6205-MgmtAcc [MBA-MBAFT-S2-CC4-5] Cover Jan25.

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MANAGEMENT ACCOUNTING

Editorial Board
Dr. Rishi Taparia
Dr. Kumar Bijoy
Content Writers
Dr. Rishi Taparia, Dr. Priyanka Ahluwalia,
CA Vishal Goel, CA Kritee Manchanda,
Dr. Vijay Lakshmi, Dr. Sanjana Monga,
CA. Mannu Goyal, Ms. Shalu Garg,
Mr. Jigmet Wangdus
Academic Coordinator
Deekshant Awasthi

© Department of Distance and Continuing Education

ISBN: 978-81-19169-12-2
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 MANAGEMENT ACCOUNTING

Disclaimer

Reviewers
Dr. Pankaj Sharma
Ms. Garima Sirohi
Disclaimer

This Study Material is duly recommended in the meeting of Standing

Committee held on 08/05/2023 and approved in Academic Council meeting
held on 26/05/2023 Vide item no. 1014 and subsequently Executive Council
Meeting held on 09/06/2023 vide item no. 14 {14-1(14-1-11)}

Corrections/Modifications/Suggestions proposed by Statutory Body, DU/

Stakeholder/s in the Self Learning Material (SLM) will be incorporated in
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 Contents

PAGE
Lesson 1: Cost Concepts in Accounting 1–26

Lesson 2: Material, Labour and Overhead Cost and Control 27–56

Lesson 3: Job, Batch and Contract Costing 57–80

Lesson 4: Process Costing 81–104

Lesson 5: Cost Concepts in Decision Making 105–144

Lesson 6: Standard Costing and Variance Analysis 145–178

Lesson 7: Budgets and Budgetary Control 179–201

Lesson 8: Cost Management 202–231

Lesson 9: Performance Measurement - Balanced Scorecard 232–259

Lesson 10: Inventory Management 260–294

Lesson 11: Performance Measurement and Evaluation 295–318

Glossary 319–322

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 L E S S O N

1
Cost Concepts in
Accounting
Dr. Rishi Taparia
Director
Management Studies
IAMR Ghaziabad
Email-Id: [email protected]

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Nature of Management Accounting
1.4 Scope of Management Accounting
1.5 Classification of Costs
1.6 Management, Cost and Financial Accounting
1.7 Reconciliation of Cost and Financial Accounts
1.8 Summary
1.9 Answers to In-Text Questions
1.10 Self-Assessment Questions
1.11 References
1.12 Suggested Readings

1.1 Learning Objectives

After having studied the first module, the student will be acquainted with the fundamentals
and will be able to:
‹ Explain basic concept of Management Accounting.
‹ Understand various objectives of Management Accounting.
‹ Appreciate how management accounting information can assist management in
planning, monitoring performance, controlling and making decisions in, their area
of responsibility.
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 MANAGEMENT ACCOUNTING

Notes ‹ Understand different managerial decisions in relation to Management

Accounting.
‹ Identify the information needs and produce financial analyses for
a range of decisions.

1.2 Introduction
In basic terms, “Management Accounting is intended for use by manag-
ers”. It begins where Financial Accounting ends. Management Accounting
supports the managerial tasks at all levels by equipping managers with the
necessary data for efficient policy formulation, control, and decision-mak-
ing. It is also considered the branch of accounting that supports managers
with performance evaluation, cost management, and cost determination for
financial reporting. In brief, Management Accounting is concerned with data
collection from internal and external sources, analysing, processing, inter-
preting, and communicating the information for use within the organisation
so that management can plan, make decisions, and control the organisation
more efficiently. To better understand the concept, a definition may be the
most useful tool. Management accounting is defined by CIMA [UK] as:
Management Accounting is an integral part of management concerned
with identifying, presenting, and interpreting information utilized for
formulating strategy, planning and controlling activities, decision making,
optimizing the use of resources,
1. disclosure to shareholders and other external entities,
2. disclosure to employees,
3. safeguarding ‘assets.
Some definitions of Management Accounting
“Management Accounting is concerned with accounting information
that is useful to management.”
—Robert N. Anthony
“Management accounting for profit control includes income account-
ing, cost accounting and budgetary, planning and control; of these,
cost accounting is the keystone.”
—W. Keller and Ferrara

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 Cost Concepts in Accounting

“Management accounting is “any form of accounting which enables Notes

a business to be conducted more efficiently.”
—The Institute of Chartered Accountants of England and Wales
“Management accounting is a more intimate merger of the two older
professions of management and accounting, wherein the information-
al needs of the manager determine the accounting means for their
satisfaction.”
—V. Smith
“Management accountancy is the term used to describe the account-
ing methods, systems, and techniques which, coupled with special
knowledge and ability, assist management in its task of maximizing
profits or minimizing losses.”
—Batty
“Accounting, which serves management by providing information as
to the cost or profit associated with some portion of the firm’s total
operations, is called managerial accounting.”
—Shillinglaw
“Management Accounting is the process of identification, measurement,
accumulation, analysis, preparation, interpretation, and communication
of financial information used by the management to plan, evaluate,
and control.”
—Management Accounting Practices Committee (MAPC)
of the United States

Thus, management accounting is accounting for decision-making. It gives

data to aid management in formulating policies and administering the
organization daily.
Management accounting relates to accounting primarily for management
(i.e., accounting that provides the necessary information to management,
enabling key personnel to discharge their functions).
Planning, organizing, directing, and controlling are these functions.
Accounting for management offers the information required for manage-
ment to exercise effective and efficient control over the firm.

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 MANAGEMENT ACCOUNTING

Notes To ensure that the decision-making process is straightforward, simple,

and efficient, management accounting was developed to integrate these
pieces of data.

1.3 Nature of Management Accounting

Any concept’s nature or features are derived from its meaning and defi-
nitions. Consequently, the nature of management accounting may be
deduced from its definition and aims.
1. Oriented toward the Future: Although financial accounting provides
historical information, that information is used to make plans and
important decisions.
2. Raising Productivity: Concepts such as responsibility accounting, cost
centres, etc., are helpful in increasing productivity and regulating
employee performance.
3. Management accounting investigates the relationship between cause
and effect when assessing the rationale for a loss or profit.
4. Flexible: Management accounting does not adhere to specific standards
or formats, such that the procedure to be followed and the way the
result is assessed is left to the discretion of the data user.
5. It Gives Only Information, Not Decisions: Management accounting
provides only information, which must be studied and correctly
interpreted by management to reach a conclusion.
6. Tools and Techniques: A variety of statistical and mathematical
tools and techniques are used to present the data.
7. Utilizes Accounting Information: It uses financial information in a
manner that meets the needs of planning, controlling, and decision-
making.

1.4 Scope of Management Accounting

It has a broad scope as it transcends the bounds of cost and financial
accounting and encompasses a variety of sectors, including:
1. A solid and well-designed financial accounting system is required
for a successful and effective management accounting system.

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 Cost Concepts in Accounting

2. Several cost accounting methods, such as marginal costing, standard Notes

costing, budgeting, etc., are utilised by management accounting
systems for decision-making.
3. A management accounting system is incomplete without appropriate
cost management procedures.
4. Management accounting utilises statistical tools, including tables,
graphs, and charts, to provide findings and reports.
5. Management accounting provides a reliable method for reporting to
top management.
6. Tax management is only possible when a solid management accounting
system is in place.
7. Budgeting and budgetary control play a crucial role in the decision-
making process.
8. The management accountant is required to utilise the internal audit
report to evaluate performance at all levels.
9. Management accountants are expected to maintain and direct office
services such as filing, copying, communication, and other auxiliary
services.

1.5 Classification of Costs

The different bases of cost classification are:
1. By time (Historical, Pre-determined).
2. By nature or elements (Material, Labour and Overhead).
3. By degree of traceability to the product (Direct, Indirect).
4. Association with the product (Product, Period).
5. By Changes in activity or volume (Fixed, Variable, Semi-variable).
6. By function (Manufacturing, Administrative, Selling, Research and
development, Pre-production).
7. Relationship with accounting period (Capital, Revenue).
8. Controllability (Controllable, Non-controllable).
9. Cost for analytical and decision-making purposes (Opportunity, Sunk,
Differential, Joint, Common, Imputed, Out-of-pocket, Marginal,
Uniform, Replacement).
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 MANAGEMENT ACCOUNTING

Notes 10. Others (Conversion, Traceable, Normal, Avoidable, Unavoidable,

Total).
1.5.1 Classification Based on Time
(i) Historical Costs: These expenses are determined after the fact. Such
expenses are only available once the production of a given item has
been completed. They are objective and verifiable through reference
to actual operations.
(ii) Pre-determined Costs: These costs are calculated in advance based
on a specification of all cost-influencing factors. Such fees may
include:
(a) Estimated Costs: Costs are estimated prior to the production
of items; naturally, these are less precise than standards.
(b) Standard Costs: This is a specific notion and method. This
strategy entails:
‹ Establishing established criteria for each element of cost
and each product;
‹ Comparing actual to standard to identify deviations;
‹ Pinpointing the causes of such deviations and taking
corrective action; and
‹ Implementing corrective measures. Obviously, standard costs,
though pre-determined, are arrived with much greater care
than estimated costs.

1.5.2 Classification by Nature or Elements

There are three broad elements of costs:
(1) Material: The substance from which the product is made is known
as material. It can be direct as well as indirect.
Direct Material: It refers to those materials which become a major part
of the finished product and can be easily traceable to the units. Direct
materials include:
(i) All materials specifically purchased for a particular job/process
(ii) All material acquired, and latter requisitioned from stores
(iii) Components purchased or produced

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 Cost Concepts in Accounting

(iv) Primary packing materials like cartoons and boxes Notes

(v) Material passing from one process to another
Indirect Material: All material that is used for purposes ancillary to
production and which can be conveniently assigned to specific physical
units is termed as indirect materials. Examples: oil, grease, consumable
stores, printing, and stationary material etc.
(2) Labour: Labour cost can be classified into direct labour and indirect
labour.
Direct Labour: It is defined as the wages paid to workers who are
engaged in the production process whose time can be conveniently and
economically traceable to units of products. For example, wages paid to
compositors in a printing press, to workers in the foundry in cast iron
works etc.
Indirect Labour: Labour employed for the purpose of carrying tasks
incidental to goods or services provided, is indirect labour. It cannot
be practically traced to specific units of output. Examples, wages of
store-keepers, foreman, time-keepers, supervisors, inspectors etc.
(3) Expenses: Expenses may be direct or indirect.
Direct Expenses: These expenses are incurred on a specific cost unit
and identifiable with the cost unit. Examples are cost of special layout,
design or drawings, hiring of a particular tool or equipment for a job;
fees paid to consultants in connection with a job etc.
Indirect Expenses: These are expenses which cannot be directly, conve-
niently and wholly allocated to cost centre or cost units. Examples are rent,
rates and taxes, insurance, power, lighting and heating, depreciation etc.
It is to be noted that the term overheads has a wider meaning than the
term indirect expenses. Overheads include the cost of indirect material,
indirect labour and indirect expenses. Overheads may be classified as:
(a) Production or manufacturing overheads,
(b) Administration overheads,
(c) Selling overheads, and
(d) Distribution overheads.
The various elements of cost can be illustrated by the following chart:

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 MANAGEMENT ACCOUNTING

Notes

Total expenditure may therefore be analysed as follows:

Materials cost = Direct materials cost + Indirect materials cost
+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost/prime cost + Overhead cost

IN-TEXT QUESTION
1. Which of the following costs would be charged to the product
as a prime cost?
(a) Component parts
(b) Part-finished work
(c) Primary packing materials
(d) Supervisor wages

1.5.3 Classification by Degree of Traceability to the Products

Cost can be distinguished as direct and indirect.
Direct Costs: The direct costs are those which can be easily traceable
to a product or costing unit or cost centre or some specific activity, e.g.
cost of wood for making furniture. It is also called traceable cost.

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 Cost Concepts in Accounting

Indirect Costs: The indirect costs are difficult to trace to a single product Notes
or it is uneconomic to do so. They are common to several products, e.g.
salary of a factory manager. It is also called common costs.
Costs may be direct or indirect with respect to a particular division or
department. For example, all the costs incurred in the Power House are
indirect as far as the main product is concerned but as regards the Power
House itself, the fuel cost or supervisory salaries are direct. It is necessary
to know the purpose for which cost is being ascertained and whether it
is being associated with a product, department or some activity.
Direct cost can be allocated directly to costing unit or cost centre. Whereas
Indirect costs have to be apportioned to different products, if appropri-
ate measurement techniques are not available. These may involve some
formula or base which may not be totally correct or exact.
1.5.4 Classification by Association with the Product
Cost can be classified as product costs and period costs.
Product Costs: Product costs are those which are traceable to the product
and included in inventory values.
In a manufacturing concern it comprises the cost of direct materials, di-
rect labour and manufacturing overheads. Product cost is a full factory
cost. Product costs are used for valuing inventories which are shown in
the balance sheet as asset till they are sold. The product cost of goods
sold is transferred to the cost of goods sold account.
Period Costs: Period costs are incurred on the basis of time such as
rent, salaries, etc., include many selling and administrative costs essen-
tial to keep the business running. Though they are necessary to generate
revenue, they are not associated with production, therefore, they cannot
be assigned to a product.
They are charged to the period in which they are incurred and are treated
as expenses.
Selling and administrative costs are treated as period costs for the fol-
lowing reasons:
(i) Most of these expenses are fixed in nature.
(ii) It is difficult to apportion these costs to products equitably.

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 MANAGEMENT ACCOUNTING

Notes (iii) It is difficult to determine the relationship between such cost and
the product.
(iv) The benefits accruing from these expenses cannot be easily established.
The net income of a concern is influenced by both product and period
costs. Product costs are included in the cost of the product and do not
affect income till the product is sold. Period costs are charged to the
period in which they are incurred.
Consider a retailer who acquires goods for resale without changing their
basic form. The only product cost is therefore the purchase cost of the
goods. Any unsold goods are held as inventory, valued at the lower of
purchase cost and net realisable value and included as an asset in the
statement of financial position. As the goods are sold, their cost becomes
an expense in the form of ‘cost of goods sold’. A retailer will also incur
a variety of selling and administration expenses. Such costs are period
costs because they are deducted from revenue without ever being regarded
as part of the value of inventory.
Now consider a manufacturing firm in which direct materials are trans-
formed into saleable goods with the help of direct labour and factory
overheads. All these costs are product costs because they are allocated
to the value of inventory until the goods are sold. As with the retailer,
selling and administration expenses are regarded as period costs.

1.5.5 Classification by Changes in Activity or Volume

Costs can be classified as fixed, variable and semi-variable cost.
Fixed Costs: The Chartered Institute of Management Accountants, Lon-
don, defines fixed cost as “the cost which is incurred for a period, and
which, within certain output and turnover limits, tends to be unaffected
by fluctuations in the levels of activity (output or turnover)”.
These costs are incurred so that physical and human facilities necessary
for business operations, can be provided. These costs arise due to con-
tractual obligations and management decisions. They arise with the pas-
sage of time and not with production and are expressed in terms of time.
Examples are rent, property taxes, insurance, supervisors’ salaries etc.
It is wrong to say that fixed costs never change. These costs may vary
depending on the circumstances. The term fixed refers to non-variability

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 Cost Concepts in Accounting

related to the relevant range. Fixed cost can be classified into the following Notes
categories for the purpose of analysis:
(a) Committed Costs: These costs are incurred to maintain certain
facilities and cannot be quickly eliminated. The management has
little or no discretion in this cost, e.g., rent, insurance etc.
(b) Policy and Managed Costs: Policy costs are incurred for implementing
particular management policies such as executive development, housing,
etc. Such costs are often discretionary. Managed costs are incurred to
ensure the operating existence of the company e.g., staff services.
(c) Discretionary Costs: These are not related to the operations and can
be controlled by the management. These costs result from special
policy decisions, new research etc., and can be eliminated or reduced
to a desirable level at the discretion of the management.
(d) Step Costs: Such costs are constant for a given level of output and
then increase by a fixed amount at a higher level of output.
Variable Cost: Variable costs are those costs that vary directly and
proportionately with the output e.g. direct materials, and direct labour.
It should be kept in mind that the variable cost per unit is constant but
the total cost changes corresponding to the levels of output. It is always
expressed in terms of units, not in terms of time.
Management decisions can influence cost behaviour patterns. The con-
cept of variability is relative. If the conditions upon which variability
was determined change, the variability will have to be determined again.

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Notes Semi-fixed (Semi-Variable) Costs: Such costs contain fixed and variable
elements. Because of the variable element, they fluctuate with volume and
because of the fixed element; they do not change in direct proportion to
output. Semi-variable costs change in the same direction as that of the
output but not in the same proportion. Depreciation is an example; for
two shifts working the total depreciation may be only 50% more than
that for single shift working. They may change with comparatively small
changes in output but not in the same proportion.

1.5.6 Functional Classification of Costs

A company performs a number of functions. Functional costs may be
classified as follows:
(a) Manufacturing/Production Costs: It is the cost of operating the
manufacturing division of an undertaking. It includes the cost of
direct materials, direct labour, direct expenses, packing (primary)
cost and all overhead expenses relating to production.
(b) Administration Costs: They are indirect and cover all expenditure
incurred in formulating the policy, directing the organisation and
controlling the operation of a concern, which is not related to
research, development, production, distribution or selling functions.
(c) Selling and Distribution Cost: Selling cost is the cost of seeking to
create and stimulate demand e.g. advertisements, market research etc.
Distribution cost is the expenditure incurred which begins with making
the package produced available for dispatch and ends with making
the reconditioned packages available for re-use e.g. warehousing,
cartage etc. It includes expenditure incurred in transporting articles
to central or local storage. Expenditure incurred in moving articles
to and from prospective customers as in the case of goods on sale
or return basis is also distribution cost.
(d) Research and Development Costs: They include the cost of discovering
new ideas, processes, products by experiment and implementing
such results on a commercial basis.
(e) Pre-production Cost: When a new factory is started or when a new
product is introduced, certain expenses are incurred. There are trial
runs. Such costs are termed as pre-production costs and treated as

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 Cost Concepts in Accounting

deferred revenue expenditure. They are charged to the cost of future Notes
production.

1.6 Management, Cost and Financial Accounting

Management Financial
Basis Accounting Accounting Cost Accounting
Meaning Concerned with ac- Concerned with re- Concerned with the
counting information cording, classifying ascertainment, alloca-
useful to the man- and summarizing the tion and distribution
agement for decision business transactions of costs
making
Objective Information is pro- To determine the It’s objective is to
vided to formulate company’s profit- ascertain cost, control
plans and to achieve ability and financial cost, evaluate per-
desired objective of position during a fi- formance and take
management nancial year remedial measures
Nature Futuristic in nature Historical in Nature Deals with historic
data but also futur-
istic in nature
Users of informa- Management Internal as well as Majorly management
tion external users like
owners, management,
banks and FIs etc.
Dependence MA depends on both Independent Independent but con-
financial accounting sider figures from
and cost accounting financial accounting
Units of measure- Can be expressed Expressed only in Expressed in both
ment both in monetary and monetary units monetary and phys-
physical units ical units.
Accounting system Not restricted to any Based on double Follows few princi-
specific accounting entry system and ples and develop a
system follows uniform ac- costing system best
counting rules and suited to its individ-
regulations ual needs
Emphasis Emphasis is on plan- Emphasis is on profit/ Emphasis is on cost
ning and controlling loss determination ascertainment, cost
control and cost re-
duction

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Notes
1.7 Reconciliation of Cost and Financial Accounts
The financial accounts are maintained to ascertain profit & loss of the
company as a whole entity as well as financial position for a particular
financial year. The financial account’s primary objective is to record,
classify and summarisation of business transactions and finished with the
preparation of financial statements i.e. Trading & Profit & Loss Account
and Balance Sheet.
Whereas, Cost accounting deals with the ascertainment of cost of product,
absorption of overheads into product cost, ascertainment of division-wise
or product-wise profitability. The accounting principles, methods, and
practices applicable under these two systems of accounting are different.
The maintenance of different sets of accounts with different objectives
will show different figures of profit or loss and thus it becomes nec-
essary to reconcile the two accounts periodically and a statement of
reconciliation is prepared to show the reasons for difference in profit
or loss shown by cost and financial accounting. The cost and financial
accounts are maintained in different forms or follow different methods,
principles and approaches and it will naturally result in different profit
or loss ascertained in cost and financial accounts which necessitates the
reconciliation of both accounting to identify the reasons for deviation.

Reasons for Necessity of Reconciliation

The important reasons necessitating the reconciliation of cost and finan-
cial accounts as follows:
1. To ascertain the reasons for the difference in profits or loss as
shown by cost accounts and financial accounts.
2. To ensure the accuracy of cost accounting methods and practices
followed by the companies like absorption and recovery of overheads,
depreciation allowance, inventory valuation and is verified with the
financial accounts.
3. To ensure the reliability of cost accounting data and financial
accounting data.
4. To promote coordination and co-operation between the financial
accounting and cost accounting departments in generating accurate

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 Cost Concepts in Accounting

and reliable accounting data for meeting statutory requirements and Notes
generation of data for managerial decision-making.
5. To explain the difference in profit or loss shown in cost accounting
and financial accounting and any mistakes in preparation of accounts
are brought out and ensures in arithmetical accuracy of both sets
of accounts.
6. To help in standardisation of policies like inventory valuation,
overhead absorption, depreciation provision etc. for better internal
control.

Reasons for Disagreement

The difference in profit or loss ascertained in cost accounting and finan-
cial accounting is due to the following reasons:
Certain Items Only Shown in Financial Accounting that are Not
Shown in Cost Accounting:
‹ Profit or loss on sale of fixed assets
‹ Discount on issue or redemption of shares and debentures
‹ Capital issue expenses
‹ Preliminary expenses written off
‹ Cash discounts and bad debts
‹ Distribution of dividend
‹ Payment of income tax
‹ Donations
‹ Transfer of profits to reserves
‹ Goodwill written off
‹ Lay off wages and retrenchment compensation
Certain Items Only Shown in Cost Accounting that are Not Shown
in Financial Accounting
‹ Notional rent on premises owned
‹ Notional interest on capital
Disagreement Due to Under- or Over-absorption of Overheads Items:
In financial accounting the actual overheads incurred are recorded and
accounted for. But, in cost accounting for ascertainment of cost of
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 MANAGEMENT ACCOUNTING

Notes production and profitability of cost unit, predetermined overhead absorp-

tion rates like machine hour rate, direct labour hour rate, percentage of
direct material, direct labour, prime cost, factory overhead, factory cost
etc. are used for absorption of overheads.
The absorption of overheads in cost accounting may be over or under
recovered than the actual overheads incurred.

Difference Due to Use of Different Methods of Stock Valuation:

‹ In financial accounting, the stocks of raw materials are valued at cost
or market value, whichever is lower. Whereas, in cost accounting,
stock may be valued under FIFO, LIFO, weighted average price
method etc.
‹ The finished goods are valued under absorption costing method
in financial accounts. But, in preparation of cost accounting, the
finished stock may be valued under absorption costing, marginal
costing, standard costing etc.

Difference Due to Use of Different Rates of Depreciation

In financial accounting, the amount of depreciation is charged as per rates
given in the Companies Act, 2013. But, in cost accounting, appropriate
and suitable method is used for calculation of the amount of depreciation.
Methods of Reconciliation:
The cost accounting and financial accounting are reconciled by preparing
any of the following:
(1) Memorandum Reconciliation Account
(2) Reconciliation statement

1. Memorandum Reconciliation Account

It is an account not being a part of double entry system of book-keep-
ing. It is a method by which a record can be made of differences in
cost accounting and financial accounting. Memorandum Reconciliation
Account, basically, is the presentation of reconciliation statement in ‘T’
shape account form.

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Steps in Preparation of Memorandum Reconciliation Account Notes

Four basic steps of preparing the Memorandum Reconciliation Account
are encapsulated in the following lines:
Step 1: Profits as per cost account is placed on the credit side of the
account and loss the debit side of the memorandum reconciliation account.
Step 2: All items which are to be added for reconciliation purpose will
be shown on the credit side of the account. For instance, if we are start-
ing from costing book’s profits, the following items will be shown on
the credit side:
(a) Purely financial incomes included in financial accounts
(b) Over-absorption of overheads in cost accounts
(c) Over-valuation of opening stock in cost accounts
(d) Under-valuation of closing stock in cost accounts.
Step 3: All those items which are to be subtracted from base profit
figure will be shown on the debit side of Memorandum Reconciliation
Account. A list of the items to be shown on debit side in case, we start
the procedure from profits as per cost accounts is given below:
(a) Purely financial charges (as listed in the preceding section) excluded
from cost accounts.
(b) Under absorption of overheads in cost accounts.
(c) Over-valuation of closing stock in cost accounts.
(d) Under-valuation of opening stock in cost accounts.
Step 4: Placing the balancing figure: If sum of credit side items > sum
of debit side, items, balancing figure is profit. If sum of debit side > sum
of credit side items, balancing figure is loss, as per financial accounts.
Dr. Memorandum Reconciliation A/c Cr.
Amount Amount
Particulars (Rs.) Particulars (Rs.)
To Loss as per cost accounts By profits as per cost accounts
To pure financial charges By pure financial income
� 
Discount on issue of shares � 
Rent Received
written off
� 
Preliminary expenses writ- � Interest Received
ten off

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Notes Amount Amount

Particulars (Rs.) Particulars (Rs.)
� Underwriter’s Commission � Profits on sale of fixed assets
� Fines and Penalties � Dividend
� Donation � Transfer fee received
� Bank interest By items charged in cost ac-
counts only.
� Interest on own capital
� Rent on own building
To depreciation under-charged By Excess of depreciation
in cost A/c charged in cost books.
To under-absorption of over- By over-absorption of overheads
heads
To under-valuation of opening By over-valuation of opening
stock in cost A/c stock in cost A/c.
To over-valuation of closing By under-valuation of closing
stock in cost A/c stock in cost A/c.
To profits as per financial A/c By Loss as per financial A/c.
(Balancing figure when sum (Balancing figure when sum
of credit items > sum of debit of Debit items > sum of credit
items) items)

Illustration 1: PQR Limited has closed its accounts for the year ended
March 31, 2021. The profit shown in financial accounting is Rs. 3,72,000
and for the same period, cost accounting showed a profit of Rs. 4,10,000.
On comparison of both accounts, the following stock balances appeared:
Financial
Stock Value Cost Accounting Accounting
Raw Material Opening Stock 1,36,000 1,45,000
Closing Stock 1,10,000 1,03,000
Finished Goods Opening Stock 2,66,000 2,58,000
Closing Stock 2,29,000 2,23,000
Additional information appearing the financial accounting:
Loss on sale of machine Rs. 35,000
Dividends received Rs. 7,000
Interest received Rs. 4,000

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 Cost Concepts in Accounting

You are required to prepare Memorandum Reconciliation Account Notes

Solution:
Memorandum Reconciliation A/c
Amount Amount
Particulars (Rs.) Particulars (Rs.)
To loss on sale of machine 35,000 By Profit as per Cost Ac- 4,10,000
counting
To undervaluation of 9,000 By Dividend Received (not 7,000
opening stock of raw ma- credited in cost accounting)
terials in cost accounting
To over-valuation of clos- 7,000 By Interest received (not 4,000
ing stock of raw materials credited in cost accounting)
in cost accounting
To over-valuation of fin- 6,000 By over-valuation of open- 8,000
ished goods closing stock ing stock of finished goods
in cost accounting in cost accounting
To Net Profit as per fi- 3,72,000
nancial accounting
4,29,000 4,29,000

2. Reconciliation Statement:
In preparation of reconciliation statement, profit shown by one set of
accounts is taken as base profit and items of difference are either added
to it or deducted from it to arrive at the figure of profit shown by other
set of accounts.
Procedure of Preparing Reconciliation Statement
1. Start with profit shown by any one set of accounts (profit as per
financial accounts or profit as per cost accounts). Take this profit
as a ‘base profit’.
2. All expenditures not taken into account in arriving at the base
profit should be deducted from it.
3. All expenditures taken into account for arriving at the base
profit but not considered for profit shown by other set should
be added back to base profit.

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Notes 4. The amount of expenditures undercharged in arriving at the base

profit should be reduced from it.
5. All income taken into account for arriving at ‘base profit’ but not
considered for profit shown by other set should be reduced from it.
6. Amount of understated income for arriving at the base profit should
be added back.
7. Amount of overstated income for arriving at the base profit should
be reduced from it.
8. Income not taken into account for arriving at the base profit but
considered for profit shown by other set should be added to base
profit.
9. Consider in isolation with the factors, the effect of differences in
valuation of opening stock on base profit. If base profit has been
overstated due to difference in valuation of opening stock, it should
be reduced. If base profit has been understated due to difference
in valuation of opening stock, the amount of difference should be
added to it.
Proforma Reconciliation Statement: Suppose we start taking the profits
as per cost accounts as base profits figure, the reconciliation statement
can be exhibited/presented as given below.

Proforma Reconciliation Statement

(When profits as per Cost Accounts is taken
as Starting point or base figure).
Particulars Amount (Rs.) Amount (Rs.)
(a) Profits as per cost accounts
(b) Add: items having the effect of higher
profits in financial accounts
(i) Over-absorption of factory, office and
selling and distribution overheads
(ii) 
I tems charged in cost accounts
only e.g.
‹ Notional Rent
‹ Notional Interest or Salaries

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 Cost Concepts in Accounting

Particulars Amount (Rs.) Amount (Rs.) Notes

(iii) Over-valuation of opening stocks
in cost A/cs
(iv) Under-valuation of closing stocks
in cost A/cs
(v) Purely financial incomes excluded
from cost A/cs
‹ Interest and dividends received

‹ Rent or transfer fees received

(c) L ess: Items having the effect of lower

profits in financial accounts
(i) Under absorption of factory, office
and selling and distribution overheads
(ii) Under-valuation of opening stock
in cost A/cs
(iii) Over-valuation of Closing stock in
cost A/cs
(iv) Purely financial charges excluded
from cost A/cs e.g. Legal charges,
donations, preliminary expenses
written off
(v) Depreciation under-charged in cost
accounts
(d) Profits as per financial accounts.
Note: In cases we have losses in cost accounting records then the figure of loss as a
starting point can be put as ‘minus’ or ‘-ive’ figure. The implication of this will be that
sum of ‘+’ items (items to be added) will be deducted and sum of ‘–’ items (items to
be subtracted) will be added to the base figure of loss to arrive at the resultant figure
(which is the profit/loss as per financial books).

Illustration 2: The financial accounts for ABC Limited indicate a net

profit of Rs. 77,348 whereas the cost accounts indicate Rs. 102,600 for
the same year. Prepare a statement of reconciliation to reconcile both the
earnings from the following data:

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Notes (i) Depreciation charged in financial accounts Rs. 6500

while recovered in cost accounts Rs. 6520
(ii) Works overheads under-absorbed in cost accounts Rs. 1650
(iii) Office overheads over-recovered in cost accounts Rs. 580
(iv) Interest on loans (credit) not included in cost accounts Rs. 4000
(v) Loss due to obsolescence charged in financial accounts Rs. 2580
(vi) Bank interest and dividends received Rs. 573
(vii) Income-Tax paid Rs. 15,020
(viii) Loss due to depreciation in inventories charged in Rs. 5733
financial accounts
(ix) Stores adjustment credited in financial accounts Rs. 732

Reconciliation Statement
Solution:
Amount Amount
Particulars (Rs.) (Rs.)
Profits as per cost books 102,600
Add:
1. 
E xcess of depreciation charged in cost A/cs 20
(6520 – 6500)
2. Over-absorption of office overheads 580
3. Interest on loans (Credit) 4,000
4. Bank interest and dividend received 573
5. Stores adjustment 732 5,905
Less:
1. Under absorption of works overheads 1,650
2. Obsolescence charged in financial books 2,580
3. Income tax paid 15,020
4. Loss on depreciation of inventories (charged in 5,733 24,963
financial books)
Profit as per financial books 83,542

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 Cost Concepts in Accounting

IN-TEXT QUESTIONS Notes

2. Cost and financial accounting are reconciled under non-integral

accounting. (True/False)
3. Rent on owned building is not included in cost accounts. (True/
False)
4. Costing P&L A/c includes all items of financial nature (like
interest) which are not included in cost ascertainment. (True/
False)
5. Dividend received but not included in cost accounts is to be
added back to costing profit in reconciling profit with financial
profit. (True/False)
6. Income tax is provided in cost accounting only. (True/False)
7. The need of reconciliation arises only under integrated accounting
system. (True/False)
8. There is only one figure of profit under integral accounting
system. (True/False)
9. Over-absorption of production overheads in cost accounts are
deducted to costing profit to reconcile it with profit as per
financial book. (True/False)
10. Loss on the sale of capital assets is not included in accounts
under integral system. (True/False)
11. No accounts of debtors and creditors are opened in integrated
accounts. (True/False)

1.8 Summary
‹ The financial accounting deals with recording, classification and
summarisation of business transactions and prepares financial
statements i.e. Income Statement and Balance Sheet.
‹ The cost accounting deals with ascertainment of cost and profitability
of products, divisions, centres etc.
‹ Different accounting principles, methods, and practices are followed
under financial accounting and cost accounting systems.
‹ The two sets of accounts show different figures and financial results
and it requires periodical reconciliation of both the accounts.
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 MANAGEMENT ACCOUNTING

Notes ‹ The reconciliation promotes the integrity of both the systems of

accounting and helps in standardisation of policies.
‹ The difference in profit as shown in cost accounting and financial
accounting may relate to the reasons like some expenses are only
shown in financial accounting like preliminary expenses, capital
issue expenses, certain items of expenses are shown only in cost
accounting like interest on capital, notional rent, overheads absorbed
in cost accounts difference in valuation of stock and WIP, difference
s in rates of depreciation charged etc.
‹ The cost accounting and financial accounting are reconciled by
preparation of either Memorandum Reconciliation Account or
Reconciliation Statement.

1.9 Answers to In-Text Questions

1. (a), (b) and (c) are all examples of direct material costs. The prime
cost includes direct material, direct labour and direct expenses.
(d) is an indirect labour cost
2. True
3. False
4. False
5. True
6. False
7. False
8. True
9. False
10. False
11. False

1.10 Self-Assessment Questions

1. State the need for reconciliation of cost and financial accounts.
2. There is generally a divergence between ‘financial profits’ and ‘cost
profits’. Explain this statement and give reasons for such divergence.
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 Cost Concepts in Accounting

3. What are the reasons for disagreement of profits as per financial Notes
accounts and cost accounts? Discuss.
4. Mention four items of expenses or incomes which will appear in one
set of accounts but not the other.
5. The financial records by Modern Industries Limited reveal the
following data for the year ended March 31, 2022:
Amount
Particulars (Rs. in ‘000)
Sales (20,000 units) 4,000
Materials 1,600
Wages 800
Factory Overheads 720
Office and Administrative Overheads 416
Selling and Distribution Overheads
Closing Stock of finished goods (1230 units)
Work-in-progress (Closing)
Materials 48
Labour 32
Factory Overheads 32 112
Goodwill written off 320
Interest on Capital 32
In the costing records, factory overhead is charged at 100% of
wages, administration overhead at 10% of works cost and selling
and distribution overhead at Rs.16 per unit sold.
Prepare a statement reconciling the profit as per cost records with
the profit as per financial records of the company. All workings
should form part of your answer.
6. Prepare Cost Sheet Profit & Loss Account from the following
information and reconcile:
Particulars Amount (in Rs.)
Material consumed 20,000
Wages 18,000
Works Overhead Charges 15,000
Office Overhead Charges 16,000
Selling Overhead 4,000
Sales 1,00,000
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 MANAGEMENT ACCOUNTING

Notes In cost records, works overhead charges are recovered at 100% on

direct wages, and office overhead charges are recovered at 25% on
works cost. Selling expenses are charged at 10% on sales.
In financial records, debenture interest paid Rs. 5,000, preliminary
expenses written off Rs.3,000.

1.11 References
‹ Saxena, V. K. and Vashist, C. D. Cost Accounting – Textbook.
Sultan Chand & Sons
‹ Kishore, Ravi M. Cost & Management Accounting. Taxmann.
‹ Arora, M. N. Cost and Management Accounting-Principles and
Practice. Vikas Publishing House, New Delhi.
‹ Jain, S. P., and K. L. Narang. Cost Accounting: Principles and
Methods. Kalyani Publishers, Jalandhar.
‹ Lal, Jawahar & Seema Srivastava. Cost Accounting. McGraw Hill
Publishing Co., New Delhi.
‹ Maheshwari, S. N., & S. N. Mittal. Cost Accounting. Theory and
Problems. Shri Mahabir Book Depot, New Delhi.

1.12 Suggested Readings

‹ “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren,
Srikant M. Datar, and George Foster.
‹ “Cost and Management Accounting” by Colin Drury.
‹ “Cost Accounting: Principles and Practice” by M.N. Arora.
‹ “Cost Accounting: An Introduction to Managerial Accounting” by
Eric W. Noreen and Peter C. Brewer.
‹ “Managerial Accounting” by Ray H. Garrison and Eric W. Noreen.

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 L E S S O N

2
Material, Labour and
Overhead Cost and
Control
Dr. Priyanka Ahluwalia
Assistant Professor
New Delhi Institute of Management
Email-Id: [email protected]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Elements of Cost
2.4 Material Cost and Control
2.5 Labour Cost
2.6 Overhead Cost and Control
2.7 Solved Numerical Questions
2.8 Summary
2.9 Answers to In-Text Questions
2.10 Self-Assessment Questions
2.11 References and Suggested Readings

2.1 Learning Objectives

After studying this lesson, you will be able:
‹ To understand the major cost drivers.
‹ To know the basis of cost identification and understand the key elements of cost.
‹ To effectually use the cost data for effective managerial decision and control analysis.
‹ To enumerate the factors affecting the quality of management decisions and policies.

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Notes
2.2 Introduction
As discussed in the last section, cost forms an integral part of laying
the foundation for estimating the revenues and profitability of any eco-
nomic activity. Commonly, the expenditure incurred on an item is termed
as “cost”. However, this is a very generic meaning of the word “cost”.
Cost is not as simple as being generally understood, its understanding
is subjective to:
(a) The subject application
(b) The industry, sector or the business characteristics
For example, the cost of land for a manufacturing business is a substantial
expense, which will support the entire manufacturing process over a very
long tenure, thus will be identified as a capital expenditure. However,
the same cost of land for a real estate business is a direct cost because
of the nature of the business as it deals with buying and selling of real
estate assets only. Thus, it can be clearly stated, that the same cost might
indicate different aspects subject to varying situations.
This dynamic feature of the cost concept makes it imperative for the
managers to understand the business model and use due diligence to
understand and accurately identify the various cost heads. This shall
give a true picture of the cost structure and lay down the significance
of each cost element.

2.3 Elements of Cost

Broadly, there are three major elements of cost:
‹ Material
‹ Labour
‹ Overheads

2.4 Material Cost and Control

Any item used to make a product to satisfy the demand in the economy
can be termed as material. The material used may be raw, semi-processed
or finished material, which can be further processed in the value chain

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for manufacturing or developing a new product. The material cost can Notes
also be classified as direct or indirect material cost.

2.4.1 Direct Material Costs

Direct material costs are those raw material and item costs which are in-
curred directly in the making of a product. The materials must be simply
distinguishable from the ensuing product. For example, the direct mate-
rials for chocolate making are cocoa powder, sugar, oil, flavourings etc.
The direct material costs are identified and observed for various financial
analysis to understand the magnitude and impact of each cost on the final
product. This also supports a better understanding to establish a justified
selling price. Consequently, it enables the management of the company
to establish the key cost drivers.
The key elements of the direct material costs can be enumerated as under:
‹ Raw Material Costs: The substances that are transformed by
losing their identity during the process of production, and become
an integral part of the product are the raw materials. For example:
Steel used in car manufacturing units, can be termed as raw material
for the Original Equipment Manufacturer (OEM).
‹ Packing Costs: The packing material used for the storage and safe
transportation of the products to the end user is a direct material
cost. Material such as bubble wrap, cardboard, cartons etc. are
included under this category.
‹ Freight and Storage Expenses: Transportation costs and storage
costs are a function of the final product features such as perishability,
fragility, size, geographical location gap between the manufacturer
and the end customer etc. This cost must be considered while
calculating the direct material cost as this function bridges the gap
between the manufacturer and the end user.
‹ Indirect Taxes: With the new tax regime in the country, Value
Added Tax (VAT) and Goods and Services Tax (GST) is levied
almost on all materials. However, the tax rates vary on the basis
of the material category and the geographical location.
With the help of the following examples, we can clearly understand
the direct material costs;

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Notes ‹ Fabric is a direct material cost for a readymade clothing business.

‹ The stitching machinery, buttons, zips etc. will also be considered
as components of direct material costs.
‹ The wood and steel used in furniture manufacturing business is
a direct material cost.
‹ The plastic used in the toy manufacturing business is also a
direct material cost.
Thus, direct material costs can be easily understood by relating it
to real life examples.

2.4.2 Indirect Material

Indirect materials are goods are those which are part of the overall manu-
facturing process however, are not transformed during the process. These
materials are consumed to support the manufacturing process and gener-
ally, the outgo on these materials is comparatively lesser than the direct
materials. It is also tedious to allocate these costs in specific quantities
to the finished product. For example, consumables such as tapes, gloves,
protective gears, stationary etc. can be termed as indirect materials which
are significant for the smooth production process but do not lose their
original form during the production process.
The calculation of direct material cost can be understood as under:
Illustration 2.1: Intech Ltd. is a pen manufacturing company. The finance
manager wishes to understand the total direct costs of the company.
The cost elements of Intech Ltd. for December, 2021are as under:
Cost of raw material purchased: Rs. 109,000
Indirect taxes: Rs. 15,200
Wages paid to the employees: Rs. 43,000
Packing and container costs incurred: Rs. 2,000
Inward Freight charges: Rs. 950
You are required to calculate the direct material cost for the company
on behalf of the finance manager.

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Solution: Notes
Particulars Amount (Rs.)
Material Cost (a) 1,09,000
Indirect Taxes (b) 15,200
Packing and Container costs (c) 2,000
Inward Freight Charges (d) 950
Total Direct Costs (a + b + c + d) 1,27,150

Further, the total direct cost per unit can also be computed as follows:
Let us assume: Total number of pens manufactured during the month of
December, 2021 is 10,000.
Therefore,
The Direct cost per unit shall be estimated as under:
Total Direct costs/No. of units manufactured
Thus, the direct cost per pen = Rs. 1,21,750/10,000 = Rs. 1.2175

Significance - Direct Materials Cost

As discussed earlier, direct material costs are substantial costs incurred
during the production process and thus must be considered by the cost
accountant and the management to take well-informed decisions for the
smooth and successful functioning of the business.
‹ The direct material costs form a significant portion of the total costs and
are crucial for setting the final product pricing, thus it is worth taking
the cost of each item that is being used to develop the final product.
‹ The direct material cost also supports a comparative cost analysis
vis-a-vis the realization per unit, thereby, establishing the profits
generated by each product.
‹ It supports the managers to understand the supplier cost structure and
make a market-wide analysis in terms of the quality and pricing of
the raw material procured. Thus, this information can be effectively
used by the managers for price negotiations with the suppliers.
‹ It helps managers to understand the costing and pricing bottlenecks
and further helps them develop an effective cost control and review
system. This shall also result in efficient utilisation of resources
and better supply management.

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Notes Thus, direct material cost analysis allows the managers to take impro-
vised business decisions backed by an in-depth understanding of the cost
elements and profits generation capacity of the business.
This cost control and review system supports better product development
at effective costs, thereby enhancing the product acceptability by the end
consumers which in turn leads to better growth prospects for the business.
For a break down free production process, the manufacturing unit always
requires an uninterrupted supply the raw materials, stores and spares and
machines. The purchase department plays a key role in procuring the
required quantity and quality of raw materials. Further, the procured raw
materials are stored efficiently and safely by the stores’ department and
released to the production department on requisition raised. This calls for
well-coordinated efforts between the various departments. Thus, material
control can be defined as the timely availability of the optimum quan-
tity at the best quality possible at the least cost possible. This calls for
minimum stock maintenance to avoid raw material shortage yet maintain
the least possible storage cost and thereby, avoiding any cost of damage
to the input materials.
Thus, in order to avoid stock-out costs, high-cost procurement of raw
materials and stock damage costs, most of business organisations main-
tain a production planning and control department whose endeavour is to
coordinate between the various organisational functions such as purchase,
production, sales and marketing departments etc. It also acts to keep the
costs at the minimum level while maintaining the quality and continuity
of the production and sales department.

2.4.3 Objectives of Material Control

As discussed in the earlier section, it is very crucial to keep the costs
under check to operate at the most efficient level. The material control
system supports to achieve the following aims:
1. To fix the Reorder Level of Raw Materials: For efficient inventory
management, it is imperative to fix the quantity of the raw material
at which it should be reordered. It is also required to set a limit
for minimum quantity, optimum quantity and maximum quantity of
the materials to monitor the overall costs.

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2. To keep a Track of the Material Stock Levels: Material control Notes

helps to facilitate updated information about the availability and
the quantity of the materials. This facilitates the timely raising of
requisitions for the purchase of the required quantity, to support
the uninterrupted manufacturing process. It also helps in identifying
the levels of re-purchase of stocks.
3. Ensures Availability of Quality Products: Every manufacturing
organisation needs a specific quality of materials in order to keep
the costs at the estimated level yet meet the customer specifications
for the final product. Any change in the quality of the raw materials
will either effect the cost structure adversely or product quality,
thereby, making the product unsuitable either in terms of final pricing
or quality of the end user. Thus, keeping a check on the quality
of input materials, yet maintaining the costs within the permissible
limits is of key significance.
4. To Monitor the Wastage Levels: In order to keep a check on the
wastage of the input due to breakage, theft, obsolescence etc.,
efficient storage facilities for various materials are maintained. This
helps in keeping the wastage at a bare minimum level and requires
an efficient controlling and monitoring system in place.
5. Effective Purchasing Costs: As material control supports maintaining
the optimum levels of stocks and also provides information about
the timely reorder levels, the materials can be procured at the right
price as there is no sudden requirement to procure materials. With
this efficient material planning system in place, the materials can be
purchased at competitive prices. This also enables management to
establish long-term relationships with the suppliers, thereby ensuring
quality consistency too. This cost-effectiveness percolates to better
profitability for the organisation.
6. Avoidance of Over-Stocking or Under-Stocking: As conferred in the
above discussion, understocking of materials might lead to production
breakdowns and overstocking might lead to higher storage and
wastage costs. Overstocking might also be impacted obsolescence.
Both these situations are likely to put profitability under pressure.
Thus, in order to manage the overstocking or understocking costs,
efficient material control systems are necessary.

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Notes 2.4.4 Material Cost Control

Requisition Order of Materials: The first step to effectively control
the material costs is to estimate the adequate quantity of raw materials,
components and other stores. Based on the best estimates, the purchases
are made by the purchasing department of the organisation. The purchase
requisition also mentions the quality of the material directed to be pro-
cured within the stipulated time frame.
Reliable Material Vendors: The purchase department on the basis of
the quality and the best pricing shortlists a few vendors for each mate-
rial procurement. On the basis of the purchase requisition, the vendor is
selected considering the time lag between the order and supply of the
materials. The vendors are continuously reviewed with a view to main-
taining the quality and striking a fine balance between the price and the
right time of procurement.
Issue of Letters Inviting Quotations: After a careful selection of the
vendors, the quotations are invited from the vendors with clear specifi-
cations regarding the price, quantity, quality, delivery time etc. This en-
ables the purchasing department to make a prudent decision on the basis
of the comparative analysis of the quotations made by the vendors. As
these quotations clearly specify the expected deal terms and conditions,
any risk of future mismatch in terms of quality, quantity or timeliness
is mitigated substantially.
Placing the Purchase Order: On the careful selection of the vendor on
the basis of the order details, the purchase order is placed with the vendor.
The purchase order indicates the quantity, quality, the delivery schedule
for the materials. In some cases, the penalty clause is also inserted to
avoid any delivery delays. It acts as a deterrent and the transfer of risk
of loss due to stock out to an extent.
Quality Checks and Approval of Invoices: Post the delivery of the
materials, the quality check inspections are conducted by the quality con-
trol department. This practice helps in minimising the wastage cost due
to any substandard quality as in case of any deviations from the agreed
features of the material, the issue is taken up with vendor, the payments
for the material ate stalled.

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Method of Material Pricing Issues Notes

After the materials are issued to the production department, the compa-
nies face issues in regard to the pricing at which the materials issued
need to be charged. The companies purchase the same type of material
at different prices at different times in different lots. There are various
methods of pricing material and they may be categorised as below:

(I) Cost Price Methods

‹ First-in-First-out Method (FIFO)
‹ Last-in-First-out Method (LIFO)
‹ Highest-in-First-out Method (HIFO)

(II) Average Price Method

‹ Simple Average
‹ Weighted Average Price Method
‹ Periodic Simple Average
‹ Moving Simple Average
‹ Weighted Moving Average

(III) Notional Price Methods

‹ Standard Price
‹ Inflated Price
‹ Market Price

1. First-in First-out (FIFO) Method

As per FIFO, materials which are purchased first are issued first. The
value of the closing stock is valued at the price of the latest purchases.
Advantages:
(i) Inventory Management System is effective as the oldest units are
consumed first and inventory comprises the latest stock.
(ii) This method is logical.
(iii) Easy to understand and operate.

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 MANAGEMENT ACCOUNTING

Notes (iv) Facilitates inter-firm and intra-firm comparisons.

(v) Inventory Valuation and cost of finished goods are regular, perpetual
and realistic.

Disadvantages:
(i) Involves lot of calculation work
(ii) Cost of production is not linked to the current prices
(iii) For pricing one requisition, more than one price may have to be
adopted
(iv) In a period of fluctuating prices, the cost of issues do not represent
market price
(v) The pricing of material returns is not easy
(vi) Cost comparisons among two batches of production become difficult
when issues are priced differently.

Inventory Valuation Problem

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Inventory Valuation using FIFO Notes

Opening Balance Purchase Issue Balance
Total Total Total Total
Date Units Rate Amt. Units Rate Amt. Units Rate Amt. Units Rate Amt.
01-01- 0 0 0
2022
01-01- 100 30 3000 100 30 3000
2022
15-01- 50 30 1500 50 30 1500
2022
01-02- 200 40 8000 200 40 8000
2022
15-02- 50 30 1500
2022
15-02- 50 40 2000 150 40 6000
2022
20-02- 100 40 4000 50 40 2000
2022
01-03- 150 50 7500 150 50 7500
2022
15-03- 50 40 2000
2022
50 50 2500 100 50 5000

So the value of closing stock is Rs. 5,000.

2. Last-in-First Out
This method is based on the assumption that the last items purchased
are issued first. The closing stock is valued at the prices of the earliest
purchase.

Advantages:
(i) LIFO helps company in avoiding tax
(ii) It conforms to the principle that cost should be related to current
price levels
(iii) The cost of material is stated at current market price and thus,
unrealised inventory profits are not reflected in the accounts
(iv) Unlike FIFO method, LIFO does not result into unrealised profit due
to inflationary trends

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Notes Disadvantages:
(i) This method is not acceptable to income tax authorities
(ii) This method is useful if the items of materials to be priced are few
in number
(iii) Under falling prices, issues are priced at lower prices and stocks are
valued at higher prices
(iv) Cost of different batches varies greatly, making inter-firm and intra-
firm comparison difficult.
Inventory Valuation using LIFO
Opening Balance Purchase Issue Balance
Total Total Total Total
Date Units Rate Amt. Units Rate Amt. Units Rate Amt. Units Rate Amt.
01-01-2022 0 0 0
01-01-2022 100 30 3000 100 30 3000
15-01-2022 50 30 1500 50 30 1500
01-02-2022 200 40 8000 200 40 8000
15-02-2022 100 40 4000 50 30 1500
15-02-2022 100 40 4000
20-02-2022 100 40 4000 50 30 1500
01-03-2022 150 50 7500 150 50 7500
15-03-2022 100 50 5000 50 30 1500
50 50 2500

Value of Closing Stock 50 30 1500

50 50 2500
4000

3. Weighted Average Price Method

Under WAP, weighted average price is calculated by dividing the total cost
of material purchased during an accounting period by the total quantity
of material purchased during that period.
WAP = Total Cost of purchases during an accounting period/Total quantity
purchased during an accounting period.

Advantages:
(i) Simple to operate
(ii) This method averages out the effect of price fluctuation
(iii) Used in process industries

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Disadvantages: Notes
(i) Cannot be used in job order industry where each individual order
must be priced at each stage upto completion
(ii) The costing of material issues gets delayed up to the end of the
period and this results in heavy burden on the staff
(iii) The closing stock does not correspond to the conventional method
of valuing stock i.e. cost or market value, whichever is lower.

