CHAPTER 1 BASIC COST CONCEPTS 1. BASICS 1. Define · PDF fileAbhimanyyu Agarrwal Jai Mata Di 9874311319 Page 1

Abhimanyyu Agarrwal Jai Mata Di

9874311319 Page 1

CHAPTER 1

BASIC COST CONCEPTS

1. BASICS

1. Define the term “Cost”.

1) Meaning of Cost:

(a) Cost refers to the expenditure incurred in producing a product or in rendering a

service.

(b) Cost is a measurement, in monetary terms, of the amount of resources used for the

purpose of production of goods or rendering services.

(c) Cost is expressed from the producer or manufacturer’s viewpoint, (i.e. not that of

consumer / end user).

(d) Cost ascertainment is based on uniform principles and techniques.

2. Define the terms “Costing”, “Cost Accounting” and “Cost Accountancy”.

1) Costing: The technique and process of ascertaining costs.

2) Cost Accounting: The process of accounting for cost which begins with recording of

income and expenditure or the bases on which they are calculated and ends with the

preparation of periodical statements and reports for ascertaining and controlling costs.

3) Cost Accountancy: The application of costing and cost accounting principles, methods

and techniques to the science, art and practice of cost control and the ascertainment of

profitability. It includes the presentation of information derived there from for the

purpose of managerial decision-making.

3. List the objectives of Cost Accounting

The primary objective of study of cost is to contribute to profitability through Cost Control

and Cost Reduction. The following objectives of Cost Accounting can be identified –

1) Ascertainment of Cost: This involves collection of cost information, by recording them

under suitable heads or account, and reporting such information on a periodical basis.

2) Determination of Selling Price: Selling Prices are influenced by internal and external

factors. However, generally, prices cannot be fixed below cost. Hence, Cost Accounting

is required for determination of appropriate Selling Prices.

3) Ascertaining the profit of each activity: Profit of each department / activity / product

can be determined by comparing its revenue with appropriate cost. So, Cost Accounting

ensures profit measurement on an objective basis.

4) Assisting Management in decision – making: Business decisions are taken after

analyzing cost and benefits of each option, and the Manager chooses the least cost option.

Thus, Cost Accounting and reporting system assists Managers in their decision – making

process.

5) Cost Control and Cost Reduction: In the long run, higher profits can be achieved only

through Cost Control and Cost Reduction. Cost Accounting seeks to ensure profit by

providing support for cost control / reduction decisions.

4. Distinguish between Cost Reduction and Cost Control.

Particulars Cost Reduction Cost Control

1. Permanence Permanent, Real and genuine savings

in cost.

Could be a temporary saving

also.

2. Saving Focus Saving in Cost per unit. Saving either in Total Cost

or Cost per unit.

3. Product

Quality

Product’s Utility, Quality &

Characteristics are retained.

Quality Maintenance is not a

guarantee.


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4. Performance

Evaluation

It is not concerned with maintenance

of performance according to

standards.

The process involves setting

up a target, investigating

variances and taking

remedial measures to correct

them.

5. Nature of

Standards

Continuous process of critical

examination includes analysis and

challenge of standards.

Control is achieved through

compliance with standards.

Standards by themselves are

not examined.

6. Dynamism Fully dynamic approach. Less dynamic than Cost

Reduction.

7. Coverage Universally applicable to all areas of

business. Does not depend upon

standards, though target amounts may

be set.

Limited applicability to

those items of cost for which

standards can set.

8. Nature of

Costs

Emphasis here is partly on present

costs and largely on future costs.

Emphasis on present and

past behavior of costs.

9. Analysis To find out substitute ways and new

means.

Competitive analysis of

actual results with

established norms.

10. Nature of

Function

(a)Value Engineering, (b)

Standardization and Simplication, (c)

Work Study, (d) Variety Reduction,

(e) Quality Measurement & Research,

(f) Operations Research, (g) Market

Research, (h) Job Evaluation and

Merit Rating, (i) Improvement in

Product Design, (j) Mechanisation and

Automation, etc.

Budgetary Control and

Standard Costing.

5. Compare Cost Accounting with Financial Accounting. Does Cost Accounting

supplement Financial Accounting? Discuss.

The broad areas of difference between Financial and Cost Accounting are –

Particulars Financial Accounting Cost Accounting

1. Users of

Information

Financial Statements are used by

Internal management and also

outside parties like Government,

Creditors, Customers, Employees,

etc.

