
products.
Essentials Factors of a Good Activity-Based Costing System
The success of the Activity-Based Costing system depends on the following factors:
(1) Objectives of costing system and level of competition.
(2) Number of products manufactured.
(3) Product diversity and the business_
(4) Adaptation of cost management measures, standardization and technical aspects.
(5) Degree of sophistication and suitability to the firm.
(6) Determination of single or combined Cost Driver.
(7) Determination number of Activity Centre, Cost Pools and Cost Drivers.
(8) Determin.ation of total overhead costs and economy.
(9) Evaluation of trade off between measurement of costs and cost of errors.
(10) Elasticity and adoptive to the changing circumstances.

Difference Between Activity-Based Costing and Conventional Costing

Activity-Based Costing Conventional Costing (or)

Traditional Costing
(I) It begins with identifying activities and then to (1) It begins with identifying cost and then to producing
producing the products the products
(2) It mainly focuses on activities performed to produce (2) It emphasises mainly on ascertainment of costs after
products they have been incurred
(3) Cost Drivers used for identifying the factors that (3) Cost unit is used for allocation and accumulation of
influence the cost of costs
particular activity (4) Overhead costs are assigned to production
(4) Overhead costs are assigned to Cost Centre or Cost departments or service departments
Pools (5) Overheads allocated on the basis of departmental
(5) Overhead costs are assigned to products using Cost overhead allocation rate
Drivers Rates (6) Costs may be allocated or assigned either on actual
(6) Variable overhead is appropriately identified to cost incurred or on standard cost basis
individual products (7) Overheads are pooled and collected department wise
(7) In ABC many activity based on Cost Pools or Cost (8) The process of allocation and re-distribution of the
Centres are created costs of the service departments to production department
(8) There is no need to allocate and redistribution of is essential to find out total cost of production
overhead of service departments to production (9) It assumes that fixed overheads do not vary with
departments changes in the volume of output.
(9) It assumes that fixed overhead costs vary in
proportion to changes in the volume of output.