Inventory Valuation using Weighted Average Price

Opening Balance Purchase Issue Balance
Total Total Total Total
Date Units Rate Amt. Units Rate Amt. Units Rate Amt. Units Rate Amt.
01-01-2022 0 0 0
01-01-2022 100 30 3000 100 30 3000
15-01-2022 50 30 1500 50 30 1500
01-02-2022 200 40 8000 200 40 8000
15-02-2022 100 40 4000 50 30 1500
15-02-2022 100 40 4000
20-02-2022 100 40 4000 50 30 1500
01-03-2022 150 50 7500 150 50 7500
15-03-2022 100 50 5000 50 30 1500
50 50 2500

Value of Closing stock = Rs. 4,000

Normal Loss of Material vs. Abnormal Loss of Material
Material loss arises due to handling, storage or during manufacturing.
Material loss is categorised into two i.e. normal loss and abnormal loss.
Normal loss is that loss which has necessarily incurred and thus is un-
avoidable. Examples:
‹ Loss due to evaporation
‹ Loss occurring due to loading and unloading
‹ Loss resulting from breaking the bulk, etc.
Normal loss of material cannot be completely avoided but can be con-
trolled to a limited extent.
The term “abnormal loss” refers to losses caused by inefficiency in op-
erations, mischief, negligence, etc. Examples:

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Notes ‹ Theft or pilferage

‹ Breakage
‹ Fire, accident, flood, etc.
‹ Use of inaccurate instruments
‹ Improper storage, etc.
Materials losses may arise in the form of waste, scrap, spoilage or de-
fectives.
Waste consists of invisible loss, visible loss that cannot be collected, and
the percentage of recovered loss that cannot be sold. Waste is not factored
into production quantity. Wastes include smoke, dust, gases, slag, etc.
Scrap is the non-usable loss that can be sold. It is a residue that can be
measured and has a negligible value. It may be caused by the processing
of materials, outdated stock, or defective parts. Metal scrap may consist
of turnings, borings, filings, etc.; sawdust in the timber sector; and off-
cuts and cut pieces in the leather business.
Spoilage refers to damaged materials or components that cannot be re-
paired or reconditioned during the manufacturing process. Some spoilage
may be sold as seconds. If they have deteriorated significantly, they can
be sold as garbage or scrap.
Defectives are the portion of process loss that can be transformed into
finished goods by investing additional material and labour costs. The
additional expenses are added to the manufacturing cost, and the rectified
units are added to the overall number of units. Substandard materials,
poor craftsmanship, inadequate inspection, a lack of blueprints, etc. can
all result in flaws.

2.5 Labour Cost

The raw material needs to process at different stages to convert the input
materials into a finished product. This needs human intervention i.e. the
human skills; knowledge and efforts are put in to manufacture a finished
product. These human efforts are to be compensated in monetary terms
and this is called the labour cost. The cost of labour comprises a variety
of charges related to employees. These can be direct monetary payments
to employees like basic wages, dearness allowance, bonuses, etc., deferred

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 Material, Labour and Overhead Cost and Control

monetary benefits like employer contributions to provident funds, gratu- Notes

ities, pensions, etc., and fringe benefits like employer contributions to the
Employees’ State Insurance scheme, subsidized food, and housing, leave
travel concessions, medical and vacation home facilities, libraries, and
other welfare measures. Like material cost, labour costs might be direct
or indirect in connection to the task or the final output.

2.5.1 Direct Labour Cost

Direct labour cost is the part of a factory’s prime cost that is allocated
to paying employees who worked there directly on the creation or manu-
facture of the items. The amount that is paid to labour for each unit they
produce or for each hour they work on a project can also be referred to
as the cost of direct labour.
Direct labour costs can be located and assigned to a particular job process
or product. Examples of direct labour cost are as follows:
Wages: The amount which is paid by company to labourer for production
of products. This is example of direct labour cost.
Payment of Subsidized Food: The amount which is paid by company for
providing the food at subsidized rates to labourers will be the example
of direct labour cost.
Subsidized Housing: If company is getting less rent from worker for
providing homes, different between actual rent and taken rent will be the
example of direct labour cost.
Educational Benefits to Children of Workers: All educational benefit’s
price which is being given to the children of workers will be the example
of direct labour cost.
Other Benefits: In order to indicate the true prime cost in the cost sheet,
bonus, allowances and other parks or benefits are added in the direct
labour cost.

2.5.2 Indirect Labour Cost

The amount given to employees who aren’t directly involved in the man-
ufacturing of goods is referred to as indirect labour cost. It is impossible
to identify and assign the indirect labour cost to a specific cost centre
or cost unit.

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Notes Indirect labour costs are typically spread evenly. Maintenance workers,
managers, supervisors, sweeping crews, etc. are all examples of indirect
labour costs. Nonetheless, they indirectly contribute to the manufacturing
of products.
Examples of indirect labour are as follows: Production manager, Market-
ing, Security, and Human Resources.
Direct and indirect labour costs must be distinguished for the following
reasons:
‹ To calculate accurate labour costs and thus provide a basis for
strict control;
‹ To facilitate calculation of labour efficiency;
‹ To ensure proper allocation of overheads;
‹ To implement incentive schemes;
‹ To facilitate inter-unit comparison; and
‹ To estimate total labour costs.

What Distinguishes Indirect Labour from Direct Labour?

The price associated with the production of goods and services is direct
labour. The number of hours of labour required to produce a product for
a consumer is used by businesses to determine the cost of direct labour.
Employees that support other departments within the company are only
taxed for indirect labour, which is not used in the manufacturing process.
Direct Labour Cost forms part of PRIME COST whereas Indirect Labour
Cost becomes part of OVERHEAD.

2.5.3 Labour Cost Control

Employees have a crucial part in an organization’s growth and productive
operations because they are its most valuable asset. The systematic and
efficient use of the organization’s human resources has a stronger impact
on the development and advancement of the company. In the same com-
parison, it is certain that its manufacturing and marketing activities will
be slowed down if this resource is not correctly exploited.
The management is concerned with keeping labour costs under control.
Labour cost control involves such systems, procedures, techniques and
tools used by the management in order to keep the labour cost of the
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 Material, Labour and Overhead Cost and Control

product or job as minimum as possible. Labour cost control includes the Notes
process of developing various forms, studying and recording the activities
and performance of workers, calculating the correct amount of wages and
making payment in time. For planning and decision-making, it also in-
cludes the process of assessing and reporting labour costs to management.
‹ Provide employees with predictable work schedules.
‹ Reduce pay overages.
‹ Reduce labour costs by optimizing schedules.
‹ Reduce employee turnover and increase productivity.
‹ Incentivize performance.

Labour Cost Management is Essential

‹ To employ labour in the industrial process economically.
‹ To produce the most output possible using the fewest materials and
resources possible.
‹ To produce better-quality work with the least amount of time and
effort from the workforce.
‹ To decrease the cost of production of products created or services
delivered.
‹ By fostering a positive work atmosphere in the factory, one may
guarantee the contentment of the employees.
‹ To implement a just system of wage payment and to reduce employee
turnover.
‹ Controlling labour costs is useful in reducing worker waste of
resources, idle time, and atypical overtime work.
‹ To maintain a secure workplace atmosphere.
‹ Controlling labour costs is crucial for maintaining accurate personnel
records and providing management with data on employee availability,
productivity, utilization, and absenteeism.
‹ To make the organisation more profitable and competitive.

Factors for Labour-cost Control

While planning the system, the following elements for labour-cost control
should also be taken into consideration:

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Notes Production-Planning: Production should be organised to utilize labour

as efficiently and effectively as possible. Production planning is made up
of the engineering of the product and the process, programming, routing,
and direction.
Setting up of Standards: The setup of time study and motion study
for industrial activities is made possible by work study. A comparison
is made between the standard labour cost that has been defined and the
actual labour cost, and any discrepancies are examined.
Use of Labour Budgets: A labour budget is created using the production
budget as a guide. The Labour budget accounts for the type and quantity
of workers required for the output as well as the cost of labour. This
budget is a plan for labour costs and is based on historical data taken
into account in the context of the future.
Analysis of the Effectiveness of Wage Policy: How much does the com-
pensation provided by departments under incentive plans aid in managerial
control over labour and labour cost management?
Labour Performance Reports: The reports on labour usage and effi-
ciency, which are acquired on a regular basis from the departments, are
useful for managing labour and regulating labour costs.
Minimization of labour cost through control does not necessarily mean
paying less to the employees. It entails getting the most out of the workers
by giving them all the amenities, both financial and non-financial. The
result is that the business is able to generate more profit. On the other
hand, if labour costs are not adequately managed, it will negatively affect
both cost savings and profit.

Illustration 2.2:
From the details given below, you are required to calculate the direct
labour cost to PRIM Corporation for the month of October, 2022
Particulars Amount (Rs.)
Wages paid to labourers 1,65,000
Raw material 7,00,000
Health insurance premium paid for direct labourers 15,000
Wages paid to employees indirectly involved in 1,30,000
manufacturing process

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Direct Labour Cost = Wages Paid to labourers + Health insurance Notes

premium paid for direct labourers.
= Rs. 1,65,000 + 15,000
= Rs. 1,80,000
Note:
The raw material cost is the direct material cost
The wages paid to other employees is an indirect labour cost

2.6 Overhead Cost and Control

Overhead costs are those costs which are incurred over and above the
direct material, direct labour and direct expenses. The overhead expenses
are those costs which cannot be directly recognised to the final product.
Thus, overhead costs are a blanket term for indirect material, indirect
labour and indirect expenses.
There are mainly three functions in a manufacturing unit.
(a) Manufacturing unit
(b) Office and Administrative services
(c) Selling and Distribution function
The overheads can be categorised on the following basis:
1. Functional Analysis
2. Behavioural Analysis
1. Functional Classification: Overheads can be divided into the following
categories on functional basis:
(a) Manufacturing or Production or Factory Overhead: These
overhead costs are manufacturing overhead costs such as
factory rent and taxes, indirect wages etc.
(b) Office and Administrative Overhead: These are non-manufacturing
overheads such as office staff salary, stationery etc.
(c) Selling and Distribution Overhead: These expenses are
indirect overheads which are incurred to enhance the sales of
the product such as sales performance bonus, sale promotion
expenses etc.

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Notes Behavioural Classification

Based on Behavioural patterns, overhead costs can also be categorised
as Variable overheads, Semi-variable overheads and Fixed overheads.
Variable overheads are directly proportional to the manufacturing scale
and thus is a dynamic cost which increases with the higher production
and vice versa. For example, performance bonus is a variable cost.
Fixed overheads are not linked to the change in the output quantity and
is fixed irrespective of the production scale. For example, Factory rent
is a fixed cost.
Semi Variable overheads are those costs which varies with the produc-
tion level but not in a linear relation. For example: Power and fuel is a
semi-variable overhead.

Methods of Segregating Semi-variable Overheads

Semi-variable overheads can be segregated into variable and fixed over-
heads can be done by applying the following methods:
(i) Scattergraph Method: This is a statistical method, where a line is
fitted to a series of data by observation.
Illustration 2.3: From the following information, draw the line of best fit
Month Output Units Cost (Rs.)
January 1,500 6,000
February 1,800 6,600
March 2,100 7,200
April 2,820 8,640
May 2,220 7,440

Output Costs Variable Fixed Cost

Month (units) (Rs.) Cost (Rs.) (Rs.)
January 1500 6000 2000 3000
February 1800 6600 3600 3000
March 2100 7200 4200 3000
April 2820 8640 5640 3000
May 2220 7440 4440 3000

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Notes

(ii) High and Low Points Method: Under this method, levels of highest
and lowest expenses are compared with one another and related to
output attained in those periods.
Illustration 2.4: Considering the following information, segregate
semi-variable costs into fixed cost and variable cost.
Month Output (Rs.) SVC (Rs.)
January 5,000 25,000
February 6,000 28,000
March 7,000 31,000
April 9,400 38,200
Considering the highest and lowest levels of output:
Highest (April) 9,400 38,200
Lowest (January) 5,000 25,000
Difference 4,400 13,200
Variable Cost per unit =
 Change in Costs/Change in Output = Rs. 13,200/4,400
= Rs. 3/unit
Month Output (Rs.) SVC (Rs.) VC (Rs.) FC (Rs.)
January 5,000 25,000 15,000 10,000
February 6,000 28,000 18,000 10,000
March 7,000 31,000 21,000 10,000
April 9,400 38,200 28,200 10,000

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Notes Thus, VC per unit = R

 s. 3 per unit and Fixed Cost is Rs. 10,000 at all
levels of output

Steps of Overhead Costing:

The overhead costs allocation involves the following procedure:
(i) Collection of Factory Overhead Costs: Firstly, the overhead costs
are assimilated from the various documents such as the invoices
issued, payrolls, distribution details etc. for the varying sources of
overhead costs.
(ii) Allocation and Distribution of Overhead Costs: Each overhead
cost should be identified to a specific cost centre. This allocation
of cumulative overhead costs to a particular cost unit is called cost
allocation.
However, when the cost centre identification is tedious or impractical,
the overhead cost is allocated based on relevance and rationality. This
approach of cost distribution over multiple cost units is called cost ap-
portionment. There are few generally accepted and practiced basis of
distribution in the industry. The below-mentioned list enumerates some
of this basis of apportionment.
(i) Rent, rates and taxes (i) Area occupied/Floor space
(ii) Insurance of Stock (ii) Value of Stock
(iii) Insurance of other fixed assets (iii) Value of fixed assets
(iv) Stores overhead (iv) Value of materials
(v) Indirect wages (v) Direct wages
(vi) Indirect materials (vi) Direct materials
(vii) Lighting/Electricity expenses (vii) W
 attage × working hours or
No. of light points
(viii) Power (viii) KW × working hours
(ix) Canteen expenses (ix) No. of workers
(x) Supervisor’s salary (x) No. of workers
(xi) Employee welfare expenses (xi) No. of workers
(xii) Workers’ compensation in- (xii) Direct wages
surance
(xiii) General expenses (xiii) Working hours or direct wages
(xiv) R epair and maintenance of (xiv) Value of assets
assets
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(iii) Allocation of Service Function Cost to the Manufacturing Function: Notes

This distribution of service costs to the other cost units is called
secondary distribution. For example, the repairs and maintenance
cost might be allocated to the various cost units on the basis of
the asset’s value.
Let us discuss the distribution of overheads and re-distribution of service
department cost to production department with an illustration.
Illustration 2.5: PQR Ltd. is a manufacturing company with three pro-
duction departments P, Q and R, and two service departments A and B.
The following is the forecasted budget for March, 2023:
Rent and rates Total Rs.
15,000
General lighting 600
Indirect wages 1,500
Power 3,000
Depreciation of machinery 20,000
Sundry expenses 10,000

Additional information: P (Rs.) Q (Rs.) R (Rs.) A (Rs.) B (Rs.)

Area (sq.m) 200 250 300 200 50
Value of machinery (Rs.) 60,000 80,000 1,00,000 5,000 5,000
Machine hour 100 200 4000 100 100
Light points (nos.) 10 15 20 10 5
Direct wages 30,000 20,000 30,000 15,000 5,000
H.P. of machines 60 30 50 10 —
Working hours 5,326 3,048 2,048 — —
You as the cost accountant of the company are required to prepare a
statement showing the apportionment of overheads.
Solution:
Statement Showing the Distribution of Overheads
Item of Basis of Total Production Service
Expenses Apportionment (Rs.) Deptt Deptt
P Q R A B
Rent and rates Floor Space 15,000 3000 3750 4500 3000 750
General Light- Light points 600 100 150 200 100 50
ing
Indirect wages Direct wages 1,500 450 300 450 225 75

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Notes Item of Basis of Total Production Service

Expenses Apportionment (Rs.) Deptt Deptt
P Q R A B
Power H.P. of machine 3,000 1200 600 1000 200 —
Depreciation Value of machine 20,000 4800 6400 8000 400 400
Sundries Direct wages 10,000 3000 2000 3000 1500 500
TOTAL 50,100 12550 13200 17150 6925 2275

Apportionment of the Overhead Costs

The basis for the apportionment of the overhead costs are as follows:
‹ Adequacy: The overhead rate should reflect an unbiased distribution
of overhead costs
‹ Suitability: The overhead rate should be convenient and easy to
comprehend and apply the same.
‹ Time Factor: The time taken to complete a task should be well
defined and the overhead cost should be in line with the time
consumed for the specific job.
‹ Manual or Machine Work: The overhead should vary on the basis
of the type of work such as manual or mechanised as both involve
different resources. The availability and cost of each process lays
the basis for the average overhead rate.
‹ Diverse Overhead Rates: In an event of varying characteristics
of work done, distinguished overhead rates should be ascertained.
‹ Information: The data availability affects the overhead cost selection
criteria.

Overhead Cost Control Systems

Similar to the overhead cost allocation and apportionment, the overhead
cost control method is complex. The overhead cost control requires the
management to plan the cost budget objectively. Further, for monitoring
purposes, well defined yardsticks should be laid down. These yardsticks
provide a foundation for the review of the check points. Thus, cost control
is a continuous process and requires dedicated resources to work effectively.
With the alteration in production processes, there is a change in the
overhead costs, that needs to be recognized and considered to reflect the
true profitability prospects of the company.

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As it has been clearly established that overhead costs are difficult to be Notes
recognised under a product or manufacturing activity, the control even
is more complicated as needs to be looked for minutely, otherwise it
might go unnoticed.

Steps to Control Overhead Expenses

The overhead costs can substantially be controlled by proactive cost
management. The management should look for the following key areas
to control and reduce the major overhead costs.
‹ With the effective working capital management, the overhead costs
can be controlled to a great extent.
‹ Implementation of total quality management in order to curb the
unnecessary and wasteful expenditure can also help the management
in achieving the cost control goal.
‹ Reducing the logistics costs by optimising the transportation expenses
should be carefully executed, as it is one of the major components
of the overheads cost in most of the supply chain.
‹ By proper and regular check-ups of the machinery and the production
infrastructure, the maintenance overheads can be kept under control.
‹ The sales expenses can be minimised by directing the sales force
efforts not only to push sales, but the team should also be trained to
work towards the profit maximisation. The sales incentives should
be offered and linked to the profits of the business.

2.7 Solved Numerical Questions

1. The following is an extract from the accounting records of PAM
Corporation for the 3QFY22 i.e. (Oct, 1st to 31st December, 2021)
Cost of Raw Material on October 1, 2021  15,000
Raw material purchases during the quarter 2,25,000
Labour cost paid during the period 1,15,000
Factory Overheads 46,000
Cost of work-in-progress on October 1, 2021 6,000
Cost of raw materials on December 31, 2021 7,500

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Notes Cost of stock of finished goods on October 1, 2021 30,000

Cost of stock of finished goods on December 31, 2021 27,500
Selling and Distribution expenses 10,000
Administrative Overheads  15,000
Sales  4,50,000
Prepare the cost sheet
Solution:
Statement of Cost
For the period (1st Oct, 2021 – 31st Dec, 2021)
Amount
Particulars (Rs.)
Opening stock of raw materials 15,000
Add: Purchases 2,25,000
Less: Closing stock of raw materials 7,500
Cost of raw materials consumed 2,32,500
Labour cost paid 1,15,000
Direct costs 3,47,500
Factory Overheads 46,000
3,93,500
Add: Opening stock of Work in Progress 6,000
Less: Closing stock of Work in Progress NIL
Factory Costs 3,99,500
Add: Administration Overhead 15,000
Cost of Goods produced 4,14,500
Add: Opening stock of finished goods 30,000
Less: Closing stock of finished goods 27,500
Cost of production of goods sold 4,17,000
Add: Selling and Distribution Expenses 10,000
Cost of sales 4,27,000
Profit (Balancing Figure) 23,000
Sales 4,50,000

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 Material, Labour and Overhead Cost and Control

Questions for Practice: Notes

1. From the following you are required to prepare a statement showing
the issues made under FIFO and LIFO method:
Date
1 Opening Balance 100 units at Rs. 10 each
1 Received 200 units at Rs. 10.50 each
2 Received 300 units at Rs. 10.60 each
4 Issued 400 units
6 Issued 120 units
7 Received 400 units at Rs. 11 each
10 Issued 200 units
12 Received 300 units at Rs. 11.40 each
13 Received 200 units at Rs. 11.50 each
15 Issued 400 units
2. Myra Industries Limited is a single product organization having a
manufacturing capacity of 6,000 units per week of 48 hours. The
output data vis-à-vis different elements of cost for three consecutive
weeks are given below:
Direct Direct Total Factory Overheads
Units Material Labour (Variable + Fixed)
2,400 4,800 6,000 37,200
2,800 5,600 7,000 38,400
3,600 7,200 9,000 40,800

As a cost accountant, you are asked by the company management

to work out the selling price assuming an activity level of 4,000
units per week and a profit of 20% on selling price.

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Notes IN-TEXT QUESTIONS

1. The process of charging costs directly to a cost centre is called:
(a) Absorption (b) Apportionment
(c) Allocation (d) Allotment
2. The labour rate is used in an event when:
(a) Majority of work is done by machines
(b) Majority of work is done by labours
(c) The work is distributed amongst different labour groups
(d) One machine operator works on several machines
3. Direct labour is a:
(a) Variable expense (b) Fixed cost
(c) Opportunity cost (d) Sunk cost
4. Basic objective of cost accounting is:
(a) Financial analysis (b) Statutory audits
(c) Tax regulations (d) Cost ascertainment
5. Material, labour and Overhead expenses are three vital __________
of costs.
(a) Methods (b) Segments
(c) Elements (d) Process
6. The synonym for direct wages is:
(a) Direct output
(b) Direct material
(c) Indirect labour
(d) Direct labour
7. Indirect material, indirect labour and indirect expense is collectively
known as:
(a) Material expense
(b) Direct wages
(c) Total cost
(d) Overheads

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Notes
2.8 Summary
The primary goal of a business is to generate profits for all the interested
parties. In most simple terms, profits are the difference between the rev-
enues and cost. Thus, it is very crucial for any organisation to study the
cost structure of manufacturing the final product. In order to understand
the cost structure, the costs have broadly been classified as three main
elements discussed in this section. The main elements of cost for any
manufacturing unit are Material, Labour and Overheads. The Material
and Labour can be directly recognised with the final product. However,
an in-depth study is required for the allocation of overheads to various
manufacturing processes. This cost identification and allocation helps
the management to keep a watch on the key components of the cost
structure. This follow up and review process, enhances the management
efficiency in controlling costs and thereby enhancing the profitability of
the organisation.

2.9 Answers to In-Text Questions

1. (c) Allocation
2. (b) Majority of work is done by labours
3. (a) Variable expense
4. (d) Cost ascertainment
5. (c) Elements
6. (d) Direct labour
7. (d) Overheads

2.10 Self-Assessment Questions

1. Cost management is futuristic in nature. Comment
2. Allocation and apportionment are interchangeable. Do you agree
with the statement? Give rationales.
3. Enumerate the key elements of cost. Discuss the significance of each
element.

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 MANAGEMENT ACCOUNTING

Notes 4. Prepare a cost sheet based on the following information provided to

you.
Apca Ltd. is a manufacturing firm. You are required to prepare a
cost sheet for the period of January, 2023.
Particulars Amount (Rs.)
Opening stock of raw material 25,000
Raw material purchases during the month 2,72,000
Closing stock of raw material 17,000
Labour cost 1,08,000
Factory overheads (50% of labour cost)
Office and administrative overhead 10% of works cost
Selling and Distribution expenses 52,000

2.11 References and Suggested Readings

‹ Moore & Jaidicke, Managerial Accounting, Chapter 7.
‹ Horngren, Charles, Cost Accounting: A Managerial Emphasis,
Chapters 2 and 3.
‹ Maheshwari S. N. and Mittal, S. N., Cost Accounting – Theory and
Problems, 26th Ed, Chapter 2.

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 L E S S O N

3
Job, Batch and Contract
Costing
CA. Vishal Goel
Ex-Associate Professor
AMITY University
IILM University
Email-Id: [email protected]

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Job Costing
3.4 Advantages of Job Costing
3.5 Limitations of Job Costing
3.6 Batch Costing
3.7 Differentiate between Job Costing and Batch Costing
3.8 Contract Costing
3.9 Differentiate between Job Costing and Contract Costing
3.10 Some Special Terms Used in Contract Costing and Their Treatment
3.11 Treatment of Various Financial Elements Involved in Contract Costing Accounting
3.12 Summary
3.13 Answers to In-Text Questions
3.14 Self-Assessment Questions
3.15 References
3.16 Suggested Readings

3.1 Learning Objectives

‹ To understand job costing method.
‹ To calculate the cost under job costing.

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Notes ‹ To understand batch costing methods.

‹ To calculate the cost for a batch.
‹ To differentiate between job costing and batch costing.
‹ Ascertain the cost of a contract.
‹ To understand concepts of value of work certified, cost of work
not certified.
‹ Compute notional or estimated profit from a contract.
‹ To differentiate between Job and contract costing.

3.2 Introduction
In past few chapters you have studied various elements of cost. And how
cost of a product is calculated in general, now we will discuss how the
cost accounting information can be presented and used according to the
needs of the management. To cater to the need of the different users of the
cost accounting information, different methods of costing are developed.
These costing methods enable the users to have customized information
of any cost object according to their need and suitability.
Different methods of costing have been developed as per the needs and
nature of industries. For this purpose, industries can be broadly classified
under two basic categories i.e. Industries doing job work (Customised
as per needs of the particular customer) and industries engaged in mass
production of a single product or identical products. For example, if a
particular Kind of a Furniture item is to be produced for a customer
or may be a batch of chairs of a particular size for a customer’s office
than Job Costing is a suitable method to calculate their cost. But for a
company producing Soaps on a mass scale Process costing may be more
suitable method as all are following same production process repeatedly.

3.3 Job Costing

Job Costing refers to a system of costing in which costs are ascertained
in terms of specific jobs or orders which are not identical or comparable
with each other. This kind of Costing method is followed in industries

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where production is not highly repetitive and, in addition, consists of Notes

different jobs or lots so that material and labour costs can be identified
by order number. Industries where this method of costing is generally
applied are automobile repair shop, Printing Press, interior designing,
construction, etc. In all these cases A separate cost sheet or an account
is opened for each job and all appropriate expenditure is charged thereto
to calculate total cost of that particular job.

Steps in Job Costing:

‹ Prepare a separate cost sheet for each job
‹ Charge full cost of materials issued for the job
‹ Charge full labour costs incurred (on the basis of Job Cards or
time cards)
‹ Charge Direct expenses of that particular job done as per customer
instructions.
‹ When job is completed, charge proportionate overhead also to
ascertain total cost.

3.4 Advantages of Job Costing

(i) It helps management to find out cost of all resources involved in
completing that particular job. As total cost of that particular job
is known so management will try to fix a price to customer which
will cover that cost and a desired profit.
(ii) Since overhead rates are to be predetermined for their absorption
in job costing, it will necessitate the application of a system of
budgetary control of overheads with all the advantages.
(iii) Spoilage and defective work can be easily identified with specific
jobs or products so that responsibility may be fixed on particular
departments or individuals.
(iv) Job costing is particularly suitable for cost plus and such other
contracts where selling price is determined directly on the basis of
costs and to be quoted to the customer.

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Notes
3.5 Limitations of Job Costing
(i) This system of costing is too time consuming and requires detailed
record keeping. This makes the method very expensive as compared
to other method.
(ii) Inefficiencies of a particular department or organization may be
charged to a job making price quoted on cost plus basis to be less
competitive.
(iii) As lot of clerical process is involved the chances of error is more.

Example 1:
Following information has been extracted from costing records of Khushi
Industries manufacturing Chairs as per customised order in respect of
particular job:
Materials Rs. 1500 per unit
Wages:
Department A 6 Hours @ Rs. 30 per hour
Department B 4 Hours @ Rs. 20 per hour
Department C 2 Hours @ Rs. 40 per hour
Overheads for the three departments are estimated as follows:
Variable Overheads:
Department A Rs. 40,000 for 4,000 direct labour
hours
Department B Rs. 30,000 for 1,500 direct labour
hours
Department C Rs. 10,000 for 500 direct labour
hours
Fixed Overheads:
Estimated at Rs. 1,00,000 for 10000 normal working hours
You are required to calculate the cost of a chair and calculate the price
to be charged so as to give a profit of 20% on cost.

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Solution: Notes
Cost Sheet for a Chair
Particulars Amount Amount
Direct Materials 1500
Direct Wages:
Department A – 6 hrs @Rs. 30 per hour 180
Department B – 4 hrs @Rs. 20 per hour 80
Department A – 2 hrs @Rs. 40 per hour 80 340
Variable Overheads
Department A – 6 hrs @Rs. 10 per hour 60
Department B – 4 hrs @Rs. 20 per hour 80
Department A – 2 hrs @Rs. 20 per hour 40 180
Fixed Overheads 12 normal working hours (6 + 4 + 120
2) @ Rs. 10 per hour
Total Cost 2,140
Profit @ 20% of Cost 428
Sale Price to be quoted 2,568

Working Notes
Variable Overhead rates have been arrived as follows:
Department A = Amount of Overheads/No. of direct labour hours
= Rs. 40000/4000 hours
= Rs. 10 per hour
Department B = Amount of Overheads/No. of direct labour hours
= Rs. 30000/1500 hours
= Rs. 20 per hour
Department C = Amount of Overheads/No. of direct labour hours
= Rs. 10000/500 hours
= Rs. 20 per hour
Fixed Overhead rate has been arrived as follows:
Amount of Fixed Overheads/Normal Working Hours
= Rs. 100000/10000
= Rs. 10 per hour

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Notes Example 2:
Anjana Fabricators Ltd. specialises in providing customised Furniture to
its clients their cost data of 2022 is given below:
Cost of Raw Material 6,00,000 Selling and Distribution Over- 3,64,000
heads
Wages 5,00,000 Office and Admin Overheads 4,20,000
Factory Overheads 3,00,000 Profit 25% of cost
They received a work order in 2023 and estimated expenses are:
Material Rs. 10,000, Wages Rs. 5000.
What selling price must be quoted to earn same rate of profit as in 2022,
if company has a policy of absorbing Factory overheads on basis of wag-
es, Office and admin overheads on the basis of factory cost and Selling
and distribution overheads on the basis of Cost of Production. Also extra
Packing and Transport cost for home delivery to customer expected to be
Rs. 10,000. This is to be recovered from customer as part of total cost.
Solution:
Step 1: Let us First Prepare Cost Sheet of Year 2022
Particulars Amount (Rs.)
Materials 6,00,000
Wages 5,00,000
Prime Cost 11,00,000
Add: Factory Overheads 3,00,000
Factory or Works Cost 14,00,000
Office and Admin Overheads 4,20,000
Cost of Production 18,20,000
Selling and Distribution overheads 3,64,000
Total Cost/Cost of Sales 21,84,000
Profit @25% of Cost 5,46,000
Sales 27,30,000
Step 2: Calculate Overhead Absorption Rates
Factory overheads as a% of Wages = (3,00,000/5,00,000)*100 = 60%
Office and Admin Overheads as a % of Factory Cost = (4,20,000/14,00,000)*100
= 30%

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Selling and Distribution Overheads as a % of Cost of production = Notes

(3,64,000/18,20,000)*100 = 20%
Step 3: Cost Sheet for Work Order in 2023
Particulars Amount (Rs.)
Materials 10,000
Wages 5,000
Prime Cost 15,000
Add: Factory Overheads @60 & of Wages 9,000
Factory or Works Cost 24,000
Office and Admin Overheads @30% of Factory Cost 7,200
Cost Of Production 31,200
Selling and Distribution Overheads @20% of Cost of Pro- 6,240
duction
Extra Packing and Transport Charges 10,000
Total Cost/Cost of Sales 47,440
Profit @25% of Cost 11,860
Selling price to be quoted 59,300

So a selling price of Rs. 59,300 to be quoted to customer for this work order.

3.6 Batch Costing

Batch Costing is a type of specific job order costing where articles are
manufactured in fixed predetermined lots, known as batch. Under this
costing method, the cost object for cost determination is a batch rather
than a single unit as in job costing method.
A batch consists of certain number of identical units which are processed
simultaneously in a manufacturing operation. Since a large number of
them are manufactured together and pass through the same process of
manufacture, it is convenient to collect their cost of manufacture together.
A separate job cost sheets are maintained for each batch of products.
Material requisitions are prepared batch wise, the direct labour is engaged
batch wise and the overheads are also absorbed batch wise. Cost of each
unit manufactured in the batch is then determined by dividing the total
cost of the batch by the number of units manufactured.
For example, in Soap manufacturing industry, it would be tough to calculate
cost of one soap at a time Also it will be very costly to manufacture one
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Notes particular soap to meet the demand of one customer. On the other hand,
the production, of say 10,000 soaps, of the same design will reduce the
cost to a sizeable extent. So the cost of a batch of whole 10,000 soaps
will be calculated and then divided by no. of units i.e. 10,000 to get the
cost of 1 unit.
So Batch costing is suitable for industries manufacturing same product
in large no which are identical in nature It is used in industries manu-
facturing soaps, pens and tyre and tube etc.

Steps in Batch Costing:

‹ One number is allotted for each batch and prepare a separate cost
sheet for each batch.
‹ Charge full cost of materials issued for the batch.
‹ Charge full labour costs incurred on basis of time devoted to
produce a full batch.
‹ Charge Direct expenses of that particular batch as per customer
instructions.
‹ When batch is completed, charge proportionate overhead also to
ascertain total cost.
‹ Calculate cost of each unit by dividing total cost of batch by no.
of units in batch.
Total Batch Cost
Cost per unit =
Total Units in Batch

3.7 Differentiate between Job Costing and Batch Costing

Basis Job Costing Batch Costing

Suitability It is suitable for the It is suitable for the
products which are to industries producing ho-
be customised as per mogeneous products and
customers’ order. having mass production.
Cost determination Cost is determined for Cost is determined for
each product. a batch.
Individuality of a prod- Each job is separate and Products are homoge-
uct different from others. neous and can’t be distin-
guished from each other.

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Example 3: Notes
VGA Limited manufactures pens which are embossed with the customers’
own logo. A customer has ordered a batch of 500 pens. The following
is the cost structure for a batch of 100 pens.
Particulars Cost per batch of 100
Direct materials 800
Direct labour 400
Machine set up 100
Design and art work 200
Total prime cost 1500

VGA Limited absorbs production overheads at a rate of 25% of direct

labour cost. Selling and Distribution overheads absorbed @10 % of total
production cost of each batch. VGA Limited requires a profit margin of
25% on cost.
Calculate the sale value of full batch of 500 as well as selling price of
each pen.
Solution:
Cost of Cost of
Particulars Batch of 100 Batch of 500
Prime cost (800 + 400 + 100 + 200) 1500 7500
Production Overheads (25% of labour 100 500
cost)
Production cost 1600 8000
Selling, distribution and admin overheads 160 800
@10% of Production cost
Total cost 1760 8800
Profit @ 25% of total cost 440 2200
Selling price 2200 11000

So the sales value of batch of 500 pens is Rs. 11000 and cost of 1 pen
can be calculated by dividing the total sales value by no. of units pro-
duced in a batch.
Selling price per pen = 11000/500 = Rs. 22

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Notes
3.8 Contract Costing
Contract costing is a form of job order costing where job undertaken is
relatively large and normally takes period longer than a year to complete.
Just like in job costing, in contract costing too, each contract is treated
as a cost unit and costs are ascertained separately for each contract.
Contract costing is usually adopted by the contractors engaged in any
type of contracts like construction of building, road, bridge, erection of
tower, setting up of plant etc. Usually, there is a separate account for
each contract and the contract account is debited with all direct and in-
direct expenditure incurred in relation to the contract. It is credited with
the amount of contract price on completion of the contract. The balance
represents profit or loss made on the contract and is transferred to the
costing profit and loss account. In the case, the contract is not complet-
ed at the end of the accounting period, a reasonable amount of profit,
out of the total profit made so far on the incomplete contract, may be
transferred to profit and loss account.
So after analyzing the above definitions we can conclude that Contract
costing has few distinct features which are as follows:
1. The cost unit in contract costing is the contract itself.
2. The major expenses incurred by the contractor are considered as
direct as they are incurred in relation to a particular contract.
3. The few indirect expenses mostly consist of office expenses, stores
and works and are absorbed proportionately on basis of some
predetermined overhead absorption rates.
4. A separate account is usually maintained for each contract.
5. The major part of the work in connection with each contract is
ordinarily carried out at the site of the contract.
As mentioned above a contract usually takes multiple accounting period
to complete and the exact result of the contract, whether it is a profit
or loss and how much is the profit or loss can be known only after the
completion of the contract.
Still in order to have a better control over the contract and cost, it is
necessary to have an idea of profitability of contracts at regular inter-
vals or at least once every year. For this purpose, a contractor needs

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to calculate expected profit or notional profit for a contract. It also Notes

helps in comparison of profit for a period with that of another period
and provide a good basis for performance measurement and evaluation
of those employees or departments who are engaged in the contract. A
suitable portion of expected or notional profit in respect of each contract
in progress is transferred to the costing profit and loss account for the
year to determine overall profitability of the contractor’s business entity.

3.9 Differentiate between Job Costing and Contract Costing

Basis Job Costing Contract Costing

Cost Allocation The cost is first allocated In contract costing, most
to cost centers and then of the expenses are of
to particular jobs. direct nature so directly
charged to that particular
contract account.
Place of Production In job costing generally In contract costing most
production carried out of the work is carried out
in factory. on site.
Determination of Sell- In job costing price is In contract costing price
ing Price largely influenced by is generally determined on
market conditions apart basis of cost plus mark
from cost of product. up or negotiation between
Both Parties.

3.10 Some Special Terms Used in Contract Costing and

Their Treatment
(i) Work-in-Progress: Work-in-progress in contract costing refers to
the cost of the contract which is not complete at the reporting date.
In Contract Accounts, the value of the work-in-progress consists of
the cost of work completed, both certified and uncertified.
(ii) Cost of Work Certified: Since a contract is a continuous process,
to know the periodic work done and to know the cost of work
completed as on a particular date; a periodic assessment of the work
is carried out by an expert, based on his assessment, the expert

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Notes certifies the work completion in terms of percentage of total work.

This value is known as Cost of work certified.
Value of Work Certified = Value of Contract × Work Certified (%)
Cost of Work Certified = Cost of work to date – (Cost of work
uncertified + Material in hand + Plant at site)
(iii) Cost of Work Uncertified: In every Contract there always will be
some work which has been carried out by the contractor but has
not been certified by the expert as its degree of completion can’t
be ascertained or too low. It is always shown at cost price. This is
known as Cost of work uncertified.
Cost of Work uncertified = Cost of work to date – (Cost of work
certified + Material in hand + Plant at site)
(iv) Progress Payment: Since a contract takes longer period to complete
and requires large investment in working capital, hence it is desirable
for the contractor to have periodic payments from the contractee
against the work done to avoid working capital shortage. For this the
contactor enters into an agreement with the contractee and agrees on
payment on some reasonable basis, which is generally calculated as
a percentage of work certified. After every period the Contractor will
get payments for work done on a contract based on work certified.
Progress payment = Value of work certified – Retention money –
Payment made till date
(v) Retention Money: The Contractor will never be paid full amount as
mentioned by expert to be work certified. To have a cushion against
any defect or undesirable work detected in future, the contractee
upholds some money payable to contractor. This security money
upheld by the contractee is known as retention money.
Retention Money = Value of work certified – Cash paid
(vi) Cash Received: It is ascertained by deducting the retention money
from the value of work certified.
Cash received = Value of work certified – Retention money
(vii) Notional Profit: It represents the difference between the value of
work certified and cost of work certified.
Notional profit = Value of work certified – Cost of work certified

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(viii) Estimated Profit: It is the excess of the contract price over the Notes
estimated total cost of the contract.
Estimated profit on contract = Contract price – Total expenditure
to date – Estimated Further expenditure to complete the contract
(including Reserve for contingencies)
(ix) Escalation Clause: As we know a contract generally takes longer
period to complete so there is a great probability that the cost which
was estimate at the start of the contract undergoes a big change
and which is beyond the control of contractor to manage. For
example, some items like cement, iron are integral elements of cost
of any construction contract and their prices are sometimes either
controlled by regulator or affected largely due to external factors
too. So, to safeguard his interest contractor requests for a clause
in the contract which will allow him to raise contract price, by a
suitable percentage, to bear this increase in cost beyond a certain
limit. In other words as per this clause, the contractor increases the
contract price if the cost of materials, employees and other expenses
increase beyond a certain limit.
(x) Cost-Plus Contracts: There are few contracts in which it’s difficult
to accurately estimate the cost of contract at the very beginning of
the contract due to the nature of ingredients used in contract or the
ongoing unstable economic environment. In such cases Cost Plus
contract is preferred by the contractors to safeguard their economic
interest.
Cost-plus contract is a contract in which the contract price is determined
by adding a specified amount or percentage of profit to the costs incurred
in the contract. In such contract agreements, the contractee undertakes to
pay to the contractor the actual cost of contract plus a stipulated profit.
It can be mutually decided that the profit to be added to cost may be
either a fixed amount or a specified percentage of cost.
Cost-plus contracts are usually entered into for executing special type of
work, like construction of dam, powerhouse, newly-designed ship, etc.,
where each project is so unique that accurate cost estimation is difficult.
Government often prefers to give contracts on ‘cost-plus’ terms.

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Notes Cost-plus contracts are beneficial to the Contractor as he will never suffer
loss on such contracts and he is protected from the risk of fluctuations
in market prices of material, labour, etc. but at the same time it is dis-
advantageous to him as he is deprived of the advantages which would
have accrued due to reduced market prices of material wages etc. Also he
has no motivation for working more efficiently as profit is already fixed.

3.11 Treatment of Various Financial Elements Involved

in Contract Costing Accounting
(a) Material: Materials may be purchased in bulk and kept in store for
supply to various contracts undertaken by contractor, as and when
required, or these may be purchased and directly supplied to the
contract on site. Whatever be the case the cost of material issued or
supplied for a particular contract would be debited to the contract
account. In case certain materials previously charged to contract
are returned to stores, the same will be credited to the contract
account. If certain materials are stolen or destroyed by fire or other
reasons, the respective cost will be transferred to profit and loss
account and finally materials in hand/at site at the end of the year
will appear on the credit side of the contract account.
(b) Labour: All labour employed at the contract site should be regarded
as direct labour and charged direct to the contract concerned
irrespective of the kind of work they perform. If large number of
contracts are carried on and workmen are made to divide their time
between two or more contracts, it would be necessary to prepare
analysis sheets of labour, for charging to each contract in such case
a separate job card for each workman needs to be prepared to keep
record of time devoted by him on a particular contract.
(c) Direct Expenses: All expenses other than material and labour are
charged to individual contracts as and when they are incurred e.g.
design charges, setup charges, architect’s fee.
(d) Overhead Costs: Though minimal in nature, still some part of
general and admin overhears need to be absorbed in each contract
as support services are provided by the back offices too to each
contract. Such costs in case of a contract will be in the nature of

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wages paid to storekeeper, men engaged as supervisors, lorry drivers Notes

and stationery, central administrative office lighting, heating etc.
These have to be allocated over several contracts on some suitable
basis e.g. as a percentage of material or labour or total cost of
contract excluding such overheads.
(e) Plant Used in a Contract: The value of plant used on a contract may
be either debited to the contract and the written down value thereof
at the end of the year entered on the credit side for closing the
contract account, or only a charge for use of the plant (depreciation)
may be debited to the contract account.
(f) Profit on Incomplete Contracts: This is perhaps the most debated and
tricky part of contract cost accounting. Since contract takes longer
period to complete so every year a notional profit is determined
to judge the periodic performance. And also to transfer a suitable
profit figure to profit and loss account from each contract. At the
end of each accounting period it may be found that certain contracts
have been completed while others are still in process and will be
completed in the coming years. The profit on completed contracts
may be safely taken to the credit of the profit and loss account. In
the case of incomplete contracts there are unforeseen contingencies
which may lead to heavy fluctuations in costs and profit. At the
same time it does not also seem desirable to consider the profits
only on completed contracts and ignore completely incomplete ones
as this may result in heavy fluctuations in the future for profit from
year to year.
Therefore, profits on incomplete contracts should be considered, of course,
after providing adequate sums for meeting unknown contingencies. There
are no hard and fast rule regarding calculation of the figures for profit
to be taken to the credit of profit and loss account.
However, the following rules may be followed in absence of any clear
guidelines:
(i) Profit should be considered in respect of work certified only, work
uncertified should always be valued at cost.
(ii) No profit should be taken into consideration if the amount of work
certified is less than 1/4th of the contract price.

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Notes (iii) If the amount of work certified is 1/4th or more of contract price
but less than 1/2 of the contract price, 1/3rd of the profit disclosed
as reduced by the percentage of cash received from the contractee,
should be taken to the profit and loss account.
Profit to be transferred = 1 /3 * Notional Profit * (Cash received/
Work certified)
The balance be allowed to remain as a reserve.
(iv) If the amount of work certified is 1/2 or more of the contract price
but less than 90% of the contract price, 2/3rd of the profit disclosed,
as reduced by the percentage of cash received from the contractee,
should be taken to the profit and loss account.
Profit to be transferred = 2 /3 * Notional Profit * (Cash received/
Work certified)
The balance should be treated as reserve.
(v) In case the contract is very much near to completion i.e. work
certified is more than 90% of contract price, if possible the total
cost of completing the contract should be estimated. The estimated
total profit on the contract then can be calculated by deducting the
estimated cost from the contract price. The profit and loss account
should be credited with that proportion of total estimated profit
on cash basis, which the work certified bears to the total contract
price.
Profit to be transferred = Estimated profit * (Work certified/Contract
price) * (Cash received/Work certified)
The balance should be treated as reserve.
(vi) In case there is a loss the whole loss, should be transferred to the
profit and loss account.
For Example: If the Notional profit on a contract for Rs. 30,00,000 is
Rs. 600,000 and the contract is 70% complete and has been certified
accordingly. The retention money is 25% of the certified value, then
the amount of profit that can be prudently credited to Profit and Loss
Account may be calculated as follows:

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Notional Profit Rs. 6,00,000 Notes

2/3rd of this is ordinarily suitable for transfer to Rs. 4,00,000
Profit and Loss Account (Since the Work certified
is more than 50%)
The percentage of cash received to certified val- 4,00,000 * 75/100 =
ue is 75% (as retention money is 25%) so The 3,00,000
amount of profit determined on cash basis being
suitable for transfer to Profit and Loss Account
or alternatively, it can be calculated on a different basis on basis of value
of work certified.
6,00,000 * (75/100) * (70/100) = 3,15,000
When Contract is Incomplete
Contract A/c
Particulars Amount Particulars Amount
Open W/P Material returned
Certified Plant returned
Add: uncertified P&L (Mat/Plant Lost)
Less: Reserve (book value)
Material Material in hand (net)
Wages Plant in hand (net)
Direct expenses Cost of Contract c/d
(Bal. Fig )
Overhead allocated
Plant
Profit
Cost of Contract b/d Closing w/p certified +
Notional Profit c/d uncertified
P&L a/c Notional Profit b/d
closing WIP (reserve)
Contractee’s A/c
To balance C/d By cash A/c

When Contract is Complete

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Notes Contract A/c

To open w/p By plant returned
Material By material returned
Wages By P&L (Mat/Plant Lost) (book value)
Overheads (o/h) By Material in hand (net)
Plant By Plant in hand (net)
P&L A/c By Contractee’s A/c (contract price)
Contractee’s A/c
Contract A/c By balance b/d
By Cash
Example 4:
Homemakers Construction Company Ltd. obtained a contract for the
construction of a small shopping complex. Construction started in April,
2022. The contract was Rs. 90,00,000. On 31st March 2023, the end of
the financial year, the cash received on account was Rs. 36,00,000, being
80% of the amount on the surveyor’s certificate.
Rs.
Materials issued to contract 24,00,000
Materials in hand at site as at 31st March, 2023 75,000
Wages 18,60,000
Plant purchased specially for the contract and to be depre- 3,00,000
ciated at 10% per annum
Direct expenses incurred 2,90,000
General overheads allocated to the contract 1,00,000
Work finished but not yet certified 3,45,000

You are required to prepare contract account for period ending 31st March
2023, indicating what proportion of the profit, the company would be
justified in taking to the credit of the profit and loss account.

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Solution: Notes
Homemakers Construction Co. Ltd.
Contract Account for the Year
Dr. Ended 31st March 2023 Cr.
Rs. Rs.
To Material issued 24,00,000 By Materials in hand c/d 75,000
To wages 18,60,000 By Plant (less deprecation) 2,70,000
To Direct expense 2,90,000 on site
To Plant purchased 3,00,000 Cost of contract c/d 46,05,000
To General overheads 1,00,000
49,50,000 49,50,000
Cost of contract b/d 46,05,000 By Work-in-progress c/d:
Notional Profit c/d 2,40,000 Work certified 45,00,000
Work not certified 3,45,000 48,45,000
48,45,000 48,45,000
31.3.07 by Notional profit b/d 2,40,000
To profit & Loss A/c 1,28,000
To Work-in-progress c/d 1,12,000
(profit in reserve )
2,40,000 2,40,000

Since cost of work certified is 50% of contract price so profit transferred

will be 2/3rd of notional profit as reduced by the proportion of cash re-
ceived as against work certified.
Profit to be transferred = 2,40,000 * 2/3 * 80/100 = 1,28,000
Example 5:
Altitude contractors began to operate on 1st April, 2022, the following
was the expenditure on a contract for Rs. 4,50,000.
Rs.
Materials issued to contract 76,500
Plant used for contract 22,500
Wages 1,21,500
Other expenses 7,500

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Notes Cash received on account 31st March, 2023 amounted to Rs. 1,92,000
being 80% of the work certified.
Of the plant and material charged to the contract, plant which cost Rs.
4,500 and materials costing Rs. 3,750 were lost.
On 31st March 2023 plant costing Rs. 3,000 was returned to stores; the
cost of work done but uncertified was Rs. 1,500 and materials costing Rs.
3,450 were in hand. Charge 15% depreciation on plant. Prepare contract
account from the above particulars.
Solution:
Contract Account for the Year Ending 31st Dec., 2023
Rs. Rs.
To Materials 76,500 By Costing profit and loss A/c
To Wages 1,21,500 Plant lost 4,500
To Plant 22,500 Material lost 3,750 8,250
To Expenses 7,500 By plant and machinery A/c
Plant returned 3,000
Less: Depreciation 450 2,550
By Materials at site 3,450
By Plant at Site* 12,750
By Cost of Contract c/d2,01,000
2,28,000 2,28,000
To cost of contract 2,01,000 By Work-in-progress: Work 2,40,000
b/d certified
Notional Profit c/d 40,500 Work uncertified 1,500
2,41,500 2,41,500
To P & L A/c Notional Profit b/d 40,500
21,600 (40,500 *
2/3 * 80/100)
To Reserve 18,900 40,500
40,500 40,500
* Value of the plant at the end has been calculated as under:

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Rs. Notes
Cost of plant 22,500
Less: Plant lost  4,500
(Assume that plant was lost in the beginning of the year)
Plant returned to stores (at cost) 3,000 7,500
15,000
Less: Depreciation @ 15% p.a. 2,250
Plant at site 12,750

IN-TEXT QUESTIONS
1. A costing system where cost is determined for each job based
on its specific requirements is known as:
(a) Batch costing
(b) Service costing
(c) Job costing
(d) Operating costing
2. Contract costing doesn’t have following feature:
(a) Long duration
(b) It’s a type of job costing
(c) Work performed at site
(d) All contracts are same
3. Which of the following terms are relevant in contract costing?
(a) Work Certified
(b) Notional Profit
(c) Escalation Clause
(d) All of the above

3.12 Summary
Job Costing refers to a system of costing in which costs are ascertained
in terms of specific jobs or orders which are not identical or comparable
with each other. This kind of Costing method is followed in industries

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Notes where production is not highly repetitive and, in addition, consists of

different jobs or lots so that material and labour costs can be identified
by order number.

Steps in Job Costing:

‹ Prepare a separate cost sheet for each job
‹ Charge full cost of materials issued for the job
‹ Charge full labour costs incurred (on the basis of Job Cards or
time cards)
‹ Charge Direct expenses of that particular job done as per customer’s
instructions.
‹ When job is completed, charge proportionate overhead also to
ascertain total cost.
Batch Costing is a type of specific job order costing where articles are
manufactured in fixed predetermined lots, known as batch. Under this
costing method, the cost object for cost determination is a batch rather
than a single unit as in job costing method.
A batch consists of certain number of identical units which are processed
simultaneously in a manufacturing operation. Since a large number of
them are manufactured together and pass through the same process of
manufacture, it is convenient to collect their cost of manufacture together.

Steps in Batch Costing:

‹ One number is allotted for each batch and prepare a separate cost
sheet for each batch.
‹ Charge full cost of materials issued for the batch.
‹ Charge full labour costs incurred on basis of time devoted to
produce a full batch.
‹ Charge direct expenses of that particular batch as per customer’s
instructions.
‹ When batch is completed, charge proportionate overhead also to
ascertain total cost.

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 Job, Batch and Contract Costing

‹ Calculate cost of each unit by dividing total cost of batch by no. Notes
of units in batch.
Total Batch Cost
Cost per unit =
Total Units in Batch
Contract costing is a form of job order costing where job undertaken is
relatively large and normally takes period longer than a year to complete.
Just like in job costing, in contract costing too, each contract is treated
as a cost unit and costs are ascertained separately for each contract.
Contract costing is usually adopted by the contractors engaged in any
type of contracts like construction of building, road, bridge, erection of
tower, setting up of plant etc.
Contract costing have few distinct features which are as follows:
1. The cost unit in contract costing is the contract itself.
2. The Major expenses incurred by the contractor are considered as
direct as they are incurred in relation to a particular contract.
3. The few indirect expenses mostly consist of office expenses, stores
and works and are absorbed proportionately on basis of some
predetermined overhead absorption rates.
4. A separate account is usually maintained for each contract.
5. The major part of the work in connection with each contract is
ordinarily carried out at the site of the contract.