Detailed cost information is

presented to internal management

for proper planning, decision –

making and cost control.

2. Statutory

Compliance

Requirements of Statutes like

Companies Act, Income Tax Act,

etc. are met through Financial

Accounting.

Generally Cost Accounting is

voluntary, except in cases where

Cost Accounting Records Rules

mandatorily apply to the

enterprise.

3. Nature /

Objectivity

Transactions are recorded in a

subjective manner. Accounting

Policies may differ from one Firm

to another Firm.

Expenditure is recorded in an

objective manner. Costing

principles and techniques are

generally uniform to all Firms.

4. Focus Focus of accounting is on recording

the transactions.

Focus of accounting is to control

cost.

5. Nature of

Cost

Generally Historical Costs are used

for recording purposes. Projected

Financial Statements may also be

drawn for budgeting purposes.

It considers both historical costs

and predetermined, i.e. Standard

Costs. It also extends to plans and

policies to improve future


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performance.

6. Stock

Valuation

Stocks are valued at Cost or Net

Realisable Value whichever is less.

Stocks are valued generally at

Cost.

7. Cost

Analysis

Cost / Expenditure and Profits are

generally shown as a whole for the

period.

Costs are analysed product – wise,

department – wise, activity – wise,

etc.

8. Time Period Financial Statements are generally

prepared at the end of the financial

period, usually one year, for

reporting purposes.

Cost data and reports are

presented on a continuous basis

for the Cost Period. The cost

period (also called Control Period)

may be shorter than the financial

year.

9. Forecasting

& Planning

Has limited use for forecasting and

planning. Only broad parameters

like GP, NP, ROI, EPS, etc. can be

laid down.

Specific and detailed plan for each

product / activity / sub – level can

be laid down. Hence, more useful

for budgeting.

10. Utility for

decisions

Helps only for future decisions with

respect to product pricing, make or

buy, asset retainment vs

replacement, etc.

Helps Current & future decisions,

e.g. product price reduction and

higher volume in order to earn

target profit, resource re –

allocation, etc.

11. Control and

Assessment

Financial Accounting suffers from

limitations of lack of analysis of

information, and absence of

detailed control and assessment

parameters.

Better tools of control, analysis

and assessment are available,

some examples are Variance

Analysis, Budgetary Control, &

Marginal Costing.

Note: Cost Accounting supplements Financial Accounting for analysis and decision – making

purposes, as described above.

COST CLASSIFICATION BASES

6. How are Costs analysed based on Behaviour / Nature / Variability?

Time – Period based

Current

Historical

Pre – determined

Variability based

Fixed

Variable

Semi –

variable

Elements based

Materials

Labour

Expenses

Relationship based

Direct

Indirect

Functions – based

Production

Administration

Selling

Distribution

R & D

Pre – production

Conversion

Controllability based

Controllable

Non – Controllable

Normality based

Normal

Abnormal

Payment – based

Explicit

Implicit

Cause & Effect based

Engineered

Discretionary

Decision – making

based

Relevant

Irrelevant

Attributabillity

based

Product

Period

COST


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On the basis of Behaviour / Nature / Variability, Costs are classified as under –

Type and Description Examples

1. Fixed Cost is the cost which does not vary with the change in

the volume of activity in the short – run. These costs are not

affected by temporary fluctuation in activity of an enterprise.

These are also known as Period Costs.

Salaries, Rent, Insurance,

Audit Fees, Depreciation,

etc.

2. Variable Cost is the cost of elements which tends to directly

vary with the volume of activity. Variable Cost has two parts –

(a) Variable Direct Cost, and (b) Variable Indirect Costs.

Variable Indirect Costs are termed as Variable Overhead.

Materials Consumed,

Direct Labour, Sales

Commission, Utilities,

Freight, Packing, etc.

3. Semi Variable Costs contain both fixed and variable

elements. They are partly affected by fluctuation in the level

of activity.

Factory Supervision,

Maintenance, Power,

Telephone, etc.

7. How are Costs classified on the basis of Elements?

On the basis of elements, Costs are classified as under –

Type and Description Explanation

1. Material Cost is the cost of

material of any nature used for

the purpose of production of a

product or a service.

Material Cost includes cost of Procurement,

Freight Inwards, Taxes & Duties, Insurance, etc,

directly attributable to the acquisition.

Trade Discounts, Rebates, Duty Drawbacks,

Refunds on account of MODVAT, CENVAT,

Sales Tax and other similar items are deducted

in determining the costs of material.