Cost-Plus Contracts
There are few contracts in which it’s difficult to accurately estimate the
cost of contract at the very beginning of the contract due to the nature
of ingredients used in contract or the ongoing unstable economic envi-
ronment. In such cases Cost Plus contract is preferred by the contractors
to safeguard their economic interest.

3.13 Answers to In-Text Questions

1. (c) Job costing
2. (d) All contracts are same
3. (d) All of the above

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Notes
3.14 Self-Assessment Questions
1. Differentiate between Job Costing and Contract Costing.
2. What is cost plus contract? What are its advantages and limitations
for the contractor?
3. What is an escalation clause?
4. How is profit transferred from incomplete contracts?

3.15 References
‹ Study Material of Institute of Chartered Accountants of India.
‹ Study Material of Institute of Cost and Management Accountant
of India.

3.16 Suggested Readings

‹ S. N. Maheshwari, Suneel Maheshwari, Sharad K. Maheshwari. A
Textbook Of Accounting for Management. Vikas Publishing House
Pvt. Limited.
‹ Asish K Bhattacharyya. Principles and Practice of Cost Accounting.
PHI Learning Private Limited.
‹ R. S. N. Pillai, V. Bagavathi. Management Accounting. S. Chand
and Company Limited.
‹ M. Y. Khan, P. K. Jain. Management Accounting: Text, Problems
and Cases. McGraw Hill Education.

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 L E S S O N

4
Process Costing
CA. Kritee Manchanda
Assistant Professor
Keshav Mahavidyalaya
Email-Id: [email protected]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Wastages: Process Losses
4.4 Valuation of Work-in-Progress
4.5 Joint Product and By-Product
4.6 Summary
4.7 Answers to In-Text Questions
4.8 Self-Assessment Questions
4.9 References
4.10 Suggested Reading

4.1 Learning Objectives

‹ To understand the meaning, concept and accounting of process costing.
‹ Calculation and treatment of normal loss, abnormal loss/gain.
‹ Understanding the calculation/valuation of Work in Progress (WIP) using the concept
of equivalent production.
‹ Understand the concept and valuation of Joint Product and By Product.

4.2 Introduction
In a manufacturing business, products that are homogeneous can be produced in bulk by
undergoing series of steps known as processes. As the goods are identical and standard,
bulk units are passed through different processes. For example, cement can be manufactured

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Notes in four stages or processes, crushing and grinding, blending, burning and
grinding. Likewise, industries like pharmaceuticals, chemicals, FMCG,
bottling and canning companies etc. are using process costing. When each
of the processes is clearly identified, costs attributable to each process
are calculated using the concept of ‘process costing’.

4.2.1 Meaning of Process Costing

According to CIMA, “Process costing is defined as the costing method
which is applicable on goods or services that result from a sequence of
continuous or repetitive operations or processes. The costs are averaged
over the units produced during the period, being initially charged to the
operation or process.” Thus, process costing is used in those industries
where the raw material passes through several processes to become fin-
ished goods.

4.2.2 Features of Process Costing

(i) Applicable if the product products are homogeneous, passes through
series of stages and the production is continuous.
(ii) Process wise costs are identifiable and accumulated before going to
the subsequent process.
(iii) Output of current process becomes input of subsequent process.
(iv) There might be normal or abnormal losses during the processes.
(v) Process accounts are maintained in T shape account with ‘Dr’ and
‘Cr’ sides.

4.2.3 Steps in Process Costing

1. Identify the stages/processes of manufacturing activities and prepare
the process account.
2. Identify and calculate various costs associated with each process and
record them in process accounts. All the input costs and expenses
are taken on the debit side while output values of each process are
identified on the credit side.
3. Output value of current process is transferred to input value of next
process.

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4. Identify the cost of finished goods by calculating output cost of the Notes
last process.

Illustration 1:
From the following information, calculate cost per unit of output at each
process if total units produced are 500.
Particulars Process I Process II Process III
Material 1,00,000 44,000 24,000
Labour 85,000 1,00,000 1,55,000
Other Expenses 36,000 84,000 25,000

Indirect Expense amounting to Rs. 85,000 can be apportioned on the

basis of labour expense.
Solution:
Dr. Process I A/c Cr.
Particulars Amount Particulars Amount
Material 1,00,000 Process II A/c 2,42,250
Labour 85,000
Other Expense 36,000
Indirect Expense 21,250
2,42,250 2,42,250
Cost per unit = 2,42,250/500 = Rs. 484.50
Dr. Process II A/c Cr.
Particulars Amount Particulars Amount
Process I A/c 2,42,250
Material 44,000 Process III A/c 4,95,250
Labour 1,00,000
Other Expense 84,000
Indirect Expense 25,000
4,95,250 4,95,250
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Notes Cost per unit = 4,95,250/500 = Rs. 990.50

Dr. Process III A/c Cr.
Particulars Amount Particulars Amount
Process II A/c 4,95,250
Material 24,000 Finished Goods A/c 7,38,000
Labour 1,55,000
Other Expense 25,000
Indirect Expense 38,750
7,38,000 7,38,000
Cost per unit = 7,38,000/500 = Rs. 1,476/-
Note: Indirect Expense can be apportioned in the ratio of 85,000:1,00,000:1,55,000 =
Rs. 21,250 in Process I, Rs. 25,000 in Process II and Rs. 38,750 in Process III.

4.3 Wastages: Process Losses

During the manufacturing process, there may be material loss at different
stages known as process loss. Process loss may be in the form of weight
loss, as in the case of preparing powder sugar from crystals or may be
due to wastage during the consumption of material in the process. Such
expected, regular and unavoidable losses may be considered normal. The
management considers this loss as a part of cost of production. There
might be losses which may not be regular, uncertain and avoidable due
to inefficiency of labour, theft or fire etc. Such losses are abnormal
losses. Such losses are not considered while calculating cost of produc-
tion. Hence, following types of losses may occur during the course of
processing operations:
(1) Normal Process Loss: Normal Process loss or normal wastage due
to evaporation, weight loss or scrap are routine of process and hence can
be anticipated by the management. These losses cannot be avoided and
are expected to occur under normal conditions. The cost of production
of normal loss units is added to the cost of production of good units
produced under the process. Thus, any amount, if realized by the sale
of normal loss units, should be deducted from total cost of production
of good units and credited to the process account thereby reducing the
burden of loss on good units.

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Following accounting treatment may be done Notes

Normal Loss A/c …Dr
To Process A/c
(With the amount of scrap realised)
(2) Abnormal Process Loss: Abnormal loss, as the name suggests, is the
loss over and above the normal loss. It is avoidable and does not occur
under the normal conditions. It may be caused by abnormal conditions
such as breakdown of machinery, inefficiencies, lack of effective super-
vision, substandard materials etc. The cost of an abnormal process loss
unit is not absorbed by good units while calculating cost of production.
Therefore, cost per unit of abnormal loss is equal to per unit cost of
production of good unit after normal loss. The calculated value of abnor-
mal loss is transferred and credited to the process account. This cost of
abnormal loss is taken to the debit of Costing Profit and Loss Account.
Computation of Abnormal Loss:
Value of Abnormal Loss = Cost of production per unit after normal loss
× Units of abnormal loss
Where:
Quantity of Abnormal Loss = Total Quantity after normal loss – Actual
Quantity = Input – Normal Loss – Actual Quantity
Following accounting treatment may be done
Abnormal Loss A/c… Dr
To Process A/c
(with amount computed above)
Bank A/c… Dr (with amount of scrap realised)
Costing Profit & Loss A/c… Dr (with difference in the value)
To Abnormal Loss A/c (with amount computed above)
(3) Abnormal Process Gain: Sometimes, due to better and improved
conditions, actual output generated is more than normal output. Thus,
when actual loss during production is less than normal loss, it gives rise
to abnormal gain. Abnormal gain is defined as unexpected gain of units
during production under normal conditions. The value of abnormal gain
is calculated in the same manner as abnormal loss i.e. cost of production

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Notes per unit of good units multiplied by abnormal gain units. The process
account is debited with abnormal gain as accounting treatment.
Process A/c… Dr.
To Abnormal Gain A/c
(Amount calculated on the basis of cost of production of units after
normal loss)
Abnormal Gain A/c…Dr. (with amount calculated above)
To Normal Loss A/c (with the amount of scrap value)
To Costing Profit & Loss A/c (difference in the above values)
Illustration 2: (Normal Loss) A product passes through Process I and
Process II. Materials issued to Process I amounted to Rs. 45,000, Wages
Rs. 32,000 and manufacturing overheads were Rs. 26,000. Normal loss
anticipated was 6% of input and net output was transferred-out from
Process I. Input raw material issued to Process I were 10,000 units. You
are required to Prepare Process I account if (a) Scrap has no realisable
value (b) scrap has realisable value of Rs. 2.20 per unit.
Particulars Process I (in Rs.)
Material 45,000
Wages 32,000
Manufacturing Expenses 26,000
Normal Loss 6%
Normal Loss (units) 600
Input units 10,000
(a)
Dr. Process I A/c Cr.
Particulars Units Amount Particulars Units Amount
Material 10,000 45,000 Process II A/c 9,400 1,03,000
Wages 32,000 Normal Loss 600 NIL
Manufacturing Ex- 26,000
pense
10,000 1,03,000 10,000 1,03,000

Cost per unit = 1,03,000 ÷ (10,000 – 600) = Rs. 10.96

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(b) Notes
Dr. Process I A/c Cr.
Particulars Units Amount Particulars Units Amount
Material 10,000 45,000 Process II A/c 9,400 1,01,680
Wages 32,000 Normal Loss 600 1,320
Manufacturing 26,000
Expense
10,000 1,03,000 10,000 1,03,000

Cost per unit = (1,03,000 – 1,320) ÷ (10,000 – 600) = Rs. 10.82

Illustration 3: (Normal Loss, Abnormal Loss, Abnormal Gain) Product
Zinga passes through three processes namely, Process A, Process B and
Process C. Output of Process A is the input of Process B and output of
Process B is input of Product C. Following information is considered:
Particulars Process A Process B Process C
Materials issued 51,000 32,000 11,200
Labour 7,200 4,800 1,200
Manufacturing Expenses 11,800 10,200 16,400
Output 14,000 13,300 12,000
Normal Loss 3% 6% 9%

Calculate the value of Zinga if 15,000 units have been issued to the
Process-A and Rs. 1.50 per unit can be realised from scrap.
Solution:
Dr. Process A A/c Cr.
Particulars Units Amount Particulars Units Amount
Material issued 15,000 51,000 Process B A/c 14,000 66,704
Labour 7,200 Normal Loss 450 675
(3% of 15000)
Manufacturing 11,800 Abnormal 550 2,621
Expense Loss
15,000 70,000 15,000 70,000

Cost per unit of completed units and abnormal loss:

= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal Loss)
= (70,000 – 675) ÷ (15,000 – 450) = Rs. 4.76

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Notes Dr. Process B A/c Cr.

Particulars Units Amount Particulars Units Amount
Process A A/c 14,000 66,704
Material issued 32,000 P r o c e s s C 13,300 1,13,641
A/c
Labour 4,800 Normal Loss 840 1,260
Manufacturing Ex- 10,200
pense
Abnormal Gain 140 1,196
14,140 1,14,901 14,140 1,14,901

Cost per unit of completed units and abnormal loss:

= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal Loss)
= (1,13,704 – 1,260) ÷ (14,000 – 840) = Rs. 8.54
Dr. Process C A/c Cr.
Particulars Units Amount Particulars Units Amount
Process B A/c 13,300 1,13,641
Material issued 11,200 Finished 12,000
Goods A/c 1,39,448
Labour 1,200 Normal Loss 1,197 1,796
Manufacturing 16,400 Abnormal 103 1,197
Expense Loss
13,300 1,42,441 13,300 1,42,441
Cost per unit of completed units and abnormal loss:
= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal
Loss) = (1,42,441 – 1,796) ÷ (13,300 – 1,197) = Rs. 11.62
Dr. Normal Loss A/c Cr.
Particulars Units Amount Particulars Units Amount
Process A A/c 450 675 Abnormal Gain 140 210
(Process B)
Process B A/c 840 1,260 Bank (Scrap Pro- 450 675
cess A)
Process C A/c 1,197 1,796 Bank (Scrap Pro- 700 1,050
cess B)

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Dr. Normal Loss A/c Cr. Notes

Particulars Units Amount Particulars Units Amount
Bank (Scrap Pro-
cess C) 1,197 1,796
2,487 3,731 2,487 3,731

Dr. Abnormal Loss A/c Cr.

Particulars Units Amount Particulars Units Amount
Process A A/c 550 2,621 Bank (Scrap Pro- 550 825.0
cess A)
Process C A/c 103 1,197 Bank (Scrap Pro- 103 155
cess C)
Costing P&L A/c 2,838
653 3,817 653 3,817

Dr. Abnormal Gain A/c Cr.

Particulars Units Amount Particulars Units Amount
Normal Loss A/c 140 210 Process B A/c 140 1,196
Costing P&L A/c 986
140 1,196 140 1,196

Dr. Costing P&L A/c Cr.

Particulars Units Amount Particulars Units Amount
Abnormal Loss 2,838 Abnormal Gain A/c 986
A/c
- 2,838 - 986

4.4 Valuation of Work-in-Progress

In the manufacturing industries, simultaneous processes are run for meeting
continuous production demands. At the end of a reporting period, there may
be certain units which are either completely processed into finished goods
or there may be raw materials left unused. Apart from these two categories,
some goods are in the incomplete stage. They are no more the raw material
as process has already started on them, but they could not be completed
into final good. Such units are known as Work-in-Progress. The calculation
of cost of work-in-progress is a challenging task as units are in different
stages of completion. Though material, directly attributable in the process
is identified on actual basis, but bifurcation of labour and other expenses

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Notes might lack some degree of accuracy. To ascertain appropriate value, we may
use the concept of equivalent production units that converts partly finished
units into equivalent finished units. For instance, 50% of work done on
four units is equivalent to 100% of work done on two equivalent units.
Equivalent Units: are the incomplete production units converted into their
equivalent completed units by multiplying the percentage of completion
with total units introduced in reference to the elements of costs classified
into material, labour and overheads.
The formula is:
Equivalent Completed Production Units = Actual number of units in the
process × Percentage (Degree) of Work completed
For example,
200 units of material were introduced in the process. 60% of the work is
completed and 40% is still under progress. Work completed is equivalent
to 200 × 60% = 120 units of complete finished goods.
Valuation of WIP can be done by either of the methods:
1. First in First Out (FIFO) Method: In case of FIFO, value of WIP
in the beginning is calculated to the extent of work done in the
given period. It is added to the total cost to calculate cost per unit.
The value added in the current period is added to the to the opening
value of WIP to get the final value of WIP.
2. Weighted Average Method: The cost of WIP in the beginning and
current cost are aggregated and not considered separately.
Step 1: (FIFO)
Calculation of equivalent units can be done by using the table below:
Output
Input Details Units Particulars Units Equivalent Units
Material Labour Overheads
% Units % Units % Units
A B C =A× B D E =A× D F G =A× F
Opening WIP Xxx Opening WIP xxx Xxx xxx xxx xxx xxx xxx
Units Introduced Xxx Finished Output xxx Xxx xxx xxx xxx xxx Xxx
(from current
units)
Normal Loss xxx - - - - - -
Abnormal Loss/ xxx Xxx xxx xxx xxx xxx Xxx
Gain
Closing WIP xxx Xxx xxx xxx xxx xxx xxx
Total Xxx Total xxx xxx xxx xxx

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Step 2: Notes
Calculation of Cost per Equivalent Unit of Production = Total Cost ÷
Equivalent Production units
Step 3:
Statement of Evaluation (FIFO)
Equivalent Cost per unit Amount
Particulars Units (Q) (Rs. per unit) (in Rs.)
Opening WIP completed during the period Xxx xxx xxx
Add: Cost of WIP in the beginning xxx
Completed cost of WIP xxx
Completely processed units Xxx xxx xxx
Abnormal Loss Xxx xxx xxx
Closing WIP Xxx xxx xxx

Illustration 4:
M/s ABC Ltd is manufacturing product P by passing through process
A and process B. The following information is available in respect of
Process A for April, 2022.
(i) Opening stock of work in progress: 800 units at a total cost of Rs.
4,000.
(ii) Degree of completion of opening work in progress – Materials 100%,
Labour 65%, Overheads 65%
(iii) Input of materials at a total cost of Rs. 36,800 for 9,200 units.
(iv) Direct wages incurred Rs. 16,440.
(v) Production overhead Rs. 8,220.
(vi) Units scrapped 1,200 units. The stage of completion of these units
was: Materials 100%, Labour 75%, Overheads 75%
(vii) Closing Work-in-Progress is 900 units. The stage of completion of
these units was Materials 100%, Labour 60%, Overheads 60%
(viii) 7,900 units were completed and transferred to the next process.
(ix) Normal loss is 8% of the total input (opening stock plus units put in)
(x) Scrap Value is Rs. 4 per unit.
You are required to:
(a) Compute equivalent production.
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Notes (b) Calculate cost per unit for each element.

(c) Calculate cost of abnormal loss/gain, WIP, and units transferred to
the next process using FIFO and weighted average method.
(d) Prepare Process Account.
Solution: FIFO Method
Statement of Equivalent Production
Inputs Units Output Units Equivalent Production
Material Labour Overhead
% Units % Units % Units
Opening WIP 800 Opening WIP 800 0 0 35 280 35 280
Raw Material 9200 Completed units 7100 100 7100 100 7100 100 7100
Normal Loss 800 0 0 0
Abnormal Loss 400 100 400 75 300 75 300
Closing WIP 900 100 900 60 540 60 540
Total 10000 10000 8400 8220 8220

Statement of Cost
Equivalent Cost per Equiva-
Element of Cost Cost Production lent unit
Material 36800
Less: Scrap Value 3200 33600 8400 4
Labour Cost 16440 8220 2
Overhead 8220 8220 1

Statement of Evaluation
Particulars Units Cost per unit Cost Total Cost
Opening WIP
Material 0 4 0
Labour 280 2 560
Overhead 280 1 280 840
Opening Value 4000
4840
Completed Units
Material 7100 4 28400
Labour 7100 2 14200
Overhead 7100 1 7100 49700

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Particulars Units Cost per unit Cost Total Cost Notes

Abnormal Loss
Material 400 4 1600
Labour 300 2 600
Overhead 300 1 300 2500
Closing WIP
Material 900 4 3600
Labour 540 2 1080
Overhead 540 1 540 5220
Dr. Process A A/c Cr.
Particulars Units Amount Particulars Units Amount
Opening WIP 800 4000 Normal Loss 800 3200
Material 9200 36800 Abnormal Loss 400 2500
Labour 16440 C o m p l e t e d a n d 7900 54540
transferred to next
process
Overhead 8220 Closing WIP 900 5220
10000 65460 10000 65460
Notes:
1. Normal Loss units are not considered for the purpose of calculation
of equivalent production units.
2. Units completed and transferred to next process include 800 units of
opening WIP and 7100 units of current stock, according to FIFO.
3. Value of completed units in Process A/c = Value of opening WIP
+ Value of current completed units.
Average Method
Statement of Equivalent Production
Inputs Units Output Units Equivalent Production
Material Labour Overhead
% units % units % units
Opening WIP 800 Completed 7900 100 7900 100 7900 100 7900
units

Normal
Raw Material 9200 Loss 800 0 0 0

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Notes Abnormal
Loss 400 100 400 75 300 75 300
Closing
WIP 900 100 900 60 540 60 540
Total 10000 10000 9200 8740 8740

Statement of Cost
Equivalent Cost per
Element of Cost Cost Production Equivalent unit
Material 40800
Less: Scrap Value 3200 37600 9200 4.086957
Labour Cost 16440 8740 1.881007
Overhead 8220 8740 0.940503

Statement of Evaluation
Total
Particulars Units Cost per unit Cost Cost
Completed Units
Material 7900 4.09 32286.96
Labour 7900 1.88 14859.95
Overhead 7900 0.94 7429.98 54576.89
Abnormal Loss
Material 400 4.09 1634.78
Labour 300 1.88 564.30
Overhead 300 0.94 282.15 2481.24
Closing WIP
Material 900 4.09 3678.26
Labour 540 1.88 1015.74
Overhead 540 0.94 507.87 5201.88
Dr. Process A A/c Cr.
Particulars Units Amount Particulars units Amount
Opening WIP 800 4000 Normal Loss 800 3200
Material 9200 36800 Abnormal Loss 400 2481.236
Completed and
transferred to next
Labour 16440 process 7900 54576.89
Overhead 8220 Closing WIP 900 5201.876
10000 65460 10000 65460
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Notes: Notes
1. Normal Loss units are not considered for the purpose of calculation
of equivalent production units.
2. Units completed and transferred to next process are 7900 units
(irrespective of being WIP or new units). The value of opening
WIP is added to the cost of material introduced. The final cost per
unit has average cost of material.

4.5 Joint Product and By-Product

4.5.1 Joint Products
Joint products are the multiple products produced simultaneously in the
same process from the use of same raw material. Joint Products are
generally equally important. However, the core product which is under
process resulting in several other products is known as joint product. For
example, crude oil refining leads to petrol, kerosene, oil tar etc. which
can be considered as joint-products.

Characteristics of Joint Products

Joint products have following important features:
(1) Same set of raw materials are used to produce joint products.
(2) They are produced in common manufacturing process.
(3) The values of joint products are almost equal.
(4) They may undergo further processing after their separation.

Methods of Apportionment of Joint Products

Some of the important methods mentioned below are used for apportion-
ment of joint costs upto the point of separation.
(i) Average Unit Cost Method: Average cost per unit of the finished
product is calculated and used as weightage to apportion the joint
cost to the respective products, under this method.
Average costs = Total joint costs up to the point of separation ÷
Total production of all the products or outputs.
(ii) Physical Unit Method: Physical units of output for each joint product
such as weight, volume or quantity of products (till the split-off
occurs) are considered for joint costs apportionment. It is suitable
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Notes if joint products can be measured in the same units. If not, joint
products must be converted to the denominator common to all the
units produced.
(iii) Survey Method or Points Value Method considers points value
or percentage assigned to each product as a result of survey or
technical evaluation to allocate the joint costs.
Share of joint costs = P
 hysical quantities of each product
× Weightage points.
(iv) Contribution Margin Method or “Gross Margin Method” is based
on calculation of contribution for each product. Contribution is the
excess of sales over variable costs. Under this method, joint costs
are bifurcated as fixed and variable costs. Contribution of each
product will be considered for ratio of apportioning Fixed Joint
costs whereas units of goods are considered for variable portion of
joint costs.
(v) Standard Cost Method: Standard costs are determined on the basis
of experience, efficiency, cost factors and technical issues etc. Joint
costs, under this method, are apportioned on the basis of standard
costs.
(vi) Market Value Method or “Relative Sales Value Method” or
Simply Sales Value Method follows allocation of joint production
costs on the basis of final market value of products. Market value
can be calculated by multiplying number of units of each product
manufactured by the product’s selling price. The portion of total
joint costs allocated to each product is, apparently, proportional to
the sales value of each product.
Market value methods can be sub-classified as:
(a) Market Value at Separation Point: As the name says, market
value of the joint products at the split-off point is identified
and used to allocate the joint production cost. The quantities
of each product are taken as weightage.
(b) Market Value after Further Processing: Final Selling Price
is considered for bifurcation of joint costs in this method.
(c) Net Realizable Value or the “Reverse Cost Method” is the one
in which reverse calculation is done on sales value by deducting

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estimated profit, selling and distribution expenses and after split-off Notes
processing costs of each joint product. Based on the ratio of value
derived, the total costs before separation point is apportioned.

4.5.2 By-Products
It refers to the products which have comparatively less value than the
main product being incidentally manufactured during the production
process. By-products are also known as “Minor Products.” The value of
by-products is significantly low from the main product, however they
are jointly manufactured with the main products. By-products remain
inseparable and are produced along with the main product till the split-
off point or point of separation.

Illustration 5:
Azba Ltd, a manufacturing company purchases a raw material that is
processed to make three products namely, Am, El and Bt. In February,
2023, the Company purchased 12,000 kg of the raw materials at the cost
of Rs. 17,50,000 and company has incurred additional joint conversion
costs of Rs. 4,50,000. February, 2023 sales and production information
are as follows:
Units of Out- Price at Split Off Further Process- Eventual
put Produced Point (per unit) ing Cost per unit Sale Price
Am 6,000 Rs. 270 - -
El 4,000 Rs. 210 - -
Bt 2,000 Rs. 180 Rs. 40 Rs. 400
For the products, Am and El, they can be sold to other manufacturing
companies at the split-off point. But for the product, Bt, it undergoes
two options, either can be sold at the split-off point or may be processed
further and packaged for sale as an advanced level of product Bt.
You are required to:
(i) allocate the joint costs of the three products by using
(a) the Physical Units Method,
(b) the Sales Value at Split-off Method, and
(c) the Net Realizable Value Method.

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Notes (ii) Suppose that in half of the month of February, 2023, manufacturing
of El could be further processed and mixed with the whole of Am,
to make a new product namely, EA. Further processing costs amount
to Rs. 2,62,000. The selling price of EA is fixed at Rs. 400 per unit.
As an analyst you are required to suggest, if the manufacturing company
shall further process Am into EA. Assume that 6,000 units as the resultant
quantity of EA must be produced.
Solution:
(i) Total Joint Cost that is required to be allocated = Rs. 17,50,000 +
Rs. 4,50,000 = Rs. 22,00,000
Physical Units Method
Proportion of Joint Cost
Units of Output on the basis of output Joint Cost
Product Produced units Allocation
Am 6,000 6,000 ÷ 12,000 = 0.5 0.5 × 22,00,000 =
11,00,000
El 4,000 4,000 ÷ 12,000 = 0.333 or 0.333 × 22,00,000 =
1/3rd 7,33,333
Bt 2,000 2,000 ÷ 12,000 = 0.167 or 0.167 × 22,00,000 =
1/6th 3,66,667

Sales Value at Split-off Point Method

Sales Proportion of
Units of Sale Value = Joint Cost on
Output Price per Output × the basis of Joint Cost
Product Produced unit Price sale value Allocation
Am 6,000 270 16,20,000 16,20,000 ÷ 0.5745 × 22,00,000
28,20,000 = = 12,63,900
0.5745
El 4,000 210 8,40,000 8,40,000 ÷ 0.2979 × 22,00,000
28,20,000 = = 6,55,380
0.2979
Bt 2,000 180 3,60,000 3,60,000 ÷ 0.1276 × 22,00,000
28,20,000 = = 2,80,720
0.1276

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Net Realisable Value Method Notes

Net Re-
alisable
Net Re- Value = Proportion of
alisable Output × Joint Cost on
Units of Out- Value NRV per the basis of Joint Cost
Product put Produced per unit unit NRV Allocation
Am 6,000 270 16,20,000 16,20,000 ÷ 0.5094 ×
31,80,000 = 22,00,000 =
0.5094 11,20,680
El 4,000 210 8,40,000 8,40,000 ÷ 0.2642 ×
31,80,000 = 22,00,000 =
0.2642 5,81,240
Bt 2,000 400 – 40 7,20,000 7,20,000 ÷ 0.2264 ×
= 360 31,80,000 = 22,00,000 =
0.2264 4,98,080
(ii) For the Joint costs are not relevant to this decision. Instead, following
costs may be considered - further processing costs and the opportunity
cost of the lost contribution margin on the El diverted to Am purification.
Incremental Revenues (Rs. 400 – Rs. 270) × 6000 units = Rs. 7,80,000
Less: Further processing cost of Am Mixture  = (Rs. 2,62,000)
Less: Contribution margin lost on El
(2000 kg & Rs. 210) =  (Rs. 4,20,000)
Increased Net Income  Rs. 98,000
Alternatively
Existing Revenue
El = 2000 kg × Rs. 210 = Rs. 4,20,000
Am = 6000 kg × Rs. 270 = 16,20,000 Rs.20,40,000
Proposed Income
EA = 6000 units × Rs. 400 = 24,00,000
Less: Processing Cost = 2,62,000  21,38,000
Increased Income  98,000
Alternatively
Joint cost
- 6,000 kg of Am Rs. 12,63,900
- 2,000 kg of El (half of Rs. 6,55,380) = Rs. 3,77,690
(at the point of split off ): Rs. 16,41,590
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Notes We will get 6,000 units of EA after incurring additional Rs. 2,62,000 of
further processing cost.
On 6,000 units of EA, the total sale revenue earned is Rs. 24,00,000.
Hence the profit can be calculated as Rs. 24,00,000 – Rs. 16,41,590 –
Rs. 2,62,000 = Rs. 4,96,410.
If 6,000 kg of Am and 2,000 kg of El were sold at the split-off point, total
profit earned (Rs. 16,20,000 + 4,20,000 – Rs. 16,41,590) = Rs. 3,98,410.
As the amount of profit on making EA of Am increases by Rs. 98,000,
therefore, company must consider the proposal and accept it.
IN-TEXT QUESTIONS
1. __________ is defined as the type of costing procedure which
can be used for calculation of cost of product in continuous or
mass production industries.
2. Cost for units lost through __________ is absorbed by the
remaining “good” units produced during the period.
3. The __________ is the number of complete units that could
have been obtained from the materials, labour and overheads
that went into the partially completed units.
4. The difference between actual loss and normal loss is termed
as __________.
5. Two or more products produced simultaneously from the same
raw materials less important than main product are known as:
(i) Joint Product
(ii) Finished Product
(iii) By-Product
(iv) Raw Materials
6. Which of these is not a method of calculating value of joint
cost:
(a) Physical Units Method
(b) Average Cost Method
(c) Net Realisable Value Method
(d) Budgeted Cost Method

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7. Which of the following is not a process loss: Notes

(a) By-Products
(b) Normal Loss
(c) Wastage
(d) Scraps
8. Which of these is not a feature of process costing:
(a) Products pass through different processes
(b) Cost of materials, labour and overheads are calculated for
each process
(c) Products produced are heterogeneous and differential
(d) Output and value of output of each process is transferred
to the next process until the finished good is completed

4.6 Summary
Process Costing is the method of costing in which costs are compiled
process wise for the standard products. Cost of one process is transferred
to the cost of next process as input. During the production, each process
may generate wastes along with goods. Process Loss including wastes,
scraps, defectives may be normal loss, abnormal loss or abnormal gains.
In case of raw material that is under production but not completed yet
as finished goods are known as work-in-progress. Calculation of value of
work-in-progress is done by calculating equivalent units of production.
Two or more products which are formed during the same process are
either joint products or by-products.

4.7 Answers to In-Text Questions

1. Process Costing
2. Normal Loss
3. Equivalent Units
4. Abnormal Loss
5. (c) By-Product

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Notes
6. (d) Budgeted Cost Method
7. (a) By-Products
8. (c) Products produced are heterogeneous and differential

4.8 Self-Assessment Questions

1. Explain Process Costing. Mention the advantages and limitations of
process costing.
2. Differentiate between joint products and by-products with example.
Briefly explain the methods used in accounting of the same.
3. Distinguish between normal loss and abnormal loss. Explain how to
treat the losses in the process accounting.
4. 500 kg of raw material was introduced in Process I at the rate of
Rs. 100. Direct Labour and Other manufacturing expenses amount
to Rs. 25,000 and Rs. 10,000 respectively. Normal loss is 10%
and the net output generated is 420 kg. Prepare a ledger account
of Process I, if the scrap realises Rs. 12 per unit.
5. Product Alpha passes through three processes during the month of
January. If 2000 units of alpha were produced, prepare the process
accounts and calculate per unit cost of each process.
Process M Process N Process O
Raw Materials 70,000 60,000 30,000
Wages 30,000 25,000 25,000
Other Expense 12,000 20,000 26,000
Overhead expenses amounting to Rs. 16,000 can be apportioned on
the basis of wages.
6. For Gabra Ltd, the product passes through three processes I, II and
III. The output of each process is passed as the input in the next
process. Following information is considered:
Particulars Process I Process II Process III
Cost of Materials consumed (Rs.) 51,000 32,000 10,500
Labour (Rs.) 6,700 4,800 5,100
Manufacturing Expenses (Rs.) 12,800 10,200 9,600

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Particulars Process I Process II Process III Notes

Finished Goods (units) 2,800 2,700 2,400
Normal Loss 3% 6% 9%
Calculate the cost of the final product if 3,000 units have been issued
to Process I and Rs. 2.50 per unit can be realised from scrap.
7. Following information relating to the cost of X product passes
through three processes. During the month of March, 1000 units
were produced. Prepare the process accounts and calculate per unit
cost of each process.
Process I Process II Process III
Raw Materials 40,000 20,000 10,000
Wages 20,000 15,000 15,000
Direct Expense 6,000 2,000 4,000
Rs. 10,000 are the overhead expenses that can be apportioned on
the basis of wages.
8. For MN Ltd, the product Generator passes through three processes
namely Alpha, Beta and Gamma. The output of each process is
passed as the input in the next process. Following information is
considered:
Process Process Process
Particulars Alpha Beta Gamma
Materials issued 31,000 22,000 7,500
Wages 6,300 4,500 800
Production Expenses 9,800 8,200 12,600
Output 19,000 18,000 16,000
Normal Loss 3% 6% 9%
Calculate the cost of the final product if 20,000 units have been
issued to the Process-Alpha and Rs. 2 per unit can be realised from
scrap.

4.9 References
‹ Arora, M. N. A Textbook of Cost and Management Accounting,
12th ed. Vikas Publishing House Pvt. Ltd.

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Notes ‹ Maheshwari, S. N. and Mittal, S. N. Cost Accounting: Theory and

Problems. Shree Mahavir Book Depot.
‹ Dr. P. Periasamy. A Textbook of Financial Cost and Management
Accounting. Himalaya Publishing House.
‹ ICAI Study Material.

4.10 Suggested Reading

‹ Datar, S. M. & Rajan, M. V. (2017). Horngren’s Cost Accounting:
A Managerial Emphasis (16th Edition), Pearson.

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 L E S S O N

5
Cost Concepts in Decision
Making
CA. Vishal Goel
Ex-Associate Professor
Amity University
IILM University
Email-Id: [email protected]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Cost Concepts in Decision Making
5.4 Objectives of a Costing System
5.5 Marginal Costing
5.6 Advantages of Marginal Costing
5.7 Limitations of Marginal Costing
5.8 Difference between Marginal Costing and Absorption Costing
5.9 Cost-Volume-Profit Analysis
5.10 Break-Even Analysis
5.11 Various Decision-Making Problems
5.12 Summary
5.13 Practical Problems
5.14 Answers to In-Text Questions
5.15 Self-Assessment Questions
5.16 References
5.17 Suggested Readings

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Notes
5.1 Learning Objectives
After reading this lesson students should be able to understand:
‹ Various cost concepts involved in decision making.
‹ Concepts of relevant, differential, incremental and opportunity costs.
‹ Objectives of various costing systems.
‹ Concepts of marginal costing.
‹ Advantages and limitations of marginal costing.
‹ Difference between absorption and marginal costing.
‹ Break-even analysis and its uses for decision making.
‹ Concept of CVP analysis and its practical application in various
decision making process like make or buy decisions, selection of
a suitable product mix, effect of change in price, Shut down or
continue, maintaining a desired level of profit.

5.2 Introduction
Meaning of Managerial Decision-Making
In simple words, Managerial decision making is the process of deciding
the particular course of action from among various alternative courses
of action available in present scenario. For every managerial problem,
generally there are various courses of action available, the manager has
to choose from among them that course of action which he/she believes
or considers to be most effective in solving that particular problem. In
deciding this he/she has to consider all the given resources and other
internal and external factors which are relevant and can impact the deci-
sions like Govt. Policies, laws of the country, Policies of the competitors.
Since all decisions are futuristic in nature, so involve lot of forecast on
what could occur in future. Due to this reason in all managerial decision
manager try to build in the concept of probability. The larger the period
of forecast, greater is the degree of analysis required. Decisions can be
routine in nature like how much of goods to be produced next week to
achieve desired level of sales, such decisions can be taken with little
consumption of time and efforts as degree of uncertainty is less.

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 Cost Concepts in Decision Making

On the other hand some non-routine decisions like to shut down a plant Notes
or not due to very little demand of product is a major decision and may
involve lot of calculations, analysis and forecasting by managers as it will
have major financial and non-financial implications. So while taking such
decision manager has to spend lot of time in discussions with various
departments involved and to be impacted by this decision.

5.3 Cost Concepts in Decision Making

Relevant and Irrelevant Costs
To take correct managerial decisions managers must always be aware
of the fact that which costs are relevant for that particular decision and
which are irrelevant.
Relevant costs are the costs which would be impacted by managerial
decisions. They are the future cost whose magnitude will be affected by
a decision, while Irrelevant costs are those which would not be affected
by the decision.
For example, if a manager is considering closing down of a factory for
1-2 years due to low demand of the goods produced in that factory, wages
payable to the workers of the factory are relevant in this connection as
they will not be paid on closing down of the factory so result in cost
saving, but prepaid rent for the factory will be irrelevant costs as it will
not be refunded so it must be ignored.

Differential Cost (Incremental and Decremental Costs)

Quite often managers are confronted with 2 or more alternatives which
have different cost implications and he/she has to choose one out of them
keeping in mind all relevant factors. When one alternative is chosen over
the other it is bound to have impact on total cost, either total cost will
be increased or decreased.
The difference in total costs between two alternatives is termed as Dif-
ferential Costs.
Differential cost is the increase or decrease in total costs resulting out of:
(a) Producing a few more or few less of products
(b) A change in the method of production

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Notes (c) An addition or deletion of a product in product mix

(d) The selection of an additional sales channel.
Differential costs can be very useful in planning and decision making and
help manager to choose the best alternative among all options available.
It helps management to know the additional profit that would be earned
if a particular alternative is selected over another one.
In case the choice of an alternative results in increase in total costs,
such increased costs are known as Incremental Costs. In case the choice
results in decrease in total costs, such decreased costs are termed as
Decremental Costs.
For example: Suppose cost of Raw material supplied by our current
Supplier A is Rs. 6 per unit while cost of material supplied by supplier
B is Rs. 8 per unit and we need 10000 units of such raw material. If
Manager decides to choose supplier B over the current supplier A as B is
giving better quality material than the differential cost will be Rs. 20000
(2*10000). Also since there is an increase in cost due to the decision it
will be called as incremental cost.

Opportunity Cost
Opportunity cost is a very important concept in decision making. It rep-
resents the best alternative that is foregone in taking the decision. The
opportunity cost emphasises that decision making is mainly concerned
with alternatives and that the cost of taking one decision is the profit or
benefit foregone by not taking the next best alternative.
In other words, this cost means the value of benefit sacrificed in favour
of an alternative course of action.
Example: If the owner starts a business and invests money in buying
plant and machinery. He has to forego the interest he was earning while
this money was in Fixed deposits from where it is withdrawn. The loss
of interest that would have been earned is the opportunity cost.
Opportunity costs are not recorded in the books as no cash payment is
involved but it is important in decision making and comparing various
alternatives. It is also known as Imputed Cost.

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Notes
5.4 Objectives of a Costing System
From the discussion in the previous section, now you are aware that there
are different types of costs and we need to carefully examine whether a
particular cost is to be considered for decision making or not.
Some costs are direct in nature while others are indirect, direct costs can
be associated to a specific product/service but indirect costs are the ones
which cannot be associated to specific product/services as there is no
direct relation between their occurrence and the production activity. So
all different costs need to be allocated on some objectives and rational
basis for calculating the total cost of a particular product or service and
thereby do the pricing which can be justifiable to customers.
Costing Systems are the systematic allocation of costs to products by
following one or the other available and suitable technique. It can be
used for planning and decision making. Since costing is mostly done in
advance for goods or services to be produced and delivered in future so
generally forecasted/budgeted figures are used.

Objectives of a Costing System

Whatever costing system we follow as per suitability in that particular
industry or type of product, basic objectives of costing system remain
same and they are:
1. Ascertainment of Cost: This is the primary objective of cost
accounting. The cost of each product, job or service is ascertained.
2. Determining Selling Price: All Business entities operate with profit
making as one of the major objectives. So it is expected that the
revenue should be greater than the costs incurred in producing goods
and services. Cost system should be so designed that it provides
complete information regarding the cost to produce and sell such
goods or services.
3. Cost Control and Cost Reduction: It must assist in cost control.
Budgets should be prepared well in advance. The standards for each
item of cost can be determined, the actual costs are compared with
the standard costs and variances to be calculated along with the
causes of variances. The aim of a good costing system is not only

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Notes to control cost but also provide important information to assist in

cost reduction without compromising on the quality of goods or
services.
4. Providing Data for Managerial Decision-making: Cost data must
provide information for various managerial decisions for example:
(a) Introduction of a new product
(b) Utilization of unused plant capacity
(c) Making components in-house or buying components from
outside suppliers
(d) Shut down or continue
(e) Selling below total cost in special orders
IN-TEXT QUESTIONS
1. The benefit which is foregone due to a particular managerial
decision is known as ___________ cost.
2. The cost which will be impacted by managerial decisions is
known as ___________ cost.

5.5 Marginal Costing

Marginal costing is the process of ascertaining marginal (additional) costs
and the effect of changes in volume of output on profit.
This is done by differentiating between fixed costs and variable costs.
Several other terms are used synonymously in place of marginal costing
like direct costing, variable costing, and incremental costing.
Marginal costing can also be defined as a process whereby each cost el-
ement is analysed and is classified into fixed cost and variable cost and
after this division managerial decisions are taken to be more effective.
Variable costs are the ones which vary with volume of production or
output, whereas fixed costs are the ones which remain unchanged irre-
spective of changes in the volume of production or output.
In other words per unit variable cost remains same at different levels
of output and total variable cost changes in direct proportion with the
number of units. On the other hand, total fixed cost remains same for all

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levels of output, while per unit fixed cost keeps changing with change Notes
in number of units; more the number of units produced lesser will be
the per unit fixed cost.

5.6 Advantages of Marginal Costing

1. It Helps in Determining the Volume of Production: Marginal costing
helps in determining the level of output which is most profitable
for a running concern. The production capacity, therefore, can be
utilized to the maximum possible extent.
2. Maximisation of Profit: It helps, in determining the most profitable
relationship between cost, price and volume in the business, which
helps the management in fixing appropriate selling price for its
products thus, maximization of profit can be achieved.
3. Helps in Selecting Optimum Production Mix: The techniques of
Marginal costing help in determining the most profitable production
mix by comparing the profitability of different products. With
analysis of data it can help in deleting the less profitable products
from the portfolio of products and adding more profitable new
products thereby creating an optimum product mix products.
4. Helps in Deciding whether to Make or Buy: The decision whether
a particular product should be manufactured in the factory or to be
bought from outside supplier can be taken. In case the purchase price
is lower than the marginal cost of production, it will be advisable
to purchase the product from outside rather than manufacturing it
in the factory.
5. Help in Deciding Method of Manufacturing: In case a product can
be manufactured by two or more alternative methods, ascertaining
the marginal cost of manufacturing the product by each method
will be helpful in deciding as to which method should be adopted
for maximum cost saving.
6. Helps in Deciding whether to Shut Down or Continue: In the
periods when company is suffering losses due to lower demand
for its products Marginal costing helps in deciding in whether the
production in the plant should be temporarily suspended or continued.

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Notes There are numerous other managerial decisions in which marginal costing
will be very helpful by providing the relevant data.

5.7 Limitations of Marginal Costing

1. Artificial Classification: Marginal costing assumes that all expenses
can be classified into fixed and variable expenses. But in real life
scenario it is difficult to analyse and classify all costs into fixed
and variable elements. Some elements of costs are partly fixed and
partly variable and their separation is mostly based on assumption
and not on facts. In reality all costs are variable in the long run.
2. Management Decision: In marginal costing most decisions are taken
based on variable costs that’s why it is also sometimes referred as
variable costing but if fixed costs are completely ignored, decisions
taken by management can be deceptive in certain circumstances.
For example, with the introduction of costly automatic machine,
the importance of fixed costs is increasing day by day.
3. Marginal Costing Ignores Time Factor and Investment: The
marginal cost of two jobs may be the same but the time taken for
their completion and the cost of machines used may differ. The true
cost of a job which takes longer time and uses costlier machine
would be higher. This fact is not covered by marginal costing.
4. Controllability of Fixed Cost: In Marginal costing the importance
of controlling fixed costs is completely ignored. No doubt, fixed
costs can also be controlled in short term but by placing them in
a separate category and by accepting them as fixed and completely
non-controllable, the importance of controllability of fixed cost is
undermined.
5. Difficult to Apply: The technique of marginal costing is difficult
to apply in industries such as ship building, and other construction
based industries where due to long operating cycle the value of
work in progress is generally high in relation to turnover.
6. Stock is Understated: Under marginal costing stocks and work in
progress are valued at variable cost only so their value is bound
to be understated.

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7. No Basis for Cost Control or Reduction: Marginal costing does not Notes
provide any standard for the evaluation of performance. A system
of budgetary control and standard costing provides more effective
tools and basis for cost control than the one provided by marginal
costing.

5.8 Difference between Marginal Costing and Absorption

Costing
Absorption Costing: The process of charging all costs, both variable and
fixed, to operations, products or process is known as absorption costing.
So in other words absorption costing is a method of costing in which
all direct costs and appropriate overheads are absorbed/charged in cost
of the product or services for finding out the total cost of production.
Stock Valuation under Absorption Costing vs. Marginal Costing:
Inventories are over-stated in absorption costing as it includes one extra
cost element in inventory value than under marginal costing, i.e. the
fixed manufacturing cost.
Inventory Value under Absorption Costing: Direct material + Direct
labour + variable manufacturing costs + Fixed manufacturing costs

Inventory Value under Marginal Costing

= Direct material + Direct labour + variable manufacturing costs
From the discussion so far one can easily understand that there are some
basic differences in basic premise on which costs are ascertained in ab-
sorption costing and marginal costing. The main difference is in treatment
of fixed cost among the two. While in absorption costing it is treated
in same manner as variable cost and forms part of total cost based on
which stock is valued but on the other hand in marginal costing only
variable costs are considered in decision making and valuing the stock.
Following are various points of difference between Absorption Costing
and Marginal Costing:

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Notes Basis of Difference Absorption Costing Marginal Costing

Classification of Costs Costs are not classified Costs have to be classified
into variable and fixed. into fixed costs and variable
costs. To establish cost-vol-
ume-profit relationship.
Treatment of Fixed Fixed production over- Fixed production costs are
Production overheads heads are charged to the regarded as period cost and
product. It is included are charged to revenue along
in cost per unit. with the selling and admin-
istration expenses, i.e., they
are not included in cost per
unit.
Calculation of Profit Profit is the difference Under marginal costing first
between sales and cost contribution is ascertained
of goods sold. by subtracting variable cost
from total revenue. After
that we deduct therefrom
the total fixed expenses to
calculate profit.
Effect of valuation of If inventories increase If inventories increase during
inventory on Profit during a period, this a period, this method gener-
method will reveal ally reports less profit than
more profit than mar- absorption costing but when
ginal costing. When inventories decrease this
inventories decrease, method reports more profit.
less profits are report- As closing stock is valued
ed because under this at lower cost as compared
method closing stock is to absorption costing.
valued at higher figures
as it includes absorbed
fixed cost also.
Over/under-absorption Arbitrary apportionment Since fixed costs are exclud-
of Overheads of fixed costs may re- ed, there is no question of
sult in under or over-ab- arbitrary apportionment of
sorption of overheads. fixed overheads and thus no
under or over-absorption of
overheads.
Let’s understand with the help of an example how profit is calculated
under absorption costing and Marginal costing. Before that understand
the format for income statement under both methods.

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Income Statement under Absorption Costing Notes

Amount
Particulars Rs.
Sales (A) XXX
Variable (Direct Material Cost) X
Variable (Direct Labour Cost) X
Variable (Direct Expenses) X
Variable Factory Overhead X
Fixed Factory Overhead absorbed (units produced × standard rate per unit ) X
Total manufacturing cost of Quantity Produced XXX
Add: Opening FG X
Less: Closing FG X
Total manufacturing cost of Quantity Sold XXX
Add: Variable Office and Admin Overhead X
Fixed Office and Admin Overhead X
Variable Selling and Distribution Overhead X
Fixed Selling and Distribution Overhead X
Add: Under absorbed Overhead (Actual Overhead incurred – Overhead X
absorbed)
X
Less: Over absorbed Overhead (Overhead absorbed – Actual Overhead
incurred)
Total Cost of Sales (B) XXX
Profit (A – B) XXX

Income Statement under Marginal Costing

Amount
Particulars Rs.
Sales XXX
‹ Less: Variable Cost
‹ Direct Material Cost X
‹ Direct Labour Cost X
‹ Direct Exp. X
‹ Variable Factory Overhead X
‹ Variable Office and Admin Overhead X
‹ Variable Selling and Dist. Overhead X

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Notes Amount
Particulars Rs.
Contribution XXX
‹ Less: Fixed Cost

‹ Fixed Factory Overhead X

‹ Fixed Office and Admin Overhead X
‹ Fixed Selling and Dist. Overhead X
Profit XXX

Example 1: VGA Ltd. produces a single product and normal level of

production is 18000 units. Information for last accounting year is pro-
vided below:
Production 20000 units sales 16000 units
Particulars Rs.
Selling Price per unit 30
Production cost:
Direct material cost per unit 7
Direct labour cost per unit 6
Variable Overheads per unit 4
Fixed Overhead incurred 54,000
Variable Selling and administration overheads per unit 4.5
Fixed Selling and administration overheads 25,000
There was no opening stock of finished goods.

Income Statement under Absorption Costing Method

Amount Amount
Particulars (Rs.) (Rs.)
Sales (A) 4,80,000
Production cost:
Direct material cost (20000*7) 1,40,000
Direct labour cost (20000*6) 1,20,000
Variable Overheads (20000*4) 80,000
Fixed Overhead incurred 60,000 4,00,000
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 Cost Concepts in Decision Making

Amount Amount Notes

Particulars (Rs.) (Rs.)
Add: Opening stock Nil
Less: Closing stock (4000*20) (80,000)
Total Production cost 3,20,000
Less: over-absorbed overheads (2000*3) (6,000)
Adjusted Production Cost 3,14,000
Variable Selling and administration overheads 72,000
(16000*4.5)
25,000 97,000
Fixed Selling and administration overheads
Total Cost of Sales (B) 4,11,000
Profit (A – B) 69,000
Fixed production overheads given are Rs. 54,000 for budgeted 18000
units so it comes down to Rs. 3 per unit (54000/18000)
Fixed production overheads absorbed for current production of 20,000
units is Rs. 60,000 (20000*3)
Therefore over-absorbed fixed production overheads 6000 (60000 - 54000)

Income Statement under Marginal Costing

Amount Amount
Particulars Rs. Rs.
Sales 4,80,000
‹ Less: Variable Cost
‹ Direct Material Cost 1,40,000
‹ Direct Labour Cost 1,20,000
Variable Factory Overhead
‹ 80,000
Total Variable cost of production 3,40,000
Add: Opening Stock Nil
Less: Closing Stock (4000*17) (68,000)

Add: Variable Selling and Administration Overheads 2,72,000

72,000 3,44,000
Contribution 1,36,000

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Notes Amount Amount

Particulars Rs. Rs.
‹ Less: Fixed Cost
‹ Fixed Production Overhead 54,000
‹ Fixed Selling and Admin Overhead 25,000 79,000
Profit 57,000

So it can be observed that there is a difference of Rs. 12,000 between

profits under two methods, this is the same amount as difference between
value of closing stock. Since closing stock under Absorption is valued
at Rs. 80,000 (Full Cost of production) while in Marginal costing it is
valued at Rs. 68,000 (Variable Cost of Production)

5.9 Cost-Volume-Profit Analysis

Cost-Volume-Profit (CVP) analysis is the systematic study of relationship
between cost of the product, volume of activity and the resultant profit.
Since all these three factors are interrelated so it’s very important to
study their relationship and how a change in one can effect the other as
well. For example, cost of the product will provide the base on which
selling price will be determined and accordingly profit will be calculated.
If we change selling price it might impact volume of sales and volume
of production and thereby will impact the cost.
So CVP analysis is very important technique used in managerial decision
making and achieving the desired results.

Assumptions in CVP Analysis

1. Any changes in the levels of revenues (Sales) and costs arise only
because of changes in the number of units produced and sold – for
example, the number of cars produced and sold by Maruti Suzuki
or the number of passengers travelling in a bus.
2. Total costs can always be separated into two elements or parts i.e.
a fixed element which does not change with the level of output and
a variable element which changes with level of output.

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3. Selling price per unit, variable cost per unit, and total fixed costs Notes
are known and constant. (Mind it, Total sales and total variable
cost will keep changing with level of output).
4. It is assumed that company is either selling a single product or that
the proportion of different products will remain constant as the
level of total units sold changes i.e. sales mix remains constant.
Before we proceed further, let us briefly discuss various concepts and
symbols used in marginal costing and CVP analysis.

Total Fixed Cost (TFC):

It remains constant or same at all levels of output.

Total Variable Cost (TVC):

It will be 0 at zero level of activity and increases proportionately with
the volume of activity.

Total Cost (TC):

It is a combination of fixed cost and variable cost so it will start from
the level of fixed cost and keep increasing following the variable cost.
Total Sales (S): It represents the total amount received as revenue by
selling the goods produced.
Profit (P): It represents the difference between Total Sales and Total Cost.

Basic equation:
Total sales = Total Fixed Cost + Total variable Cost ± Total Profit
TS = FC + VC + P
Contribution (C): When only Variable cost is subtracted from Sales
the resultant figure is called Contribution. Since in Marginal costing it
is assumed that fixed cost will remain same at least in short run for all
levels of production activity. So, contribution is an important concept to
help in decision making in marginal costing.
Contribution = Total Sales – Total Variable Cost
OR Contribution = Fixed Cost + Profit
Standard Marginal Cost Statement (Simplified)

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Notes Amount
Particulars (Rs.)
Sales (S) XXX
Less: Variable Cost (VC) XXX
Contribution (C) XXX
Less: Fixed Cost (FC) XXX
Profit (P) XXX

Concepts Used in Marginal Costing for Decision Making

1. Profit Volume (P/V) Ratio:
This ratio helps in knowing the profitability of the operations of a
business. It establishes the relationship between Contribution and Sales.
Since Fixed cost does not change with the level of output any increase
in contribution will lead to increase in profit.
So profitability of the different Goods produced by a company can be
ascertained by comparing their P/V ratio. The higher the P/V ratio high-
er the profit of that particular product and vice-versa. P/V ratio is also
known as Contribution Margin Ratio or Contribution to Sales Ratio.
Contribution
P/V Ratio = × 100
Sales
Contribution per unit
Or × 100
Sales per unit
Change in contribution
Or × 100
Change in sales
Change in profit
Or × 100
Change in sales
Let us see how all of these formulas will give same result for a given
set of information.
Example 2: Khushi Enterprises shares with you their cost data for 2 years.
Particulars Year 1 Year 2 Change
Production 5000 units 8000 units 3000 units
Sales @ 5 per unit 25000 40000 15000
Variable cost @ 3 per Unit 15000 24000 9000
Contribution @ 2 per unit 10000 16000 6000
Fixed cost 4000 4000 0
Profit 6000 12000 6000

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Let’s check P/V ratio with all Formulas mentioned above. Notes
Contribution
P/V Ratio = × 100 For Year 1 (10000/25000)*100 = 40%
Sales
Contribution per unit
Or × 100 For year 1 (2/5)*100 = 40%
Sales per unit
Change in contribution
Or × 100 (6000/15000)*100 = 40%
Change in sales
Change in profit
Or × 100 (6000/15000)*100 = 40%
Change in sales
So, that’s the benefit of this formula that as per given information we
can use any of its version still getting same answer.

5.10 Break-Even Analysis

Though many believes that there is no difference in CVP analysis and
Break-even analysis and they refer to same concept others believe that
CVP is a broader term and include Break-even analysis. But if we carefully
observe concepts used in them we can say that Break-even analysis is
actually a method to apply the CVP analysis in decision making process
by including many more related concepts into it.

Break-Even Point
Break-even point is production and sales level where there will be no
profit and loss i.e. total cost (TC) is equal to total sales revenue (S).
or Sales = Total Fixed Cost + Total Variable Cost & Profit = 0
Break-even Point can be calculated both in units and Rs. When calculated
in Terms of Rs., it is also referred as Break-even sales.
Let us calculate Break-even point for the given set of data we used in
CVP analysis above.
Particulars Year 1 Year 2 Change
Production 5000 units 8000 units 3000 units
Sales @ 5 per unit 25000 40000 15000
Variable cost @ 3 per Unit 15000 24000 9000
Contribution @ 2 per unit 10000 16000 6000
Fixed cost 4000 4000 0
Profit 6000 12000 6000

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Notes Fixed costs

Break-even point (in units) = BEP =
Contribution per unit
So for given set of values Break-Even Point = (4000/2) = 2000 units
We can crosscheck this by simple calculations.
Suppose we produce 2000 units and selling price is 5 per unit so total
sales 10000.
Variable cost @ 3 per unit will be (2000 *3) = 6000 so contribution will
be 4000 and fixed cost given is 4000 so profit will be 0.
Break-even Point (in Rs.) = BES (Break even Sales)
Fixed costs
= × Sales per unit
Contribution per unit
Fixed Cost
Or BEP in units * Selling Price per unit or
P/v ratio
In our example BES (Break even Sales) = 2000 * 5 = Rs. 10000 Or
4000/40% = Rs. 10000
Let’s see few other related concepts which further help in decision making.
Break-Even Point with Desired Profits: BEP with DP (in units)
Since no business entity would like to settle at Break-even point, their
main objective of existence is to earn profit for shareholders or owners
so it makes sense to calculate particular level of units to be produced
and sold to earn desired profits.
Fixed cost + Desired profit
BEP with DP (in units) =
Contribution per unit
And following the same concept which we discussed for BEP in rupees,
BEP with desired profit in rupees can also be calculated in similar manner.
BEP with DP (In Rs.) = BES with DP
Fixed cost + Desired profit
= × Sales per unit
Contribution per unit
Or BEP with DP in units * Selling Price per unit
Fixed cost + Desired profit
Or
P/V ratio

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Let us assume in our example shareholders have given a target of Notes

Rs. 24000 Profit to be earned.
So BEP with DP in Units = (4000 + 24000)/2 = 14000 units
BEP with DP in Rs. = 14000*5 = Rs.70000 or (4000 + 24000)/40% =
Rs. 70000
This can be verified with following calculations:
Production 14000 units
Sales @ 5 per Unit 70000
Variable cost per unit @ 3 per unit 42000
Contribution @ 2 per unit 28000
Fixed Cost 4000
Profit 24000
So it can be clearly observed that by producing and selling 14000 units
the revenue will be Rs. 70000 and a profit of Rs. 24,000 is expected to
be achieved.

Margin of Safety (MOS)

Margin of safety is the difference between actual sales and Break-even
sales. It can be expressed in absolute terms or as a % of Actual sales.
MOS (Absolute) = Actual Sales – Break-Even Sales
MOS can also be calculated with following Formula:
MOS = Profit/P/V ratio
MOS (%) = MOS/Actual sales
So in our example, if we calculate Margin of Safety for 2nd year it will be:
MOS (Absolute) Actual Sales – BES = 40000 – 10000 = Rs. 30000
MOS = 12000/40% = Rs. 30000
MOS (%) = MOS/Actual Sales = 30000/40000 = 0.75 or 75%
Let us see with few more examples that with the minimal information
given how we can calculate all these components which will help in
decision making process to a great extent.
Example 3: Homemakers Pvt Ltd. gives you following data:

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Notes Amount
Particulars in Rs.
Sales 500000 units 15,00,000
Fixed Cost 4,50,000
Profit 3,00,000
You need to find BEP, MOS
Solution:
Since all marginal costing concepts revolve around contribution and P/V
ratio lets first calculate that
Contribution = Fixed Cost + Profit
= 4,50,000 + 3,00,000 = 7,50,000
P/V Ratio = (Contribution/Sales)*100
= (7,50,000/15,00,000)*100 = 50%
BEP in Rs. (in Sales) = Fixed Cost/P/V ratio
= 4,50,000/50% = 9,00,000
BEP in Units = BEP in sales/Selling Price per unit
= 9,00,000/3 = 3,00,000 units
(Note: Selling price per unit = sales/no. of units = 15,00,000/5,00,000
= 3 per unit)
Margin of Safety (in Rs.) = Actual sales – Break-even sales
= 15,00,000 – 9,00,000 = Rs. 600000
Margin of safety (in %) = MOS/Actual Sales
= 6,00,000/15,00,000 = 0.4 or 40%
Angle of Incidence
The angle which the Total Sales Line makes with the Total Cost Line is
known as the Angle of Incidence.
The angle indicates the profit-earning capacity of the company over the
break-even point.
A large angle of incidence indicates a high margin of profit and a mall
angle of incidence indicates earning of low margin of profit.

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Notes

Let us see with a few more examples that with the minimal information
given how we can calculate all these components which will help in the
decision-making process to a great extent.
Example 4: Mrs Anju is running a business named “AHAAR” for sup-
plying packed foods to nearby offices. She supplied you the following
information and asked for answers to few questions.
Particulars Year 1 Year 2
Sales 20,00,000 30,00,000
Profit 2,00,000 4,00,000
Answer the following:
1. P/V ratio
2. Variable cost for year 1
3. Fixed Cost
4. BEP
5. Sales to earn a Profit of Rs. 6,00,000
6. Profit when sales are 50,00,000
7. MOS for a Profit of 6,00,000

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Notes Solution:
1. P/V ratio = (Change in Profit/Change in Sales)*100
= (2,00,000/10,00,000)*100 = 20%
2. Variable cost in 1st year = Sales – Contribution
Contribution in year 1 = Sales *P/V ratio
= 20,00,000* 20% = 4,00,000
Therefore Variable cost = 20,00,000 – 4,00,000 = 16,00,000
3. Fixed Cost = Contribution – Profit
= 4,00,000 – 2,00,000 = Rs. 2,00,000
4. BEP = FC/P/V ratio
= 2,00,000/20% = 10,00,000
5. Sales to earn a profit of 6,00,000
BEP with DP = (FC + DP)/P/V ratio
= (2,00,000 + 6,00,000)/20%
= Rs. 40,00,000
6. Profit when sales are 50,00,000
Contribution = Sales * P/V ratio
= 50,00,000*20%
= 10,00,000
Profit = Contribution – fixed cost
= 10,00,000 – 2,00,000 = Rs. 8,00,000
7. MOS for a profit of 6,00,000
MOS = Profit/P/V ratio
= 6,00,000/20%
= 30,00,000

5.11 Various Decision-Making Problems

In every organisation Management uses marginal costing and CVP analysis
concepts for making various decisions. Generally, short-term decisions
are related with temporary gaps between demand and supply for available
resources.

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In this section, we will learn how the concepts of marginal costing and Notes
CVP is applied for analysis of identified options for short-term decision
making. Some of the Decision problems faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs. Export sale
4. Make or Buy/In-house-processing vs. Outsourcing
5. Shut-down or continue decision etc.

1. Limiting Factor (Key Factor)

In normal circumstances, the company will always prioritise the product
to be produced which will give the greatest contribution. To maximise
profit, resources should be mobilised towards that product which gives
the maximum contribution. But in real life, there may be several factors
which may put a limit on the number of units to be produced even if
the products give a high contribution. These factors limit the volume of
output at a particular point of time or over a period. These are called
key factors, scarce factors, limiting factors.
The limiting factors may be, raw material available, labour hours available,
Machine hours available, availability of capital etc. For example, for a
factory in a remote location, labour may be a key factor or the factory
in a location with limited power supply may have limited machine hours
for production. Contribution per unit of key factor should be considered
and that particular course of action should be adopted which gives the
highest contribution per unit of key factor.
Example 5:
You are given the following information in respect of products X and Y
of Altitude Ltd.
Product X Product Y
Selling price 55 35
Direct material 10 5
Labour hours (Rs. 2 per hour) 5 hours 10 hours
Variable overheads 20% of Direct wages

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Notes Show which product is more profitable during labour shortage. Also if
Labour hours available are 25000 hours and demand for X and Y is 2000
and 3000 units respectively.
Solution:
Particulars Product X Product Y
Selling price per unit in 37 49
Direct Material per unit in 10 5
Labour cost per unit ( Hrs *2 per hour) 10 20
Variable overhead (20% of Labour Cost) 2 4
Total Variable Cost per unit 22 29
Contribution per unit 15 20
Since Labour is in shortage it will be treated as Key factor and the
product which is generating higher contribution per unit of labour hour
will be produced first.
Contribution per unit 15 20
Number of Hrs required per unit 5 10
Contribution per labour hour: 3 2
So you can see that though contribution per unit is higher for Y but con-
tribution per labour hour for product X is higher so product X is more
profitable in the case labour hours are limited.
So we will first use labour hours for producing X to maximum possible
extent i.e. 2000 units in our case as demand is only for 2000 pieces
remaining labour hours will be used for Y.
Total labour hours available 25000
Labour hours for X (2000*5) 10000
Remaining labour hours 15000
Maximum Production of Y possible is 15000/10 (labour hr per unit for Y)
So only 1500 units of Y can be produced with remaining labour hour.
Now we can calculate Total Contribution by multiplying the unit produced
with the per unit contribution.
X(2000*15) = 30000
Y(1500*20) = 30000
Total = 60000

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2. Processing of Special Order/Accepting Export Order Notes

Sometimes company is faced with a situation that it receives an order to
supply goods below its normal selling price. In that case if company has
additional idle capacity, only additional cost in producing and processing
such order shall be compared with additional revenue to be generated.
In simple words only Marginal cost to be considered and if it is less
than the price offered by exported or new local customer then it can be
accepted, if it’s not going to impact current selling price of local market.
Example 6:
Anjana Industries manufactures and sells toys and has following cost
structure for each unit of product:
Amount
Particulars Rs.
Materials 10.00
Labour 8.00
Variable expenses 10.00
Fixed expenses 17.00
Total cost 45.00
Per unit Selling Price of the product is Rs. 52.00.
The company’s normal capacity is 1,00,000 units. The figures given above
are for 70,000 units. The company has received an offer for 20,000 units
@ Rs. 40 per unit from a customer in USA.
Advice the manufacturer on whether the order should be accepted. Also
give your advice if the order is from a local merchant.
Solution:
Marginal cost for additional 20,000 units:
Per unit For 20,000 units
Rs. Rs.
Material 10.00 2,00,000
Labour 8.00 1,60,000
Variable expenses 10.00 2,00,000
Marginal cost/ variable cost 28.00 5,60,000
Additional revenue to be realised 40 8,00,000
Marginal cost 5,60,000
Net additional contribution) 2,40,000
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Notes The offer should be accepted because it gives an additional contribution

of Rs. 2,40,000. The total profit will also increase by Rs. 2,40,000 be-
cause fixed expenses have already been recovered from the local market.
As regarding answer to 2nd part of question, the order from the local
customer should not be accepted at Rs. 40 per unit or at any rate below
the normal price i.e., Rs. 52 because it will result in the general reduction
of selling prices of the product.
Note: If circumstances are such that acceptance of the additional order is
beyond the present capacity of the organization then in that case, some
fixed expenses may also go up substantially. If there is an increase in
fixed expenses, the increase should also be considered by including it
in the total additional cost and then it shall be compared with the addi-
tional revenue.
3. Make or Buy Decision
Sometimes company is faced with a decision whether to buy a component
or part, required for its product from outside supplier or manufacture it
on its own.
In such cases, Marginal cost of producing that item internally shall be
compared with purchase price to come to a conclusion.
Example 7: SAANVI Automobile Ltd. manufactures 20,000 units of Part
UVW each year. At current level of activity, the cost per unit follows:
Direct materials Rs. 4.80
Direct labour Rs. 7.00
Variable manufacturing overhead Rs. 3.20
Fixed manufacturing overhead Rs. 10.00
Total cost per part UVW Rs. 25
An outside supplier has offered to sell 20,000 units of Part UVW each
for Rs. 22 per part. You are required to advice which option is better.
Solution:
Total Marginal Cost of Producing the Part in Factory
Direct materials Rs. 4.80
Direct labour Rs. 7.00
Variable manufacturing overhead Rs. 3.20

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Total Marginal cost of manufacturing Rs. 15 Notes

Total cost of purchase Rs. 22
It is advisable to manufacture in our own factory as cost saved by not
manufacturing is less than the purchase price. It is assumed that fixed
cost will still need to be incurred.
4. Product Profitability
In the event that a company produces multiple products, the issue of
the product mix that maximises profitability will arise. Due to a lack
of resources or capabilities, the company must deal with this issue. A
company should use a combination of sales that results in higher profit
or maximum contribution. The key or limiting component should also be
taken into account while choosing the profitable blend.
For example 8: The following describes a company’s sales/production mix:
1. The company produces 500 units each of Product A and Product B.
2. 1500 units of product C.
3. 300 units each of product B and C, and 500 units of product A.
Product A Product B Product C
Particulars (Rs.) (Rs.) (Rs.)
Direct Material 5 5 6
Direct Labour 3 5 4
Variable Cost 4 4 3
Fixed Cost 1500 1500 1500
Selling Price 20 30 25
Determine the profitable product mix.
Solution: First of all let us calculate the contribution per unit. Formula
to calculate Contribution per unit = Selling Price – (Direct material +
Direct Labour + Variable cost)
Contribution per unit Product A = 20 – (5+3+4) = Rs. 8 per unit
Contribution per unit Product B = 30 – (5+5+4) = Rs. 16 per unit
Contribution per unit Product C = 25 – (6+4+3) = Rs. 12 per unit
Then, evaluate different alternatives one by one:

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Notes Alternative 1: The company produces 500 units each of Product A and
Product B.
Total Contribution = (Contribution per unit Product A × No. of units of
Product A) + (Contribution per unit Product B ×
No. of units of Product B)
= (Rs. 8 per unit × 500 units) + (Rs. 16 per unit ×
500 units)
= Rs. 4000 + Rs. 8000 = Rs. 12,000
Profit = Total Contribution – Fixed cost
= 12,000 – 1500
= Rs. 10500
Alternative 2: 1500 units of Product C.
Total Contribution = (Contribution per unit Product C × No. of units of
Product C)
= (Rs. 12 per unit × 1500 units)
= Rs. 18000
Profit = Total Contribution – Fixed cost
= 18,000 – 1500
= Rs. 16500
Alternative 3: 300 units each of product B and C, and 500 units of
product A.
Total Contribution = (Contribution per unit Product A × No. of units of
Product A) + (Contribution per unit Product B ×
No. of units of Product B) + (Contribution per unit
Product C × No. of units of Product C)
= (Rs. 8 per unit × 500 units) + (Rs. 16 per unit ×
300 units) + (Rs. 12 per unit × 300 units)
= Rs. 4000 + Rs. 4800 + Rs. 3600 = Rs. 12,400
Profit = Total Contribution – Fixed cost
= 12,400 – 1500
= Rs. 10900

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Conclusion: As a result of its larger profit of Rs. 16500, product mix 2 Notes
is more profitable than the other product mixes.
5. Dropping a Product Line
When a company produces multiple products and needs to stop one of
them, management should make a decision based on the product’s con-
tribution, the impact on sales of other products, the plant’s capacity, etc.
Using the marginal costing technique, management can decide whether
to add or remove a product or product line. The product that contributes
the least should be discontinued.
Since the goal of every corporate organisation is to maximise profits, the
company can think about the efficiencies of doing away with unproductive
items and replacing them with more lucrative one(s).
In such circumstances, the company may have two options, as follows:
(a) To discontinue the unprofitable product and not use the available
capacity.
(b) To stop producing the unprofitable product and use the available
resources to start producing a more lucrative product.
For choosing whether to add or remove a product line the contribution
technique is used for this purpose, accounting for the following elements:
‹ Contribution from a product that isn’t viable (i.e. Sale Revenue
Less Variable Costs)
‹ Specific unprofitable product fixed costs that can now be avoided
or minimised.
‹ Contribution from a different profitable product that would be
produced using all available capacity.
The following considerations should be made into account whenever a
decision is made on whether or not the capacity will be increased.
‹ Additional fixed costs will be incurred.
‹ Possibility of a drop in selling price as a result of increased output.
‹ Whether there is enough demand to accommodate the extra production.
‹ The cost schedule will be developed based on the aforementioned
points.

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Notes ‹ The division of fixed expenses and the marginal contribution cost
must be considered while considering whether to shrink the firm.
Example 9: XYZ Ltd. manufactures three products:
A—500 units @ Selling price Rs. 25 Per unit;
B—400 units @ Selling price Rs. 30 Per unit;
C—300 units @ Selling price Rs. 28 Per unit;
The company decides to stop producing one product, which will result
in a 50% increase in the production of other products. The other details
are as follows:
Particulars Product A (Rs.) Product B (Rs.) Product C (Rs.)
Direct Material 5 6 7
Direct Labour 4 7 6
Variable cost 6 5 4
Fixed cost 8 7 9
You must determine which product needs to be discontinued.
Solution: First of all, let us calculate the contribution per unit. Formula
to calculate Contribution per unit = Selling Price – (Direct material +
Direct Labour + Variable cost)
Contribution per unit Product A = 25 – (5 + 4 + 6) = Rs. 10 per unit
Contribution per unit Product B = 30 – (6 + 7 + 5) = Rs. 12 per unit
Contribution per unit Product C = 28 – (7 + 6 + 4) = Rs. 11 per unit
Situation 1: Now let us suppose that production of products B and C
will each be boosted by 50% if product A is discontinued. 600 units of
B and 450 units of C would be produced, respectively.
Total Contribution = (Contribution per unit Product B × No. of units of
Product B) + (Contribution per unit Product C ×
No. of units of Product C)
= (Rs. 12 per unit × 600 units) + (Rs. 11 per unit ×
450 units)
= Rs. 7200 + Rs. 4950 = Rs. 12,150
Total Fixed Cost = (Fixed Cost per unit Product B × No. of units of
Product B) + (Fixed cost per unit Product C × No.
of units of Product C)
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= (Rs. 7 × 600) + (Rs. 9 × 450) Notes

= Rs. 4200 + Rs. 4050
= Rs. 8250
Profit = Total Contribution – Fixed cost
= 12,150 – 8250
= Rs. 3900
Situation 2: Now let us suppose that production of products A and C
will each be boosted by 50% if product B is discontinued. 750 units of
A and 450 units of C would be produced, respectively.
Total Contribution = (Contribution per unit Product A × No. of units of
Product A) + (Contribution per unit Product C ×
No. of units of Product C)
= (Rs.10 per unit × 750 units) + (Rs. 11 per unit ×
450 units)
= Rs. 7500 + Rs. 4950 = Rs. 12,450
Total Fixed Cost = (Fixed Cost per unit Product A × No. of units of
Product A) + (Fixed cost per unit Product C × No.
of units of Product C)
= (Rs. 8 × 750) + (Rs. 9 × 450)
= Rs. 6000 + Rs. 4050
= Rs. 10050
Profit = Total Contribution – Fixed Cost
= 12,450 – 10,050
= Rs. 2400
Situation 3: Now let us suppose that production of products A and B
will each be boosted by 50% if product C is discontinued. 750 units of
A and 600 units of B would be produced, respectively.
Total Contribution = (Contribution per unit Product A × No. of units of
Product A) + (Contribution per unit Product B ×
No. of units of Product B)
= (Rs. 10 per unit × 750 units) + (Rs. 12 per unit ×
600 units)
= Rs. 7500 + Rs. 7200 = Rs. 14,700
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Notes Total Fixed Cost = (Fixed Cost per unit Product A × No. of units of
Product A) + (Fixed cost per unit Product B × No.
of units of Product B)
= (Rs. 8 × 750) + (Rs. 7 × 600)
= Rs. 6000 + Rs. 4200
= Rs. 10200
Profit = Total Contribution – Fixed cost
= 14,700 – 10,200
= Rs. 4500
Conclusion: If product C is discontinued, production of products A and
B will each be boosted by 50%. As a result of its larger profit of Rs.
4500, this product mix is more profitable than the other product mixes.
6. Shut down vs. Continue Operations
When a corporation decides to shut down, it signifies that production will
stop temporarily. That indicates that the company will restart production in
the future. Reasons of shut down production include - decline in demand;
financial difficulty; high tax rates and technological change; inadequate
raw material availability a market downturn and mismanagement.
In general, all businesses should have greater revenue than total cost
(Revenue > Total Cost) in order to remain in operation. But in the short
run, all businesses disregard fixed costs; as a result, Revenue must be
equal to or higher than variable cost.
If the items are helping to pay for fixed costs, or if the selling price is
higher than the marginal cost then it is preferable to continue because
the losses are kept to a minimum.
Shut Down Point determines whether to shut down. The shutdown point
describes the precise point at which a company’s revenue and variable
costs are equal. Labour costs, supplies for production, and other varying
costs. It describes the precise point at which a company’s revenue and
variable costs are equal. A corporation is said to be operating at a shut-
down point when there is no advantage to continuing such operations.
in order to decide to temporarily or, in certain situations, permanently
shut down.

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Depending on the nature of the industry, certain fixed expenses can be Notes
avoided by pausing production while other fixed expenses may go up.
The contribution must be more than the difference between fixed expens-
es incurred during normal operation and fixed expenses incurred during
plant shutdown before a decision can be made. The formula below can
be used to determine the shutdown point.
Shutdown point is calculated as Total Fixed Cost – Shutdown Cost =
Contribution per unit
1. A Short-run Criterion
Depending on the company, the short-run is for a finite amount of time,
such as quarterly, half-yearly, or yearly. For choosing whether to stop
or continue in short run, only variable cost is taken into account during
the short-term outage. In other words, we analyze whether or not the
business can cover its variable costs for the short period during which
sales occur. Otherwise, the Firm must close.
As an illustration, suppose a company’s income is Rs. 500 and its vari-
able cost is Rs. 400 then the contribution will be Rs. 100. There is no
need to turn the product off in this case. However, the corporation must
discontinue that product if the variable cost exceeds the sales.
2. Long-term Criterion
Depending on the sort of business, the long run may be annually or
more frequently than annually. Both fixed and variable costs are taken
into account when considering a long-term shutdown. As an illustration,
let’s say a corporation sells for Rs. 500, with Rs. 450 in variable costs
and Rs. 100 in fixed costs. Then a loss of Rs. 50 occurs.
That suggests that while the business won’t last in the long run, it will
likely survive in the short term.
Marginal costs are useful when a department or product is being discon-
tinued. The marginal costing technique demonstrates how each product
affects the profit at fixed costs. If a department or product makes the
smallest contribution, it may be closed or its production may be stopped.
It implies that just the product with the highest level of contribution
should be used, and the rest should be discarded.

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Notes IN-TEXT QUESTIONS

Following information is available of Anvi enterprises for year ended
June, 2022:
Fixed cost Rs. 3,00,000
Variable cost Rs. 12 per unit
Selling price Rs. 15 per unit
Output level 1,50,000 units
3. P/V Ratio is:
(a) 80%
(b) 20%
(c) 100%
(d) 33.3%
4. BEP in units:
(a) 200000
(b) 100000
(c) 600000
(d) 300000
5. BEP in Rs.:
(a) 10,00,000
(b) 12,00,000
(c) 15,00,000
(d) 20,00,000
6. Sales required to earn profit of Rs. 6,00,000:
(a) 30,00,000
(b) 45,00,000
(c) 60,00,000
(d) 20,00,000

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Notes
5.12 Summary
Costing Systems are the systematic allocation of cost to products by
following one or the other available and suitable technique. It can be
used for planning and decision making. Objectives of a Costing System:
1. Ascertainment of cost.
2. Determining selling price.
3. Cost Control and Cost Reduction.
4. Providing data for managerial decision-making:
(a) Introduction of a new product,
(b) Utilization of unused plant capacity,
(c) Making components in house or buying components from
outside suppliers.
(d) Shut down or continue.
(e) Selling below total cost in special orders.
Marginal costing is the process of ascertaining marginal (additional)
costs and the effect of changes in volume of output on profit.
Advantages of Marginal Costing
1. It helps in determining the volume of production
2. Maximisation of Profit
3. Helps in selecting optimum production mix
4. Helps in deciding whether to Make or Buy
5. Helps in deciding method of manufacturing
6. Helps in deciding whether to shut down or continue
Limitations of Marginal Costing
1. Artificial Classification
2. Faculty Decision
3. Marginal costing ignores time factor and investment
4. Controllability of Fixed cost
5. Difficult to apply
6. Stock is understated
7. No Basis for cost control or reduction

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Notes Marginal Costing vs. Absorption Costing

The main difference is in treatment of fixed cost among the two. While
in absorption costing it is treated in same manner as variable cost and
form part of total cost based on which stock is valued but on the other
hand in marginal costing only variable costs are considered in decision
making and valuing the stock.
Cost-Volume-Profit (CVP) analysis is the systematic study of relationship
between cost of the product, volume of activity and the resultant profit.
Since all these three factors are interrelated so it’s very important to study
their relationship and how a change in one can effect the other as well.

Decision Making Problems

In this section, we have learned how the concepts of marginal costing
and CVP are applied for analysis of identified options for short-term
decision making. Some of the Decision problems faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs. Export sale
4. Make or Buy/In-house-processing vs. Outsourcing
5. Shut-down or continue decision etc.

5.13 Practical Problems

1. Two competing companies HERO Ltd. and ZERO Ltd. sell the same
type of product in the same market. Their forecasted profit and loss
accounts for the year ending December 2022 are as follows:
Particulars Hero Ltd. Zero Ltd.
Sales Rs. 5,00,000 Rs. 5,00,000
Less: Variable Costs Rs. 4,00,000 Rs. 3,00,000
Less: Fixed Costs Rs. 50,000 Rs. 50,000
Forecasted Profit Rs. 50,000 Rs. 50,000
You are required to state which company is likely to earn greater
profits in conditions of:
(a) Low demand
(b) High demand
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 Cost Concepts in Decision Making

2. Two manufacturing companies which have the following operating Notes

decided to merge:
Particulars Company A Company B
Capacity Utilization (%) 90 60
Sales (Rs. in lacs) 540 300
Variable Costs (Rs. in lacs) 396 225
Fixed Assets (Rs. in lacs) 80 50
Assuming that the proposal is implemented, calculate:
(a) Break-even sales of the merged plant and the capacity utilization
at that stage
(b) Profitability of the merged plant at 80% capacity utilization
(c) Turnover of the merged plant to earn a profit of Rs.75 lacs
(d) When the merged plant is working at a capacity to earn a
profit of Rs. 75 lacs, what percentage increase in selling price
is required to sustain an increase of 5% in fixed overheads
3. Croma manufactures and sells four types of products under the brand
names A, B, C and D. The sales mix in value comprises of 33-1/3%,
41-2/3%, 16-2/3% and 8-1/3% of A, B, C and D respectively. The
total budgeted sales are Rs.60,000 per month.
Operating costs of the company are as follows:
Product % of Sale Price
A 60%
B 68%
C 80%
D 40%
Fixed Cost is Rs. 14,700 per month.
The company proposes to change the sales mix for the next month
as follows and it is estimated that total sales would be maintained
at the same level as the current month:
Product Sales Mix
A 25%
B 40%
C 30%
D 5%
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 MANAGEMENT ACCOUNTING

Notes You are required to calculate:

(a) Break-even point for the products on an overall basis for the
current month.
Break-even point for the products on an overall basis for the next
month assuming that the proposal is implemented.
All Formulas at a Glance
1. Basic Cost equation:
Total sales = Total Fixed Cost + Total variable Cost ± Total
Profit
TS = FC + VC + P
2. Contribution = Total Sales – Total Variable Cost
OR Contribution = Fixed Cost + Profit
Contribution
3. P/V Ratio = × 100
Sales
Contribution per unit
Or × 100
Sales per unit
Change in contribution
Or × 100
Change in sales
Change in profit
Or
Change in sales
Fixed costs
4. Break-even point (in units) = BEP =
Contribution per unit
Fixed cost
5. Break-even Point (in Rs.) = BES =
Contribution per unit
× Sales per unit
Fixed Cost
Or BEP in units * Selling Price per unit or
P/v ratio
Fixed cost + Desired profit
6. BEP with DP (in units) =
Contribution per unit
Fixed cost + Desired profit
7. BEP with DP (in Rs) = BES with DP =
Contribution per unit
× Sales per unit
Or BEP with DP in units * Selling Price per unit

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 Cost Concepts in Decision Making

Fixed Cost + Desired Profit Notes

Or
P/V ratio
8. MOS (Absolute) = Actual Sales – Break-Even Sales
MOS can also be calculated with following Formula:
MOS = Profit/P/V ratio
9. MOS (%) = (MOS/Actual sales)*100

5.14 Answers to In-Text Questions

1. Opportunity
2. Relevant
3. (b) 20%
4. (b) 1,00,000
5. (c) 15,00,000
6. (b) 45,00,000

5.15 Self-Assessment Questions

1. What are various Cost concepts involved in managerial decision
making?
2. What is Marginal Costing? How is it different from Absorption
Costing?
3. What is CVP analysis and what are its uses?
4. What are advantages of Marginal Costing?

5.16 References
‹ Study Material of Institute of Chartered Accountants of India.
‹ Study Material of Institute of Cost and Management Accountant
of India.

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 MANAGEMENT ACCOUNTING

Notes
5.17 Suggested Readings
‹ S. N. Maheshwari, Suneel Maheshwari, Sharad K. Maheshwari. A
Textbook of Accounting For Management, Vikas Publishing House
Pvt. Limited.
‹ Asish K Bhattacharyya. Principles and Practice of Cost Accounting,
PHI Learning Private Limited.
‹ R. S. N. Pillai, V. Bagavathi. Management Accounting, S. Chand
and Company Limited.
‹ M. Y. Khan P. K. Jain. Management Accounting: Text, Problems
and Cases, McGraw Hill Education.

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 L E S S O N

6
Standard Costing and
Variance Analysis
Dr. Vijay Lakshmi
Assistant Professor
Ramanujan College
University of Delhi
Email-Id: [email protected]

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Standard Cost
6.4 Standard Costing
6.5 Classification of Variances
6.6 Summary
6.7 Answers to In-Text Questions
6.8 Self-Assessment Questions
6.9 References and Suggested Readings

6.1 Learning Objectives

After this chapter, learners will be able to:
‹ Understand the standard costing and its relevance.

‹ Learn the pre-requirements for the success of the standard costing in the company.
‹ Analyse the classification of the overhead variances.
Develop an understanding and examining the reasons behind the variances within the
actual and planned results.

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Notes
6.2 Introduction
The business organisation’s success depends upon how effectively and ef-
ficiently it is able to control the costs. In a wider context the cost can be
calculated and reported through predetermined costing and historical costing.
Where the historical cost refers to identification and reporting of the actual
cost that has been incurred post-production. Moreover, efficiently ascertain-
ing and controlling the cost is one of the essential goal of cost accounting.
Historical costing has not been considered as an efficient method for exer-
cising the cost control since it is not applicable as per plan of action. Also,
it is unable to furnish any benchmark which may be utilised for gauging the
actual performance. Hence on the basis of these shortcomings of historical
costing, it is considered important to understand before the production phase
begins what costs should be examined for finding the exact cause of failures
(if any) for achieving the target and fixation of responsibility thereupon.
Therefore, standard costing has been considered as an essential equipment
that helps management for planning and controlling the operations of the
business. In standard costing each cost i determined beforehand, where a
comparison is made between these pre-determined costs and actual costs.
Moreover, the difference in between these two costs (predetermined and
actual) has been named as Variance. And these variances are informed to
the management of the company for taking the corrective measure so that
actual costs adhere to the pre-determined costs.
Accordingly, in historical costing, actual costs are evaluated once they
were incurred. These costs have been not considered useful to the man-
agement for decision purposes and controlling of costs. As a result,
standard costing is being considered as a useful technique to plan, make
various decisions and controlling the business operations. In this unit
you are going to study about the standard costing and variance analysis.

6.3 Standard Cost

Standard costs are the costs which have been pre-determined and used
as benchmark for measuring the effectiveness on the basis of which the
actual costs were incurred under the given situations. For instance, the
quantum of raw material needed for producing one unit of a product
can be ascertained and the cost can be estimated for that raw material.
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This became the standard material input. As per official terminology of Notes
C.I.M.A. (Chartered Institute of Management Accountants), standard cost
comprises of unit cost of a product, component or service planned by an
organisation. This cost could be evaluated on various number of base.
Its utility lies in measuring performance, valuation of stock, control and
formulating selling price. Hence it can be said that standard cost is:
‹ Planned
‹ Decided upon single or several bases

6.4 Standard Costing

Standard Costing is a costing technique used by the company’s management
as a tool of control. Where controlling is function of the management
besides other functions of management such as directing, staffing and
planning. Each company sets a target and for achieving it the management
of the company has to make plans, thereafter, get them in execution and
oversee the work for checking any deviation (comparison of actual with
that standard) from the planned one.

6.4.1 Meaning
Standard costing is a method employed for determining the standard
cost and making comparison between them and actual costs in order to
ascertain the reasons behind such differences, for taking any remedial
measures that must be taken with immediate effect. According to Char-
tered Institute of Management Accountants (C.I.M.A.)¸ standard costing
has been defined as “the preparation of standard costs and applying them
to measure the variations from actual costs and analysing the causes of
variations with a view to maintain maximum efficiency in production”.
Hence it is a method of the cost accounting for comparing the standard
cost for every product with that of the actual cost, for determining the
operation’s efficiency. So, standard costing includes the subsequent steps:
(a) Determining the standard costs of several elements for costs.
(b) Documenting the actual costs.
(c) Making a comparison in between actual costs and standard costs for
finding variances.
(d) Examining the causes of the variances.
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Notes (e) Informing the management on the variance analysis in order to take
corrective steps where required.

6.4.2 Purpose of Standard Costing

(a) Controlling of Costs: It has been one of the essential aims of
standard cost whereby it assists the management in the controlling
of all the costs.
(b) Creating an Environment of Awareness on Cost: This objective
helps to make an environment of consciousness about costs in the
organisation. This further helps to ensure that employees recognize
the significance of the efficiency in the business operations wherein
the cost can be optimized because of combined efforts of all.
(c) Management Plans: Standard costing is appropriate for budgetary
plans made by the company on several stages since it has been
made in a prudent way by considering all the technicality related
in the business.
(d) Developing Policies and Setting of Prices: It intends to support
the management in policies formulation and determination of the
prices involved in the operations of the business.

6.4.3 Establishing the Standard Cost

The accuracy and trustworthiness determine the success of a standard
costing system. Hence, each operation must be considered during setting
the standards. The standard costs have been made for every component
of the cost namely:
‹ Direct labour
‹ Direct material and
‹ Overheads
Standards are determined both in Physical manner and Monetary manner
for every element of cost.
‹ Physical Standards: It refers to recording of the standards in hours
or units. At this point the standard hours and quantity have been
fixed for a specific service or product. The intent of fixing the
standards is to achieve the economies of scale in the production

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stage and setting the price for quoting it. During the process of Notes
setting the standards the following things must be considered:
‹ Company’s Budget.
‹ Production of final output.
‹ Where multiple inputs are there then the material’s proportion
that has to used must be determined.
‹ Specification of the material in terms of quality and quantity
as required.
‹ Availability and skills of the workers.
‹ Production method.
‹ Internal and external factors.
‹ Working conditions.
‹ Material Quantity Standards: The process for setting up of material
quantity standard has been enumerated as follows:
(a) Products Standardization: In this stage decision has been on the
products to be made on the basis of the plan of production and
customers’ orders. Normally questions to name a few – what
has to produce, how many products to be made and what type
of the product has to be made are answered during this stage.
(b) Study of the Product: The production and development of the
product requires its thorough analysis. This analysis is being
carried by the specialized departments or product experts.
During this stage the answers to questions like how product
can be produced, what are preconditions, what type of material
has to be used, how to make the acceptability of the product
in markets, etc. have been addressed.
(c) Formulating the Specification List: Once product has been
studied thereafter a list of the materials is made specifying
the quantity as well as the quality of the material that has to
be utilized, preconditions, procedure to be used, necessary
conditions, expected wastage etc.
(d) Sample Runs: The trial runs with specific circumstances must
be conducted and the sample is being tested of the desirable
quantity and quality.

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Notes ‹ Labour Time Standards: The steps for determining the labour
quantity standards are as follows:
(a) Product Standardization and its study as conducted in case
of material quantity standards.
(b) Labour Description: In this type and time of labour has been
mentioned. Time specification of labour has been established
from the past records along with considering the normal time
wastage.
(c) Process Standardization: Selecting the appropriate machine
to be used for correct sequence and modalities of operations.
(d) Manufacturing Framework: A design of operation of every
product enlisted and required in operations has to be made.
(e) Motion and Time Study: This study helps to select best path
required in the completion of a motion or job that worker will
execute along with considering the standard time required to
take by an average worker for every job.
(f) Training: Training must be provided to workers for doing their
work and time used up during dry run.
‹ Quantity Standards/Overheads Time: Indirect costs are known
as overheads. Variable overhead quantity/time is ascertained on
the basis of specification as required by the specific departments.
These variable overheads are based on labour hour or direct
material quantity.
‹ Fixed overhead time has been based on the budgeted volume
of production.
Challenges associated with the setting up of physical standards:
The issues faced when fixing physical standards might differ from one
industry to another and are as follows:
‹ In case of introduction of a new product line, a company has to
employ workers with minimal or no experience of the job at times.
In such situations setting of the standard time involves a problem

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as requisite adjustments have to be made on timely basis for the Notes

workers with less/no experience.
‹ Where changes in the technology have to be made new machinery
are being installed. Under such scenario exact valuation of the output
as well as efficiency in standards might be an issue and requires a
considerable time and work.
‹ On account of diversification of the product line, the issue also
arises because of redefining the production facilities.
‹ Unavailability of the materials also poses problems in the establishment
of the standards.

Difference between Standard Cost and Estimated Cost

Standard Costs and estimated costs are the predetermined costs which
vary in their objectives. The differences between the two are:
Standard Cost Estimated Cost
It aims at what the cost should be. It gives an estimate of what the
These costs are developed scien- cost would be.
tifically. These costs are based on past aver-
Standard costs are used only with ages and future anticipations.
the standard costing system. These costs are used in any organ-
The objective is to control costs. isation working with a historical
costing system.
These costs are usually entered in
the accounting system and used in The objective is to provide a basis
variance computation and analysis. for price fixation.
These costs do not enter the ac-
counting system.

Difference between Standard Costing and Budgetary Control

Both Standard costing and budgetary control are cost-control techniques
involving the comparison of predetermined costs with the actuals and
further followed with corrective action. However, the two techniques
differ from each other in many aspects:

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Notes Standard Costing Budgetary Control

Standard costing is based on scien- It is based on past performance and
tific calculations. future anticipations.
The standard costing system is mainly Budgetary control is used in various
used by the manufacturing division. departments like production, sales,
It is used to measure efficiency. finance etc.
Its main objective is the ascertain- It is used for forecasting.
ment of costs and cost control. It’s mainly concerned with the prof-
Standard costing is a projection of itability of the business.
cost accounts. It’s a projection of financial accounts.
It is intensive in the application It is extensive in the application and
and requires a detailed analysis of does not call for rigorous analysis
variances. of deviations.
Rate or Price Standards: Generally, such standards are set on following
ways:
‹ Normal prices anticipated to persist during cyclical seasons for
several years.
‹ Average actual price anticipated to prevail within upcoming time.
Material Price Standards: The prices of the material used in manufac-
turing are not in the manufacturer’s control entirely. At the same time an
approximation can be made by the purchase department after knowing
the requirement of production quantities from their understanding of the
present market trends. It will further help in stating the sufficiently the
price accuracy of the constituent elements. The following factors must
be considered generally for setting standards for material prices provided
fluctuations in prices are minimal and not significant:
(a) In hand materials stock along with the prices upon which they were
held.
(b) Expected price fluctuations.
(c) Minimal support price determined by the competent authority.
(d) The prices of future material deliveries for which orders have been
place already.

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Wage Rate Standards: The labour type required for doing a particular Notes
work is an essential element in fixing the wage rate for workers. The
wage rate standards for unskilled and skilled workers are determined as
per following grounds:
(a) Piece rate or time prevalent in the industry and it can be learned
from the fellows.
(b) The wage agreement in between the workers union and management.
(c) Time which has been taken by workers for completing a single
production unit.
(d) Laws prevalent in the operation area such as Payment of Bonus Act,
payment of minimum wages act, etc.
Overhead Expense Standard: For ascertaining the standards for overhead
expenses, deliberation must be made on the output level and budgeted
expenses. The budget representing the output level which is examined
for reaching the standards for overhead expenses might be on the basis
of average capacity of sales or budgeted capacity to be employed in the
following year. Post choosing one bases for the computation of the level
of output, then expenses perhaps budgeted with respect to variable and
fixed categories. Hence the standards for overhead expenses are fixed by
ascertaining the optimal output level for production unit and then pre-
paring a budget considering variable and expenses that has been incurred
this level. A flexible budget can be prepared for seasonal production or
during fluctuations in a year which facilitates comparison in between
actual expenditure and target for the period.

6.4.4 Kinds of Standards

The significance and exactness for stating the standard cost rests on the
credibility for the standards that are being established. For setting stan-
dards, it is important to identify the level of certainty with the proximate
standards with that of actual outcome. Therefore, the following standards
are enumerated as follows:
(a) Ideal Standard: It denotes the performance level which can be
attained when labour and material prices are utmost favourable
and when the maximum output is realized from the best layout as
well as tool and where highest efficiency by utilizing the resources

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Notes leads to maximization of output with minimal cost. However, these

standards are subject to following criticisms:
‹ As standards are not attainable so they are not taken seriously
by anyone.
‹ The variances reported are the one from that of ideal standards.
Hence do not reflect the extent to avoid them in a reasonable
manner.
‹ Absence of rational way to dispose these variances.
(b) Normal Standard: Such standards are achievable under the normal
operating circumstances. The normal work is being defined as
number of the standard hours that will produce at the normal
level of efficiency which will be adequate in meeting the average
demand of sales over the period of years. Though they are difficult
to determine since they need a forecasting level. In case of actual
performance is abnormal, then it could result into larger variances,
and it requires standards revision.
(c) Basic Standard: They are used when standards are probably to remain
fixed or constant over longer time. In this a base year is selected
for comparing. These standards are suitable for small products range
and are set for a longer term with less revisions. In these variances
are not estimated and actual cost has been stated in percentage of
the basic cost and current cost is also expressed similarly, thereafter
a comparison is made in these two percentages to ascertain how far
the current standards deviated from actual cost. And the percentages
are then compared with that of former periods for establishing trend
of current and actual standard from the basic cost.
(d) Current Standard: Such standards represent the anticipation of the
management on actual costs for the current period and these costs
are the one which business will make in case expected prices have
been paid for goods as well as services and usage appear to be
believed necessary for the production of planned level of output.

6.4.5 Process of Standard Costing

Following is the procedure for standard costing:

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Notes

6.4.6 Types of Variances

The difference in the actual and standard cost or the deviation from the
standard performance is known as Variance. The primary purpose of vari-
ance computing and analysing variance is to enable the management to
find out reasons for deviation from the budgeted profit. In other words,
variance analysis helps the management to know the responsibility centres
which can be held accountable for various variances.
According to CIMA London, “Variance Analysis is the process of com-
puting the amount of variance and isolating the causes of variance
between actual and standard.”
For achieving the objective of the standard costing, a report on vari-
ance analysis is prepared to show the actual cost, standard cost, and the
variances (along with the causes) and submitted to the management for
further action. The report is prepared to indicate the direction (favourable
or unfavourable), nature (controllable or uncontrollable) and the quantum
of variance. The variances may be cost variances or sales variances.
In the case of cost variances, when the actual cost is less than the
standard cost, the variance is favourable and vice versa. Both favour-
able and unfavourable variances need analysis. Favourable variance not
always implies efficiency. It may be due to certain favourable external
factors or the standards are loosely set. In the same way, an unfavourable
variance does not always mean inefficiency. Controllable variances are
those variances which can be or are within the influence of a particular
responsibility centre or a particular individual. Uncontrollable variances
are to be disposed of by apportioning to the unit of the finished good
and work in progress.
The aim of standard costing involves investigation of the causes behind
important variances with a view to find the issues and taking remedial
actions. The following are the types of variances:

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Notes (a) Controllable and Uncontrollable Variances: The variances which are
controllable by the department are known as controllable variances
while those variances beyond the control of the department are
termed as uncontrollable. Controllability has been considered as
a subjective thing and differs as per the situations. In case the
uncontrollable variances have been of a significant kind and are
continuous, then it calls for revision in the standards.
(b) Favourable and Adverse Variances: The variances which provide
profits to the company are considered as favourable variances and
those variances that drives losses have been categorized as adverse
variances. In the computation of cost variances, the favourable
variances are standard cost minus actual cost. While adverse variances
are where actual cost is in excess of the standard cost. The situation
is inverse in case of sales variance. Favourable variance occurs
when actual exceeds the budgeted and adverse variances are when
actual lowers the budgeted. They have been credited and debited
in costing profit & loss account respectively.
‘F’ denotes the favourable variance and ‘A’ represents the adverse variance.
IN-TEXT QUESTIONS
1. The standard hour can be considered as a hypothetic hour
representing the quantum of the work to be performed in an
hour given subject to specific situations. (True/False)
2. Standard cost can be utilised as a benchmark for measuring
the effectiveness on the basis of which actual costs are being
incurred. (True/False)
3. Generally, standards are fixed for long time and are revised on
annual basis. (True/False)
4. For controlling the costs either budgetary controls or standard
costing can be employed and not both of the methods. (True/
False)
5. Standard costs project the cost accounts however budgeting
projects the financial accounts. (True/False)
6. Standard costing is suitable for those companies where products
are repetitive and standardised. (True/False)

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7. It is important for a standard costing system to be accurate and Notes

trustworthy in order to be successful. (True/False)
8. Budgeting involves preparation of the plans for the future events
of a company. (True/False)
9. Expected standards are the figures of the past average performances
after considering the cyclical/seasonal changes. (True/False)
10. Standard costing includes the determination of:
(a) Actual Costs
(b) Standard Costs
(c) Budgeted Costs
(d) Estimated Costs
11. The difference between the standard costs and actual costs has
been considered as:
(a) Variances
(b) Loss
(c) Profit
(d) Historical Costs
12. The aim of standard costing:
(a) Measuring efficiency
(b) Controlling prices
(c) Reducing costs
(d) Examining the variances

6.5 Classification of Variances

Variances can be broadly classified into – Revenue Variance and Cost
Variance. Revenue Variance can be calculated by comparing the actual
sales with budgeted (standard) sales. The Cost side variances, on the
other hand, get reflected in the cost components.
Computation of Variances: As mentioned earlier variances can be clas-
sified into two parts. Hence, we will begin the discussion with all the
components of cost side and then move to labour side variance.