2. Labour Cost means the

payment made to the employees,

permanent or temporary, for

their services. (N 01)

Labour Cost includes Salaries and Wages paid

to permanent employees, temporary employees

and also to employees of the contractor.

Salaries & Wages include all Fringe Benefits

like PF Contribution, Gratuity, ESI, Overtime,

Incentives, Bonus, Ex-Gratia, Leave

Encashment, Wages for Holidays and Idle Time,

etc.

3. Expenses are other than Material

Cost or Labour Cost, which are

involved in an activity.

Expenditure on account of utilities, payment for

bought – out services, job processing charges, etc. can

be termed as Expenses.

8. How are Costs classified on the basis of Relationship?

Based on Relationship, costs are classified into –

Type and Description Components

1. Direct Costs:

Costs which are directly related to / identified with /

allocated to a Cost Centre or a Cost Object, in an

economically feasible way, are called Direct Cost.

Total of all Direct Costs is called Prime Cost.

Direct Material Cost,

Direct Labour Cost, and

Direct Expenses.

2. Indirect Costs:

All Costs other than Direct Costs are called Indirect Costs.

Total of all Indirect Costs is called as Overheads (or

Oncost), since they are generally incurred over various

products (Cost Units), various departments (Cost Centres)

and over various heads of expenditure accounts.

Indirect Material,

Indirect Labour, and

Indirect Expenses.

A summary of Direct and Indirect Costs is given below –


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Item and Description Example

1. Direct Material: Costs of Material which can

be directly allocated to a Cost Centre or a Cost

Object in an economically feasible way.

Raw Materials Consumed for production for

a product or service, which are identifiable

in the product or service.

2. Direct Labour: Cost of Wages of workers

who are readily identified or linked with a

Cost Centre or Cost Object.

Wages include all Fringe Benefits like PF

Contribution, Gratuity, ESI, Overtime,

Incentives, Bonus, Ex – Gratia, Leave

Encashment, Wages for holidays and idle

time, etc.

3. Direct Expenses: Expenses other than Direct

Material or Direct Labour, which can be

identified or linked with the Cost Centre or

Cost Object.

Expenses for special moulds used in a

particular Cost Centre, Hire Charges for

tools & equipments for a Cost Centre,

Royalties in connection to a product, Job

Processing Charges, etc.

4. Indirect Material: Cost of Material which

cannot be directly allocable to a particular

Cost Centre or Cost Object.

Consumable Spares and Parts, Lubricants,

etc, i.e. materials which are of small value

and cannot be identified in or allocated to a

product / service.

5. Indirect Labour: Wages of Employees which

are not directly allocable to a particular Cost

Centre.

Salaries of Staff in the Administration and

Accounts Department, Salaries of Security

Staff, etc. (N 01)

6. Indirect Expenses: Expenses other than of

the nature of Material or Labour, and cannot

be directly allocable to a particular Cost

Centres.

Insurance, Taxes and Duties, etc. not being

allocable to a particular Cost Centre.

9. Distinguish between Controllable & Uncontrollable Costs.

One the basis of controllability, Costs are classified into –

1) Controllable Costs: These are costs which can be influenced and controlled by managerial

action.

2) Non – Controllable Costs: These are costs that cannot be influenced and controlled by a

specific member(s) of the organization.

Note: The line of difference between controllable and non – controllable costs is very thin. No

cost is uncontrollable. Controllability is a relative term and is subject to the following factors –

(a) Time: Certain costs are controllable in the long – run and not in the short – run.

(b) Location: Certain costs are not influenced and decided at a particular location / cost centre.

For example, if rent agreements of all factory premises are executed centrally at the Head

Office, Factory Mangers cannot control the incurrence of Rent Cost.

(c) Product / Output: Certain costs are controllable by reference to one product or market

segment and not by reference to the other. For example, some products require more

advertising and sales promotion efforts than other products.

10. How are Costs classified on the basis of Normality?

On the basis of Normality / Expectation, Costs are classified into –

Type Description Treatment

1. Normal

Cost Costs which can be reasonably expected to be

incurred under normal, routine and regular

operating conditions.

Cost that is normally incurred at a given of

output in the conditions in which that level of

output is achieved.

They are included in

the Cost Sheet as

regular cost and used

for decision - making

purpose.

2. Abnormal Costs over and above normal cost, which is not They are not


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Cost incurred under normal operating conditions, e.g.

fines and penalties, abnormal wastages, etc.