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Notes (a) Material Cost Variance: It is the difference between the standard
cost and actual cost. Mathematically, it can be written as below:
MCV = (SQ × SP) – (AQ × AP)
Where
MCV = Material Cost Variance
SQ = Standard Quantity
SP = Standard Price
AQ = Actual Quantity
AP = Actual Price
Reasons: The Material cost variance results from – (a) difference in
the material as well standard price, (b) variation between material
and standard consumption else may be due to both causes. Material
cost variance evaluation could be obtained by – Material Price
variance and Material Usage variance.
(i) Material Price Variance: This estimates the variance that arises in
the material cost due to the difference in actual material purchase
price and standard material price. Mathematically, it can be written
as below:
‹ Material Price Variance = Actual Quantity* × (Standard
Price – Actual Price)
Or
MPV = AQ × (SP – AP)
*In this the actual quantity denotes actual quantity of the material
that has been purchased. In case the question does not mention the
material purchase then it is equivalent to the material consumed.
‹ Material Price Variance is also calculated by taking the material
utilised as the actual quantity rather than material that has been
purchased. This technique is correct as well however, it does not
serve the purpose of computation of variance. Material Price Variance
can arise due to many reasons – some of them can be controlled
and some cannot be controlled by the purchase department. If
the price variance arises from the inefficiency of the purchase
department or due to any other reason which is well within control
of the organisation, in that case it is essential to inform about
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this variance at the earliest and it is done by taking the purchase Notes
quantity as actual quantity for the computation of price variance.
‹ Responsibility: Generally, the purchase department purchases
the material from market. Purchase department must perform
its functions prudently so that the company does not incur any
losses because of the inefficiency. Purchase department is made
accountable if any adverse price variance results from the factors
that could have been controlled by the department.
(ii) Material Usage Variance: This measures the variance that arises
in the material cost due to consumption/usage of the materials.
Mathematically, it can be written as:
Material Usage Variance (MUV) = Standard Price (Standard Quantity –
Actual Quantity*)
*Where Actual Quantity is actual quantity of the material that has
been used.
Responsibility: The purchase department has the onus of the Material
Usage, and it is held accountable for the adverse usage variance.
Reasons of the Material Usage Variance: Actual Market consumption
can differ with the standard quantity because of either the variation
in usage of the proportion from that of standard proportion or
because of the difference in the actual yield from standard yield.
Material usage variance has been divided into 2 categories: (a)
Material Usage Mix variance, (b) Material Yield variance.
(a) Material Mix Variance: Variations in the material consumption
arise because of difference in the proportion that has been
used in real terms from standard proportion/mix. It is due to
the reason(s) in case two or more inputs are being used in
the manufacturing of the product. Therefore,
Material Mix Variance (MMV) = (Revised Standard Quantity
– Actual Quantity) × Standard Price
Where,
Revised Standard Quantity (RSQ)
Standard Quantity of one material
=
Total of standard quantities of all materials
× Total of actual quantities of all materials
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Notes (b) Material Yield Variance or Material Sub-usage Variance:

Variances in the material consumption that occurs because
of the yield or productivity of the inputs. It can arise due
to using the below average quality of the materials, workers
inefficiency or because of the inaccurate processing.
Material Revised Usage Variance (MRUV)
= (Standard Quantity – Revised Standard quantity) × Standard
Price
Or
Material Yield Variance (MYV)
= (Actual Yield – Standard Yield) × Standard output price
Note: MRUV can be referred as Material Sub – Usage Variance.
Where there is only 1 variance i.e., either Material Yield or
Material Revised Usage Variance.
Verification of the formulae:
Material Cost Variance = Material Usage Variance + Material
Price Variance*
Or Material Cost Variance = (Material Mix Variance +
Material Revised Usage Variance) + Material Price Variance
*In case where material consumed quantity as well as material
purchase quantity are one and same

Meaning of the Terms Used in the Formulae

Terms Meaning
Standard Quantity (SQ) Quantity of the input that has to be
used for producing actual output.
Actual Quantity (AQ) Quantity of input used in real terms
for producing the actual output.
Revised Standard Quantity (RSQ) In case actual total quantity of the
input are being used in the standard
proportion.
Actual Yield (AY) It denotes the Actual Output.
Standard Yield (SY) It signifies the Actual output when
input is being used in the standard
ratio.
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Terms Meaning Notes

Standard Output Price (SOP) It refers to Standard material cost
for the actual output.
Illustration 1: Calculate material cost variance from the given actual and
standard amount for the product “ABC” are as follows:
Particulars Standard Actual
Quantity of material 60 units 50 units
Price per unit of material 3.00 2.00
Answer:
(a) Material cost variance (MCV) = SC – AC = 180 – 100 = Rs. 80 (F)
(b) Price variance (PV) = AQ (SP – AP) = 50 (3 – 2) = Rs. 50 (F)
(c) Usage variance (UV) = SP (SQ – AQ) = 3(60 – 50) = Rs. 20 (F)
Illustration 2: Calculate the material mix variance and yield variance
from the following information:
The information for producing 1 unit of the product is:
Material Units Rate per unit
X 55 13
Y 70 19
Z 90 24
But in the month of May, 10 units had been produced as well as con-
sumed and the information was as follows:
Material Units Rate per unit
X 600 15.50
Y 875 17.50
Z 730 21
Answer:
Material Standard for 10 units Actual for 10 units
Unit(s) Rate Amount Unit(s) Rate Amount
X 550 13 7130 600 15.50 9300
Y 700 19 13300 875 17.50 15312.50
Z 900 24 21600 730 21 15330
Total 2150 42030 2205 39942.5

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Notes (a) Material Cost Variance (MCV) = Standard Cost (SC) – Actual Cost
(AC) = 42030 – 39942.5 = Rs. 2087.5 (F)
(b) Material Price Variance (MPV) = Actual quantity (standard price –
actual price)
X = MPV= 600 (13 – 15.50) = Rs.1500 (A)
Y = MPV = 875 (19 – 17.50) = Rs.1312.5 (F)
Z = MPV = 730 (24 – 21) = Rs. 2190 (F)
(c) Material Usage Variance (MUV) = Standard price (standard quantity –
actual quantity)
X = MUV = 13 (550 – 600) = Rs. 650 (A)
Y = MUV = 19 (700 – 875) = Rs. 3325 (A)
Z = MUV = 24 (900 – 730) = Rs. 4080 (F)
(d) Material Mix Variance (MMV) = Standard price (Revised standard
quantity – Actual quantity)
X = MMV = 13 (566.5 – 600) = Rs. 435.5(A)
Y = MMV = 19 (721 – 875) = Rs. 2926(A)
Z = MMV = 24 (927 – 730) = Rs. 4728(F)
Revised standard quantity has been calculated for all the three
materials:
X = (2205/2150)550 = 566.5
Y = (2205/2150)700 = 721
Z = (2205/2150)900 = 927
(e) Material Yield Variance
In order to calculate material yield variance, certain calculations are
required:
Standard yield variance = Actual usage of the material/Standard usage
per unit of output = 2205/215 = 10.26 units
Standard material cost per unit (SOP) = 42030/10 = Rs. 4203
Material yield variance = (Actual yield – Standard yield) Standard
material cost per unit = (10 – 10.26) 4203 = Rs. 1092.78(A)
[Note: Actual yield is the actual output]

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Material Revised Usage (sub-usage) Variance (MRUV) = (Standard Notes

quantity – Revised standard quantity) Standard price
Any of the one can be calculated i.e., Material mix variance or
Material revised sub-usage (usage) variance, as both are always
equal.
Illustration 3: X Chemical Ltd. manufactures chemical X using three kinds
of raw material A, B and C. The company uses standard costing system
and furnishes following information about manufacturing of chemical X.
Compute all material cost variances.
Standard price of raw material A Rs. 100 per kg
Standard price of raw material B Rs. 50 per kg
Standard price of raw material C Rs. 60 per kg
Actual price of raw material A Rs. 90 per kg
Actual price of raw material B Rs. 60 per kg
Actual price of raw material C Rs. 70 per kg
Standard quantity of raw material A to produce 1 300 kg
tonne of chemical X
Standard quantity of raw material B to produce 1 400 kg
tonne of chemical X
Standard quantity of raw material C to produce 1 500 kg
tonne of chemical X
Actual quantity of raw material A used to produce 3,50,000 kg
chemical X
Actual quantity of raw material B used to produce 4,20,000 kg
chemical X
Actual quantity of raw material C used to produce 5,30,000 kg
chemical X
Actual output of chemical X 1000 tonnes
Solution:
Given,
SP of A = Rs. 100, B = Rs. 50, C = Rs. 60
AP of A= Rs. 90, B = Rs. 60, C = Rs. 70
SQ = Standard quantity of material required for actual output
A = 300 1,000 = 3,00,000 kg

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Notes B = 400 1,000 = 4,00,000 kg

C = 500 1,000 = 5,00,000 kg
AQ = Actual quantity of material used for actual output
A = 3,50,000 kg
B = 4,20,000 kg
C = 5,30,000 kg
RSQ = Revised standard quantity based on actual quantity of material
used in standard ratio
3
A= ×13, 00, 000 = 3,25,000 kg
12
4
B = ×13, 00, 000 = 4,33,333 kg
12
5
C = ×13, 00, 000 = 5,41,667 kg
12
1
Standard Yield for actual input = 1300000 × = 1083.33 tonnes
1200
Standard cost per unit of output = (300 ×100) + ( 400 × 50 ) + ( 500 × 60 ) =
Rs. 80000
Material Cost Variance MCV = ( SQ × SP ) − ( AQ × AP )
Material A MCV
= ( 300000 ×100 ) − ( 350000 × 90 ) = 1500000 (A)
Material B MCV
= ( 400000 × 50 ) − ( 420000 × 60 ) = 5200000 (A)
Material C MCV
= ( 500000 × 60 ) − ( 530000 × 70 ) = 1500000 (A)
MCV=13800000 (A)
Material Price Variance MPV = AQ × ( SP − AP )
Material A MPV= 350000 × (100 − 90 ) = 3500000 (F)
= 420000 × ( 50 − 60 ) = 4200000 (A)
Material B MPV
= 530000 × ( 60 − 70 ) = 5300000 (A)
Material C MPV
MPV = 6000000 (A)
Material Usage Variance MUV =SP × ( SQ − AQ )
100 × ( 300000 − 350000 ) = 5000000 (A)
Material A MUV =
50 × ( 400000 − 420000 ) = 1000000 (A)
Material B MUV =
60 × ( 500000 − 530000 ) = 1800000 (A)
Material C MUV =
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MUV = 7800000 (A) Notes

Material Mix Variance
= MMV SP X ( RSQ − AQ )
100 × ( 325000 − 350000 ) = 2500000 (A)
Material A MMV =
50 × ( 433333 − 420000 ) = 666650 (F)
Material B MMV =
60 × ( 541667 − 530000 ) = 700020 (F)
Material C MMV =
MMV = 11,33,330 (A)
MSuV SP X ( SQ − RSQ )
Material Sub-Usage Variance=
100 × ( 300000 − 325000 ) = 2500000 (A)
Material A MSuV =
50 × ( 400000 − 433333) = 1666650 (A)
Material B MSuV =
60 × ( 500000 − 541667 ) = 2500020 (A)
Material C MSuV =
MSuV = 66,66,670 (A)
Material Yield Variance
MYV = ( AY − SY ) × SC per unit of output
(1000 – 1083.34) 80000 = 6666670 (A)
Material Yield Variance = Material Sub-Usage Variance
Labour Cost Variance: It is the variation between actual labour cost as
well as standard cost. Hence,
Labour Cost Variance (LCV)
= (Std. hours for actual output × Std. rate per hour) – (Actual hours ×
Actual rate per hour)
Reason: Because of the differences in labour cost that results either due
to the differences in actual labour rate from standard rate or difference in
the numbers of hours worked from standard hour. Labour Cost Variance
has been divided into the two categories: (i) Labour Rate Variance (LRV)
and (ii) Labour Efficiency Variance (LEV).
(i) Labour Rate Variance: It occurs because of differences in actual
rate which is being paid and standard rate. It is very similar to the
material price variance. It is being calculated as follows:
Labour Rate Variance (LRV) = Actual time*(Std. rate – Actual
rate)
*In this the Actual Time refers to the time where wage is being paid.

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Notes Responsibility: Normally labour rate is being impacted due to external

factors which are not in the control. But personnel manager can be
held responsible for negotiating the labour rate.
(ii) Labour Efficiency Variance (LEV): It occurs because of digression
in the hours of working from standard(s) set.
Labour Efficiency Variance = Standard rate (Standard hour for
actual output – Actual hour*)
*Actual time which is being worked
Responsibility: The variance in efficiency arises because of unsuitable
team the of workers, production manager’s or foreman’s inefficiency
etc. However, production manager may hold accountable in case of
any of the adverse variances which can be controlled.
LEV can be further divided into the following variances:
(a) Idle Time Variance (IDV)
(b) Labour Mix Variance (LMV) or Gang Variance (GV)
(c) Labour Yield Variance (LYV) or Labour Revised-efficiency
Variance (LREV)
(a) Idle Time Variance: It is being estimated for the labour hours
which were considered as unproductive. In this the idle time
refers to the idle time of labour which occurs because of the
abnormal causes. It can be calculated as:
Idle Time Variance (ITV) = Idle hours × Standard Rate
(b) Labour Mix Variance: It occurs because of either change in
the proportion or the combination of different skill set, i.e.,
skilled worker, semi-skilled worker as well as unskilled worker.
Labour Mix Variance (LMV) = (Revised standard hour –
Actual hour) × Standard rate
(c) Labour Revised Efficiency Variance (LREV) or Labour
Yield Variance (LYV): It occurs because of the productivity
of the workers.
Labour Revised Efficiency Variance (LREV)
= (Standard hour for the actual output – Revised standard hour)
× Standard rate

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Or Notes
Labour Yield Variance (LYV) = (Actual yield – Standard
yield from the actual input) × Standard labour cost per unit
of output
Verification:
Labour Cost Variance (LCV) = Labour Rate Variance (LRV)
+ Labour Efficiency Variance (if hour paid as well as hour
worked are same)
Or
Labour Cost Variance (LCV) = Labour Rate Variance (LRV)
+ Idle Time Variance (ITV) + Labour Efficiency Variance (in
case idle time exists)
Labour Efficiency Variance (LEV) = Labour Mix Variance
(LMV) + Labour Yield Variance (LYV)
Illustration 4: From the following information on an organisation:
Standards: Standard time for work 900 hours
Standard rate on hourly basis for work Re. 1
Actuals: Actual time for work 700 hours
Actual rate to be paid for work Rs. 300
Calculate:
(a) Labour Cost Variance (LCV)
(b) Labour Rate Variance (LRV)
(c) Labour Efficiency Variance (LEV)
Answer
Std. labour cost (900 hours @ Re.1 per hour) = Rs. 900
Actual wages to be paid Rs. 300
Actual rate on hourly basis (300/700) = Rs. 0.43
LRV = Actual time (Std. rate – Actual rate) = 700 (1 – 0.43) = Rs. 399(F)
LEV = Std. rate per hour (Standard time – Actual time) = 1 (900 – 700)
= Rs. 200(F)
LCV = Std. labour cost – Actual labour cost = 900 – 300 = Rs. 600(F)

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Notes Illustration 5: X Ltd. is a cement manufacturing company using standard

costing system. It furnishes following information about manufacturing
of cement in tonnes. Compute all labour cost variances.
Standard rate of labour per hour Rs. 50
Actual rate of labour per hour Rs. 45
Standard hours required to produce one tonne of cement 15
Actual hours 15300 hours
Actual output 1000 tonnes

Solution:
Given,
SR = Rs. 50
AR = Rs. 45
ST = Standard hours of labour required for actual output = 15 1000 =
15000 hours
AT = Actual hours of labour = 15300 hours
Labour Cost Variance

LCV = ( SR × ST ) − ( AR × ATp )
LCV = ( 50 ×15000 ) − ( 45 ×15300 )
LCV 750000 − 688500
=
LCV = 61500 ( F )
Labour Rate Variance

LRV = ( SR − AR ) × AT
LRV= 15300 × ( 50 − 45 )
LRV = 76500(F)
Labour Efficiency Variance

LEV = ( ST − AT ) × SR
50 × (15000 − 15300 )
LEV =
LEV= 50 × −300
LEV = 15000 ( A )

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Verification: Notes
LCV = LRV + LEV
61500 (F) = 76500 (F) + 15000 (A)
Labour mix variance, labour revised efficiency variance and idle time
variance are not computed as only one type of labour used and no in-
formation about idle time is given.
Illustration 6: X Ltd. is a steel pipe manufacturing company using standard
costing system. It furnishes following information about manufacturing of
steel pipes for work scheduled to be completed in 30 hours in a week.
Compute all labour cost variances and verify them.
Particulars Unskilled Semi-skilled Skilled
Standard number of workers in 9 15 26
one group
Actual number of workers em- 8 18 24
ployed
Standard wage rate per week 100 200 400
Actual wage rate per week 120 180 400
During the week, the gang produced 1600 standard labour hours.
Solution:
Type of Workers Standard Actual
Hours Rate Amount Hours Rate Amount
Skilled 780 400 312000 720 400 288000
Semi-skilled 450 200 90000 540 180 97200
Unskilled 270 100 27000 240 120 28800
1500 429000 1500 414000

Standard cost of actual output

Labour Cost Variance
=LCV Standard cost of actual output − Actual Cost
LCV 457600 − 414000
=
LCV = 43600 ( F )
Labour Rate Variance
LRV = ( SR − AR ) × AT

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Notes Skilled LRV = ( 400 − 400 ) × 720 = 0

Semi-skilled LRV = ( 200 − 180 ) × 540 = 10800 (F)
Unskilled LRV = (100 − 120 ) × 240 = 4800 (A)
LRV = 6000 (F)
Labour Efficiency Variance
LEV = ( ST − AT ) × SR
Skilled LEV = ( 832 − 720 ) × 400 = 44800 (F)
Semi-skilled LEV = ( 480 − 540 ) × 200 = 12000 (A)
Unskilled LEV = ( 288 − 240 ) × 100 = 4800 (F)
LEV = 37600 (F)
ST= Standard hours for actual output
1600
Skilled = × 780 = 832
1500
1600
Semi-skilled = × 450 = 480
1500
1600
Unskilled = × 270 = 288
1500
Labour Mix Variance
LMV = ( RST − AT ) × SR
Skilled LEV = ( 780 − 720 ) × 400 = 24000 (F)
Semi-skilled LEV = ( 450 − 540 ) × 200 = 18000 (A)
Unskilled LEV = ( 270 − 240 ) × 100 = 3000 (F)
LEV = 9000 (F)
Labour Yield Variance
LYV = ( AY − SY ) × SC
LYV = ( 1600 − 1500 ) × 286 = 28600 (F)
429000
SC = Standard rate per hour of work = = 286
1500
Verification:
LCV= LRV + LEV
43600 (F) = 6000 (F) + 37600 (F)
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LEV = LMV + LYV Notes

37600 (F) = 9000 (F) + 28600 (F)
Overhead Variance: Overhead involves the indirect labour, indirect ma-
terial and indirect expenses. The overhead variances have been classified
into variable overhead and fixed overhead.
Variable Overheads Cost Variance (VOCV): Variable Overhead involves
the expenses other than that of direct material as well as direct labour
expense which varies with level of the production. VOCV has been divid-
ed into two parts – (i) Variable Overhead Expenditure Variance (VOEV)
and (ii) Variable Overhead Efficiency Variance (VOEV).
Variable Overhead Cost Variance (VOCV) = Std. Cost – Actual Cost
OR
(Std. Rate × Std. Hour) – (Actual Rate × Actual Hour)
(i) Variable Overhead Expenditure Variance (VOEV)
= Actual Hour (Standard Rate – Actual Rate)
(ii) Variable Overhead Efficiency Variance (VOEV)
= Standard Rate(Standard Hours – Actual Hour)
Fixed overhead cost variance (FOCV): It occurs because of differences
in Absorbed Fixed Overhead and Actual Fixed Overhead. Fixed Overhead
consists of two parts – Fixed Overhead Expenditure Variance (FOEV)
and Fixed Overhead Volume Variance (FOVV).
Fixed Overhead Cost Variance (FOCV) = Absorbed Fixed Overhead
– Actual Fixed Overhead
or
= (Standard hour for the actual output × Standard fixed overhead rate)
– Actual Fixed Overheads
(i) Fixed Overhead Expenditure Variance (FOEV) = Budgeted Fixed
Overhead (BFO) – Actual Fixed Overheads (AFO)
or
= (Standard hour for actual output × Standard fixed overhead rate)
– Actual Fixed Overhead
(ii) Fixed Overhead Volume Variance (FOVV) = Absorbed Overheads
– Budgeted Overheads
= Std. Rate (Std. hour for the actual output – Budgeted hour)
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Notes Fixed Overhead Volume Variance (FOVV) is divided under three variances:
(a) Efficiency Variance (b) Capacity Variance (c) Calendar Variance
(a) Fixed Overhead Efficiency Variance (FOEV) = (Absorbed fixed
overheads – Standard fixed overheads)
= (Standard hour for the actual output – Actual hour) × Standard
fixed overhead rate
(b) Fixed Overhead Capacity Variance (FOCV) = (Std. fixed overheads
– Budgeted Overheads)
= (Actual Hour – Budgeted Hour) × Standard Fixed Overhead Rate
(c) Fixed Overhead Calendar Variance (FOCV) = (Actual number
of working days – Standard number of working days) × Standard
fixed rate per day
or = (Revised Budgeted Hour – Budgeted hour) × Standard fixed
rate per hour
Where,
Revised Budgeted Hours = (Actual days × [Budgeted Hours/Budgeted
Days])
Illustration 7: The information has been extracted from the GHJ company.
Estimate the overhead variances using the information provided below:
Particulars Budget Actual
Output given in units 20000 22000
Hours 20000 23000
Fixed overhead 55000 60000
Variable overhead 70000 78000
Number of working days 24 25
Answer:
Standard hours per unit = Budgeted hours/Budgeted units = 20000/20000
= 1 hr.
Standard hours (SH) for the actual output = 22000 × 1 = 22000
Standard overhead (SO) rate per hour = Budgeted overhead/Budgeted hour
In case of the fixed overheads = 55000/20000 = Rs. 2.75

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In case of the variable overheads = 70000/20000 = Rs. 3.50 Notes

Standard fixed overheads rate per day = 55000/25 = Rs. 2200
Recovered overheads = Standard hour for the actual output × Standard rate
In case of the fixed overheads = 22000 × 2.75 = Rs. 60500
In case of the variable overheads = 22000 × 3.50 = Rs. 77000
Standard overhead (SO) = Actual hour × Std. rate
In case of the fixed overheads = 23000 × 2.75 = Rs. 63250
In case of the variable overheads = 23000 × 3.50 = Rs. 80500
Revised budgeted hour = (Budgeted hour/Budgeted day) × Actual day
= (20000/24) × 25 = 2083.3 hours
Revised budgeted overheads for fixed overheads = 2083.3 × 2.75 = Rs.
5729.08
Calculation of fixed overhead variance:
(i) Fixed overhead cost variances = Recovered overhead (RO) – Actual
overhead (AO) = 60500 – 60000 = Rs. 500 (F)
(ii) Fixed overhead expenditure variances = Budgeted overheads – Actual
overheads = 55000 – 60000 = Rs. 5000 (A)
(iii) Fixed overhead volume variances = Recovered overheads – Budgeted
overheads = 60500 – 55000 = Rs. 5500 (F)
(iv) Fixed overhead efficiency variances = Recovered overheads – Standard
overheads = 60500 – 63250 = Rs. 2750 (A)
(v) Fixed overhead capacity variances = Standard overheads – Revised
budgeted overheads = 63250 – 5729.08 = Rs. 57520.92 (F)
(vi) Calendar variance = (Actual days – Budgeted days) × Std. rate per
day = (25 – 24) × 2200 = Rs. 2200 (F)
Calculation of the variable overhead variance:
(i) Variable overhead cost variances = Recovered overheads – Actual
overheads = 77000 – 78000 = Rs. 1000 (A)
(ii) Variable overhead expenditure variances = Standard overheads –
Actual overheads = 70000 – 78000 = Rs. 8000 (A)
(iii) Variable overhead efficiency variances = Recovered overheads –
Standard overheads = 77000 – 80500 = Rs. 3500 (A)

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Notes Sales Variances: Those variances that occur because of change in the
actual sales price and the actual quantity of sold units from what it was
budgeted have been termed as sales variance(s).
Sales value variance = Actual sale(s) – Budgeted sale(s)
= (Actual price × Actual quantity) – (Budgeted price × Budgeted quantity)
In case variances have been given on the basis of margin then:
Sales margin variance = Actual margin – Budgeted margin
Actual margin = Actual sale price per unit – Std. cost per unit
Budgeted margin = Budgeted sales price per unit – Std. cost per unit
The sales value variance has been divided into sales price variances and
sales volume variances:
(i) Sales price variance = Actual quantity (Actual price – Budgeted
price)
In case variance have given on margin basis
Sales price variance = Actual quantity (Actual margin – Budgeted
margin)
(ii) Sales volume variance = Budgeted price (Actual quantity – Budgeted
quantity)
In case variances have been given on margin basis
Sales margin volume variance = Budgeted margin (Actual quantity –
Budgeted quantity)
Illustration 7: Ascertain the sales variances from the following information:
Budgeted Budgeted Actual Actual Price
Service Quantity (BQ) Price (BP) Quantity (AQ) (AP)
A 3000 2 2600 2.50
B 2500 5.50 2000 4
C 1000 8 900 7.50
Answer:
Service BQ × BP AQ × AP AQ × BP
A 6000 6500 5200
B 13750 8000 11000
C 8000 6750 7200
Total 27750 21250 23400
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 Standard Costing and Variance Analysis

(i) Sales price variance = AQ (AP – BP) = (AQ × AP) – (AQ × BP) = Notes
(21250 – 23400) = Rs. 2150 (A)
(ii) Sales volume variance = BP (AQ – BQ) = (BP × AQ) – (BP × BQ)
= (23400 – 27750) = Rs. 4350 (F)
(iii) Total variance = Actual sales – Budgeted sales = 21250 – 27750
= Rs. 6500 (F)

6.6 Summary
Standard costing refers to the pre-specified costs used as benchmark for
measuring efficiency where actual costs must be incurred under the given
situations. Further, analysis of variances involves measuring the deviations
of the actual performance from that of desired performance, and then
gauging the reasons of those deviations with a view to take remedial
actions on timely basis. Variances are bifurcated on the basis of cost
variances and sales variances. Moreover, as labour is also involved into
the business operations, which call for measuring labour variances which
is another form of variances. Overhead variances have been categorised
in two parts – fixed and variable. Variable overhead varies directly with
the production on the other hand fixed overheads are dependent on the
activity level or volume and any changes in the activity level lead to
changes in overhead rates as well.

6.7 Answers to In-Text Questions

1. True
2. True
3. False
4. False
5. True
6. True
7. True
8. True
9. False

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 MANAGEMENT ACCOUNTING

Notes
10. (b) Standard Costs
11. (a) Variances
12. (a) Measuring efficiency

6.8 Self-Assessment Questions

1. Explain your understanding on standard costing.
2. Mention the purpose of standard costing.
3. You are working in a company as team leader for setting up standard
costing system. In lieu of this state how would you assure success
of this system?
4. Describe how the standards are fixed.
5. Explain briefly the following terms:
(a) Normal Standard
(b) Ideal Standard
(c) Basic Standard
(d) Standard Hour
6. From the following information of the Reliance group evaluate the
material usage, price and total cost of variance (considering quantity
of 1,000 kg).
The 10 kg of sanitizer, the requirement of standard raw materials
X and Y are:
Material Quantity Per kg rate
X 10 9
Y 7 5
However, because it is being anticipated by the company that demands
for sanitizer might increase leading to production of 1,000 kg of
sanitizer. This makes the actual consumption as:
Material Quantity Per kg rate
X 500 10
Y 350 8

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 Standard Costing and Variance Analysis

7. From the following provided by the TCZ company, you are required Notes
to calculate the following labour variances:
(a) Labour cost variances
(b) Labour rate variances
(c) Labour efficiency variances
(d) Labour mix variances
Type of Workers Standard Wages Actual Wages
Skilled worker 85 workers @ Rs. 1.50 78 workers @ Rs. 2 per
per hour hour
Unskilled worker 73 workers @ Rs. 4 per 75 workers @ Rs. 1 per
hour hour
Budgeted hours 1100 Actual hours 950
8. The information provided has been obtained from the AXC company
records. Since you are working as a Cost accountant in this company,
so you wanted to know the position of the overhead variances.
Hence in this respect estimate the following:
(a) Fixed overhead variances
(b) Variable overhead variances
Particulars Standard Actual
Production 2000 units 1500 units
Number of working days 10 12
Fixed overhead 30000 27000
Variable overhead 10000 9000
9. Compute the sales value variances, sales price variance and sales
volume variance as per the details provided from the records of
GYT company:
Budgeted Budgeted Actual Quan- Actual
Product Quantity (BQ) Price (BP) tity (AQ) Price (AP)
X 2200 5 3000 4
Y 3400 2.50 1400 6.25
Z 1100 4 3700 5
T 3200 7.45 4750 3.75

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Notes
6.9 References and Suggested Readings
‹ Maheshwari, S. N., & Mittal, S. N. Cost Accounting: Theory and
Problems. Shree Mahavir Book Department.
‹ Arora, M. N. Cost Accounting principles and practice. Vikas
Publishing House.
‹ Maheshwari, S. N., Maheshwari, S. K., Mittal, S. N. Cost Accounting:
Principles & Practice. Shree Mahavir Book Depot.
‹ Nigam, B. M. Lal & Jain, I. C. Cost Accounting: Principles and
Practice. PHI Learning.
‹ Mitra. Cost and Management accounting. Oxford University Press.

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 L E S S O N

7
Budgets and Budgetary
Control
Dr. Rishi Taparia
Director - Management Studies
Institute of Advanced Management & Research
Email-Id: [email protected]

STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Meaning of Budget and Steps in Budgetary Control
7.4 Types of Budgets
7.5 Zero-Based Budgeting
7.6 Summary
7.7 Practical Problems
7.8 Answers to In-Text Questions
7.9 Self-Assessment Questions
7.10 References
7.11 Suggested Readings

7.1 Learning Objectives

After studying this chapter, the students will be able to understand:
‹ Meaning of Budget, Budgeting and Budgetary Control.
‹ Distinction between Budget and Forecast.
‹ Objectives and functions of the Budget.
‹ Advantages and disadvantages in budgeting.
‹ Budgeting Process.

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Notes ‹ Steps involved in Budgetary control.

‹ Various types of Budgets.
‹ Distinction between Fixed and Flexible Budgeting.
‹ Zero Based Budgeting and its comparison with Traditional Budgeting.

7.2 Introduction
Every company makes plans. Some plans are more formal than others
and some companies plan more formally than others but all make same
attempt to consider the risk and opportunities that lie ahead and how to
face them. In most businesses, this process is formalised in short term
with considerable effort put into preparing annual budgets and monitoring
performance against those budgets. Budgeting is a management tool used
for short-term planning and control.
For effective running of a business, management must know:
‹ Where it intends to go i.e. organizational objectives
‹ How it intends to accomplish its objectives i.e. plans
‹ Whether individual plans fit in the overall organizational objective
i.e. coordination and
‹ Whether operations conform to the plan of operations relating to
that period i.e. control.
Budgetary Control is the device that a company uses for all these purposes.

7.3 Meaning of Budget and Steps in Budgetary Control

7.3.1 Meaning of Budget, Budgeting and Budgetary Control
Budget: CIMA has defined a Budget as “a financial and/or quantitative
statement, prepared and approved prior to a defined time, of the policy
to be pursued during that period for the purpose of attaining a given
objective”
A budget is necessary to plan for the future, to motivate the staff associ-
ated, to coordinate the activities of different departments and to control
the performance of various persons operating at different levels.

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 Budgets and Budgetary Control

ACTIVITY Notes

Suppose you are planning to travel with your friends, You are re-
quired to prepare a Budget including all the expected expenditures
keeping in mind the following:
1. Budget has to be in monetary terms.
2. It should only consider quantitative aspect.
3. It has to be for defined period of time.

Budgeting
Budgeting is the whole process of designing, implementing and operat-
ing budgets. The main emphasis in this is short-term budgeting process
involving the provision of resources to support plans which are being
implemented.

Budgetary Control
CIMA has defined Budgetary Control as “the establishment of budgets
relating the responsibilities of executives to the requirements of a policy,
and the continuous comparison of actual with budgeted results, either
to secure by individual action the objective of that policy or to provide
a basis of its revision”.

Difference between Budget and Forecast

S. No. Forecast Budget
1 An estimate of what is likely Depicts the policy and pro-
to happen. It is a statement of gramme to be followed in a
probable events. period under planned conditions.
2 Forecasts, being statements of A budget is a tool of control
future events, do not connote since it represents actions that
any sense of control. can be shaped according to will
so that it can be suited to the
conditions which may or may
not happen.
3 Forecasting is a preliminary step It begins when forecasting ends.
for budgeting. It ends with the Forecasts are converted into
forecast of likely events. budgets.
4 Forecasts are wider in scope. Budgets have limited scope.

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Notes 7.3.2 Objectives and Functions of Budgeting

The following are the various objectives and functions of budgeting:
(a) Planning: Planning is an important managerial function. Budgeting
allows us to plan ahead of time what to do, how to do it, when to
do it, and who will do it. Planning enables managers to anticipate
and plan for contingencies in order to achieve their goals. Budget
preparation motivates managers to plan ahead of time. Thus, budgeting
is an important planning device.
(b) Coordination: To coordinate is to harmonise all the activities of a
company so as to facilitate its working and its success. Coordination
will lead to following results:
‹ Each department will work in harmony with others.
‹ Each department will know their specific role to play in the
accomplishment of overall organizational objectives.
‹ Overlapping of activities and wastage of time and labour could
be avoided by the sequential arrangement of activities of different
departments.
(c) Communication: Budgets effectively communicate the information
to the employees within the organization. Budgets keep different
sections of the organization informed about the contribution of
different sub-units in the attainment of overall organizational
objective.
(d) Control: Budgets act as a great tool to control various activities
within the organization. Many ‘adjustments’ are made to make
functional budgets align with organisational goals.
(e) Performance Evaluation: Budgets assist businesses in determining
variances by comparing budgeted, estimated, or anticipated activity
against actual activity. Budgets also aid in reviewing employee
performance to determine whether or not they have met the business’s
objectives.

7.3.3 Requirements of a Good Budgeting System

Following are the requirements of a good budgeting system:
‹ Budgeting process should be backed and well supported by the
CEO of an organization.

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 Budgets and Budgetary Control

‹ The organizational goal should be quantified and clearly stated. Notes

‹ The organizational goal must be divided in functional goals.
‹ All employees should mentally accept the exercise of budget preparation.
‹ The persons responsible for the execution of budget should participate
in budget preparation.
‹ The budget should be realistic and attainable.
‹ The budgeting should be a continuous process.
‹ Periodic reports should be prepared to compare the actual results
with the budgeted one to find out the deviations.

7.3.4 Advantages of Budgeting

The following advantages of budgeting are:
1. A budget forces management to plan ahead so that long-term
objectives are achieved.
2. It establishes a basis of internal audit by regularly evaluating
departmental results.
3. All members of top management participate in budget committee.
For this reason even planning at departmental level gets benefit of
experience of seasoned executives.
4. All functional heads are compelled to make plans in harmony with
the plans of other departments.
5. Only reporting information which has not gone according to plan,
it economises on managerial time and maximises efficiency. This
is called ‘Management by Exception’ reporting.
6. Scarce resources should be allocated in an optimal way, thus controlling
expenditure.
7. Communication increased throughout the company and coordination
also improves.
8. Areas of efficiency and inefficiency are identified. Remedial measures
are taken with the help of variance analysis.
9. People are made responsible for items of cost and revenue.
10. It facilitates periodic self-analysis of the organisation.
11. It helps in obtaining bank credit.

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Notes 7.3.5 Disadvantages of Budgeting

Budgeting has numerous benefits, but it also has some drawbacks. The
following are some of the drawbacks of budgeting:
1. Budgeting is based on estimation. As a result, it is subjective in
nature, and those involved in budgeting exercise their discretion.
As a result, budgeting based on inaccurate estimates is pointless.
2. The circumstances are changing constantly and therefore, budgets
and budgetary techniques will not be useful, till they are continually
adapted.
3. Budgeting could only be successful only when there is coordination
and cooperation among all the departments, management, and
employees and thus, the organization will be able to achieve its
goals and objectives.
4. Budgeting is just a tool to control the business activities and can
only help in achieving the objectives of the company only when
all managerial functions are performed efficiently and effectively.
5. Preparing a budget is time-consuming and requires great amount of
effort.
6. Management places a lot of pressure on lower-level employees to
achieve goals, which causes them to offer inaccurate information
to upper-level management.
7. When upper level employees see that the expenses that have occurred
are far less than those that were intended, they have an urge to
spend more extravagantly, resulting in a decrease in the company’s
revenues.

7.3.6 Steps in Budgetary Control

The following steps are to be followed in budgetary control:
1. Standards are established
2. Actuals are measured
3. Comparison of standards with the actual is done
4. Finding out deviations
5. Remedial measures taken

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 Budgets and Budgetary Control

Features of Budgetary Control: Notes

1. Establishment of budgets for each purpose of the business.
2. Revision of budget in view of changes in conditions.
3. Comparison of actual performances with the budget on a continuous
basis.
4. Taking suitable remedial action, wherever necessary.
5. Analysis of variations of actual performance from that of the
budgeted performance to know the reasons thereof.
IN-TEXT QUESTIONS
1. A quantitative expression of management objectives is a(n)
__________.
2. Is budget futuristic in nature? (Yes/No)
3. Budget is prepared for a __________ period of time.
4. The first step in Budgetary control is to __________.

7.4 Types of Budgets

To achieve the overall company’s objectives, the company makes various
types of budgets. Let us study few of them.

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Notes 7.4.1 Sales Budget

The sales budget is the most common functional budget. If sales figure is
incorrect, practically all functional budgets and consequently the master
budget will get affected. Sales budget can be prepared showing sales
under any one or combination of the following headings:
1. Product
2. Territory
3. Types of customers
4. Salesman
5. Month, quarter, week
The exercise of preparing sales budget can be broadly divided into two
categories:
1. Sales Forecast
2. Evaluating Sales Forecast

7.4.2 Production Budget

After having established sales budget, production budget is made as
it shows the quantities to be produced for achieving sales targets and
keeping sufficient inventories. Budgeted production is equal to projected
sales plus closing inventory of finished goods minus opening stock of
finished goods. Thus, production budget is based on sales budget and
desired inventory levels. Production budget is prepared in physical units.
Units to be produced = B
 udgeted Sales (+) Desired Closing Stock (–)
Opening Stock

Illustration 1:
The Rama & Company plans to sell 1,08,000 units of a certain product
line in 1st quarter, 1,20,000 units in 2nd quarter, 1,32,000 in 3rd quarter,
1,56,000 units in 4th quarter and 1,38,000 units in the 1st quarter of the
following year. At the beginning of the 1st quarter of the current year,
there are 18,000 units in stock. At the end of each quarter the company
plans to have an inventory equal to 1/6th of the sale for the next quarter.
How many units must be manufactured in each quarter of the current year?

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Solution: Notes
Production = Sales + Closing Stock – Opening Stock
Rama and Company Production Budget
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
Particulars (Units) (Units) (Units) (Units)
Sales Budget 1,08,000 1,20,000 1,32,000 1,56,000
Add: Closing Inventory 20,000 22,000 26,000 23,000
Total 1,28,000 1,42,000 1,58,000 1,79,000
Less: Opening Inventory 18,000 20,000 22,000 26,000
Estimated Production 1,10,000 1,22,000 1,36,000 1,52,000

7.4.3 Raw Material Budget

Direct Materials budget is prepared to compute standard material cost
per unit. The Raw Material Budget shows the projected quantity of all
raw materials and components required for the production budgeted. This
budget serves the following purposes:
‹ It helps the purchasing department to plan purchase schedule to
avoid default in delivery of material.
‹ It forms basis for purchase cost budget.
‹ It forms basis for determination of minimum and maximum levels
of inventory of material and components.
7.4.4 Purchase Budget
Purchase budget sets out ‘purchase’ plan of the company during the budget
period. Material budget only gives an idea of the material requirements
of the company during the budget. For preparing purchase budget, it is
also necessary to know the level of inventories to be maintained. The
purchase budget can be expressed in terms of both quantity and mone-
tary value. The governing points for preparation of purchase budget are:
1. Opening stock of different types of materials and components
2. Closing stock of different types of materials and components
3. Orders already placed
4. Storage space available
5. Economic Order Quantity

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Notes 6. Price to be paid

7. Seasonal discounts that can be availed of
8. Finance available

7.4.5 Cash Budget

A cash budget is a concise statement of a company’s expected cash reve-
nues and payments over a given time period. A cash budget projects cash
inflows and outflows over some specified period of time. The basis is
mostly the sales forecast and the level of assets that will be required to
meet those forecasts. A cash budget can be created for any interval but
firms typically use a monthly cash budget for the coming year, mostly for
planning purposes and a daily or weekly budget for actual cash control.
A typical cash budget consists of three sections:
‹ Sales and Expenses worksheet that summarizes the firm’s sales
income and expenses incurred in purchasing materials.
‹ Cash Gain or Loss section that indicates the cash inflows and
outflows with the ‘bottom line’ indicating either a gain or loss.
‹ Cash surplus or Loan requirement (Net Cash Balances) section that
summarizes the firm’s surplus cash held or total loans needed.
This will be estimated by deducting total expenses for a given period
e.g. a month from the total cash receipts for that period. The result will
either indicate a surplus or deficit.
‹ In case of surplus, it can be invested in bonds, equities or in
savings accounts.
‹ In case of a deficit, it can be bridged by:
1. Borrowing short-term funds e.g. through overdrafts.
2. Delaying capital expenditures until the firm’s cash position
improves.
3. Requesting suppliers for a longer credit period.
4. Delay payment of taxes.
5. Postpone payment of dividends.
Note: Since the cash budget represents a forecast, all the values shown
are expected values.

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‹ If the firm’s inflows and outflows are not uniform over the budget Notes
interval, the cash budget for that period will overestimate or
underestimate the firm’s cash needs.
‹ A cash budget can be used to help set the firm’s target cash balance
i.e. the desired cash balance that a firm plans to maintain in order
to conduct business. The target balance can be adjusted over time
depending on the size of the firm’s operations during various business
cycles.
‹ Even though depreciation amounts do not appear directly in the
budget, they still affect the amount of taxes shown.

Advantages of Cash Budget

1. Helps determine future cash flows thus enabling the company to plan
for its financing.
2. Helps management know when to borrow and how much to borrow.
3. Helps in determining when there will be a cash surplus so management
can plan for its use i.e. whether to pay dividends or invest in short-
term securities.
4. Helps management to control expenditure based on the forecasted
income and expenditure.
5. Assists management in planning for its obligations and knowing
when and how to meet those obligations.
6. Strengthens the liquidity position of a company since it helps a
company know its accurate cash position and what measures to
take depending on its position.

Disadvantages of Cash Budget

1. Uncertainty: It assumes that everything remains constant while in
reality, anything can actually happen.
2. Forecasting budgets isn’t always accurate since one can predict
expenses but can’t accurately predict income/sales.
3. Requires highly skilled personnel to forecast and prepare a cash
budget.
4. If there is any deviation from the fixed budget, a new budget has
to be designed again.

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Notes Format of Cash Budget

Particular January February March
Opening Cash Balance ‐ ‐ ‐
Add: Cash Receipts:
Cash Sales ‐ ‐ ‐
Receipts from Debtors ‐ ‐ ‐
Interest Received ‐ ‐ ‐
Dividend Received
Sale of fixed assets/Investments ‐ ‐ ‐

Bank Loan ‐ ‐ ‐
Issue of Equity Shares ‐ ‐ ‐
Issue of Debenture
Other cash receipts ‐ ‐ ‐
Total Receipts (A) ‐ ‐ ‐
Less: Cash Payments
Cash purchases ‐ ‐ ‐
Payment to creditors ‐ ‐ ‐
Salaries paid ‐ ‐ ‐
Wages paid
Administrative expenses ‐ ‐ ‐
Selling expenses ‐ ‐ ‐
Dividend paid ‐ ‐ ‐
Purchase of long-term assets ‐ ‐ ‐
Repayment of Loan ‐ ‐ ‐
Taxes Paid ‐ ‐ ‐
Total Payments (B) ‐ ‐ ‐
Closing Balance (A – B) ‐ ‐ ‐

7.4.6 Master Budget

The Master Budget is consolidated summary of the various functional
budgets. Master Budget is defined as “a summary of the budget schedules
in capsule form made for the purpose of presenting, in one report, the
highlights of the budget forecast”.

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The master budget is prepared by the budget committee on the basis of Notes
co-ordinated functional budgets and becomes the target for the company
during the budget period when it is finally approved by the committee.
This budget summarises functional budgets to produce a Budgeted Prof-
it & Loss Account and a Budgeted Balance Sheet as at the end of the
budget period.
Advantages of the Master Budget are as follows:
1. A summary of all functional budgets in capsule form is available
in one report.
2. The accuracy of all the functional budgets is checked because the
summarised information of all functional budgets should agree with
the information given in the master budget.
3. It gives an overall estimated profit position of the company for the
budget period.

7.4.7 Fixed and Flexible Budget

Fixed Budget: A fixed budget is a budget that does change during the
budget period. It is prepared for a particular activity level and it does
not change with actual activity level being higher or lower budgeted
activity level. This budget does not highlight the ‘activity variance’. In
this budget, there is no absolute difference between budgeted figures and
actual figures.
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Notes Following are the advantages of fixed budget:

1. It is misleading
2. It is inadequate for control purposes
3. It violates logic
Flexible Budget: A flexible budget is a budget which is designed to
change as volume of output changes – CIMA. The flexible budget is also
known as a variable budget because it keeps on fluctuating. A flexible
budget takes into account the cost classification into fixed, variable, and
semi-variable.
A flexible budget may be more effective in the following circumstances:
‹ When the level of activity varies from one period to the next.
‹ Where the firm is new and forecasting demand is tough.
‹ Where the organisation is experiencing a scarcity of any production
element. For example, material, labour, and so on, as the amount
of activity is determined by the availability of such a thing.
‹ Where the nature of the business is such that sales fluctuate.
‹ Where changes in fashion or trend have an impact on production
and sales.
‹ Where the organisation frequently offers new products or changes
the patterns and styles of its products.
‹ When a significant portion of output is destined for export.

Format of Flexible Budget

Capacity Utilization
Particulars 50% 70% 90%
Sales xxx xxx Xxx
Less: Variable Overheads
Contribution
Less: Fixed Overheads
Profit

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 Budgets and Budgetary Control

Difference between Fixed Budget and Flexible Budget Notes

S. No. Basis Fixed Budget Flexible Budget
1. Activity level Based on one single ac- Based on different lev-
tivity. els of activity.
2. Nature of the Static in nature thus is Dynamic in nature
budget rigid. That means this and thus flexible. This
budget does not change means this budget
with the level of output. changes with the lev-
el of output achieved.
3. Difficulty in True picture is not de- True picture is shown
comparing picted on comparing the on comparing the actual
actual level of output level of output with
with the budgeted level the budgeted level of
of output. output.
4. Working con- Assumes that the busi- Assumes that the busi-
ditions of the ness conditions remain ness situations keep on
business the same and does not changing and takes this
consider this fact. fact into consideration.
5. Differentiation Does not consider the Consider the differ-
in cost difference between fixed ence between fixed
cost, variable cost, and cost, variable cost, and
semi-variable cost. semi-variable cost.
6. Cost ascertain- Correct cost ascertain- Correct cost ascertain-
ment ment is difficult as busi- ment is easy as the
ness working conditions budget changes with
are not static. the volume of output.
7. Tool for cost It has a limited applica- It has more applications
control tion and is ineffective as and can be used as a
a tool for cost control. tool for effective cost
control.
8. Price fixation If the budgeted and ac- It helps in fixation of
tual activity levels vary, price and submission of
the correct cost ascer- tenders due to correct
tainment and fixation of cost ascertainment.
prices become difficult.

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 MANAGEMENT ACCOUNTING

Notes IN-TEXT QUESTIONS

5. The production budget is determined by the sales budget. (True/
False)
6. The budget that specifies the amount of raw materials that
will be utilised during the manufacturing process is called as
__________.
7. The raw material consumption budget and the raw material
purchasing budget are the same. (Yes/No)
8. The __________ budget includes cash inflows and outflows.
9. A budget that is a compilation of all budgets is termed as
__________.

7.5 Zero-Based Budgeting

ZBB may be better termed as ‘De nova budgeting’ or budgeting from
the beginning without any reference to any base-past budgets and actual
happening. Zero-Based Budgeting is a subset of budgeting. As the name
implies, we start budget preparation from zero. In basic terms, we begin
budget preparation from the scratch, that is, from the beginning. Zero
Base Budgeting is:
1. A technique of planning and decision-making.
2. Reverses the working process of traditional budgeting.
3. In traditional incremental budgeting, departmental managers need to
justify only increases over the previous year budget. This means
what has been already spent is automatically sanctioned.
4. In case of ZBB, no reference is made to the previous level of
expenditure. Every department function is reviewed comprehensively
and all expenditures rather than only increases are approved.
5. ZBB is a technique, by which the budget request has to be justified
in complete detail by each division manager starting from the Zero-
base. The Zero-base is indifferent to whether the total budget is
increasing or decreasing.

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 Budgets and Budgetary Control

Advantages of Zero Base Budgeting: Notes

1. Results in efficient allocation of resources as it is based on needs
and benefits.
2. Drives managers to find out cost-effective ways to improve operations.
3. Detects inflated budgets.
4. Useful for service departments where the output is difficult to identify.
5. Increases staff motivation by providing greater initiative and responsibility
in decision-making.
6. Increases communication and coordination within the organization.
7. Identifies and eliminates wastage and obsolete operations.
8. Identifies opportunities for outsourcing.
9. Forces cost centers to identify their mission and their relationship
to overall goals.

Disadvantages of Zero Base Budgeting:

1. Difficult to define decision units and decision packages, as it is very
time-consuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D
department is threatened whereas the production department benefits.
3. Necessary to train managers. ZBB should be clearly understood by
managers at various levels otherwise they cannot be successfully
implemented. Difficult to administer and communicate the budgeting
because more managers are involved in the process.
4. In a large organization, the volume of forms may be so large that
no one person could read it all. Compressing the information down
to a usable size might remove critically important details.
5. Honesty of the managers must be reliable and uniform. Any manager
that is prone to exaggeration might skew the results.
Traditional budgets are based on historical performance and costs from
the previous accounting period. However, with Zero-Based Budgeting,
we do not take anything from the prior accounting period.

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Notes We focus on the goals and objectives that we need to achieve in zero-based
budgeting, and the rest of the budgeting technique is the same as we do
in traditional budgeting.
Comparison of ZBB from Traditional Budgeting is as follows:
Traditional Budgeting Zero-based Budgeting
It takes into consideration the pre- It does not take into consideration
vious accounting period’s data to the previous accounting period’s
make the new budget. data for making the new budget,
rather it starts from scratch.
It has a major focus on money. It has a major focus on the attain-
ment of goals and objectives.
It does not consider different ap- It takes different approaches to
proaches. achieve similar results.

IN-TEXT QUESTIONS
10. Zero base Budgeting means starting from the __________.
11. Zero base Budgeting takes into consideration previous accounting
period’s data. (True/False)
12. Zero base Budgeting is time-consuming. (Yes/No)
13. Traditional Budgeting takes into consideration previous accounting
period’s data. (True/False)
14. The primary emphasis of Zero-based Budgeting is on __________
and __________.
15. Budget is drawn for __________.
16. Key factor is also known as __________.
17. __________ requires classifications of cost as fixed, variable
and semi-variable.
18. Flexible budget is drawn for __________ level of activity.
19. __________ budget is prepared for a longer period.
20. __________ is a summary of all the functional budgets.
21. __________ shows estimate of sales in future.

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 Budgets and Budgetary Control

22. Flexible budget is useful for __________. Notes

23. Budget defines __________ of a concerned manager.

24. __________ shows budgeted receipts and payments.

7.6 Summary
In a nutshell, a budget is a financial statement that is based on estimates.
And if there are any differences between the intended level of activity and
the activity achieved, these are referred to as deviations, and corrective
procedures can be implemented to address them. The budget serves as a
regulating tool and aids in the achievement of the organisation’s goals
and objectives. Budgets are classified into several types, including sales
budgets, production budgets, raw material consumption budgets, raw
material purchase budgets, cash budgets, master budgets, fixed budgets,
and flexible budgets. There is also the idea of zero-based budgeting,
which indicates that no data from prior accounting periods is used and
the budget is created from start.

7.7 Practical Problems

1. Bharat Forging Limited manufactures a single product for which market
demand exists for additional quantity. Present sales of Rs. 60,000 per
month utilises only 60% capacity of the plant. Marketing Manager
assures that with the reduction of 10% in the price he would be
able to increase the sale by about 25% to 30%.
The following data are available:
Selling Price Rs. 10 per unit
Variable Cost Rs. 3 per unit
Semi-variable Cost Rs. 6,000 fixed + 50 paise per unit
Fixed Cost Rs. 20,000 at present level estimated to be
Rs. 24,000 at 80% Output

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 MANAGEMENT ACCOUNTING

Notes You are required to prepare the following statements:

(a) The operating profits at 60%, 70% and 80% levels at current
selling price, and
(b) The operating profits at proposed selling price at the above
levels
2. A factory is currently running at 50% capacity and produces 5,000
units at a cost of Rs. 90/- per unit as per details below:
Material Rs. 50
Labour Rs. 15
Factory Overheads Rs. 15 (Rs. 6 fixed)
Administrative Overheads Rs. 10 (Rs. 5 fixed)
The current selling price Rs. 100 per unit.
At 60% working, material cost per unit increases by 2% and selling
price per unit falls by 2%.
At 80% working, material cost per unit increases by 5% and selling
price per unit falls by 5%.
Estimate profits of the factory at 60% and 80% working and offer
your comments.
3. Based on the following information, prepare a Cash Budget for the
three months ending 30th June, 2022
Month Sales Materials Wages Overheads
February Rs. 14,000 Rs. 9,600 Rs. 3,000 Rs. 1,700
March Rs. 15,000 Rs. 9,000 Rs. 3,000 Rs. 1,900
April Rs. 16,000 Rs. 9,200 Rs. 3,200 Rs. 2,000
May Rs. 17,000 Rs. 10,000 Rs. 3,600 Rs. 2,200
June Rs. 18,000 Rs. 10,400 Rs. 4,000 Rs. 2,300
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, Overheads ½
month

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 Budgets and Budgetary Control

‹ Cash and Bank Balance on 1st April, 2022 is expected to be Rs. Notes
6,000.
Other relevant information is:
‹ Plant & Machinery will be installed in February 2022 at a cost
of Rs. 96,000. The monthly installments of Rs. 2,000 is payable
from April onwards.
‹ Dividend @ 5% on Preference Share Capital of Rs. 2,00,000
will be paid on 1st June.
‹ Advance to be received for sale of vehicles Rs. 9,000 in June.
‹ Dividends from investments amounting to Rs. 1,000 are expected
to be received in June.
‹ Income Tax (advance) to be paid in June is Rs. 2,000.

7.8 Answers to In-Text Questions

1. Quantitative Statement
2. Yes
3. Defined
4. Set Standards
5. True
6. Raw material consumption budget
7. No
8. Cash budget
9. Master budget
10. Scratch or zero
11. False
12. Yes
13. True
14. Goals and Objectives

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 MANAGEMENT ACCOUNTING

Notes
15. Future
16. Limiting factor
17. Flexible budget
18. Fixed
19. Capital
20. Master budget
21. Sales budget
22. Control
23. Responsibility
24. Cash budget

7.9 Self-Assessment Questions

1. Define budgetary control.
2. Define budget and budgetary control. State the advantages of budgetary
control in an organization.
3. Distinguish between cost control and cost reduction.
4. Distinguish between fixed and flexible budget. Briefly state the
circumstances in which flexible budgets are used.
5. Write short note on Zero Based Budgeting.

7.10 References
‹ Arora, M. N. (2016). Cost And Management Accounting. Penguin
Random House.
‹ Saxena & Vashist. Cost Accounting. Sultan Chand & Sons.
‹ Ravi M Kishore. Cost & Management Accounting. Taxmann.
‹ Jain S. P. & Narang K. L. Cost and Management Accounting.
Kalyani Publishers.

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 Budgets and Budgetary Control

Notes
7.11 Suggested Readings
‹ Pandey, I. M. Management Accounting. Vikas Publishing.
‹ Khan M. Y. & Jain P. K. Theory and Problems of Management and
Cost Accounting. McGraw Hill Education.
‹ Horngren C. T. Cost and Management Accounting - A Managerial
Emphasis. Pearson Education.

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 L E S S O N

8
Cost Management
Ms. Sanjana Monga
Sessional Faculty
Niagara College, Toronto, Canada
Email-Id: [email protected]

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Cost Management, Cost Control and Cost Reduction
8.4 Strategies for Cost Management
8.5 Activity-based Costing
8.6 Accounting and the Theory of Constraints
8.7 Throughput Accounting
8.8 Target Costing
8.9 Value Chain Analysis
8.10 Life Cycle Costing
8.11 Just-in-Time (JIT)
8.12 Backflush Costing
8.13 Summary
8.14 Self-Assessment Questions
8.15 References
8.16 Suggested Readings

8.1 Learning Objectives

Learning objectives of this unit are:
‹ Explain the concept of cost management, cost control and cost reduction.
‹ Describe activity based costing in detail.
‹ Concept of value chain analysis.
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 Cost Management

‹ Target costing and life cycle costing. Notes

‹ Modern accounting techniques like throughput and backflush costing.

8.2 Introduction
The business environment has changed considerably over last few decades.
Many of the organisations have already adopted automated modes for
most of their operations following the lean business model resulting in
decrease in direct labour but increase in indirect overheads. Therefore,
direct labour is no more considered a good base or predictor for over-
heads allocation. Besides that, increased competition in the market has
led to emergence of organisations that are manufacturing multiple types
of products or services. Diverse nature of manufactured products or ser-
vices generally consume resources or overheads in different proportion
and it is not possible to correctly capture this diversity by following
traditional costing systems.

8.3 Cost Management, Cost Control and Cost Reduction

Companies utilise cost reduction analysis as a method to lower their
expenses and boost earnings. Depending on the goods or services they
provide, many businesses adopt various strategies. Every choice made
during the product development process has an impact on the price.
Companies frequently launch new products without concentrating on how
much value there will be. However, the importance of pricing changes
drastically when market rivalry rises and prices of goods and services
become a significant point of differentiation.
The action is regulated by cost management to maintain the cost compo-
nents within the predetermined bounds. Contrarily, cost reduction refers to
a real, long-term decrease in the unit price. Understanding the distinction
between cost reduction and cost control will be helpful.

8.3.1 Control of Costs

The goal of cost control is to rationalise overall value through the use of
competitive analysis. The goal of this technique is to keep the real price
in line with the specified policy. The operational costs must not exceed
the budgeted amount, thus this must be ensured.
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 MANAGEMENT ACCOUNTING

Notes Cost control encompasses a number of tasks, beginning with the creation
of the budget for the operation, evaluation of the performance, computa-
tion of the differences between the actual costs and the budgeted value,
and identification of the causes of those differences. The final task is
carrying out the appropriate corrections to address the discrepancies.

Importance of Cost Control and Cost Reduction

‹ Better utilization of resources
‹ To prepare for meeting a future competitive position
‹ Reasonable prices for the customers
‹ Firm standing in domestic and export markets
‹ Improved methods of production and use of latest manufacturing
techniques which have the effect of rising productivity and minimizing
cost
‹ Improves rate of return on investment
‹ Improves the image of the company for long-term benefits

8.3.2 What Distinguishes Cost Reduction from Cost Control?

The distinction between the two can be summed up as follows: cost
management ensures that costs are within defined criteria; cost reduc-
tion focuses on trying to continuously improve costs while ignoring any
standards.
The key advantages of cost reduction initiatives are that they can improve
an organization’s cash flow and profitability. The essential components
and variables for programme design and implementation are presented.
The results of a cost-cutting programme can also be guaranteed to align
with the organization’s beliefs and aims. The fact that a corporation must
implement a cost reduction programme is widely understood, especially
given the abundance of options available to managers who are cost-con-
scious. Last but not least, a comprehensive tax reduction programme
can lessen the heavy financial obligations that can stabilise a business’s
growth and can free up valuable capital that can result in the long-term
advantage of the organisation.

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 Cost Management

S. No. Cost Control Cost Reduction Notes

1 This process undertakes the This process finds out the sub-
competitive analysis of actual stitute by finding new ways or
results with established norms. methods.
2 Under this method, varianc- Under this process, necessary
es are appraised and reported steps are taken for further mod-
and necessary course of action ification in the method.
will be taken to revise norms,
standards.
3 It starts from established cost It challenges the standards forth-
standards and attempts to keep with and attempts to reduce cost
the costs of operation of a process on a continuous basis.
in line with those of materials.
4 It is a preventive function. It is a corrective function.
5 The main stress is on the present The emphasis is partly on the
and past behaviour of costs. present costs and largely on
future costs.

8.4 Strategies for Cost Management

Businesses generally use different strategies to cut costs. The techniques
include Just-in-Time (JIT), Activity-Based Costing (ABC), Value Engi-
neering (VE), Target Costing (TC) and Life Cycle Costing. Some more
advanced techniques like Throughput Costing and Backflush Costing.

8.5 Activity-based Costing

Consider the cost computation of manufacturing a product. It is not dif-
ficult to trace the cost of direct materials and labour on the cost object.
Problem arises for overheads that are difficult to trace and need to be
allocated taking some suitable and rational measure. The accuracy of
allocation of overhead relates to how well the consumption of labour by
the production activity tracks the incurrence of the overhead cost. If the
incurrence of overhead is unrelated to consumption of direct labour, the
allocation of overheads to the cost of object using direct labour as the
base of allocation can cause significant errors. It should be made clear
that choice of any base for allocation will be prone to some errors because
the correlation between the overhead cost incurrence and the use of allo-

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Notes cation base will be less than perfect. It can be considered a fundamental
challenge when costs are not directly traceable while computing produc-
tion cost. It produces the concept of Activity Based Costing (ABC) as an
alternative approach for cost allocation with aim to enhance the accuracy
in overhead allocation by providing reliable estimates of product cost.
Activity-Based Costing is a method of cost allocation that attempts to
assign overheads cost to cost objects more accurately than the traditional
costing methods. The basic idea underlying concept of ABC is that every
order from a client or customer for a service or product triggers to num-
ber of activities; a number of different types of resources are required to
carry out these activities; and money is involved in using these resources.
Through activity based costing, an attempt is made to trace these costs
directly to the activities causing them. The activities are believed to drive
the cost, that’s the reason they are called cost drivers.
CIMA defines ABC as “cost attribution to cost units on the basis of benefit
received from indirect activities like ordering, setting-up, assuring quality”.
ABC has been defined as “the collection of financial and operational
performance information tracing the significant activities of the firm to
product costs”.

Definition of Terms:
Cost Objects: The products under consideration for computing cost are
generally cost objects. But with the widening of the scope of managerial
consideration for numerous purposes besides computing cost, customers
or clients, services that are being provided or even the area or territory
can also be cost objects.
Activities: The most common term used in concern of ABC is “activity”.
An activity may be defined as the aggregation of various tasks or functions
that are being performed concerning the cost objects. Activities can again
be of two different types. It can be either any support activity or it can be
any activity that is related to the process of production. Activities that are
grouped under support activities need to be performed before or after the
production process. For example, deciding about the schedule of production,
setting up of machine, queuing the customer orders, an inspection of different
items, etc., while activities performed during the process of production like
using machines or assembling are called production process activities.

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Cost Pool: The cost centre described above may also sometimes be Notes
termed a Cost pool. Hence cost pool is nothing but the other name of
the cost centre.
Cost Drivers: The reason or cause due to which some overhead occurs
or is incurred, is known as a cost driver. In other words, cost drivers can
be termed as the factor because of which the cost of production gradual-
ly changes. With the change in the level of cost driver, the level of the
total cost of production also changes. Some examples of cost drivers are
the setup of machines, an inspection of quality, scheduling of production
orders, receiving material, shipments, units of power consumed, etc.
The activity measure expresses the carried out part of activity i.e. volume
of activity. This activity measure is generally used as base for allocation
of overheads to product and service cost. For example, number of com-
plaints received from customers can be a natural choice of an activity
measure for the activity handling customer’s complaints.
Each activity has its own activity rate that is used to apply cost of over-
heads.

Predetermined Activity Rate = E

 stimated activity costs/Estimated
activity volume
For example, the activity maintenance would be having its own activity
cost pool. If we assume that total cost in this pool is Rs. 100,000 and
total expected activity is 1000 hours, the activity rate will be Rs. 100
per maintenance hour. This amount calculated for activity rate is not
dependent on number or size of job. Whether the job is big or small, all
will be charged at the same rate per maintenance hour.

Objectives of ABC:
The primary objectives of ABC system are as follows:
(a) To improve the accuracy of product costs by carefully changing
the type and number of factors used to assign costs, and
(b) To use this information to improve product mix and pricing decision.
The other important objectives of ABC systems are as below:
‹ To identify value-added activities in transactions
‹ To chalk out ways to eliminate non-value-added activities

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Notes ‹ To distribute overheads on the basis of activities

‹ To ensure accurate product costing of decision-making process
‹ To focus the high cost activities
‹ To identify the opportunities for improvement and reduction of costs

8.5.1 Steps Involved in Designing Activity-based Costing System

Designing of activity-based costing system requires commitment and time
from almost all levels of managers and involves the following seven
steps, which sometimes vary from organisation to organisations. These
are general steps that are expected to be followed while implementing
Activity-Based Costing (ABC). These steps are:
1. Identification of activities and creation of activity dictionary.
2. Creation of pools of activity cost.
3. Identification of consumed resources by individual activity cost pools.
4. Identification of activity measures for each cost pool.
5. Estimation of total activity volume for each cost measure.
6. Computation of predetermined activity rate for each activity cost pool.
7. Allocation of cost to the desired cost objects.
Step 1: Identification of Activities and Creation of Activity Dictionary
In most of the organisations, overheads are caused due to hundreds or
even thousands of activities. For example, taking calls over telephone,
making invoices, ordering materials, training of staff, packaging and dis-
patching orders, etc. It may be extremely difficult to design and maintain
a complex costing system that can include and record every activity.
The main challenge faced while designing the activity based costing
system may be identification of activities that are manageable and able
to explain the variations in overhead costs. The simplest and most
common way to do this is interviewing the broad range of managers to
identify activities that they think are most relevant and consumes major
portion of resources. This list may be more refined by consulting top
managers; activities that are related can be combined that can help in
reducing cost of keeping details and records. At the end of this process,
an activity dictionary will be created that defines all the activities and
how to measure them.

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Step 2: Creation of Pools of Activity Cost Notes

In manufacturing organisations, it is not necessary that all the activities
mentioned in activity directory are performed every time whenever addi-
tional units are produced. Some activities may require to perform every
time an additional unit is manufactured, but others may not be. To have
more clarity regarding this aspect of activities, generally manufacturing
units divide all activities into four groups.
(a) Unit level activities, performed every time a unit is produced.
(b) Batch level activities, consist of tasks that are required to be performed
every time a batch or a lot is processed.
(c) Product level activities, that are related to specific products and must
be performed every time regardless of number of batches of units
produced.
(d) Facility level activities, also sometimes called as organisation sustaining
activities and are regularly performed regardless of which products
or how many batches are being manufactured. These are generally
related to administration like salary, insurance etc., are combined
into single cost pool and then allocated taking some arbitrary base
such as direct labour-hours.
Exhibit 8.1: Activities and Activity Measures in a Manufacturing
Organisation
Activity Type Activity Activity Measure
Unit level Assembly Direct labour hours
Machining Machine hours
Batch level Production Scheduling Number of orders
Material Receipts Number of receipts
Product Testing Number of tests
Product level Administration of Parts Number of parts numbers
Facility level Factory general adminis- Direct labour hours
tration
Using such a classification allows the designer of ABC system to exam-
ine whether the activities can be combined in a meaningful manner so
that system is simplified and proper activity measure can be identified
to allocate cost to different cost objects.

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Notes Step 3: Identification of Consumed Resources by Individual Activity

Cost Pools
Next important step after creation of cost pool is identifying the total cost
that is consumed by each of the cost pool. For example, to identify the
resources consumed by an activity cost pool testing of products, expenses
like time taken by tester, depreciation of testing equipment, supplies used
during testing procedure are traceable and directly allocated to the cost
pool. But other costs like rent of building, electricity, maintenance of
building that are common across all of the activities cost pools, must be
allocated to individual cost pools taking some suitable base, like rent of
building can be allocated on the basis of percentage area allotted to testing
activity. Other examples for taking base for common expenses may be:
‹ Fringe benefits of employees – Direct labour hours
‹ Electricity – Number of machine hours
‹ Maintenance of Equipment – Number of machine hours
‹ Maintenance of Factory – Area in Sq. Feet
Step 4: Identification of Activity Measures for Each Cost Pool
After the determination of assigned amount of cost to each cost pool,
the next is to assign the cost of the pool to the cost objects by using an
activity cost measure. For example, once the total cost assigned to testing
activity is determined, the next is to identify the activity measure that
will be used to allocate the cost of this cost pool to the final cost object,
like number of testings done on a particular cost object.
Step 5: Estimation of Total Activity Volume for Each Cost Measure
Remaining of the steps are related to designing the mechanism of activ-
ity pool cost allocation to final cost objects. Like in example of product
testing activity, the activity volume will be the estimated numbers of
tests conducted in a given period of time. Because testing of products
generally is a batch level activity, it is dependent on volume of the esti-
mated number of batches produced and policy of testing (like testing 10
batches per day), what will be the volume of activity measure.
Step 6: Computation of Predetermined Activity Rate for Each Activity
Cost Pool
The activity measure expresses the carried out part of activity i.e. volume
of activity. This activity measure is generally used as base for allocation
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of overheads to product and service cost. For example, number of com- Notes
plaints received from customers can be a natural choice of an activity
measure for the activity handling customer’s complaints. Each activity
has its own activity rate that is used to apply cost of overheads.
Predetermined Activity Rate = E
 stimated activity costs/Estimated activity
volume
Step 7: Allocation of Cost to the Desired Cost Objects
At this stage, costs obtained from different cost pools are finally allocat-
ed to different cost objects using the activity rate and volume of activity
measure consumed by this cost object. For example, if the activity rate
per test is Rs. 55, and production of a particular product requires 100 test
to be performed, 55*100, i.e. 5500 will be assigned to this product. Here
it is necessary to mention that the information regarding number of tests
required must be gathered. Such information again can prove a tool to
manage and control cost which might not be necessary under traditional
costing system, and is generally considered a key plus point of ABC system.

Different Categories of Cost Pools and its Cost Drivers

Cost Pools Cost Drivers
Customer Order Processing No. of customers
No. of order source
No. of orders by quantity
No. of orders by value
No. of customer visits
Material Planning/Acquisition No. of items/parts/components
No. of deliveries
No. of material receipts
No. of material orders
No. of stock shortages/discrepancies
No. of material transactions
No. of material movements

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Notes Cost Pools Cost Drivers

Inspection and Quality Control No. of inspections
No. of rejections
No. of product changes
No. of set-ups
Batch sizes
Production Control No. of product changes
No. of parts operational
No. of production hours
No. of machine changes
No. of schedule changes
No. of machine layout changes
No. of set-ups
No. of work orders
Maintenance No. of set-ups
No. of machine break-downs
No. of defects
Capital Expenditure
Maintenance schedule
Research and Development No. of research projects
Technical complexities of projects
Customer Service No. of service calls
No. of products serviced
No. of hours spent on servicing products

8.5.2 Activity-based vs. Traditional Costing

Assume the Busy Ball Company makes two types of bouncing balls; one
has a hollow center and the other has a solid center. The same equip-
ment is used to produce the balls in different runs. Between batches, the
equipment is cleaned, maintained, and set up in the proper configuration
for the next batch. The hollow center balls are packaged with two balls
per package, and the solid center balls are packaged one per package.

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During the year, Busy Ball expects to make 2,000,000 hollow center balls Notes
and 4,000,000 solid center balls. The overhead costs incurred have been
allocated to activity pools as follows:

Material purchased 4,00,000

Expenses on machine setup 7,00,560
Packaging expenses 6,00,000
Testing expenses 5,40,000
Maintenance 5,77,080
Total overheads cost 28,17,640
Amount (in Rs.)
After analysing the activity pools, cost drivers are identified, total units
to be produced for each product are estimated and unit cost for each cost
driver is calculated:
Unit Cost
Total Estimated per Cost
Units for Cost Total Cost Driver 3 =
Activity Cost Driver Driver (1) (2) (2)/(1)
Material Purchased Number of purchase 200 4,00,000 2,000
orders
Expenses on ma- Number of setups 504 7,00,560 1,390
chine setup
Packaging expenses Number of contain- 50,00,000 6,00,000 0.12
ers filled
Testing expenses Number of tests 6,000 5,40,000 90
Maintenance Number of runs 504 5,77,080 1,145

Following table shows activity by product:

Unit Hollow Solid Hollow Solid
Cost Center Center Center Center
Activity Cost Driver (3) (4) (5) (3)*(4) (3)*(5)
Material Pur- Number of pur- 2,000 100 100 2,00,000 2,00,000
chased chase orders
Expenses on ma- Number of set- 1,390 252 252 3,50,280 3,50,280
chine setup ups
Packaging ex- Number of con- 0.12 10,00,000 40,00,000 1,20,000 4,80,000
penses tainers filled
Testing expenses Number of tests 90 2,000 4,000 1,80,000 3,60,000
Maintenance Number of runs 1,145 168 336 1,92,360 3,84,720
Total 10,42,640 17,75,000

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Notes Further, for the purpose of calculating per unit overhead rate under activity
based costing, the total cost that have been assigned to each product is
divided by number of units manufactured.
Overhead cost assigned to hollow centre balls 10,42,640
Number of hollow centre balls
= 20,00,000 = Rs. 0.521
Overhead cost assigned to solid centre balls 17,75,000
Number of solid centre balls
= 40,00,000 = Rs. 0.444
If following traditional costing, total overhead cost will be allocated on
basis of direct labour cost, where total of overheads will be divided by
total combined labour cost for both types of balls. Estimated direct labour
cost for the year is Rs. 30,24,000 out of which Rs. 7,56,000 is for hollow
center balls and Rs. 22,68,000 is for solid center balls. The per unit direct
labour cost will be for hollow centre ball Rs. 0.378 (7,56,000/20,00,000)
and Rs. 0.567 for solid center balls (22,68,000/40,00,000).
Step 1: Calculation of overhead per direct labour hour
Total overhead cost 28,17,640
= = 0.932
Total direct labour hours 30,24,000
Step 2: Allocation of overhead
Overhead cost per direct labour hour * per unit direct labour hours
Hallow center balls = 0.932 * 0.378 = Rs. 0.352 overhead per unit
Solid center balls = 0.932 * 0.576 = Rs. 0.528 overhead per unit
A comparison of the overhead per unit calculated using the ABC and
traditional methods often shows very different results:
ABC Traditional
Hollow center ball Rs. 0.52 Rs. 0.35
Solid center ball Rs. 0.44 Rs. 0.53
In above example, as per ABC, overheads are Rs. 0.52 per hollow ball,
much higher than the Rs. 0.35 that is calculated using traditional cost-
ing. The cost calculated using ABC is more accurate while pricing the
production. For the balls with solid center, cost of overheads per unit is
Rs. 0.44 under ABC method while it is Rs. 0.53 under traditional costing.
The reason behind this is under traditional costing, overheads have been
allocated on the basis of direct labour cost, so the product having high
direct labour cost gets higher of the overhead cost as well.

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8.5.3 Advantages of ABC Notes

(i) Gives accurate manufacturing costs for particular products.
(ii) More properly allocates manufacturing costs to the activity’s user-
facing products and processes.
(iii) Identifies wasteful procedures and aims to improve them.
(iv) More correctly calculates product profit margins.
(v) Identifies the procedures with wasteful and excessive expenditures.
(vi) Provides a better explanation and defense of manufacturing overhead
costs.
8.5.4 Limitations of ABC
(i) Data preparation and collection take time.
(ii) Information gathering and analysis are more expensive sources of data
aren’t always easily accessible from standard accounting reports.
(iii) It is not usually possible to utilize ABC reports for external reporting
because they don’t always follow widely accepted accounting rules.
(iv) Data generated by ABC could be at odds with managerial performance
standards that were previously established using conventional costing
methodologies.
(v) For businesses where overhead is low relative to total operating
costs, it might not be as helpful.

8.6 Accounting and the Theory of Constraints

The principles of the Theory of Constraints are used to clarify decisions
after throughput accounting has laid the groundwork for a more straight-
forward approach to operational accounting.
When some of the limiting factors prevent production, this is referred
to as a theory of constraint situation. Production plans must be managed
in accordance with these limits because they can also be referred to as
bottlenecks or scarce resources.
The Theory of Constraints, developed by Eliyahu M. Goldratt and popu-
larised by his best-selling book “The Goal” and other works, led to the
introduction of throughput accounting in the 1980s.

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Notes The foundation of management by constraints is the idea that the major
constraint—typically represented by a bottleneck close to or directly at
the entry of the constrained resource—limits the amount of money that
can flow out of an industrial or commercial structure.

8.7 Throughput Accounting

Businesses utilise throughput accounting as a clever production planning
tool. Profit maximisation is the goal of employing this accounting strat-
egy. When producing several products, this idea is relevant if there is a
particular constraint. So it’s more about manufacturing and production
planning.
Consider the possibility that you may need to use raw materials (the bot-
tleneck) in a variety of your company’s goods. A bottleneck is a material
or any other element that lowers your production capacity. Any produc-
tion-related factor, such as a limited supply of raw materials, manpower,
or machine hours, may be the bottleneck.
Only the following situation makes this style of accounting appropriate.
‹ There is a bottleneck in your company.
‹ Your company makes more than one product, and each product uses
bottleneck resources differently.
In this case, throughput accounting can assist in creating a production
schedule that maximises your business’s profits.

8.7.1 Process of Throughput Accounting

Step 1: Knowing your production facility is important for identifying
bottleneck resources. Consequently, this stage entails a thorough study
of the production stages. For various enterprises, there may be various
bottlenecks. An example of a scarce resource would be labour hours,
machine hours, raw materials, or any other production factor. Understand-
ing the actual source of the problem is therefore more important when
finding constrained resources.
Step 2: Calculate the contribution for each product, per unit. It involves
using the product in some math. Just subtract all variable expenses from
revenue.

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Step 3: Divide the contribution per unit by the scarcity of the resource Notes
Again, simple math requires dividing the contribution per unit by the
limited resource. Throughput value is the name of it.
Step 4: Rank the values from step 3 in order of importance. The step
three throughput value’s top-ranked values show the highest use of scarce
resources to produce profit. Simply said, we have found a product that
makes the most contribution while utilising the fewest scarce resources.
Therefore, the top-ranked products should be prioritised. The maximum
demand for each product should, however, be taken into account while
developing a product plan.
The product that uses the least amount of a scarce resource to provide
the most contribution has been identified. We have also graded prod-
ucts according to how well they use limited resources. Consequently, a
production plan with the maximum overall contribution can be created
using this information.

8.7.2 Throughput Ratio

Throughput accounting ratio is equal to throughput value divided by fixed
cost per unit, where contribution/unit of a scarce resource determines
throughput value.
If the value determined is more than one, the throughput value can pay
for the fixed cost. A throughput ratio of less than one, on the other hand,
indicates that the business’s fixed costs are not covered by the throughput
value. Consequently, knowing if it is profitable to produce a product may
be useful to the firm.

8.8 Target Costing

Target Costing is defined as “as a cost management tool for reducing
the overall cost of a product over its entire life cycle with the help of
the production, engineering, R&D”.
Target costing is a market-driven design methodology and involves es-
timating a cost for a product and then designing the product to match
the cost.
Target costing is a cost management tool for reducing product costs over
its entire life cycle. It becomes an important reference point for cost

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Notes management. Target costing includes actions management must take to

establish reasonable target costs, develop methods for achieving those
targets and develop means by which to test the cost effectiveness of
different cost-cutting scenarios.
Sakurai discusses the most important procedure of target costing as follows:
1. To plan and design high quality products that meet customers’ needs.
2. To set a target cost for the products through the use of value
engineering.
3. To attain the target cost at the production stage by use of standard
costs.

8.8.1 How Does Target Costing Work?

Target costing is more than simply a way of costing; it is also a man-
agement technique in which prices are set by the market, taking into
account a number of variables, including homogeneous product offerings,
the intensity of competition, the cost of switching for the end user, etc.
Management seeks to keep expenses under control when these elements
are present since they have limited or no control over the selling price.
Target costing is used to manage expenses prior to the company incurring
any manufacturing expenditures, which saves a significant amount of time
and money. Target costs can also be continuously employed to keep costs
under control throughout the whole production life cycle.
The following may be construed as the components in the product target
costing:
‹ Type of product
‹ Technical specifications
‹ Technical requirements
‹ Customer
‹ Resource consumption (acquisition price)
‹ Resource consumption (cost)

Formula for Target Cost:

Where the profit margin is based on selling price, target total cost can
be calculated as follows:

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Target Cost = Selling Price – Required Profit Notes

Required Profit = (Gross Profit/Sales) × Selling Price
Where the profit margin is based on cost, target cost can be found as
follows:
Selling Price
Target Cost =
1 + Profit Percentage
Targets can be set for each individual cost component based on the
standard costing.
Example:
M&M is a dress manufacturer that operates in extreme competition. It
sells dresses to different resellers market dresses under their own brands.
M&M can only charge Rs. 5 per meter. If the company’s intended profit
margin is 25% on cost, calculate the target cost per unit. If 20% of the
cost per meter of dress is related to direct materials, what’s the target
cost per unit for direct materials.
Solution:
M&M wants to earn a margin of 25% on cost, so the following formula
need to be applied to get the total target cost per unit.
Rs. 5 per meter
Target cost per unit = = Rs. 4
1 + 25%
M&M has to keep its cost per unit below Rs. 4 in order to generate 25%
profit margin on cost.
If 20% of the unit cost is related to direct materials, target cost for direct
materials shall be Rs. 0.80 (0.2 * Rs. 4).
If M&M wants to earn 25% on selling price, the total target cost per
unit shall be worked out as follows:
Target cost per unit = Rs. 5* (1 – 25%) = Rs. 3.75

8.8.2 Target Costing Advantages

‹ By using ABC, target costing offers a better way to test various
cost scenarios and specific information on the expenses associated
with developing a new product.
‹ Target costing shortens the product development cycle.

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Notes ‹ Target costing significantly boosts the profitability of new products

by encouraging cost-cutting while preserving or enhancing quality.
Target price also encourages consumer demands, which makes it
more well-liked than competing products.
‹ Target costing is also used to project future costs and offers
encouragement to hit cost targets.
‹ Target costing is used to manage expenses prior to the company
incurring any manufacturing expenditures, which saves a significant
amount of time and money. Target costs can also be continuously
employed to keep costs under control throughout the whole production
life cycle.

8.9 Value Chain Analysis

With highly competitive environment, the organizations are aiming to be
‘customer driven’ i.e. customer satisfaction is priority one. One of the
key tools in the hands of the management to achieve this aim is value
chain analysis.
Value Chain Analysis ‘is a strategic managerial tool to assess and review
the various business functions in which utility is added to the products
or services’.
Michael Porter first proposed the concept of a value chain in 1985 to
illustrate how customer value builds up along a chain of processes that
result in a final good or service.
The internal procedures or actions carried out by a business “to create,
produce, promote, distribute, and support its product,” according to him,
comprise the value chain. According to him, “a firm’s value chain and the
manner in which it carries out certain operations are a reflection of its
history, its strategy, its method to achieving its plan, and the underlying
economics of the activities themselves.”
Porter divided business activities into two categories: primary, line, and
support activities. The conversion of inputs into outputs, as well as deliv-
ery and post-sale support, are the main operations. In other words, they
cover tasks like order processing, distribution, and the transformation
of inputs into finished goods. They also cover communication, pricing,

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and channel management, as well as installation, maintenance, and part Notes

replacement.
The activities that assist primary activities are known as support activ-
ities. They include the following and are handled by the organization’s
staff functions:
1. Procurement—acquiring assets as well as raw materials, suppliers,
and other consumables.
2. Each value chain activity requires specific technical knowledge,
processes, and inputs.
3. Human resource management, including hiring, promoting, and placing
employees as well as providing them with feedback and rewards.
4. The organisational framework of the company, including general
management, planning, finance, accounting, legal, public affairs,
and quality management.
The value chain for a typical organization is shown in Figure 8.1.

Figure 8.1: Value Chain Analysis for a Business

Support Activities may be Human Resource; Finance;

Information Technology
The value chain breaks down the company into each of its unique stra-
tegic activities. Value chain analysis looks at how customer value can be
increased or expenses can be reduced across the company’s operations,
from new product creation to distribution.
The main inquiries are:
(i) Is it possible to minimise expenditures in this activity while keeping
revenue value constant?
(ii) Is it possible to raise profits while maintaining the same costs in
this activity?
(iii) Is it possible to minimise assets while maintaining costs and profits
in this activity?

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Notes (iv) Most crucially, is it possible to complete steps 1, 2, and 3 all at

once?
The business unit can get a competitive edge in terms of cost and rev-
enue differentiation by methodically analysing expenses, revenues, and
assets in each activity.
All of the aforementioned roles play a part in carrying out a company’s
competitive strategy, and each must create its own strategy in order to do
so. Here, a process’ or function’s strategy refers to what it will specifi-
cally strive to accomplish. A company’s planned portfolio of new items
is laid out in a product development strategy. Additionally, it determines
whether the development work will be done internally or externally. A
marketing and sales strategy outlines the market segmentation, product
positioning, pricing, and promotion plans. The type of raw material
procurement, material transportation to and from the business, product
manufacture or operation to provide the service, and distribution of the
product to the customer are all determined by a supply chain strategy,
along with any follow-up services and a specification of whether these
processes will be carried out internally or externally. Given that businesses
are rarely fully vertically integrated, it is crucial to understand that the
supply chain strategy outlines both the internal processes that the busi-
ness should optimise and the roles that each supply chain entity should
perform. The overall structure of the supply chain as well as what are
commonly referred to as “supplier strategy,” “operations strategy,” and
“logistics strategy” are all included in supply chain strategy.

8.10 Life Cycle Costing

Every cost matters when you run a small business. If you make bad
choices about what to buy, it can cost your business more money than
it needs to and hurt your bottom line over time. Life cycle costing is
something you should do before buying new assets for your business.
The life cycle cost, also called the whole-life cost, of an asset affects
how a business budget, prices its products, and makes decisions.

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8.10.1 What is Costing over the Life Cycle? Notes

Life cycle costing, also called whole-life costing, is a way to estimate
how much you will spend on an asset over the course of its useful life.
Whole-life costing takes into account the costs of an asset from the time
you buy it until you get rid of it.
When you buy an asset, you are making a financial commitment that
goes beyond the price tag. Think about a car as an example. The price
of the car is only one part of how much it will cost over its whole life.
You also need to think about the costs of car insurance, interest, gas, oil
changes, and any other repairs the car might need. If you don’t plan for
these extra costs, it can set you back.
Costs add up when you buy, use, and take care of a business asset. Whether
you’re buying a car, a copier, a computer, or stock, you should think about
and plan for how much the asset will cost you in the future. Costing for
the whole life cycle refers to getting a better idea of how much a new
asset will cost your business when you do a life cycle cost assessment.

Lifecycle Costing Example

Your business needs a new copier.
‹ Price of Copier: Rs. 2,500.
‹ Installation and Delivery Cost: Rs. 75.
‹ Operating Cost: You expect to spend Rs. 1,000 on ink cartridges
and paper during its lifetime. You estimate Rs. 300 in copier
electricity use.
‹ Maintenance: You estimate Rs. 450 to fix the copier.
‹ Financing: Your store credit card charges 3.5% per month for the
copier. Next month, you pay off the printer, owing Rs. 87.50 in
interest (Rs. 2,500 × 3.5%).
‹ Depreciation: You estimate Rs. 150 in annual copier depreciation.
‹ Disposal: You estimate that an independent contractor will charge
Rs. 100 to remove the copier from your firm.
The copier costs Rs. 2,500, but its life cycle might cost your organisation
over Rs. 4,500.

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Notes Product Life Cycle Costing

The innovation of a new product and its degeneration into a common
product is termed as the ‘life cycle of a product’. Following are the five
distinct phases in the life cycle of a product:
‹ Introduction
‹ Growth
‹ Maturity
‹ Saturation
‹ Decline

Project Life Cycle Costing

The term ‘project life cycle cost’ has been defined as ‘it includes the
costs associated with acquiring, using, caring of physical assets, includ-
ing the feasibility studies, research, design, development, production,
maintenance, replacement and disposal, as well as support, training and
operating costs generated by acquisition, use, maintenance and replace-
ment of permanent physical assets’.
The project life cycle costs of a capital asset can be grouped into three
broad categories:
‹ Initial costs
‹ Operating costs
‹ Disposal costs

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Notes

Project Life Cycle Cost Iceberg

8.11 Just-in-Time (JIT)

With a Just-in-Time (JIT) inventory system, a business receives products
as close as feasible to the moment they are actually required. As a result,
if an auto assembly facility wants to install airbags, it doesn’t maintain
a supply on hand; instead, it gets them as the cars are put together.
Schonberger defines JIT as “to produce and deliver finished goods just
in time to be sold, sub-assemblies just in time to be assembled into fin-
ished goods, fabricated parts just in time to go into sub-assemblies and
purchased materials just in time to be transformed into fabricated parts”.
The Just-in-Time (JIT) inventory system reduces stock and boosts pro-
ductivity. Because manufacturers receive supplies and parts as needed for
manufacturing and do not incur storage costs, JIT production techniques
reduce inventory costs. Furthermore, in the event that an order is can-
celled or not filled, manufacturers are not left holding extra inventory.
A vehicle manufacturer that runs with minimal inventory levels but sig-
nificantly relies on its supply chain to deliver the parts it needs to produce
automobiles on an as-needed basis is one example of a JIT inventory
strategy. As a result, the manufacturer only places an order for the parts

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Notes needed to assemble the automobiles after receiving one. Companies need
consistent production, excellent workmanship, faultless plant machinery,
and trustworthy suppliers for JIT manufacturing to flourish.

Features of JIT
The main features of JIT are as follows:
‹ Operates as a ‘pull’ system, producing on demand i.e. ‘making to
order’
‹ Uses small lot sizes and therefore, frequent production runs
‹ Aims to minimize set-up time
‹ Take steps to reduce process time
‹ Use a ‘kanban’ system to drive the usage of parts and control the
flow of materials
‹ Uses planned production systems
‹ Uses process capability analysis
‹ Adopts TQM approach
Kaplinsky and Hoffman highlighted seven key elements of JIT as:
‹ Demand-driven production
‹ Multi-skill and multi-task work
‹ Flexibility in product and process
‹ Just-in-time production (Minimum inventory)
‹ Zero defect policies
‹ Giving responsibility back to the worker
‹ Worker involvement in technical improvements

8.11.1 Benefits of JIT Inventory Systems

JIT inventory systems have a number of benefits over conventional
methods. Short production runs enable firms to switch swiftly from one
product to another. This technique also lowers expenses by reducing the
requirement for warehousing space. Additionally, businesses spend less
on raw materials because they only purchase what they need to produce
the products that have been requested.

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8.11.2 Drawbacks of JIT Inventory Systems Notes

‹ The risk for supply chain disruptions is one of JIT inventory
systems’ drawbacks.
‹ The entire manufacturing line might be stopped if a supplier of
raw materials experiences a problem and is unable to deliver the
products on time.
‹ The delivery of finished items to customers may be delayed by an
unforeseen sudden order for goods.

8.12 Backflush Costing

Backflush accounting focuses on “post production issuing.”
Backflush accounting is defined as ‘a cost accounting system which
focuses on the output of the organization and then work backwards to
allocate costs between cost of goods sold and inventory”.
Product costing is postponed until things are finished under a Just-In-Time
(JIT) operational environment. Backflush accounting records expenses
after the events, then uses standard costs to “flush” out manufacturing
costs. This eliminates expense tracking. Standard costs are used to as-
sign costs to units when journal entries to inventory accounts are made.
The backflushing procedure has two steps: one reports the created part
to raise its amount on hand, and the other relieves the inventory of all
component parts. Component part numbers and quantities-per are from
the standard Bill of Material (BOM). This saves a lot compared to the
old technique of (a) issuing component parts one at a time, usually to a
discrete work order, (b) receiving the finished parts into inventory, and
(c) returning any unused components to inventory.

8.12.1 Features
(i) Backflush costing is an accounting technique created to track
expenditures under particular circumstances.
(ii) Backflush costing is often referred to as backflush accounting.
(iii) Companies that typically have short production cycles, commoditized
products, and low or constant inventories use backflush costs.

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Notes (iv) Backflush costing can be challenging to execute, and not all businesses
can qualify to perform it.
The thorough tracking of expenses, such as raw material and labour costs
throughout the manufacturing process, which is a component of traditional
costing systems, is eliminated when costs are “flushed” to the end of
the production run. This enables the company to streamline its expense
tracking procedures, saving money on administrative and process costs,
but it may also limit the amount of detail that the organisation retains
regarding specific production and sales prices.
At the conclusion of the procedure, the entire cost of a production run
is documented. Therefore, businesses that use backflush costing typi-
cally work backward, figuring out how much a product costs after it is
sold, finished, or shipped. Businesses do this by putting a set price on
the products they make. Companies must eventually acknowledge the
variations between standard costs and actual costs because costs can
occasionally vary.
The cost of a product is typically determined at numerous points along the
production cycle. Backflush costing is intended to streamline accounting
procedures while reducing costs for firms by getting rid of Work-in-Pro-
cess (WIP) accounts.

8.12.2 Backflush Costing’s Pros and Disadvantages

Theoretically, backflushing seems to be a reasonable solution to sidestep
the numerous challenges posed by ascribing costs to goods and inventory.
Companies can save time and money by not documenting costs during the
various production steps. Backflush costing is an accounting technique
that businesses may utilise when looking for methods to cut their bottom
lines, but it isn’t always simple to put into practise.
Backflushing, however, is not always an option for businesses and can
be difficult to execute. Additionally, backflush costing organisations
lack a sequential audit record and may not always adhere to generally
accepted accounting principles. These are two major drawbacks of this
costing system.

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Businesses that employ backflush costing should typically fit all three Notes
criteria:
Short Production Cycles: Products that require a lot of time to manu-
facture shouldn’t be costed backwards. It is harder and harder to appro-
priately assign standard costs as time goes on.
Customized Goods: Since the fabrication of customised goods necessitates
the development of a distinct bill of materials for each item created, the
technique is not appropriate for this task.
Low or Stable Amounts of Material Inventory are Present: The ma-
jority of production expenses will flow into the costs of goods sold when
inventories, or the variety of finished items maintained by a company,
are low rather than being postponed as inventory charges.

8.13 Summary
‹ The unit covers Activity based costing, Target costing, Value chain
Analysis, Throughput costing, Life Cycle Costing, Backflush costing.
‹ Value chain analysis assesses customer value.
‹ A corporation must price a new product based on comparable
products on the market.
‹ Target costing lets a corporation set product prices, costs, and
margins in advance.
‹ Theory of constraints fosters dialogue and appreciation for cost-
cutters, who are typically seen as reactionary and non-value-adders.
‹ Life cycle costing costs the cost object—product, project, etc.—over
its predicted lifespan. It describes a system that tracks and collects
costs and revenues and attributes to cost objects from inception to
abandonment.
‹ Traditional cost accounting systems report cost object profitability
weekly, quarterly, and yearly. Life cycle costing does not. Life cycle
costing tracks product-by-product cost and revenue over numerous
calendar months.
‹ Backflush accounting focuses on “post production issuing.”

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 MANAGEMENT ACCOUNTING

Notes
8.14 Self-Assessment Questions
1. Briefly explain the main difference between a job-order cost system
and a process cost system.
2. What is Activity based costing? Give examples of cost drivers
commonly used to allocate overhead costs to products and services.
3. What do you mean by Value chain analysis?
4. Explain the main differences between traditional and activity-based
costing systems.
5. What are advantages of JIT inventory system? How does JIT help
decision making?
6. What is Target costing? How does it benefit? What are the stages
of target costing?
7. Write short notes on:
‹ Theory of constraints
‹ Backflush costing
‹ Throughput accounting

8.15 References
‹ Bhar. K. B. (2008). Cost Accounting, Methods & Problem, Academic
Publishers.
‹ Lal, Jawahar & Srivastava, Seema. (2009). Cost Accounting, 4th
Edition, Tata McGraw Hill Education.
‹ Nigam, Lal B. M. & Jain I. C. (2001). Cost Accounting: An
Introduction, PHI Learning Pvt. Ltd.
‹ Thakur. S. K. (2009). Cost Accounting: Theory and Practice, Excel
Books.
‹ https://fundamentalsofaccounting.org/what-is-throughput-costing/
‹ https://efinancemanagement.com/costing-terms/backflush-costing

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 Cost Management

Notes
8.16 Suggested Readings
‹ Anthony, R. N., Hawkins, F. D., & Merchant, K. A. (2013).
Accounting: Text and Cases (13th Ed.). Tata McGraw Hill.
‹ Horngren, T. C., Datar, S. M., & Rajan, M. V. (2017). Horngren’s
Cost Accounting: A Managerial Emphasis (16th Ed.). Pearson.
‹ Horngren, T. C., Sundem, G. L., Schatzberg, J., & Burgstahler, D.
(2014).Introduction to Management Accounting (16th ed.). Pearson.
‹ Spiceland, D., Thomas, W. M., & Herrmann, D. (2018). Financial
Accounting (5th Ed.). McGraw Hill.
‹ Horngren, T. C., Datar, S. M., & Rajan, M. V. (2014). Cost
Accounting, Student Value Edition (15th Ed.). Pearson.

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 L E S S O N

9
Performance Measurement -
Balanced Scorecard
Ms. Shalu Garg
Assistant Professor
University of Delhi
Email-Id: [email protected]

STRUCTURE
9.1 Learning Objectives
9.2 Introduction
9.3 Performance Measurement
9.4 Balanced Scorecard
9.5 Performance Drivers and Weighting Performance Measures
9.6 Summary
9.7 Answers to In-Text Questions
9.8 Self-Assessment Questions
9.9 References
9.10 Suggested Readings

9.1 Learning Objectives

In this lesson we will learn the concept of performance measurement, various traditional
performance measurement techniques and the limitations of these techniques. We will
also be going to learn the meaning of balanced scorecard, perspectives of scorecard. This
chapter will also teach us the characteristics of good balanced scorecards and requisites
of the balanced scorecards.
After studying this lesson, students will be able to:
‹ Understand the Performance Measurement.
‹ Explain the Traditional Performance Measurement Techniques.
‹ Get acquainted with Strategic Management Model.
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 Performance Measurement - Balanced Scorecard

‹ Explain the meaning, characteristics, requisites, factors, or perspectives Notes

of Balanced Scorecards.
‹ Learn Performance Drivers and Weighting Performance Measures.

9.2 Introduction
Performance measurement is observing the spending plans or focusing
on genuine outcomes to lay out how well the business and its workers
are working overall and as individuals. Performance measurements can
connect with short-term goals (for example, cost control) or long-term
measures (for example, consumer loyalty).
A balanced scorecard is an essential organization’s performance manage-
ment measurement tool that helps organizations distinguish and work on
their internal operations to help in improving their external outcomes.
It estimates past execution information and furnishes organizations with
criticism on the most proficient method to pursue better choices later.

9.3 Performance Measurement

Comparing performances to established criteria in companies is how
performance measurement is defined. Performance evaluation is the
methodical procedure used to assess an organization’s efficiency and ef-
fectiveness. Measurements serve as the yardsticks that inform us of our
performance and motivate us to improve. Measuring involves observing
how people move and rating their performance in order to continuously
improve. Performance measurement is prepared to embrace change that
helps organisations achieve the necessary level of quality. Although
measurement sounds simple and uncomplicated, it is a challenging and
time-consuming process.
D.S. Sink in his article ‘Accomplishing World Class Quality and Produc-
tivity Management; the Role of Measurement remarks:
Measuring is an art. In the long term, the vast majority of people who
analyse the task of developing measuring frameworks come to this con-
clusion. In fact, despite a worrying fact, even those who are regarded as
experts quickly admit that measurement is hard. Measurement is difficult,
disappointing, challenging, important, and handled improperly.

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Notes 9.3.1 Traditional Performance Measurement Techniques

The customary way to deal with performance depends on data and proce-
dures accessible in financial accounting, cost accounting and management
accounting. The conventional methods utilized by organizations are basi-
cally financial measures like ROI, RI, net benefit, EPS, and so forth. The
conventional methods are backward looking. That is, they focus around
past financial performance rather than on how administrators are making
future shareholder value.

Limitations of Traditional Performance Measurement:

(a) Short-term Focused: Every activity is directed towards the present
moment. Many organisations collect information that is purely functional
and financial. Numerous financial and functional measurements can
be found in all enterprises. We can understand the organization’s
overhead costs, salaries, and benefits, as well as a few other
numbers derived from the accounting system. One of the reasons
organizations struggle to endure over an extended period of time is
their singular attention on the present. These organizations succeed
for a brief period of time before failing and eventually going out
of business. Any organisation should think about the following
long-term measures:
(i) Consumer loyalty
(ii) Employee satisfaction
(iii) Item/administration quality
(iv) Public responsibility measures
(b) Outdated and Irrelevant Principles: The requirements of the modern
business environment must be taken into consideration because
all traditional measures are frequently based on out-of-date and
unnecessary criteria.
(c) More Focus on Cost and Revenue Data, Less on Process: Performance
measures place more emphasis on cost and revenue data while putting
less emphasis on the process. It frequently provides irrelevant or
false information. Financial outcomes that are the primary focus of
performance measures have passed the point at which meaningful
corrective action can be taken.

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(d) Lack Activity and Process Analysis: Performance measures lack Notes
the examination of movement and interaction that is essential to
choose worth-added and non-worth-added movement and interaction.
Business companies must determine whether processes are capable
of meeting customer requirements repeatedly.
(e) Based on Tracking Single Dimensions of Performance: Performance
measures are dependent on the following discrete performance
components and do not provide an integrated or thorough understanding
of performance. Administrators frequently learn that they are ill-
equipped to assess the effectiveness of their system implementation
since performance is only reviewed in clearly defined areas.
(f) Encourage Competition and Discourage Teamwork: Traditional
performance measurements promote rivalry and discourage cooperation.
Instead of comparing each specialty unit’s performance to its own
performance and goals, performance reports typically compare the
performances of two specialty units. This is a common technique to
discourage teamwork. The individual in charge takes pride in their
position and has no desire to share any information with the other
specialist units or sectors because they like their job. When employees
are informed of their position in respect to their co-workers, the biggest
threat arises. Teamwork is destroyed when people try to measure
themselves against others, whether they are ranked one or fifteen.
The majority of performance appraisal frameworks also include elements
that encourage competitiveness while discouraging representative group-
ings from working together. In many systems, people, not groups, are
judged. Additionally, individuals, not organisations, receive promotions
and raises. A typical but harmful strategy in an organisation seeking to
promote a sense of participation and sharing is focusing solely on indi-
vidual performance proportions.
Johnson and Kaplan (1987) have voiced their concern as follows:
The organization’s financial detailing framework generates the current
administration accounting data, which is beyond the point of no return,
excessively collected, and too deformed to even comprehend being ap-
plicable for the preparation and control decisions of the chiefs.
Afterward, Kaplan refers explicitly to current business conditions which
utilize standards such as TQM, JIT, Design for Manufacture (DFM) and
Flexible Manufacturing System (FMS) finished up:
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Notes Existing frameworks for cost and performance estimation gave little in-
spiration to help organizations’ attitude to incorporate TQM, JIT, DFM,
and FMS ideas into ongoing, continuous improvement exercises. In cer-
tain occurrences, the customary financial exhibition measures hindered
the improvement exercises.
This worry demonstrates the dire requirement for taking a gander at better
approaches for finding progress wherever it is made without fundamen-
tally evaluating any result in financial terms.
Qualities of this new way to deal with estimating organizational perfor-
mance are ideas like the accompanying:
(a) Less is better - focus on estimating the crucial few key factors as
opposed to the numerous variables.
(b) Measures ought to be connected to the variables required for progress:
key business drivers.
(c) Measures ought to be a blend of past, present, and future to guarantee
that the organization is worried about each of the three viewpoints.
(d) Measures ought to be based on the necessities of clients, investors,
and other key partners.
(e) Measures ought to begin at the top and stream down to all degrees
of workers in the organization.
(f) Various records can be consolidated into a solitary list to give a
superior in the general evaluation of performance.
(g) Measures ought to be changed or possibly changed as the climate
and methodology change.
(h) Measures need to have targets or objectives laid out that depend on
research as opposed to inconsistent numbers.

9.3.2 Strategic Management Model

In performance measurement, the challenge is estimating the appropriate
variables and learning to ignore other interesting data that does not help
us advance to the next level in the model. To start, we characterize what
an organisation does and what the future goal is. The firm should then
identify the techniques and crucial success variables it needs to concentrate

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on to stand out from rivals. The organisation also determines key busi- Notes
ness requirements on which it should concentrate at this stage in order
to maintain its success.
Company basics are typically matters on which all business organisations
must concentrate, such as benefit, development, or guidelines. A funda-
mental component of a business system is selecting the main achievement
elements for a company so that it can concentrate on the designated per-
formance areas. These may be advantages they will continue to exploit
or flaws that need to be fixed. The actions, or metrics, are derived from
the major success factors and business fundamentals. Clear objectives or
goals should be established for each measurement once the organization has
identified the significant measures on its overall scorecard.
Research-based objectives should help the organisation realise its over-
arching goal. It is important to check that each aim is cohesively related
to the others so that a strong showing on one metric doesn’t result in a
decline in performance on another. Following the identification of the
objectives or targets, activity plans that will enable their accomplishment
should be identified. Finally, to ensure that the exercises and performance
are in line with the objectives and aims, they must be monitored and
controlled. It is also anticipated that performance reports and follow-up
reports contain relevant and useful information.

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Notes IN-TEXT QUESTIONS

1. The performance measurement is the systematic assignment of
numbers to the __________ and results in the organization.
2. The traditional performance measurement is short-term focused.
(True/False)
3. Performance measures focus more on cost and revenue data.
(Yes/No)
4. Traditional performance measurement is not outdated. (True/
False)
5. Traditional performance measures encourage __________ and
discourage teamwork.

9.4 Balanced Scorecard

Balanced Scorecard is a procedure of performance estimation created by
Robert Kaplan, a Harvard Professor and David Norton, an expert.
Kaplan and Norton remark on Balanced Scorecard (BSC) as follows:
The Balanced Scorecard (BSC) gives managers the tools they need to
look for future significant accomplishments. The Balanced Scorecard
translates an organization’s strategy and mission into a comprehensive
set of performance projections that provide the groundwork for a key
projection and the board framework. The fair scorecard places a strong
emphasis on reaching financial objectives while also taking into account
the presentation-related factors that influence these objectives. According
to four adjusted points of view—financial, client, internal business process-
es, and learning and development—the scorecard measures authoritative
performance. The BSC gives organisations the ability to monitor financial
results while also monitoring their progress in developing the capacities
and acquiring the illusive resources they require for long-term growth.

9.4.1 Meaning of Balance in Balanced Scorecard

As per Atkinson, Banker, Kaplan, and Mark Young, to be adjusted, per-
formance measurement frameworks should meet two necessities:
1. In other words, the performance measurement framework should screen
both the organization’s presentation and what the board accepts are
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the drivers of performance on the organization’s essential goals. Notes

They should reflect the comprehension organization might interpret
reasons for the successful performance of the organization’s essential
goals. This is the most important aspect of adjustment.
2. The most fundamental views or distinguishing characteristics of
organisational performance should be quantified by the performance
measurement framework. These viewpoints offer the organisation
its remarkable abilities to achieve its primary objective. This is the
general requirement for adjustment.
The balanced scorecard’s main component is a set of performance estimates
that businesses use to monitor their progress toward both mandatory and
optional goals. In this view, the planning and procedure of the company
characterise the focus and scope of the fair scorecard as well as the con-
nections the business should forge with its personnel, suppliers, and the
community in order to achieve long-term success with its targeted clients.

9.4.2 Balanced Scorecard Example

System: To continuously improve and adapt to our present environment in
order to be the leading organisation in our sector. Regarding the develop-
ment of investor and client esteem, employee learning and development,
and our outstanding corporate citizenship, we shall evaluate progress.

Balanced Scorecard Example

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Notes 9.4.3 Characteristics of Good Balanced Scorecards

For balanced scorecards to be effective and helpful, the following traits
must be present:
(a) Focus on Cause-and-Effect Relationship: A balanced scorecard should
highlight an organization’s process by putting an emphasis on the
circumstances and logical linkages between the results. Accept that
Hindustan Unilever Ltd. wants to spend as little as possible while
advancing development. The balanced scorecards should specify clear
objectives and gauge performance from a “learning and development
point of view” that could advance internal business procedures. Thus,
they would lead to greater consumer loyalty, a larger market share,
higher worker wages, and greater shareholder profit.
(b) Strategy translated to Coherent and linked set of Understandable
and Measurable Operational Targets: By converting the process
into a logical and connected set of understandable, achievable, and
quantifiable functional targets, balanced scorecards should aid in
the communication of the methodology developed to all members
of a company. In order to implement the organization’s system,
directors and representatives take actions while taking the scorecard
into consideration. It is preferable over fostering scorecards at the
division and office levels to work with decisions and actions as per
scorecards.
(c) Emphasis on Financial Objectives and Measures: When evaluating
how well a company is performing financially, the balanced scorecard
focuses a significant emphasis on financial measurements and objectives.
Although development, quality, and customer loyalty are frequently
prioritised by business executives, they may not always result in
tangible benefits. Non-financial indicators are seen as an essential
component of a strategy or plan to attain and enhance future financial
performance in a balanced adjusted scorecard. When correctly paired
in modified scorecards, a variety of non-financial performance criteria
serve as predictors of future financial performance.
(d) Critical Measures Only: The balanced scorecard reduces the number
of measures used by focusing only on the most fundamental ones.
Avoiding a proliferation of measures focuses on those that are
essential for the successful execution of procedure.

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(e) Suboptimal Trade-offs: The scorecard illustrates the sub-optimal Notes

trade-offs that managers may make if they don’t take both functional
and financial indicators into account. For instance, a company that
prioritises innovation could achieve unmatched short-term financial
results by cutting back on R&D expenditures. A balanced adjusted
scorecard would demonstrate that decisions may have been made
that harmed the future in order to achieve the short-term financial
performance. Financial performance on the basis that R&D spending
and R&D yield, a proactive aspect of that presentation, have
decreased.

9.4.4 Requisites of Balanced Scorecards

In order to fit the organization’s primary goals, a balanced scorecard re-
quires a suitable organising structure and an understanding of organisational
processes. However, developing and incorporating balanced scorecards for
performance measurements are challenging tasks. Prior to adopting the
balanced scorecard, organisations must meet the requirements listed below:
(a) Management Should Define Organization’s Goals and Objectives:
The executives should describe the main objectives of the company.
This is often advantageous because the majority of benefit-seeking
businesses have a clear objective in mind, namely to grow shareholder
value. The board should describe how leaders should accomplish
each of these goals in order to find companies that have fundamental
aims that include both social and owner wealth goals. Legislative
bodies are examples of non-profit organisations where the board
should clearly state its objectives.
(b) Organization’s Understanding about Stakeholders and Processes:
The company needs to understand how stakeholders and processes
contribute to its key objectives. Many managers admit that this
is dangerous. For instance, it is unclear from the organisational
behaviour literature if increased employee motivation actually results
in improved worker and benefit performance. Even if they work
on large, high-quality projects, many businesses genuinely don’t
understand how value affects performance and prefer to speak in
platitudes, such as “quality isn’t a problem; you need quality just
to play the game.”

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Notes (c) Development of Secondary Objectives by the Organization: The

company should support a number of secondary objectives that drive
the achievement of primary objectives. Perhaps the most challenging
and important stage in implementing the balanced scorecard is this
one. This assignment must be completed with matching processes
and results. The organization should invest resources to support
the methods it believes will produce results. This project seeks
answers to questions like how much should be invested on consumer
loyalty, representative preparedness, quality improvement, or superior
strategy frameworks. Such decisions should be made in light of an
understanding of how increased expenditure further develops process
outcomes, such as further established customer loyalty, which in
turn improves the performance of the organization’s key objectives.
(d) Development of Set of Measures to Monitor Performance on Both
Primary and Secondary Objectives: The organisation should develop
a number of metrics to monitor performance on both primary and
secondary goals. This is management accounting’s typical task. The
question of where to find the relevant variable is brought up in this
phase. How does the organisation gauge the model’s commitment
or inspiration to the organisation? These performance indicators are
crucial because they bring methodology into sharp focus because
the acts that people are instructed to supervise are what will
determine their performance. If the organisation chooses a bad set
of policies, it will lead to poor performance. Consider, for example,
that the company, lacking the ability to assess motivation, equates
motivation with lavish incentive money and measures inspiration
by the amount of motivator compensation it provides to employees.
However, compensation for motivational forces may actually have
a negligible long-term effect on inspiration.
(e) Development of Set of Processes with the Attendant Implicit and
Explicit Contracts with Stakeholders: To achieve those crucial
objectives, the organisation should support a number of processes
and the associated implicit and explicit contracts with partners. The
balanced scorecard’s suggested level of complexity is much higher
than what is typically done, despite the fact that this administrative
necessity is unquestionably acknowledged. For instance, many
managers adopted the maxim “value at any cost” in light of the
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events of the 1980s. Directors would evaluate the costs and benefits Notes
of proposals to go to the next level of excellence under the balanced
scorecard.
(f) Specific and Public Statements must be Made by Organizations:
The organization should express its beliefs about how processes lead
to results in a clear and open manner. Responsibility is based on
public pronouncements, specific commitments to courses of action,
and anticipated outcomes. They address a part of the management risk
in this way since the board’s shortcomings can be scrutinized more
closely. This level of risk can bother a lot of top managers. However,
owners might find these candid statements enlightening.
CASE STUDY
A Case Study of a National Bank
A national bank believed a few years ago that the Internet would rev-
olutionize the way banks dealt with their customers and would force
the bank to become a more agile and customer-focused organisation.
As a result, the bank replaced its previous scoring system, which
was 90% geared toward financial execution, with a fair scorecard.
Three “mark of appearance” metrics were highlighted on the score-
card, and these were:
(i) Customer Fulfilment List and a Proportion of Consumer Loyalty.
(ii) A percentage of representative opinion and confidence is listed
under employee relations.
(iii) Comparative execution of a competitive position-conveyance
strategy.
Required: Why did the bank include non-financial indicators and a
fair scorecard in its new execution estimation framework?

9.4.5 Perspectives or Factors in Balanced Scorecards

The balanced scorecard consists of a number of performance goals and
outcomes that relate to the four performance components of financial,
customer, internal process, and innovation. It believes that businesses
depend on a variety of partner groups, including employees, suppliers,
clients, local communities, and investors. The balanced scorecard displays
how well a firm does at setting goals and interacting with shareholders.
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Notes Shareholders can occasionally have a range of needs. Employees, for

instance, depend on an organisation for their business. Investors depend
on a company to keep up with their bets. The company needs to balance
such conflicting needs. Therefore, the purpose of a balanced scorecard
is to assess how well a business is performing in light of the needs of
its stakeholders.
The majority of firms use four points of view or four categories of per-
formance measures. The organization’s system and activities are evaluated
from a financial standpoint to see if they benefit investors. The financial
perspective shows how well the approach and activities help to work
on the organization’s financial well-being for companies that try not to
have investors. The perspective of the client shows how the organiza-
tion’s methods and endeavours benefit clients. The internal business and
creation process viewpoint displays the ability of the internal business
processes to raise client value and further the development of investor
wealth. The framework for development and long-term development is
strong, as shown by the learning and development perspective. Through
its four perspectives, the balanced scorecard system demonstrates its
power by providing a comprehensive view of corporate value.
These four viewpoints have been briefly discussed underneath:

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ACTIVITY Notes

Produce is transported by Mahindra & Mahindra Trucking from

farms to markets. According to the entity’s mission statement, “We
strive to be the industry leader in cost-effective and timely supply
of produce,” its managers made the decision to establish a balanced
scorecard. For each of the four perspectives in the balanced score-
card for Mahindra & Mahindra Trucking, provide two alternative
performance measurements.

(i) Financial Perspective

Since for-profit firms use financial execution measures like net gain and
return on investment, the balanced scorecard makes use of these. Finan-
cial performance indicators provide a common vocabulary for analysing
and examining businesses. Financial institutions and investors are two
examples of people who donate assets to businesses, and they heavily
rely on financial execution criteria when deciding whether to lend money
or provide reserves. Financial measures that are properly developed can
provide a comprehensive view of an organization’s success.
Financial indicators by themselves do not provide progress-motivating
forces. Financial measures are vital but cannot serve as a guide or aid

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Notes in adding value to performance because they only reflect the past and
not the future.
As per Brown, a sound way to deal with financial estimation is to ensure
that your information base incorporates three sorts of data:
(i) Historical Data: How did we in all actuality do last month, last
week, this year, last year, etc.?
(ii) Current Data: How are we doing at present, today?
(iii) Future Data: How will we be doing in the following couple of
months or years?
From a financial perspective, a business exists to generate wealth for its
owners. A company can monitor who is winning and how successfully it
is generating wealth by using yield metrics or other verifiable financial
measures. Because they are based on events that have already occurred,
this information is always past tense: our net profit for the year compared
to last year, our deals income this year compared to last year, and our
usual offer value this month compared to last month. These are histor-
ical indicators of company performance. Any financial information that
is included in a report for investors or other partners would typically be
considered to be authentic information.
The amount of money the company has on hand or the total value of its
resources in relation to its liabilities are additional aspects of financial
data. This accounts for a respectable amount of an organization’s overall
financial health. These financial metrics should provide an answer to the
question, “How are we performing today?”
The third type of financial data needed for a comprehensive set of mea-
surements is used to predict how the company will display its finances in
the future. These projections are used to project future asset and respon-
sibility needs. The amount invested in innovative work relative to deal
income or benefit is another typical future-focused financial assessment.
Organizations usually cut back on these expenses during difficult times,
which can make them contract their future for the aim of short-term finan-
cial profits. If the company intends to expand into untapped or emerging
market segments, growth in deals from a certain region or industry may
also be a financial indicator for the future.

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ACTIVITY Notes

Imagine a car dealership decided to stop paying sales commissions

to employees and instead offer a salary with bonuses for good cus-
tomer satisfaction ratings. What issues could arise financially for the
dealership, in your opinion?

CASE STUDY
A business manager delivers the following phrase: “The alliance en-
hances the worth of investors, as shown by the financial perspective
of the decent scorecard. I work with two organisations: a sanctuary
believe that does not have investors and a private firm that is an
organisation. Although the fair scoring seems fine to me, the finan-
cial perspective is plainly unnecessary for these two associations.”
Required: How would you respond to this claim?

(ii) Customer Perspective

Managers understand the client and market segments in which the spe-
cialty unit will compete as well as the proportions of the specialty unit’s
performance in these targeted segments from the perspective of the client
as seen through the lens of the Balanced Scorecard. This viewpoint fre-
quently includes a few fundamental or traditional indicators of the effective
outcomes from a thoroughly developed and applied process. Consumer
loyalty, client maintenance, gaining new clients, client benefit, and mar-
ket share in targeted areas are all included in the key result measures.
However, the customer’s perspective should also include details of the
offers that the company will provide to customers in particular market
segments. The target specific drivers of core client results speak to the
essential elements that influence a client’s decision to switch providers
or remain loyal to their current ones. Clients may value, for example,
short lead times and timely delivery, a steady flow of innovative goods
and services, or a supplier prepared to anticipate their changing needs and
capable of developing new goods and strategies to meet those demands.
The client point of view gives specialist unit managers the ability to
describe the market- and client-based methodology that will produce the
majority of future financial returns.

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Notes In many businesses, the primary measurement group of client outcomes

is standard. The primary estimation category includes indicators of:
(i) Share of the overall industry
(ii) Client maintenance
(iii) Client procurement
(iv) Consumer loyalty
(v) Client benefit

Figure 9.1
(Source: Lal, J. (2017). Advanced Management Accounting (Text, Problems & Cases))

CASE STUDY
A Case Study of Household Products Division, a Maker of Kitchen
Dishwashers
The Household Products Division, which manufactures kitchen dish-
washers, is led by Ashok Dhawan, who just saw the division’s fair
rating for 2016. Amit, the division’s administrative bookkeeper, is
summoned right away to his office for a meeting. “I believe that
the consumer loyalty and representational fulfilment percentages are
very low. These figures are based on an erratic sample of emotional
assessments conducted by various supervisors and client delegates.
My personal experience is that we are doing particularly well in

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both of these areas. I believe that by revealing such low scores for Notes
representative and customer loyalty, we are doing our organisation
and ourselves harm until we do a thorough assessment of employees
and clients at some point in a year. At the division commanders’
meeting in a month, these results will make us seem bad. We wish
to increase these figures. Even though Amit is aware that the repre-
sentative and customer loyalty scores are hypothetical, his method
for the current year was the same as his past methods. He was aware
from the comments that he had asked that the scores take into ac-
count the suffering of representatives due to the most recent work
regulations and the despair of clients due to delayed deliveries. He
also understood that these problems will be resolved in due course.
Required:
1. How about the Household Products Division’s respectable scorecard
include random measurements of representative fulfilment and
customer loyalty? Logically explain.
2. How should Amit to react?

(iii) Internal Business Process Perspective

Managers understand the fundamental internal business processes that the
organisation needs to flourish from this perspective. These procedures
give commercial entities the ability to:
‹ Communicate the offers that will entice and retain customers in
specific market categories.
‹ Meet investor expectations for great financial returns.
Any firm can achieve success if its processes are managed to produce
reliable products and services. The correct procedures being followed cor-
rectly results in consistent levels of product and service quality. Finding
the proper process components to measure and establishing guidelines
that are appropriate for the performance levels of each process measure
are difficult tasks. Edge estimations that are even more present-focused
are driven by process and functional measurements. These are the mea-
surements that are frequently and probably regularly observed.
Even some interaction elements are observed to ensure the development
and supervision of great goods and services. Excellent process or functional

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Notes measure execution results in high-quality goods and services, which, in

turn, produce thrilled or satisfied customers, who then encourage repeat
business and support an organization’s long-term survival and success.
Process measures provide the data necessary to predict and manage the
nature of goods and services. When a problem with products or services
arises, the root cause is typically found by looking at the process data.
For all organisations, results and outcomes matter. Truth be told, they
might be overwhelmingly important. However, it is also important to
consider how those achievements are achieved in the process measures.
According to Brown, successful companies gauge their operational out-
comes and business processes in the following ways:
(a) Cycle Time: Process duration for all key cycles is estimated.
(b) Rework Time: Revise time as well as expenses are followed for
key creation and administration conveyance processes.
(c) Key Measures of Productivity: Key proportions of efficiency are
recognized and followed for significant process in the organization.
(d) Identification of Key Measures: Key processes have been recognized
in each unit, capability, and division of the organization, and handle
measures have been characterized for each vital process.
(e) Correlation of Process Measures: Process measures furnish with
the information expected to foresee and control the quality of items
and administrations.
(f) Setting of Standards or Goals: Guidelines or objectives are set for
all key process measures, and those norms depend on benchmark
organizations and client prerequisites.
(g) Preventive Approach: Process measures elevate a preventive way to
deal with accomplishing reliably high-quality products and services.
(h) Development of Safety Index: The organization has fostered a
general security record that is followed no less than once a month
and comprises of a few result estimates like lost-time mishaps, as
well as various preventive or social measures.
(i) Future-Oriented Process: A couple of future-situated process measures
are followed that will assist with guaranteeing long-term survival
and achievement.

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Notes

(iv) Learning and Growth Perspective

For incentive purposes, the learning and growth viewpoint concentrates on
the abilities of individuals. Managers would be liable for creating worker
capacities. Key measures for assessing managers’ performance would be
worker satisfaction, worker maintenance, and employee efficiency.
(a) Employee Satisfaction: Employee fulfilment perceives the significance
of worker assurance for further developing efficiency, quality,
consumer loyalty, and responsiveness to circumstances. Managers
can measure employee fulfilment by sending reviews, talking with
workers, or on the other hand noticing employees at work.
(b) Employee Retention: Firms focused on holding workers perceive that
employees develop organization-specific intellectual capital and give
an important non-monetary resource to the organization. Moreover,
firms cause costs when they should find and recruit great ability to
replace individuals who leave. Firms measure worker maintenance
as the inverse of employee turnover - the percent of individuals
who leave every year.
(c) Employee Productivity: Employee efficiency perceives the significance
of output per employee. Employees make actual results (i.e., miles
driven, pages delivered, or lawns cut), or monetary results (i.e.,
income per employee or benefits per worker). The number of credits

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Notes handled per credit official each month would give a straightforward
proportion of efficiency for loan officers at a bank.

ACTIVITY
Government agencies and social service organisations, for example,
have financial systems that budget expenses as well as track and
manage actual spending. Explain why these organisations ought to
think about creating a balanced scorecard of metrics for performance
monitoring and reporting. What other viewpoints should this balanced
scorecard of measurements include?

CASE STUDY
A Case Study of Hero Honda Bikes Company
The phrase “The financial point of view Hero Honda Bikes (HHB)
needs to carry out a competent scorecard” is provided by a business
manager. Its mission statement is, “We manufacture top-notch, dura-
ble bicycles at rock-bottom prices.” The substance’s rigorous process
entails continuously improving the utility, dependability, and quality
of its bicycles while holding competition-level demonstrations. The
material now produces three different types of trailblazing bicycles
through three separate units that are coordinated around the product

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offered for each type. Engineers are now making progress on the designs Notes
for the assembly system for the fourth bicycle line improvement, which
includes a finished blueprint. HHB operates an online store where bicycle
shops can place orders for customised items and sells directly to them.
Required:
(a) Describe the fair scorecard’s execution cycle at HHB.
(b) Describe the four perspectives of the fair scorecard and list at
least one execution goal for each perspective that HHB should
consider.
(c) Choose one execution goal for each viewpoint, while keeping
in mind that there may be two or more potential measures.
Understand the relationship between each activity and the work
done on the financial execution.
(d) Outline the benefits and drawbacks of implementing a fair
scorecard for HHB.

IN-TEXT QUESTIONS
6. The External Business perspective is a part of balanced scorecard.
(True/False)
7. Employee retention, employee productivity and employee __________
is the part of learning and growth perspective.
8. The Financial perspective is a part of balanced scorecard. (True/
False)
9. In Internal perspective of balanced scorecard __________ time
for all key processes are measured.
10. Financial perspective of balanced scorecard studies historical
data, current data and __________ data.

9.5 Performance Drivers and Weighting Performance

Measures
Performance Drivers
Results metrics and performance drivers should be mixed in a well-balanced
scorecard. Without execution drivers, result measures cannot explain how

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Notes the results are to be achieved. They also don’t provide a quick indication
of how well the strategy is being used. However, performance drivers such
as process lengths and Part-Per-Million (PPM) imperfection rates without
result measures might enable the specialty unit to achieve short-term func-
tional improvements but will fail to reveal whether the functional improve-
ments have been translated into increased business with both current and
new clients and, in the end, to improved financial execution. The results
(incidental results) and execution drivers (driving marks) of the specialist
unit’s process should be properly balanced in a balanced scorecard.

ACTIVITY
The “Balanced Scorecard” strategy attempts to give management
information to aid in the creation and implementation of strategic
policy. It emphasises the necessity of giving the user a set of data
that covers all pertinent performance areas impartially and objectively.
Requirements:
(i) Describe in basic terms the primary type of information that
a manager would need to use this method of performance
measurement;
(ii) Comment on three specific examples of performance metrics
that might be utilised by a business in the service sector, such
a consulting firm.

Four Perspectives: Are they Sufficient

The reasonable scorecard’s four points of view should be viewed as a layout
rather than a restriction. There is no quantitative hypothesis to show that
four points of view are both necessary and sufficient. The organization’s
owners and capital contributors are identified on each scorecard through
financial goals and metrics. Since customers are essential to achieving
the financial goals, client measures are also included on each scorecard
(from the client’s perspective). When exceptional performance along
this aspect can prompt advancement execution for clients and investors,
objectives and measures for workers appear on the reasonable scorecard.
Organizations almost never employ less than four points of view, although
in some cases, at least one additional viewpoint may be necessary due to

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market conditions, a speciality unit’s system, and other factors. For instance, Notes
some managers take into account the interests of other important partners,
such as suppliers and the neighbourhood. The internal business process
viewpoint of the company should be combined with result and execution
driver metrics for provider connections at the point when connections are
crucial for the strategy driving forward client and financial execution. Tar-
gets and metrics for that perspective also become an essential component
of an organization’s scorecard when exceptional natural and local area
performance is the system’s focal point.

Weighting Performance Measures

For each of the four points of view or elements, the organisation using
a reasonable scorecard will construct three to five performance metrics.
The actions are then linked to the organization’s method for advancement.
The method for weighing various performance estimations is problematic
for those who create adjusted scorecards. Assigning a set weight to each
presentation metric (for example, 15% of the overall presentation score
will be based on customer loyalty) ignores adaptability when assessing
performance and fails to take into account challenges that arise unex-
pectedly during the display period.
For instance, while it is typical for planners to give consumer loyalty
a weight of 15%, a particular division did outstanding work to increase
consumer loyalty. Such execution should be rewarded by senior admin-
istration more than the 15% weighting suggests. According to research,
the use of adaptability might lead to concerns about bias. For instance,
shifting workloads to execution measurements after the exhibition time
frame and combining emotional execution assessments are two examples.
CASE STUDY
A Case Study of Rastogi & Co.
New Delhi’s Rastogi & Co. is a legal practise. The company has a
very informal and laid-back management style that has previously
worked effectively for it. Rastogi & Co., however, has not been
gaining new customers as quickly as more competitive legal firms.
Mahesh, the managing partner, learned about the balanced scorecard

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Notes when he recently attended a conference on performance monitoring

in legal companies. He believed it might be a useful tool for Rastogi
& Co., one that would let the company maintain its ethos while still
acting more fiercely to attract new clients. The following strategic
objectives were determined by Mahesh to be compatible with the
firm’s score values and to offer a framework for monitoring the
firm’s progress toward its objectives:

Financial
(a) To steadily increase the firm’s revenues and profits.

Customer
(a) To understand the firm’s customers and their needs.
(b) To value customer service over self-interest.

Internal Business Process

(a) Encourage knowledge sharing among the legal staff.
(b) To communicate with each other openly, honestly, and often.
(c) To empower staff to make decisions that benefit their clients.

Organisation Learning
(a) To maintain an open and collaborative environment that attracts
and retains the best legal staff.
(b) To seek staff diversity.

Required:
(i) Develop at least one measure for each of the strategic objectives
listed.
(ii) Explain how Rastogi & Co. can use this balanced scorecard to
evaluate staff performance.
(iii) Should staff compensation be tied to the scorecard performance
measures? Why or why not?

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IN-TEXT QUESTIONS Notes

11. A good balanced scorecard is the one which have outcome

measures. (True/False)
12. The balanced scorecard contains __________ number of perspectives.
13. A good balanced scorecard does not necessarily contain performance
drivers. (True/False)
14. Customer __________ plays a huge role in weighting performance
measures.
15. The four perspectives of the balanced scorecard should be
considered as a template. (Yes/No)

9.6 Summary
We have learned about balanced scorecards and performance measurement
in this lesson. The reasonable scorecard is a management tool designed
to turn an organization’s primary goals into a series of hierarchical per-
formance goals that can then be estimated, checked, and modified as
necessary to ensure that an organization’s primary goals are achieved.
The monetary accounting measurements that businesses often use to
monitor their primary goals are insufficient to keep businesses on track,
which is a key justification for the balanced scorecard approach. Finan-
cial results provide information about what has already happened, not
about where the business is or should be heading. By adding additional
variables that evaluate performance in areas like customer loyalty and
product development to monetary indicators, the reasonable scorecard
framework hopes to provide partners with a more comprehensive picture.

9.7 Answers to In-Text Questions

1. Performances
2. True
3. Yes
4. False

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 MANAGEMENT ACCOUNTING

Notes
5. Competition
6. False
7. Satisfaction
8. True
9. Cycle
10. Future
11. True
12. Four
13. False
14. Satisfaction
15. Yes

9.8 Self-Assessment Questions

1. In what way customer perspective is important in balanced scorecard?
[Source: Lal, J. (2017). Advanced Management Accounting (Text,
Problems & Cases)]
2. What problems arise if any, from monitoring and rewarding senior
executives by a combination of financial and non-financial measures?
[Source: Lal, J. (2017). Advanced Management Accounting (Text,
Problems & Cases)]
3. When implementing balanced scorecard, why do some managers use
a different term to describe it. [Source: Lal, J. (2017). Advanced
Management Accounting (Text, Problems & Cases)]
4. Discuss the importance of balanced scorecard for a not-for-profit
organization. [Source: Lal, J. (2017). Advanced Management Accounting
(Text, Problems & Cases)]

9.9 References
‹ F. (2021, May 6). Where Performance Measurement Fits Into a
Small Business. Small Business Success in Wilmington, NC! https://

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 Performance Measurement - Balanced Scorecard

small-business-success-wnc.com/performance-measurement-fits-into- Notes
small-businesses
‹ Veyrat, P. (2019, May 3). 3 Balanced Scorecard Examples and their
Application in Business. HEFLO BPM. https://www.heflo.com/blog/
balanced-scorecard/balanced-scorecard-examples/
‹ Getz, A. (2020). Balanced Scorecard Defined. BI / DW Insider.
https://bi-insider.com/business-intelligence/balanced-scorecard-defined/
‹ Dudic, Z. (2019). The Innovativeness and Usage of the Balanced
Scorecard Model in SMEs. MDPI. https://www.mdpi.com/2071-
1050/12/8/3221
‹ Todd, R. J. (2021). From Net Surfers to Net Seekers: The WWW,
Critical Literacies and Learning Outcomes. IASL Annual Conference
Proceedings, 231-242. https://doi.org/10.29173/iasl8173
‹ Stamoulis, K., & Mark Spearing, S. (2004). Influence of Macro- and
Nanotopography, Thin Film Thermomechanical Behavior and Process
Parameters on the Stability of Thermocompression Bonding. MRS
Proceedings, 854. https://doi.org/10.1557/proc-854-u9.11
‹ Evolute Consulting. (2018). A. https://evolute.be/reviews/bsc.html

9.10 Suggested Readings

‹ Lal, J. (2017). Advanced Management Accounting (Text, Problems
& Cases). S. Chand & Company Limited.
‹ Arora, M. N. (2016). Cost and Management Accounting. Penguin
Random House.

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 L E S S O N

10
Inventory Management
Jigmet Wangdus
Assistant Professor
DDCE/SOL/COL
University of Delhi
Email-Id: [email protected]

STRUCTURE
10.1 Learning Objectives
10.2 Introduction
10.3 Inventory Management
10.4 Cost Associated with Goods for Sales
10.5 Techniques of Inventory Management and Control
10.6 Economic Order Quantity [EOQ]
10.7 Just-in-Time (JIT)
10.8 Method of Inventory Valuation
10.9 Solved Practical Questions
10.10 Summary
10.11 Answers to In-Text Questions
10.12 Self-Assessment Questions
10.13 References
10.14 Suggested Readings

10.1 Learning Objectives

After studying this lesson, you will be able to understand:
‹ Meaning and definition of Inventory.
‹ Objective and Management of Inventories.
‹ Tools and techniques of Inventory management and control.
‹ Method of Inventory valuation.

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Notes
10.2 Introduction
In this lesson we will understand the meaning of inventory and inventory
management, the need and the objective of holding inventories, factors
affecting the level of inventory, tools and techniques of inventory man-
agement and methods of inventory valuation. Every organization which
is into production, trading, sale and service of a product will necessarily
hold stock of various physical resources to aid in future consumption and
sale. The organizations hold inventories for various reasons, e.g. specu-
lative purposes, functional purposes, physical necessities etc.

10.3 Inventory Management

10.3.1 Meaning and Types of Inventories
Inventory is the assets a business intends to sell to customers for prof-
it. Inventory describes the stockpile of the item(s) a business is selling
as well as the individual items that make up the item. To put it another
way, the inventory is utilised to indicate the total amount of the tangible
assets that are:
‹ Held for sale normally as part of operations.
‹ In the production phase for such a transaction.
‹ To be currently consumed in the production of goods or services
to be available for sale.
The inventory may be classified into three categories:
Raw Materials and Supplies: It refers to the unfinished goods used in
the process of manufacturing.
Work in Progress: It describes semi-finished goods which are not 100%
complete but some work has been done on them.
Finished Goods: It refers to the goods on which all work has been
completed and they are ready for sale.

10.3.2 Meaning of Inventory Management

Inventory management is the technique of managing and controlling
the ordering, storage, and use of components that a business employs

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Notes in the production of the goods it sells. Inventory management is a part

of supply chain management which regulates the movement of products
from producers to warehouses and from these locations to points of sale.
Inventory control entails effectively managing the money spent on sup-
plies, raw materials, work-in-progress, and finished goods.

10.3.3 Significance of Holding Inventory

One of a company’s most valuable assets is regarded as its inventory.
Inventory management must be precise, effective, and proactive. Every
business needs inventory to guarantee that the production process runs
smoothly, to lower the ordering cost of inventory, to take advantage of
quantity discounts, to avoid missing out on sales opportunities, to max-
imise and optimise plant capacity, and to reduce the total price. As a
result, inventory must be maintained in an appropriate quantity and is
therefore necessary. However, the idea of Just-in-Time (JIT), which is
an inventory strategy used by businesses to boost productivity and cut
waste by acquiring products only as they are required in the production
process, is gaining popularity. JIT lowers the inventory costs but require
producers to forecast demand accurately.

10.3.4 Objectives of Inventory Management

Maintaining right level of inventory is the objective of inventory manage-
ment to prevent excess or shortfall of inventory. Inventory management
systems reduce the cost of carrying inventory and guarantee a steady
supply of raw materials and finished goods throughout the cycle of busi-
ness operations. The objectives can be separated into the two categories
listed below:
‹ Operating Objectives: They are related to the operating activities
of the business like purchase, production, sales etc.
(a) To ensure a steady supply of materials.
(b) To guarantee a continuous flow of production.
(c) To reduce the risks and losses incurred due to inventory
shortages.
(d) To ensure enhanced customer services.
(e) Reducing the risk of stockouts.

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‹ Financial Objectives: Notes

(a) To reduce the capital investment in the inventory.
(b) To reduce the cost of inventories.
(c) Economy in the purchase.
Inventory management places a strong emphasis on reducing the
negative effects of having excess inventory in addition to the goals.
The following effects resulted from holding surplus inventory:
‹ Unnecessary investment of funds and reduction in profit.
‹ Increase in holding costs.
‹ Loss of liquidity.
‹ Deterioration in inventory.

10.3.5 Factors Affecting the Level of Inventory

The level of inventory should be appropriate. There are several factors
which determine the appropriateness level of inventory. Some of the
important factors are explained below:
‹ Nature of Business: Whether a retail business, a wholesale business,
a manufacturing business, or a trading business, the level of inventory
will depend on the nature of business.
‹ Inventory Turnover: Inventory turnover discusses the quantity
and frequency of sales of inventory. It directly affects the amount
of inventory a business need to maintain.
‹ Product Type: The goods sold by the businesses could be either
durable or perishable goods. Consequently, maintaining the inventory
is required.
‹ Economies of Production: The volume of inventory retained is also
influenced by the size at which manufacturing is done. A company
might operate on a huge scale to take advantage of the economies
of production.
(i) Inventory Costs: The business will incur additional operating
expenses as more inventory is kept on hand. Inventory retained
must be balanced against the entire cost of inventory, which
includes purchase cost, ordering cost, and holding cost.

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Notes (ii) Financial Position: The supplier’s credit terms can occasionally
be rigid and the credit period can be quite short. The inventory
must then be maintained in accordance with the company’s
financial status.
‹ Duration of Operating Cycle: If the operating cycle duration is
long, it will also take a long time to realise the money from the
sale of inventory. As a result, the managed inventory should match
the operational cycle’s time and the need for working capital.
‹ Management Attitude: The top management may embrace the idea
of zero inventories or hold a high level of inventories. Accordingly,
the inventory policy will be designed for the business.

10.4 Cost Associated with Goods for Sales

Companies must effectively manage costs that fall into the following
six categories in order to effectively manage inventories and increase
net income:
‹ Purchasing costs include the price of incoming freight as well as
the price of goods purchased from suppliers. Generally, the largest
cost category for goods for sale is comprised of these costs. Purchase
costs are impacted by discounts for different purchase order sizes
and supplier payment terms.
‹ Ordering costs occur during the preparation and issuance of purchase
orders, the acquisition and inspection of the ordered goods, and the
matching of invoices received, purchase orders, and delivery records
to determine payments. The price of getting purchase approvals is
included in the ordering costs, along with any additional fees for
special processing.
‹ Carrying costs arise while holding an inventory of goods for sale. The
opportunity cost of the investment tied up in inventory and the other
costs associated with storage such as insurance, rent of warehouse,
obsolescence and spoilage all are included in carrying costs.
‹ Stockout costs arise when a business runs out of a specific item
that customers are demanding. In order to satisfy that demand,
the business must act quickly to replenish inventory or suffer the
costs of not meeting it. In order to address a stockout, a business
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may expedite an order from a supplier, which can be costly due to Notes
additional ordering and transportation costs. Or the stockout might
result in the company losing sales. The opportunity cost of the
stockout in this instance consists of the contribution margin lost
on the unrealized sale as well as any contribution margin lost on
upcoming sales as a result of unfavourable customer behaviour.
‹ Quality costs incurs when a product or service’s features and
characteristics do not meet customer requirements. The four types
of quality costs are as follows: (prevention costs, appraisal costs,
internal failure costs, and external failure costs).
‹ Shrinkage costs are caused by employee fraud, theft by outsiders,
misclassifications, and clerical errors. Shrinkage is measured by
the difference between the cost of the inventory when physically
counted and the cost of the inventory recorded on the books in
the absence of theft and the other incidences. Shrinkage is a key
indicator of management effectiveness.

10.5 Techniques of Inventory Management and Control

An efficient control system for inventories is necessary for effective
inventory management. Proper inventory management not only aids in
resolving the urgent liquidity issue, but also boosts profits and signifi-
cantly lowers the company’s need for working capital. The following are
crucial methods and tools for managing and controlling inventory:
1. Determination of Stock Levels
2. Determination of Economic Order Quantity
3. ABC Analysis
4. VED Analysis
5. Just-in-Time Inventory

10.5.1 Determination of Stock Levels

Both carrying too much, and too little inventory is detrimental for the
business organisation. A low inventory level will result in frequent stock-
outs and high ordering costs, while a high inventory level will result in
unnecessary capital ties up. A company must therefore maintain an ideal

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Notes level of inventory to ensure that inventory costs are kept to a minimum
while also preventing stock-outs, which could lead to sales loss or a halt
in production. Different stock levels are discussed in this circumstance.
(a) Minimum Level: This represents the amount that must always be
on hand. The work will stop due to a lack of supplies if stocks fall
below the minimum level. When determining the minimum stock
level, the following factors are taken into consideration.
Lead Time: A purchasing company needs some time to process the
order, and a supply company needs time to carry out the order.
Lead time refers to the period of time needed to process the order
before it is executed.
Rate of Consumption: It is the average consumption of materials
in the factory. Utilizing past performance and production plans, the
rate of consumption will be determined.
Nature of Material: The minimum level is also influenced by the
nature of the inventory. A minimum amount of stock is not necessary
for materials that are only needed for special orders from customers.
Minimum stock level = Re-ordering level-(Normal consumption
× Normal Re-order period)
(b) Re-ordering Level: A new order is sent to obtain materials when the
quantity of materials reaches a specific level. Prior to the materials
reaching the minimum stock level, the order is sent. The level of
reordering is fixed between the minimum and maximum level. When
determining the reorder level, the rate of consumption, the number
of days needed to replenish the stock, and the maximum amount of
material needed on any given day are all taken into consideration.
Re-ordering Level = Maximum Consumption × Maximum Re-
order period
(c) Maximum Level: It is the quantity of materials beyond which a firm
should not exceed its stocks. Overstocking occurs if the quantity
exceeds the maximum level allowed. Overstocking should be avoided
by a business as it will increase material costs.
Maximum Stock Level = Re-ordering Level + Re-ordering Quantity
-(Minimum Consumption × Minimum Re-ordering period)

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(d) Danger Level: It is the level beyond which materials should not Notes
fall in any case. If danger level arises then immediate steps should
be taken to replenish the stock even if more cost is incurred in
arranging the materials. If materials are not arranged immediately
there is possibility of stoppage of work.
Danger Level = Average Consumption × Maximum reorder period
for emergency purchases.
(e) Average Stock Level
The average stock level is calculated as such:
Average Stock level = Minimum Stock Level + ½ of re-order
quantity
Illustration 1:
In a manufacturing company, a material is used as follows:
Re-order quantity = 3,600 units
Maximum consumption = 900 units per week
Minimum consumption = 300 units per week
Normal consumption = 600 units per week
Re-order period = 3 to 5 week
Calculate: (a) Re-order level; (b) Minimum stock level; (c) Maximum
stock level.
Solution:
Reorder level = Maximum consumption × Maximum re-order
period
= 900 × 5 = 4500 units
Minimum Stocks level = R
 e-order level – (Normal consumption
Normal re-order period)
= 4500 – (600 × 4) = 2100 units
Note: Normal re-order period is the average period.
Maximum Stock Level = R
 e-order level + re-order quantity – (Minimum
consumption Minimum re-order period)
= (4500 + 3600) – (300 × 3) = 7200 units.

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Notes Illustration 2:
In a manufacturing company, a material is used as follows:
Maximum consumption - 12000 units per week
Minimum consumption - 4000 units per week
Normal Consumption - 8000 units per week
Re-order quantity - 48000
Time required for delivery - Minimum: 4 weeks, Maximum: 6 weeks
Calculate: (a) Re-order level, (b) Minimum level, (c) Maximum level;
(d) Danger level and (e) Average stock level.
Solution:
Reorder level = Maximum consumption × Maximum re-order period
= 12000 × 6 = 72,000 units
Minimum Stocks level = R
 e-order level – (Normal consumption × Nor-
mal re-order period)
= 72,000 – (8000 × 5) = 32,000 units
Maximum Stocks level = R
 e-order level + Re-order quantity + (Minimum
consumption × minimum re-order period)
= 72,000 – 48,000-(4000 × 4) = 1,04,000 units
Danger Level = Average consumption × Maximum re-order period for
emergency purchases
= 8000 × 2 week = 16000 units
Average Stock Level = Minimum level + ½ (48000) = 56,000 units

10.5.2 ABC Analysis

ABC (Always Better Control) analysis is believed to have originated in
General Electric Company of America. It is based upon the classifica-
tion of inventory for selection control. It measures the monetary value
i.e., cost significance of each inventory/material in relation to total cost
and inventory value. The logic behind this kind of analysis is that the
management should study each item of stock in terms of its usage, lead
time, technical or other problems and its relative money value in the total

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investment in inventories. Critical, or high value, items require very close Notes
attention, while low value items require the least amount of expense and
effort when it comes to inventory control.
Under ABC analysis, the various stock items can be ranked according
to their average material investment or according to their annual rupee
usage. Materials segregation or inventory control involve several crucial
steps, including:
(i) Find out how much of each stock item will actually be used in the
future for the review and forecast period.
(ii) Determine the price per unit for each item.
(iii) Determine the total project cost of each item by multiplying its
expected units to be used by the price per unit of such item.
(iv) Beginning with the item with the highest total cost, arrange different
items in order of their total cost as computed under step (iii) above.
(v) Express the units of each item as a percentage of total costs of all
items.
(vi) Compute the total cost of each item as a percentage of total costs
of all items.
If it is convenient different items may be classified into only three cate-
gories and labelled as A, B, and C respectively depending upon whether
they are high value items, middle value items or low value items. If
need be, percentage of different items may be plotted on a chart. The
entire working of ABC analysis may be explained with the help of the
following simplified example:

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Notes

VED Analysis: Vital, Essential, and Desirable (VED) analysis states that
highest control must be over vital items, medium control over essential
items and least control is inferred over desirable items.
SDE Analysis: SDE stands for Scarce, Difficult and Easy. Highest control
is exercised over scarce items, medium control over difficult items and
least control over easily available items.

10.6 Economic Order Quantity [EOQ]

Economic Order Quantity [EOQ]
The two fundamental problems in material control are how much of a
given item should be ordered at once and when to place the next or-
der. The objective is to determine the ideal order size before choosing
an economical ordering quantity. Considerations like material carrying
costs and the ordering cost associated with placing purchase orders must
be taken into consideration while determining the ideal order size; the
total cost (ordering + storing cost) be minimised. The costs associated
with carrying material include interest on the capital used to purchase
the material stores, rent for the storage space, salaries and wages for
the department in charge of keeping the stores, any loss from theft and
deterioration, costs associated with store insurance, stationery and other
supplies used by the stores, taxes on inventories, etc.

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Ordering costs may include the rent for the office space that purchasing Notes
department occupies, the salaries and wages of its employees, the depre-
ciation on its equipment and furniture, postage, telegraph, and telephone
bills, the stationaries, and other consumables it needs, any travel expenses
incurred, the costs of inspection etc.

Assumption of Economic Order Quantity

The following formula determines the economic ordering quantity, which
is the quantity for which the cost of holding plus the cost of purchasing
is minimum:
‹ The EOQ model assumes only ordering and carrying cost.
‹ At each reorder point, same quantity is ordered.
‹ Consumption, ordering costs, and carrying costs are all well known.
It is also certain how long it will take to fulfil a purchase order
from the time it is placed.
‹ The order quantity has no impact on the purchasing cost per unit.
Due to the assumption that the purchase price is the same regardless
of the order size, purchasing costs are irrelevant when determining
EOQ.
‹ There are no stockouts. This assumption is based on the idea that
managers keep enough inventory to prevent stockouts because the
costs of stockout are so high.
‹ Managers only take quality and shrinkage costs into account when
determining the size of a purchase order to the extent that these
costs have an impact on ordering or carrying costs.

Calculation of EOQ
EOQ is that quantity at which total relevant cost is minimum.
Total relevant costs = Relevant ordering costs + Relevant carrying costs
We use the following notion:
D = Total demand in units for a specific period (e.g., 1 year)
Q = Size of each order
Number of purchase orders per period (one year)
Demand inunits for a period ( one year ) D
= =
Size of each order Q
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Notes Q
The average inventory in units = , because each time the inventory
2
goes down to 0, an order for Q units is received. The inventory varies
0+Q
from Q to 0 so the average inventory is
2
P = relevant ordering cost per purchase order
C = Relevant carrying cost of one unit in stock for the time period used
for D (one year)
For any given quantity Q

The EOQ model is solved using calculus but the key intuition is that
relevant total costs are minimized when relevant ordering costs equal
relevant carrying costs.
To solve EOQ we set

2Q 2DP
Multiplying both sides by we get Q2 =
C C
2DP
Q =
C
Where,
Q = EOQ
D = Annual units’ consumption during the year
P = Cost of placing an order (Ordering costs)
C = Annual cost of storage of one unit (Carrying costs)

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The above formula indicates that EOQ increases with increase in D (An- Notes
nual consumption) and/or P (Ordering Cost).
The graphical representation of EOQ is given below:

Figure 10.1

In Figure 10.1 ordering cost, carrying cost and total cost are plotted on
y-axis and quantity on x-axis. The EOQ is achieved when the Ordering
Cost is equal to Carrying Cost. At EOQ level the total inventory cost is
minimum.
Example 10.1: ABC Ltd. is an independent stationary store that sells pen.
ABC Ltd. purchases the pen from XYZ Ltd. at Rs. 14 a package (each
package contains 20 pens). All the incoming freight is borne by XYZ
Ltd. No inspection is necessary at ABC Ltd. because XYZ Ltd. supplies
quality pens. ABC Ltd.’s annual demand is 13,000 packages, at a rate of
250 packages per week. ABC Ltd. requires a 15% annual rate of return on
investment. The purchase-order lead time is two weeks. Relevant order-
ing cost per purchase order is Rs. 200. Other relevant cost of insurance,
materials handling. Breakage, shrinkage and so on per year is 3.10.
Solution:
Weekly consumption = 250
Cost of placing an order = 200
Annual carrying cost (per unit) = required annual return on investment
+ other relevant carrying cost = 0.15 * 14 + 3.10 = 5.20
Calculate the EOQ.

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Notes Solution:
2D * P
EOQ =
S
Where
U = Annual Consumption in units = 250*52 = 13,000
P = Cost of Placing an order = 200
S = Annual Carrying cost per unit = 5.20
2 (13000 ) * 200
EOQ = = 1000 units.
5.20
13000
Calculation of number of orders in a year = = 13 orders
1000
D  Q 
Calculation of Relevant Total Cost =  × P  +  × C 
Q  2 
 13000 × 200   1000 
=  + 5.20 
 Q   2 
= 2600 + 2600 = 5200.

10.7 Just-in-Time (JIT)

Using a Just-in-Time (JIT) inventory system, suppliers can place orders
for raw materials that are directly in line with production schedules. By
only ordering the goods they actually need for the production process,
businesses can cut down on inventory costs while increasing efficiency
and reducing waste. With this strategy, producers must precisely forecast
demand.
The “nervous system” of lean JIT production, kanban regulates inventory
movement and work-in-progress production. When it comes to reducing
manufacturing waste brought on by overproduction, kanban is essential.
Push inventory tactics are used in more conventional mass production tech-
niques and are based on the anticipated quantity of sales. The pull approach
used by Kanban allows for greater production floor flexibility because a
business can only generate items in response to genuine customer requests.
On a factory floor, Kanban uses cards—either paper or digital—to monitor

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the status of output. Kanban cards track the flow of inventory through the Notes
manufacturing process and can indicate when it’s time to place an order
for additional stock.

10.7.1 Features of JIT

‹ The Just-in-Time (JIT) inventory system is a management technique
that reduces inventory and boosts efficiency.
‹ JIT manufacturing is also known as Toyota Production System
(TPS) because Toyota, a car manufacturer, adopted JIT system in
the 1970s.
‹ To prevent work-in-process overcapacity, JIT is frequently used in
conjunction with the scheduling system known as kanban.
‹ The JIT production process depends on consistent output, excellent
craftsmanship, no equipment failures, and trustworthy suppliers for
its success.
‹ The Motorola and IBM terms for the JIT system are short-cycle
manufacturing and continuous-flow manufacturing, respectively.

10.7.2 Elements Involved in JIT

Continuous Improvements:
‹ Addressing core issues and everything that does not improve the
product.
‹ Creating mechanisms to locate issues with manufacturing and related
problems.
‹ A layout focused on the product such that movement of materials
and parts consumes minimum time.
‹ Quality control at source to ensure every worker is solely responsible
for the quality of their own produced output.
Eliminating Waste:
One of the primary goals of the Just-in-Time system is waste reduction.
This requires efficient inventory management across the whole supply
chain. There are seven types of waste:
‹ Waste from product defects.
‹ Waste of time.

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Notes ‹ Transportation waste.

‹ Inventory waste.
‹ Waste from overproduction.
‹ Processing waste.

10.7.3 Advantages of JIT

‹ The manufacturers can easily move from one product to another.
‹ JIT reduces the costs by minimizing the warehouse needs.
‹ The businesses spend less on raw materials because they only purchase
what they need to produce the products that have been ordered.
‹ Less working capital is needed because, with this management
approach, only essential stocks needed for manufacturing are acquired.
‹ By setting a minimum reorder level and only placing orders for
new stock when that level is reached, this approach also benefits
inventory management.
‹ The organisation’s overall ROI (Return on Investment) is high as
a result of the aforementioned low level of stocks held.
‹ Since this strategy relies on a demand-pull model, all goods produced
would be sold, making it simple to account for unforeseen changes
in demand.
‹ Due to the erratic and unstable nature of market demand today,
JIT is appealing.
‹ In order to reduce rework costs and inspection costs, JIT places a
strong emphasis on the “right-first-time” principle.
‹ JIT can lead to higher productivity and higher-quality products.
‹ A JIT system promotes better communication along the manufacturing
chain.

10.7.4 Disadvantages of JIT

‹ The JIT approach states that there should be ZERO tolerance for
errors, which makes rework challenging in practise because inventory
is kept to a minimum.

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‹ JIT implementation requires a high reliance on suppliers, whose Notes

performance is out of the manufacturer’s control.
‹ JIT lacks buffers, which can lead to production line idling and
downtime, which would be detrimental to both the financial situation
and the production process.
‹ Given that there won’t be any extra finished goods on hand, the
odds of failing to fulfil an unexpected rise in orders are quite high.
‹ Depending on the frequency of transactions, transaction charges
would be relatively significant.
‹ Due to the frequent delivery, JIT may have some unfavourable
environmental implications because more transportation would be
needed, which would increase the use and cost of fossil fuels.

Example of JIT
Toyota Motor Corporation, which is renowned for its JIT inventory system,
only orders parts in response to new car orders. The company started using
this technique in the 1970s, but it took 20 years to get it just right. Sad-
ly, a fire at the Japanese-owned automotive parts supplier Aisin severely
damaged its ability to produce P-valves for Toyota’s vehicles in February
1997, threatening to put an end to Toyota’s JIT inventory system. Toyota
had to halt production for a few days because Aisin is the only supplier
of this component, and its weeks-long shutdown caused that.
As a result, other Toyota parts vendors were forced to temporarily close
their doors because the automaker was no longer in need of their com-
ponents. This fire consequently cost Toyota 160 billion yen in revenue.

JIT in Service Industries

It is possible to use JIT purchasing and production processes in the ser-
vice sector as well. For instance, more than a third of the expenses at
most hospitals are related to inventory, supplies, and the labour costs.
Eisenhower Memorial Hospital in Palm Springs, California, decreased its
inventory and supplies by 90% in just 18 months by introducing a JIT
purchasing and delivery system. To produce hamburgers, McDonald’s has
utilised JIT production techniques. Previously, McDonald’s precooked a
batch of hamburgers that were kept warm under heat lamps until orders
were placed. The discarding of the hamburgers in cases where it didn’t

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Notes sell within a specified time period resulted in significant inventory holding
costs and spoiling costs. Also, the longer the hamburgers lay beneath the
heat lamps, the worse their quality became. Finally, clients who ordered a
hamburger with a particular request (such one without cheese) had to wait
for the burger to cook. Today, McDonald’s is able to cook hamburgers
just when they are ordered, considerably decreasing inventory holding
and spoilage costs. This is made possible by the use of new technology
(including an inventive bun toaster) and JIT production processes. Most
significantly, JIT has increased consumer satisfaction by enhancing ham-
burger quality and slashing the time required for special orders.
Kanbans = D.L(1 + α)/EOQ
Where
D = Daily Demand
L = Lead Time
Α = Safety Stock
Illustration 3:
Calculate the number of Kanbans needed at the ABC company for the
following two products, produced in a factory that works eight hours per
day, five days per week.
Product 1 Product 2
Usage 300/week 150/week
Lead time 1 week 2 week
Container size 20 units 30 units
Safety stock 15 percent 0
Solution:
Product 1 Product 2
Daily Demand (D) 300/5 150
Lead time (L) 5 days 10 days
EOQ 20 units 30 units
Kanbans = D.L( 1+ α)/EOQ 17.25 = 18 50 Cards
Cards
Total number of Kanban in the system 18 + 50 = 68 Cards

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Notes
10.8 Method of Inventory Valuation
When materials are issued to production department, a difficulty arises
regarding the price at which materials issued are to be charged. The same
type of material may have been purchased in different lots at different
times at several different prices. This means that actual cost can take on
several different values and same method of pricing the issue of materials
must be selected.
There are numerous methods of pricing issues. They may be classified
as follows:

10.8.1 Cost Price Method

(a) Specified Price (Identifiable Method): Sometimes materials are
bought to be used in a specific job or problems can be found with
a specific receipt. The actual purchase price may be levied in these
circumstances. When prices are stable or when the materials are
covered by price control orders, this method can be used. This
technique only has a few applications.
(b) First-in First-out (FIFO) Method: It is based on the assumption
that materials issued first are those that were purchased first. It uses
the price of first batch of materials purchased for all issues until
all units from this batch have been issued and so, the materials
in stock are valued at the cost of the most recent purchases since
they are issued at the oldest cost price listed in the store’s ledger
account. Although normally materials would be expected to move
out of stock on approximately a FIFO basis because oldest stocks
are typically used up first, it should be noted that the assumption

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Notes of FIFO is only for accounting purposes, i.e., the physical flow of
materials need not necessarily be in the order of the flow of costs.
Example 10.2:
Receipts: 12 March 100 kgs. @ Rs. 10.00 per kg.
22 March 150 kgs. @ Rs. 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
100 kgs. @ Rs. 10.00 per kg.
100 kgs. @ Rs. 9.00 per kg.
Balance 50 kgs @ Rs. 9.00 per kg.
Advantages:
‹ This approach is beneficial because it prioritises the oldest units
while keeping inventory up to date.
‹ This method is logical along with easy to use and understand.
‹ This method helps in inter and intra-firm comparisons.
‹ Valuation of inventory and cost of finished goods is consistent
and realistic.
Disadvantages:
‹ The cost of production is independent to the current prices.
‹ The production cost is underestimated if prices are rising. However,
if the rate of stock turnover is high, the inventory will reflect
current prices The effect of current market prices is not revealed
in issues when prices are rising.
‹ When multiple lots are bought at different levels of price, the
true picture is not presented. Calculation became challenging.
‹ The pricing of material returns is difficult.
‹ High inflation makes it difficult to replace used materials; FIFO
does not address this issue.
‹ Usually more than one price has to be adopted for a particular
issue.
‹ Cost comparisons between two batches of production become
difficult when issues are priced differently.

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(c) Last-in First-out (LIFO) Method: The principle adopted is that the Notes
production only uses materials that have recently been purchased.
The inventory is valued using the oldest costs. As the method
applies the current cost of materials to the cost of units, it is also
known as the replacement cost method. This method is crucial for
matching costs and revenues in the process of determining income.
Example 10.3:
Receipts: 12 March 100 kgs. @ Rs. 10.00 per kg.
22 March 150 kgs. @ Rs. 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
150 kgs. @ Rs. 9.00 per kg.
50 kgs. @ Rs. 10.00 per kg.
Balance 50 kgs @ Rs. 10.00 per kg.
Advantages:
‹ When there are few transactions, it is easy to use.
‹ It is a good method of avoiding tax.
‹ It is a systematic method. It matches current costs with current
revenues in a better way.
‹ It illustrates real income during periods of price inflation.
‹ It minimises unrealised inventory gains and losses and tends to
stabilise reported operation profits especially when the industry
is prone to sharp price fluctuations.
Disadvantages:
‹ When rates of material receipts are highly fluctuating, the method
becomes complicated.
‹ More than one price may have to be adopted for an issue.
‹ Cost of different batches vary greatly, making inter-firm and
intra-firm comparison difficult.
‹ The stocks require to be adjusted during falling prices.
‹ Unless purchases and sales occur in equal quantities the current
costs cannot be easily matched with current revenue.

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Notes ‹ The company can time the purchases to cause high or low costs
thus changing reported income at will.
‹ Existing profit sharing and bonus can be affected by an accounting
change. Employees will have difficulty in understanding the
cause for these changes.
(d) Highest in First-out Method: The inventory is valued at the lowest
feasible price, and the most expensive materials are issued first.
The procedure calls for thorough documents. It is typically applied
to cost-plus contracts or monopoly goods. The creation of a hidden
reserve occurs when stocks are undervalued.
(e) Base Stock Method: A certain minimum stock of a material is
always carried and is priced at the original cost (usually at the
lowest purchase price). The portion of stock above this level is
issued and priced under any one of the methods.
The disadvantage of this method is that the stock may be undervalued
and hence the computation of return on capital will not be reliable.

10.8.2 Average Price Method

(a) Simple Average Method: The simple average is the average of prices
ignoring the quantities involved. It can be used when the prices are
normally stable and the stocks purchased are in equal quantities or
the stock value is small. It is calculated by dividing the total rates
of materials by the number of rates of prices. A new average is
worked out after every receipt.
Example 10.4:
Receipts: 12 March 100 kgs. @ Rs. 10.00 per kg.
22 March 150 kgs. @ Rs. 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
200 kgs. @ Rs. 9.50 [(10 + 9)/2] per kg.
Balance 50 kgs @ Rs. 9.50 per kg.
(b) Weighted Average Method: In this approach, the average price is
determined after accounting for both total quantities and total costs.
Every time a purchase is made, it is calculated by multiplying the
cost of the purchase by the cost of the stock on hand, then adding
the quantity received to the stock on hand. To calculate the value,

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divide the total cost by the total quantity. This approach prevents Notes
price changes, minimises the number of calculations, and provides
a stock price that is reasonable.
Example 10.5:
Receipts: 12 March 100 kgs. @ Rs. 10.00 per kg.
22 March 150 kgs. @ Rs. 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
200 kgs. @ Rs. 9.40 [(10*100 + 9
*150)/250] per kg.
Balance 50 kgs @ Rs. 9.40 per kg.
Advantages:
‹ It is rational and consistent.
‹ The issues and inventory are not affected by changes in the prices.
‹ The values of the inventory reflect the actual costs.
Disadvantages
‹ It requires a significant amount of clerical work.
‹ It is cumbersome and difficult when prices vary frequently.
‹ It is not realistic as it is not the actual price.
(c) Periodical Simple Average Method: Some business may price
materials by taking average of the prices of all receipts during a
period, e.g., a month, a week, etc. for the subsequent period. Only
those prices - relevant to the period is taken into account. Both
closing stock and purchases made during the time are considered.
Illustration 4:
The prices of the receipts during the week are Rs. 8, Rs. 9, Rs.
10, Rs. 11. The periodic simple average will be:
= Total Prices of Material/Total Number of Price
= (8 + 9 + 10 + 11)/4 = Rs. 9.5
Disadvantages:
(i) Pricing of issues ignores heavy fluctuations in price during the
current period.
(ii) It is not an exact cost method.
(iii) It involves heavy clerical work.
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Notes (d) Periodic Weighted Average Method: The average price is calculated
periodically and not every time the material is received. It is
computed by dividing the total amount purchased by the total value
of materials purchased over the course of a period.
Example 10.6: If the total receipt during a week is 100 kg. costing
Rs. 2500, the periodic weighted average will be
= Rs. 2,500/100 = Rs. 25 per kg.
Advantages:
(i) It reduces the clerical costs.
(ii) It is useful in process costing.
(iii) The issue price is not affected by short-term fluctuations.
Disadvantages:
(i) At the end of the accounting period, heavy clerical work is
involved.
(ii) Violent fluctuations are ignored till the end of the period.
(iii) Closing stock can be erroneously valued and nil stock may
have a residual value.
(e) Moving Simple Average Method: In this method, periodic simple
average prices are further averaged. The moving average is calculated
by dividing periodic average prices by the total number of periods
taken. The period chosen should cover the period in which the
material is issued. The closing stock’s value could be overvalued
or undervalued. In times of rising prices, the issue price calculated
is lower than the period’s average prices, and vice versa.
Example 10.7:
Periodic Moving Average
Month Average Price Price
April 2.50
May 2.60 2.60
June 2.70 2.72
July 2.85 2.85
August 3.00 3.03
September 3.25

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(f) Moving Weighted Average Method: The material issue price is Notes
computed by dividing the total of the periodic weighted average
prices for a number of periods by the total number of such periods.

10.8.3 Notional Price Methods

(a) Standard Price Method
For a given time period, the price of issues for each item is predetermined,
taking into account all the variables that affect price, such as market trends
and transportation costs. For each material, standard prices are determined.
The standard price is maintained for all issues and inventories. Periodically,
these should be revised. Standard could be basic or current standard. The
basic standard is set for an extended period of time and provides the best
price. It aids in planning ahead. The current standard keeps product costs
updated to reflect current market trends. Contrarily, basic standards support
the analysis of production cost trends over time period.
The difference between standard and actual is transferred to the purchase
price variance account.
Advantages:
(i) It simplifies accounting as only quantities are recorded.
(ii) Inconsistency is avoided since only one rate is adopted.
(iii) It helps to determine purchase efficiency. If actual cost is more
than the standard then there is unfavourable purchasing efficiency
and vice versa.
(iv) It is simple to operate.
(v) It provides stability to the costing system.
Disadvantages:
It does not reflect the actual or expected cost but only a target.
(b) Inflated Price Method
The inflated price includes carrying costs, evaporation losses, etc. It seeks
to recover the full cost of the materials purchased.
(c) Market Price Method
Materials may be provided at replacement price. The price of identical
materials in the market at any given time is the replacement cost.

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Notes Advantages:
(i) It measures results correctly and accurately as current revenues are
matched against current costs.
(ii) It differentiates between holding gains and operating gains.
(iii) A realistic and competitive selling price can be determined.
Disadvantages:
(i) In the absence of a market price, replacement price cannot be
determined.
(ii) As it is not based on actual cost, they may increase the confusion
and complication in accounting.
The replacement price is used in respect of items used in manufacturing
whereas the realisable price is used for items kept in stock.
The realisable price is useful for calculating the issue price of obsolete
and slow-moving stores. If issues are priced at current market price, price
reduced due to bulk purchases, are not reflected.
The market price method introduces elements of uncertainty and involves
excessive classical labour to maintain records of latest prices for various
items.
IN-TEXT QUESTIONS
1. In ABC technique, A items are those which are used in largest
quantities. (True/False)
2. Value of closing stock under FIFO and LIFO methods is the
same. (True/False)
3. Reorder level is equal to normal consumption * normal reorder
period. (True/False)
4. When the prices are showing a raising tendency, FIFO method
results in higher profits. (True/False)
5. There is an inverse relationship between carrying cost and
ordering cost. (True/False)
6. The JIT production process depends on consistent output,
excellent craftsmanship, no equipment failures, and trustworthy
suppliers for its success. (True/False)

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Notes
10.9 Solved Practical Questions
1. Following is the information by ABC Ltd. related to first week of
December 2013.
The transactions in connection with the materials are as follows:
Receipts
Rate per Issues
Days Units unit (units)
1st 40 15
2nd 20 16.5
3rd - 30
4th 50 17.1 -
5th - 20
6th - 40
Calculate the cost of materials issued under (i) FIFO method; (ii) LIFO
method; and (iii) Weighted average method of issue of materials and
value of closing stock under the above methods.
Solution:
(i) Cost of materials issued and value of closing stock under FIFO
Method
Rs. Rs.
December 3, 2013. issued 30 units @ Rs. 15
per unit 450
December 5, 2013: issued 10 units @ Rs. 15 150
issued 10 units @ Rs. 16.50 165 315
December 6, 2013: issued 10 units @ Rs. 16.50 165
Issued 30 units @ 17.10 513 678
Closing stock: 20 units @ 17.10 342
(ii) Cost of materials issued and value of closing stock under LIFO
Method:
Rs. Rs.
December 3, 2013: issued 20 units @ Rs. 16.50 330
issued 10 units @ Rs. 15.00 150 480
December 5, 2013: issued 20 units @ Rs. 17.10 342

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Notes December 6, 2013: issued 30 units @ Rs. 17.10 513

Issued 10 units @ 15.00 150 663
Closing stock: 20 units @ 15.00 300
(iii) Cost of materials issued and value of closing stock under Weighted
Average Method:

2. From the following you are required to prepare a statement showing

the issues made under LIFO method:
Date Opening Balance 100 units at Rs. 10 each
1 Received 200 units at Rs. 10.50 each
2 Received 300 units at Rs. 10.60 each
4 Issued 400 units to Job A vide MR No. 3
6 Issued 120 units to Job B vide MR No. 4
7 Received 400 units at Rs. 11 each
10 Issued 200 units to Job C vide MR No. 5
12 Received 300 units at Rs. 11.40 each
13 Received 200 units at Rs. 11.50 each
15 Issued 400 units to Job D vide MR No. 6
Solution:
Receipts Receipts Balance
P.O. M.R.
Date No Qty Rate Amt Date No Qty Rate Amt Qty. Rate Amt
100 10.00 1000
1st 200 10.50 2100 100 10.00 1000
200 10.50 2100
100 10.00 1000

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2nd 300 10.60 3180 200 10.50 2100 Notes

300 10.60 3180
4th 3 (400)
300 10.60 3180 100 10.00 1000
100 10.50 1050 100 10.50 1050
6th 4 (120)
100 10.50 1050 80 10.00 800
20 10.00 200
7th 400 11.00 4400 80 10.00 800
400 11.00 4400
10th 5 200 11.00 2200 80 10.00 800
200 11.00 2200
12th 300 11.40 3420 80 10 .00 800
200 11.00 2200
300 11.40 3420
13th 200 11.50 2300 80 10.00 800
200 11.00 2200
300 11.40 3420
200 11.50 2300
15th 6 (400) 80 10.00 800
200 11.50 2300 200 11.00 2200
200 11.40 2280 100 11.40 1140
Closing Stock: 380 Units, Value: 4140
3. Prepare a statement showing the pricing of issues, on the basis of (a)
Simple Average, and (b) Weighted Average Methods from the following
information pertaining to material ‘X’.
Date
1 Purchased 100 units @ Rs. 10.00 each
2 Purchased 200 units @ Rs. 10.20 each
5 Issued 250 units to Job A vide MR No. 1
7 Purchased 300 units @ Rs. 10.50 each
10 Purchased 200 units @ Rs. 10.80 each
13 Issued 200 units to Job B vide MR No. 2
18 Issued 200 units to Job C vide MR No. 3
20 Purchased 100 units @ Rs. 11.00 each
25 Issued 150 units to Job D vide MR No. 4
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Notes Solution:
(a) Simple Average Method
Receipts Receipts Balance
P.O. M.R.
Date No Qty Rate Amt Date No Qty Rate Amt Qty. Amt
1 st
100 10.00 1000 100 1000
2nd 200 10.20 2040 300 3040
5th 1 240 (10+10.20)/2 2525 50 515
7 th
300 10.50 3150 350 3665
10th 200 10.80 2160 150 5825
13 th
2 200 (10.2+10.5+10.8)/3 2100 350 3725
18th 3 200 (10.5+10.8)/2 2130 150 1595
20 th
100 11.00 1100 250 2695
25 th
4 150 (10.80+11.00)/2 1635 100 1060

Closing Stock: 100 units, Value Rs. 1060

(b) Weighted Average Method

Receipts Receipts Balance
P.O. M.R.
Date No Qty Rate Amt Date No Qty Rate Amt Qty. Rate Amt
1st 100 10 1000 100 10.00 1000
2nd 200 10.2 2040 300 10.31 3040
5th 1 240 10.13 2533.30 50 10.31 515
7th 300 10.5 3150 350 10.45 3665
10th 200 10.8 2160 150 10.58 5825
13th 2 200 10.58 2116.00 350 10.58 3725
18th 3 200 10.58 2116.00 150 10.58 1595
20th 100 11 1100 250 10.74 2695
25 th
4 150 10.74 1611.00 100 10.74 1060

Closing Stock: 100 Units Value: 1073.70

Note: Rate 1 = 3040/300 = 10.13, Rate 2 = 3656.70/350 = 10.45
Rate 3 = 5816.70/550 = 10.58, Rate 4 = 2684.70/240 = 10.74
4. The following data pertain to material X:
Supply period 4 to 8 months

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Consumption rate: Notes

Maximum 600 units per month
Minimum 100 units per month
Normal 300 units per month
Yearly 3600 units
Storage costs are 50% of stock value, ordering costs are Rs. 400 per
order, price per unit of material Rs. 64.
Compute: (i) Re-order level (ii) Minimum stock level (iii) Maximum
stock level (iv) Average stock level.
Solution
2D * P
EOQ =
S
Where
U = Annual Consumption in units = 3600
P = Cost of Placing an order = 400
S = Annual Carrying cost per unit = 0.5*64 = 32
2 ( 3600 ) * 400
EOQ = = 300 units
32
Reorder level = Maximum consumption × Maximum re-order
period
= 600 × 8 = 4,800 units
Minimum Stocks level = R
 e-order level – (Normal consumption ×
Normal re-order period)
= 4800 – (300 × 600) = 3000 units
Note: Normal re-order period is the average period = (4 + 8)/2 = 6 months
Maximum Stock Level = R
 e-order level + re-order quantity – (Minimum
consumption × Minimum re-order period)
= (4800 + 300) – (100 × 4) = 4,700 units
Average Stock Level = (Minimum level + Maximum level)/2
= (3000 + 4700)/2 = 3850 units

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Notes
10.10 Summary
‹ Inventory control is the systematic control and regulation of purchase,
storage and usage of materials in such a way as to maintain an
even flow of production and at the same time avoiding excessive
investment in inventories.
‹ ABC analysis is a value based system of material control, in which
materials are analysed according to their value so that costly and
more valuable materials are given greater attention and care.
‹ Economic Ordering Quantity (EOQ) is that size of the order which
gives maximum economy in purchasing any material and ultimately
contributes towards maintaining the material at the optimum level
and at minimum cost.
‹ The Just-in-Time (JIT) inventory system is a management technique
that reduces inventory and boosts efficiency.
‹ JIT manufacturing is also known as Toyota Production System
(TPS) because Toyota, a car manufacturer, adopted JIT system in
the 1970s.
‹ Materials are issued to production department on cost price, average
price or notional price methods.

10.11 Answers to In-Text Questions

1. False
2. False
3. False
4. True
5. True
6. True

10.12 Self-Assessment Questions

1. XYZ Ltd. requires 10,000 units of a product during the year. The
cost of ordering is Rs. 50 and the carrying cost per unit is Rs. 3

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per year. Lead time of an order is 7 days and the company will Notes
keep a safety stock of three days usage.
You are required to calculate the following:
(a) Minimum Inventory
(b) Maximum Inventory
(c) Average Inventory
(d) Re-order Point
(e) Economic Order Quantity
2. Laxmi Enterprise manufactures a product “ABC”. The following
particulars are collected for the year 2016:
(a) Annual demand of ABC – 1000 units
(b) Cost of placing an order Rs. 100
(c) Annual carrying cost per units Rs. 10
(d) Normal usages 100 units per week
(e) Minimum usage 50 units per week
(f) Maximum usages 150 units per week
(g) Re-order period 2 to 6 weeks
Calculate the following:
(a) Re-order Quantity
(b) Re-order Level
(c) Minimum Level
(d) Maximum Level
(e) Average stock Level.
3. What do you mean by minimum level, maximum level and re-order
level? How are they fixed?
4. Discuss the advantages and disadvantages of FIFO and LIFO methods
of pricing. Under condition of rising prices which of these methods
would you recommend and why?
5. Briefly describe the various methods of pricing the material issues.
6. Explain the weighted average method of pricing. How it is different
from normal average method.

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Notes 7. X Ltd. has purchased and issued the materials in the following order:
Unit Cost Rs.
1st January Purchased 300 3
4th January Purchased 600 4
6th January Issued 500
10th January Purchased 700 4
15th January Issued 800
20th January Purchased 300 5
23rd January Issued 100
Ascertain the quantity of closing stock as on 31st January and state
what would be its value (in each case) if issues were made under
the following methods: (i) Average cost. (ii) First-in First-out. (iii)
Last-in First-out. (Weighted average = Rs. 2,218/-; FIFO Rs. 2,300/-;
LIFO Rs. 1,900/-)

10.13 References
‹ Cost and Management Accounting. Study Material Module 1 Paper
2. The Institute of Company Secretaries of India.
‹ Arora, M. N. (2016). Cost and Management Accounting, Penguin
Random House.

10.14 Suggested Readings

‹ Arora, M. N. (2016). Cost and Management Accounting, Penguin
Random House.
‹ Maheshwari, S. N., & Mittal, S. N. Cost Accounting: Theory and
Problems. Shree Mahavir Book Department.

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 L E S S O N

11
Performance Measurement
and Evaluation
CA. Mannu Goyal
Assistant Professor
School of Open Learning
University of Delhi
Email-Id: [email protected]
Mr. Jigmet Wangdus
Assistant Professor
SOL/COL
University of Delhi
Email-Id: [email protected]

STRUCTURE
11.1 Learning Objectives
11.2 Introduction
11.3 Responsibility Centres and its Performance
11.4 Performance Management System
11.5 Divisional Performance Measures
11.6 Pros and Cons of the Use of Performance Measures
11.7 Financial Performance Measures
11.8 Economic Value Added (EVA)
11.9 Limitations of EVA
11.10 Non-Financial Performance Measures
11.11 Balanced Scorecard
11.12 Performance Pyramid
11.13 The Building Block Model
11.14 Performance Prism
11.15 Triple Bottom Line (TBL)
11.16 Summary
11.17 Self-Assessment Questions
11.18 References and Suggested Readings
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Notes
11.1 Learning Objectives
After studying this chapter, you will be able to:
‹ Describe how performance measurement and control systems contribute
to the creation of value, the implementation of strategies, and the
monitoring of performance to enhance strategies.
‹ Examine both conventional and unconventional methods of performance
measurement.
‹ Determine non-financial performance indicators, interpret them, and
make suggestions for ways to raise the performance.
‹ Explain the causes and issues caused by short-termism and the
financial manipulation of results, and offer strategies to promote a
long-term perspective.
‹ Compute and evaluate performance measures relevant in a divisionalized
organisational structure, including return on investment, residual
income, and economic value added.
‹ Examine and assess performance, and make recommendations for
ways to enhance both financial and non-financial performance.

11.2 Introduction
It is essential to measure and evaluate performance because it enables
management to assess how well the business is performing in relation to
both prior years and its competitors.
Responsibility accounting is the process of gathering, compiling, and
disclosing financial information in which each manager is responsible for
particular costs, revenue, or assets of the company. The information is
about the decision centers throughout the organization. It is also known
as profitability accounting or activity accounting.
Responsibility accounting is appropriate where top management has del-
egated decision-making authority. According to the principle of respon-
sibility accounting, a manager’s effectiveness should be assessed based
on how effectively he handles the matters that fall under their direct
control. Performance measurement is directly linked to the organisational
structure of a business.

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Notes
11.3 Responsibility Centres and its Performance
According to Deakin and Maher ‘a responsibility centre is a specific unit
of an organisation assigned to a manager who is held responsible for its
operation and resources’.
CIMA London has defined Responsibility Accounting as “a system of
management accounting under which accountability is established accord-
ing to the responsibility delegated to various levels of management and
management information and reporting system instituted to give adequate
feedback in terms of the delegated responsibility. Under this system, divi-
sion of units of an organization under specified authority in a person are
developed as a responsibility centre and evaluated individually for their
performance. A good system of transfer pricing is essential to establish at
the performance and results of each responsibility centre. Responsibility
accounting is thus used as a control technique:”.
To enhance the application of responsibility accounting in decision-mak-
ing, it is essential for an organisation to attach a level of responsibility
(decentralised power/s) to different divisions/departments and designate
as either of cost, profit, revenue or investment centre.

Cost or Expense Centres

Cost or Expense Centres are responsibility centres where the manager
‘has control over the costs’ (other than those of capital nature) owning to
function, for which he/she is responsible. For example, the paint depart-
ment in an automobile firm. Performance report of cost centre is focused
on budgeted and actual costs (cost in term of quantity of input resource
(may be money, material, man-hours) to appraise the performance. Cost
variances are relevant measures.

Revenue Centres
Revenue Centres are the responsibility centres where the manager has
‘control over the generation of revenue from operation’ with no respon-
sibility for costs. To illustrate, booking counter of any Airline Company
is revenue centre.
The key measures used to appraise performance are sales variances.

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Notes Profit Centres

Profit Centres are the responsibility centres where the manager of such
a centre or division has ‘control on both revenue and costs’ (other than
those, which are of capital nature) earned out of and incurred on. Thus,
performance is measured in terms of the difference between the revenues
and costs, assets assigned to the division respectively. To illustrate, the
facility of canteen can be considered as the profit centre.

Investment Centres
Investment Centres are the responsibility centres where the manager has
responsibility for not just the revenues and costs relating to the centre,
but also the assets that cause these costs and generate these revenues and
the investment decisions relating to disposal and acquisition of assets.
The performance of an investment centre can be measured by appraising
profit/return in relation to investment base of centre, ROI, RI, and EVA
are some prominent financial performance measures.
Investment centre can be referred to as Strategic Business Units (SBUs).
Mind it each division is not SBU. For being SBU capabilities to work
independently and in isolation are essential.

11.4 Performance Management System

Performance management shall be considered as an essential aspect of
management accounting. Performance management may be seen as four-
stage solution to take any organisation towards sustainability.
Aspects related to the first two phases are already covered in the previous
heading, now it’s turn to study the performance measure (both financial
and non-financial), based upon which performance can be measured.

11.5 Divisional Performance Measures

Performance management system plays a key role in deploy strategy, but
it has a prerequisite and that is, measure the existing performance. As
already mentioned in the first section of this chapter that performance
measurement is directly linked to the organisational structure. If organ-
isation is divisionalised then performance also needs to be measured at
the division level for each division. It is obvious, that to measure the
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performance of division certain performance measures or indicators need Notes

to be established.
The division can be on the basis of functional, geographical, enterprise,
geographical and functional.

It is important here to note that if any organisation opts for divisional

structure, then there are verities of issues, which need to be addressed while
establishing performance measures to determine performance. These issues
are such as inter-dependence of divisions, goal congruence, allocation of
costs of shared services or head office, and internal transfer pricing policy
and etc. These factors affect the divisional performance substantially.
A good performance measure should:
‹ Provide the divisional manager a justifiable incentive to make decisions
that are in the best interests of the entire business (goal congruence).
‹ Only include elements for which the divisional manager is liable.
‹ Recognise both short-term and long-term organizational goals.

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Notes The issues of evaluating the performance of divisions in multinational

companies arise due to:
‹ The differences in economic, legal, political, social, and cultural
environments in different countries.
‹ In some nations, the government may impose restrictions and set
a ceiling on product prices.
‹ Costs of materials, labour, and infrastructure, as well as the availability
of skilled labour and materials, may vary widely between nations.
‹ Divisions that operate in various nations maintain track of their
performance in various currencies.

11.6 Pros and Cons of the Use of Performance Measures

David Otley, Jane Broadbent, and Anthony Berry suggest the pros and
cons of the use of performance measures the benefits are:
‹ Develops agreed measures of activity.
‹ Define and clarifies the objectives of the organization.
‹ Helps in the setting targets for managers.
‹ Greater understanding of the process.
‹ Facilitate comparison between divisions.
‹ Promotes accountability to stakeholders.
Poorly designed performance management system (where performance
measures are not appropriately chosen and applied) may result in wrong
signaling. Wrong signals may lead to inappropriate action and decisions;
hence it is important to identify and overcome the problems associated
with the use of performance measures.

11.7 Financial Performance Measures

In order to be a sustainable business, the essentials are profitability, sur-
vival, and growth. Since the financial performance measures/indicators,
can be considered as best indicators of profitability and easy indicators
of growth and survival (solvency and liquidity); hence must be part of
performance measurement metrics. These are:

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Return on Investment Method (ROI) Notes

The American company DuPont was the first to recognise the importance
of taking into account the level of investment as well as the income from
such investment when evaluating the performance of the investment centre in
the 1920s. Since then, many businesses have begun focusing on a division’s
Return on Investment (ROI) rather than just its absolute size of profits.
The DuPont technique emphasises that any action that boosts return on
sales or investment turnover leads to a rise in ROI. When keeping the
other two variables constant, ROI rises with:
1. Increases in revenues,
2. Decreases in expenses, or
3. Declines in investments
“ROI expresses divisional profit as a percentage of the assets employed
in the division. Assets employed can be defined as total divisional assets,
assets controllable by the divisional manager or net assets.”
ROI is a widely used metric, making it the perfect tool for comparing
corporate divisions of similar size and operating in related industries. But
it also has limitations. It’s possible that divisional ROI can be increased
by actions that will lower the overall ROI of the company, and vice versa,
actions that decrease divisional ROI may improve the situation for the
company as a whole.
In other words, evaluating divisional managers on the basis of ROI may
not encourage goal congruence. (It’s already mentioned in the beginning
of topic ‘Divisional Performance Measures’ that certain issues will arise
due to establishing measures at a divisional level which need to be ad-
dressed and goal congruence is one among these)
ROI = (Profit margin/Investment) × 100
ROI = (Net Profit/Sales) × (Sales/Capital Employed) × 100
Division A Division B
Available Investment Project Rs. 40 lacs Rs. 40 lacs
Controllable Contribution Rs. 4.4 lacs Rs. 3.2 lacs
Return on the Proposed Project 11% 8%
Presently the ROI of Divisions 14% 6%
Overall Cost of Capital is 9%
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Notes The manager of division “A” is unwilling to invest the additional Rs. 40
lacs because the proposed project’s return is 11%, which would cause a
decrease of the current ROI of 14%.
The manager of division “B,” on the other hand, would like to invest the
Rs. 40 lacs because the proposed project’s 8% return is higher than the
division’s current ROI of 6% and would boost the divisions ROI.
Decisions made by the managers of the two divisions would not be in
the company’s best interests. Only projects with an ROI greater than the
cost of capital (9%) should be approved by the company; however, the
manager of division “A” would reject a potential return of 11%, while
the manager of division “B” would accept a potential return of 8%.

Residual Income Method (RI)

To overcome some of the dysfunctional consequences of ROI (lack of goal
congruence), the residual income approach can be used for the purpose
of evaluating the performance of divisional managers.
“Residual income is excess of controllable profit over a predetermined
organisation-wide minimum hurdle rate (cost of capital charge) on the
investment controllable by the divisional manager. So higher the residual
income means better the performance.”
Residual income can be characterised as the divisional profit contribution
less a cost of capital charge on the total amount invested in assets used
by the division for assessing the division’s economic performance.
There is a greater probability that managers will be encouraged to act in
the company’s best interests as well as their own if residual income is
used to gauge the managerial performance of investment centres.
A typical divisional residual income statement is shown below:
Amount
Particulars Details (Rs.)
Sales xxx
Less: Variable Costs xxx
Contribution xxx
Less: Controllable fixed costs xxx
Controllable Profit xxx
Less: Interest on controllable investment xxx

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Amount Notes
Particulars Details (Rs.)
Controllable residual income xxx
Less: Uncontrollable cost (allocated head office charges) xxx xxx
Less: Interest on uncontrollable investment xxx xxx
Net Residual Income xxx
Returning to our previous example in respect of the investment decision for
divisions A and B, the residual income calculations are as shown further:
Division A Division B
(in Rs. lacs) (in Rs. lacs)
Proposed Investment Rs. 40.00 Rs. 40.00
Controllable Contribution Rs. 4.40 Rs. 3.20
Cost of Capital (9%) Rs. 3.60 Rs. 3.60
Residual Income Rs. 0.80 – Rs. 0.40
If both managers accept the project, this calculation shows that division
“A” residual income will increase and division “B” residual income will
decrease. As a result, the manager of division “A” would make an in-
vestment, as opposed to the manager of division “B,” who would not.
The best interests of the business as a whole are served by these actions.
The residual income cannot be used as a comparison tool for divisional
performances of various sizes because it is an absolute measure. It is
obvious that a large division is more likely than a small division to gen-
erate a higher residual income.
For each division, targeted or budgeted residual income levels that are in
line with asset size and market conditions should be established in order
to make up for this shortfall.

Advantages of Residual Income

‹ When investments that generate returns above the cost of capital
are made and those that generate returns below the cost of capital
are eliminated, the residual income will increase.
‹ Due to the ability to apply a different cost of capital to investments
with various risk profiles, residual income is more adaptable.

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Notes Disadvantage of Residual Income

The drawback of Residual Income is that it does not facilitate compari-
sons between investment centres, nor does it relate the size of a centre’s
income to the size of the investment.
Differences between ROI and RI are shown below:
Particulars ROI RI
Emphasis Percentage Ratio Money Amount
Involves same rate of return for Yes No
all assets?
Profit/Loss Relates to capital It is residual

Example ROI vs. RI

The department A of XYZ Ltd. has the following profit, capital employed
and imputed interest charges of 13% on the operating asssets.
Operating profit 30000
Operating assets 100000
Imputed interest (13%) 13000
Return on investment 30%
Residual Income 17000
Let’s assume that the department has proposed an additional investment
of 10000, which will increase the operating income in department A by
1500. The effect of the investment would be:
Operating profit 31500
Operating assets 110000
Imputed interest (13%) 14300
Return on investment 28.64%
Residual Income 17200
The manager A is made responsible for the performance of department
A. He would be interested for additional investment of 10,000 if he had
to judge on the basis of Residual Income as there would be marginal
increase of 200 from 17,000 to 17,200, but if the same investment is
judged on ROI basis then he would resist the additional investment as
ROI is reduced by 1.36% from 30% to 28.64%.
The marginal investment offers a return of 15% (1,500 on the additional
investment of 10,000), which is above the cut-off rate of 13%. The overall
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divisional performance will be reduced as the original ROI was 30%. To Notes
summarize, any additional investment which offers an annual accounting
rate of return of less than 30% would reduce the overall performance.

11.8 Economic Value Added (EVA)

EVA is a performance measurement system that aims to overcome the
limitations of other divisional performance measures which are based upon
accounting profit. The major shortcomings of relying upon accounting
profit include:
‹ Profit disregards the cost of equity capital. Companies can only
become wealthy when they produce a return greater than the return
demanded by equity and debt investors. The cost of debt financing
is considered in the financial statements when calculating profit,
but the cost of equity financing is not taken into account.
‹ Profits calculated in accordance with accounting standards are
susceptible to manipulation by accountants and do not accurately
reflect the wealth that has been created.
An alternative to accounting profit is economic profit and EVA is a
measure of economic profit.

Calculation of EVA
Economic profit is measured by economic value added. The Economic
Value Added is calculated as the difference between the Net Operating
Profit After Tax (NOPAT) and Opportunity Cost of Invested Capital. This
opportunity cost is calculated by multiplying the capital employed by the
Weighted Average Cost of Debt and Equity Capital (WACC).
EVA = NOPAT – WACC × Capital employed
Where,
NOPAT means net operating profit after tax. This profit figure shows
profits before taking out the cost of interest.
Two approaches to adjusting for interest are taken.
‹ Subtract the adjusted tax charge from the operating profit. Since the
tax charge includes the interest tax benefit, it should be adjusted. Since
the interest is a tax-deductible item, having interest in the income

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Notes statement means that the tax charge is lower. Since we are taking the
cost of interest out of the income statement, it is also necessary to
subtract the tax benefit of it from the tax charge. To do this, multiply
the interest by the tax rate, and add this to the tax charge, or
‹ Start with profit after tax, and add back the net cost of interest.
This is the interest charge multiplied by (1 – rate of corporate tax).

11.9 Limitations of EVA

‹ EVA is also, an absolute measure hence not free from shortcomings
like comparison between performances of enterprises of different
size is not possible, and
‹ Largely based upon historical data.

11.10 Non-Financial Performance Measures

Financial measures, as previously mentioned, have a number of flaws that
make them unsuitable for a system of effective performance management,
especially when used in isolation. These flaws include a short-term ori-
entation, historical nature, internal focus only (which does not comprise
the entire picture), and window dressing. A balance between financial and
non-financial measures must be maintained because profitability is crucial
in relation to stability (so that financial performance can be measured,
but in the context of long-term viability).
The following non-financial control measures should also be considered
for evaluation of divisional:
‹ Market position
‹ Productivity
‹ Product leadership
‹ Personnel department
‹ Employee attitudes
‹ Public responsibility
‹ Balance between short-range and long-range goals
Tools like balanced scorecard, performance pyramid, building block
model, and performance prism is capable to serve the purpose because
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these encompass non-financial performance measures apart from financial Notes

performance measures.

11.11 Balanced Scorecard

Information has become a crucial component in the business world today,
and it is essential for gaining a competitive edge over competitors. A com-
pany cannot survive in the information age’s competitiveness by making
only huge capital investments in cutting-edge technology for its physical
assets or by exercising excellent financial asset and liability management.
Both manufacturing and service entities need new capabilities to succeed
in the information age. An organisation must be able to mobilise and ex-
ploit its intangible or invisible assets in order to succeed. This is because
managing and investing in physical, tangible assets alone is not sufficient.
Intangible assets enable an organisation to:
‹ Maintain and further development in customer relationships to maintain
the loyalty of current clients and to effectively and efficiently serve
new client/market segments.
‹ Introduce goods and services in accordance with the preferences of
the targeted market and customer segments.
‹ Produce personalised, high-quality goods and services economically in
a short period of time.
‹ Mobilise employee skills and motivation in order to improve and
maintain consistency in the evaluation of process capabilities, quality,
and response times.
‹ Implement databases, information technology, and efficient management
information systems.
Balanced scorecard is a method that divides an organization’s performance
into four categories: financial, customer, internal, and innovative. The four
dimensions take into account both long-term and short-term objectives
while recognising the interests of shareholders, customers, and employees.
Kaplan and Norton classified performance measures into four business
‘perspectives’:
Financial Perspective: “How Do We Look to Shareholders?”

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Notes In this step, the manager of a division or unit connects the division’s or
unit’s business objectives to the company’s overall corporate strategy.
Financial performance measures exhibit whether the company’s execu-
tion of its strategy is generating revenue and profits. Managers inquire
“How do we look to shareholders” during strategic planning to identify
key performance measures from this perspective.
Corporate strategy and strategic initiatives are examined from the fi-
nancial perspective to see feasibility of these initiatives of being met.
The financial objectives chosen at the onset of the balanced scorecard
implementation should serve two purposes:
‹ To provide definite performance that was expected at the time of
strategies selection.
‹ To provide a focus for objectives and appropriate measures in each
of the other three perspectives.
Customer Perspective: “How Do Customer View Us?”
Companies identify the markets and customer segments in which they
compete as well as the ways in which they add value to these markets
and customers during this stage. Managers recognise the distinguishing
characteristics that set one business unit or product apart from others.
Depending on the market segment or the customer, the lead indicator
may change. For instance, on-time delivery becomes a lead indicator if
a customer values it. Various customer considerations, such as the fol-
lowing, are examples of lead indicators:
‹ On-time delivery
‹ On-site service
‹ After-sales support
‹ Defects per order
‹ Cost of the product
‹ Free shipments etc.
By delivering quality as per the customer demand and need, business units
can improve outcome measures such as customer satisfaction, retention,
acquisition and loyalty.
Internal Business Perspective: “At What Must We Excel?”

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Companies identify at this stage the procedures and actions required to Notes
accomplish the set objectives at the stage of the financial and customer
perspectives. By re-evaluating the value chain and making the neces-
sary adjustments to the current operating activities, these goals may be
accomplished. If a company’s financial goal is to maintain net earnings
and after-sales service can boost customer retention, internal business
perspective must improve after-sales services to meet customer demands
in order to preserve net earnings. For instance, offering toll-free customer
support lines and establishing service centres in all major cities are two
ways to accomplish this goal.
Learning and Growth Perspective: “How Do We Continue to Improve
and Create Value?”
The learning and growth perspective helps businesses identify the initia-
tives and support systems needed to foster long-term growth and meet
the goals outlined in the first three perspectives. The three main sources
of organisational learning and growth are as follows:
‹ People i.e. employee capabilities
‹ Systems i.e. information system capabilities and
‹ Organisational procedures i.e. motivation, empowerment and alignment.
Since the balanced scorecard aims to boost long-term performance,
managers may invest in short-term resources, but this shouldn’t have an
impact on the performance of the business unit.
An improved long-term financial performance should be the end result of
using the balanced scorecard strategy. Since the scorecard accords equal
weight to relevant non-financial measures, it ought to deter short-termism,
which results in spending reductions on new product development, human
resource development, etc., all of which are ultimately harmful to the
company’s future prospects.
Why Balanced Scorecard Fails to Provide for the Desired Results?
The following are some reasons why Balanced Scorecards sometimes fail
to provide for the desired results:
‹ Managers mistakenly think that since they already use non-financial
measures, they already have a Balanced Scorecard.
‹ Senior executives misguidedly delegate the responsibility of the
Scorecard implementation to middle level managers.
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Notes ‹ Companies try to copy measures and strategies used by the best
companies rather than.
‹ Developing their own measures suited for the environment under
which they function.
‹ There are times when Balanced Scorecards are thought to be
meant for reporting purposes only. This notion does not allow a
Business to use the Scorecard to manage Business in a new and
more effective way.

11.12 Performance Pyramid

K. F. Cross and R. L. Lynch, in the year 1989 published an article ‘The
SMART way to define and sustain success.’ In this article they suggest
Strategic Measurement Analysis and Reporting Technique (SMART) which
is popularly known as performance pyramids due to 4 level hierarchy
applied in the framework.

The attractiveness of this framework is that it integrates the business’

strategic objective with operational performance dimensions, consider the
internal efficiency vis-à-vis external effectiveness. Performance pyramid

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contains the hierarchy of financial and non-financial performance mea- Notes

sures divided into following four levels:
L-1 Through corporate vision, organisation defines how the long-term
success and competitive advantage will be attained.
L-2 In order to achieve corporate vision, the initial focus is on the
attainment of CSFs related to market and finance at SBU or
division level.
L-3 Market and financial strategies become a guiding force to achieve
a strategic objective, which includes Customer Satisfaction, In-
creased Flexibility and High Productivity.
L-4 Operational performance dimensions such as Quality, Delivery,
Cycle Time and Waste etc. will be used as status check to stra-
tegic objective designated at level 3.

11.13 The Building Block Model

Fitzgerald and Moon proposed a Building Block Model which suggests
the solution of performance measurement problems in service industries.
But it can be applied to other manufacturing and retail businesses to
evaluate business performance. It is based on the three building blocks
of dimensions, standards, and rewards.

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Notes Dimensions: Dimensions are the goals for the business, i.e. the CSFs
and suitable measures must be developed to assess each performance
dimension. They are further divided into two sub-categories.
Determinants: These are performance areas which influence the results.
These are:
‹ Quality: Consistently delivering goods and services is what quality
is. The eyes of the customer should be used to evaluate quality.
The level of benefits that customers anticipate from a product is its
quality. A product’s quality ought to be adequate for the price paid.
‹ Flexibility: This quality refers to the ability to adapt to changes in
the factors affecting business performance. For instance, the capacity
to handle a spike in sales demand.
‹ Innovation: The ability of a company to create new goods and
methods of operation, like environmentally friendly (recyclable)
product packaging.
‹ Resource Utilization: It is the capacity to utilise resources to
accomplish business goals. Business assets should be used in the
best possible way and for the intended purpose. For instance, only
loading delivery vans with approved goods and using them to their
fullest capacity.
Results: It reflects the success or failure of determinants identified above.
‹ Financial Performance: In monetary terms, financial performance
provides a quick indication of the state of the business as a whole.
You can use these to identify area of strengths and weaknesses. It
might also highlight other previously noted areas that are important
for business success.
‹ Competitive Performance: How do they compare to their rivals?
How do they differ from their rivals? For instance, offering products
with higher quality than rivals and products with unique features
from rival products.
Standards: These are the measures used, i.e. the KPIs, should have the
following characteristics:
Equity: All areas of the business should have performance measures that
are equally challenging. A business division receiving relaxation causes
the perception of unfair treatment, which reduces productivity.
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Ownership: Everyone should be able to accept the performance measure. Notes

Instead of forcing measures upon employees, they should be identified
with them. Ownership in this context refers to taking accountability for
the outcomes.
Achievable: Performance measure should be realistic. Employee will not
be motivated to achieve targets if he considers them impossible.
Rewards: To ensure that employees are motivated to meet standards,
the standards need to be clear and linked to controllable factors. Reward
schemes should possess the following characteristics:
Motivation: The design of the reward scheme should encourage employees
to meet the company’s objectives. If sales growth is desired then bonuses
can be tied to performance indicators, such as an increase in the number
of units sold over the previous year.
Clear: Employees should be informed in advance of the rewards pro-
gramme. How will their performance be evaluated and what kind of
performance will be rewarded?
Controllability: Employees should only be rewarded or penalized for the
results over which they have some control or influence.

11.14 Performance Prism

The creators of Performance Prism, Andy Neely and Chris Adams, not-
ed that the more well-known Balanced Scorecard framework only pays
attention to shareholders and customers. An approach to performance
management called the Performance Prism aims to successfully satisfy the
needs and demands of all stakeholders. This is in contrast to value-based
management, which puts the needs of shareholders first, as well as the
performance pyramid, which tends to focus on customers and shareholders.
‹ Instead of using the organization’s strategy as the foundation for
developing performance measures, it starts with the needs of the
stakeholders.
‹ It recognises the need to work with stakeholders to ensure that
their needs are met.
There are five ‘interrelated facets’ to the Performance Prism which lead
to key questions for strategy formulation and measurement design:

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Notes Stakeholders Satisfaction: The businesses need to concentrate on who

the stakeholders are? What are the stakeholders’ needs and desires?
Strategies: What strategies will the businesses need to implement in
order to satisfy the needs and wants of the stakeholders?
Processes: What are the necessary processes required for satisfying the
above strategies?
Capabilities: What capabilities are the businesses going to need in order
to run and improve the process?
Stakeholders Contributions: It also considers what the management
needs from its stakeholders in terms of contributions.

Comprehensiveness of Performance Prism

The Performance Prism enables organisations to create strategies, operational

procedures, and performance measure geared to the unique requirements
of all significant stakeholder groups. The Performance Prism enables an
organisation to more directly address the risks and opportunities in its
business environment by adopting a broad stakeholder perspective that
includes regulators and business communities. It is easier to communicate
with stakeholders and implement a strategy when measures are developed
using the PP for each important and relevant stakeholder.

11.15 Triple Bottom Line (TBL)

British business author John Brett Elkington in the year 1994 coined the
term TBL. But the origin of concept actually lies in Brundtland report

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by World Commission on Environment and Development, (now known Notes

as Brundtland Commission) published in the year 1987, in which Sus-
tainable Development is explained as development that meets the needs
of the present without compromising the ability of future generations to
meet their own needs.
It is also important here to note that United Nations Conference on En-
vironment and Development taken place in the year 1992, gave stress
on sustainable development.
To measure performance of business decision in economic terms we
consider only one bottom line i.e. profit, but to consider sustainability
of business decision there are three bottom lines i.e. People, Planet and
Profit (also known as dimensions of TBL).

TBL truly extends the scope of traditional accountancy, to transform it

into modern-day sustainability reporting (which is beyond financial re-
porting because it considers social and environmental performance too).
Some organisations even have separate business sustainability reporting
system and they apply the standard of sustainability reporting pronounced
by Global Reporting Initiative, Which is the independent, international
organization that helps businesses and other organizations take respon-
sibility for their impacts, by providing them with the global common
framework (standards) to report those impacts.

Dimension (sets) of TBL

Planet, the environmental bottom line measures the impact on resources,
such as air, water, ground and emissions to determine the environment
impact and ecological footprints.
People, the social equity bottom line relates to corporate governance,
motivation, incentives, health and safety, human capital development,
human rights and ethical behaviour.

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Notes Profit, the economic bottom line refers to measures maintaining or im-
proving the company’s success in term of adding value to shareholders.

11.16 Summary
Responsibility Accounting is defined as the collection, summarization,
and reporting of financial information where the accountability of certain
costs, revenue or assets of firm is held by individual manager.
Cost or Expense Centres are responsibility centres where the manager
‘has control over the costs’ (other than those of capital nature) owning
to function, for which he/she is responsible.
Revenue Centres are the responsibility centres where the manager has
‘control over the generation of revenue from operation’ with no respon-
sibility for costs.
Profit Centres are the responsibility centres where the manager of such
a centre or division has ‘control on both revenue and costs’ (other than
those, which are of capital nature) earned out of and incurred on.
Investment Centres are the responsibility centres where the manager has
responsibility for not just the revenues and costs relating to the centre,
but also the assets that cause these costs and generate these revenues and
the investment decisions relating to disposal and acquisition of assets.
Financial Performance Measures
‹ Return on Investment (RoI)
‹ Residual Income (RI)
‹ Economic Value Added (EVA)

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Non-Financial Performance Measures Notes

‹ Balanced Scorecard
‹ Performance Pyramid
‹ The Building Block Model
‹ Performance Prism
‹ Triple Bottom Line (TBL)

11.17 Self-Assessment Questions

1. Explain the concept of Responsibility Accounting.
2. What are different Responsibility Centres?
3. Explain the different Financial Performance Measures.
4. Write a short note on:
(i) Economic Value Added (EVA)
(ii) Balanced Scorecard
(iii) Performance Pyramid
(iv) The Building Block Model
(v) Performance Prism
(vi) Triple Bottom Line (TBL)
5. Supply the missing data in the following table:
Particulars Division A Division B Division C
Sales Rs. 60,000 Rs. 75,000 Rs. 1,00,000
Operating Income (a) Rs. 25,000 (e)
Operating Assets Rs. 30,000 (c) Rs. 50,000
Return on Investments (ROI) 15% 10% 20%
Minimum required rate of return 10% (d) (f)
Residual Income (RI) (b) Rs. 5,000 0

11.18 References and Suggested Readings

‹ Maheshwari, S. N., & Mittal, S. N. Cost Accounting: Theory and
Problems. Shree Mahavir Book Department.
‹ Arora, M. N. Cost Accounting - principles and practice. Vikas
Publishing House.
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 MANAGEMENT ACCOUNTING

Notes ‹ Maheshwari, S. N., Maheshwari, S. K., Mittal, S. N. Cost Accounting:

Principles & Practice. Shree Mahavir Book Depot.
‹ Nigam, B. M. Lal & Jain, I. C. Cost Accounting: Principles and
Practice. PHI Learning.
‹ Mitra. Cost and Management accounting. Oxford University Press.

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 Glossary

Absorption Costing: The process of charging all costs, both variable and fixed, to oper-
ations, products or process is known as absorption costing.
Activity-based Costing (ABC): Assigns overhead and indirect costs—such as salaries and
utilities—to products and services.
Aggregation: It is the sum total of all.
Allocation of Expenses: It means assigning a particular expense to a particular unit.
Ascertainment: It means to find out something.
Attain: To attain anything is to achieve something.
Backflushing: Used in perpetual inventory systems. Periodic inventory management is
still used by small organisations with few goods.
Batch Costing: A type of specific job order costing where articles are manufactured in
fixed predetermined lots, known as batch.
Break-even Analysis: Actually a method to apply the CVP analysis in decision making
process by including many more related concepts into it.
Cash Received: It is ascertained by deducting the retention money from the value of
work-certified.
Contract Costing: A form of job order costing where job undertaken is relatively large
and normally takes period longer than a year to complete.
Correlation: The relationship between two factors or variables under study.
Cost Management: Estimates, allocates, and controls project costs.
Cost of Work Certified: The expert certifies the work completion in terms of percentage
of total work. This value is known as Cost of work certified.
Cost of Work Uncertified: In every Contract there always will be some work which has
been carried out by the contractor but has not been certified by the expert as its degree
of completion can’t be ascertained or too low. It is always shown at cost price. This is
known as Cost of work uncertified.
Costing Systems: The systematic allocation of cost to products by following one or the
other available and suitable technique.

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Notes Cost-plus Contract: A contract in which the contract price is determined

by adding a specified amount or percentage of profit to the costs incurred
in the contract. In such contract agreements, the contractee undertakes to
pay to the contractor the actual cost of contract plus a stipulated profit.
Costs: Price paid for something.
Cost-Volume-Profit (CVP): The systematic study of relationship between
cost of the product, volume of activity and the resultant profit.
Deviation: It shows the amount of difference between the two things.
Differential Costs: The difference in total costs between two alternatives.
Equivalent Production: Converting incomplete production into equivalent
level of completed units.
Escalation Clause: As per this clause, the contractor increases the con-
tract price if the cost of materials, employees and other expenses increase
beyond a certain limit.
Estimated Profit: It is the excess of the contract price over the estimated
total cost of the contract.
Fixed Overhead Variance: It is variation between the standard fixed
overhead and the actual fixed overhead.
Ideal Standard: It is a standard that has been fixed under ideal circum-
stances.
Irrelevant Costs: Those which would not be effected by the decision.
JIT Inventory Management: Connects supplier raw-material orders with
production schedules.
Job Costing: A system of costing in which costs are ascertained in
terms of specific jobs or orders which are not identical or comparable
with each other.
Life Cycle Costing: Life cycle costing costs the cost object—product,
project, etc.—over its predicted lifespan. Describes a system that tracks
and aggregates cost object costs and profits from inception through
abandonment.
Marginal Costing: The process of ascertaining marginal (additional) costs
and the effect of changes in volume of output on profit.

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 Glossary

Notional Profit: It represents the difference between the value of work Notes
certified and cost of work certified.
Opportunity Cost: This cost means the value of benefit sacrificed in
favour of an alternative course of action.
Progress Payment: The contactor enters into an agreement with the
contractee and agrees on payment on some reasonable basis, which is
generally calculated as a percentage of work certified.
Relevant Costs: The costs which would be impacted by managerial de-
cisions. They are the future cost whose magnitude will be effected by
a decision.
Remedial Action: The corrective action which needs to be taken in the
case of deviation.
Retention Money: This security money upheld by the contractee is known
as retention money.
Sales Value Variance: It is the difference between actual overhead vari-
ances sales and budgeted sales.
Scrap: Waste material from manufacturing process.
Split-off Point: Location in the production process where jointly manu-
factured products will be henceforth manufactured separately.
Standard Cost: Pre-specified cost of any product or service.
Standard Costing: A method of cost accounting that compares each
product per service standard cost with that of the actual cost for deter-
mining the effectiveness of a company.
Standard Hour: The output quantity that must be produced in an hour.
Target Audience: A group of people who will become our potential
customers.
Target Costing: Market-driven design entails calculating a product’s cost
and designing it to match it.
Tooling: Tooling up for production can entail establishing a production
line costing several millions of rupees, manufacturing expensive jigs,
buying special purpose machine tools, or otherwise making a substantial
expenditure.

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Notes Traditional Cost: Accounting reports cost object profitability regularly,

quarterly, and annually.
Valuation: Judgement on worth of something.
Value Chain Analysis: The value chain is a company’s internal procedures
to “create, develop, sell, deliver, and support its product”.
Variable Overhead Variance: The variation between the actual overhead
and standard variance overhead.
Variances: The difference between the actual costs and the pre-deter-
mined costs.
Work-in-Progress: In contract costing refers to the cost of the contract
which is not complete at the reporting date.

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