Unusual or a typical cost whose occurrence is

usually irregular and unexpected and due to some

abnormal situation of production.

considered in the cost

of production for

decision – making,

and are charged to

Profit & Loss A/c.

11. Distinguish between Product Cost and Period Cost.

Why should Product Costs be computed?

On the basis of attributability to the product, Costs are classified as under –

Particulars Product Cost Period Cost (N 08)

1. Meaning These are costs which are assigned to the

product and are included in inventory

valuation. These are also called as

Inventoriable Costs.

These are costs which are not

assigned to the products but

are charged as expenses

against the revenue of the

period in which they are

incurred.

2. Examples Manufacturing Costs, e.g. Cost of Raw

Materials, Direct Wages, Production OH,

Depreciation of Plant, Equipments, etc.

Non – Manufacturing Costs,

e.g. General Administration

Costs, Salesmen Salary,

Depreciation of Office

Assets, etc.

3. Inclusion in

Inventory

Valuation

These are included in inventory valuation.

They are treated as assets till the goods to

which they are assigned are actually sold.

These are not included in

Inventory Valuation. They

are written off as expense in

the period in which they are

incurred.

Note:

Absorption vs Marginal Costing: Under Absorption Costing System, Total

Manufacturing Costs (i.e. Variable and Fixed) are regarded as Product Costs. However,

under Marginal Costing system, only variable Manufacturing Costs are considered as

Product Costs.

Purposes of computing Product Costs are as under –

(a) Preparation of Financial Statements – focus on Inventory Valuation and reporting

profits.

(b) Product Pricing – focus on costs assigned & incurred on the product till it is made

available to customer / user.

(c) Cost – plus – Contracts with Government Agencies – focus is on reimbursement

of costs specifically assigned to the particular job / contract.

12. List the various items of costs on the basis of relevance to decision-making.

On the basis of relevance to decision – making, Costs are classified into (A) Relevant, and (B)

Irrelevant Costs.

(A) Relevant Costs: These are costs which are relevant and useful for decision – making

purposes.

1) Marginal Cost: Marginal Cost is the total Variable Cost, i.e. Prime Cost plus Variable

Overheads. It is assumed that variable Cost varies directly with production whereas Fixed

Cost remains constant irrespective of volume of production. Marginal Cost is relevant for

decision – making, as this cost will be incurred in future for additional units of production.

2) Differential Cost: It is the change in costs due to change in the level of activity or pattern or

method of production. Where the change results in increase in cost it is called Incremental

Cost, whereas if costs are reduced due to decrease of output, the difference is called

Decremental Costs.


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3) Opportunity Cost: This refers to the value of sacrifice made or benefit of opportunity

foregone in accepting an alternative course of action. For example, a Firm may finance its

expansion plan by withdrawing money from its bank deposits. Then, interest lost on the Bank

Deposit is the opportunity cost for carrying out the expansion plan. Similarly, if a person quits

his job and enters into business, the salary forgone from employment constitutes opportunity

cost. Opportunity Cost is a relevant cost where alternatives are available. However,

opportunity cost is not recorded in formal accounts and is computed only for decision –

making and analytical purposes.

4) Out – of – pocket Costs: These are costs which entail current or near future outlays of cash

for the decision at hand. Such costs are relevant for decision – making, as these will occur in

near future. This cost concept is a short – run concept and is used in decisions relating to

fixation of selling price in recession, make or buy, etc. Out – of – pocket Costs can be avoided

or saved, if a particular proposal under consideration is not accepted.

5) Replacement Cost: It is the cost at which there could be purchase of an asset or material

identical to that which is being replaced or revalued. It is the cost of replacement at current

market price and is relevant for decision – making.

6) Imputed Costs: These are notional costs appearing in the cost accounts only, e.g. notional

rent charges, interest on capital for which no payment has been made. Where alternative

capital investment projects are being evaluated, it is necessary to consider the imputed interest

on capital before a decision is arrived at, as to which is the most profitable project. These

costs are similar to Opportunity Costs.

(B) Irrelevant Costs: These are costs which are not relevant or useful for decision – making.

1) Sunk Cost: It is a cost which has already been incurred or sunk in the past. It is not relevant

for decision – making. Thus, if a Firm has obsolete stock of materials originally purchased for

Rs.50,000 which can be sold as scrap now for Rs.18,000 or can be utilized in a special job,

the value of stock already available Rs.50,000 is a sunk cost and is not relevant for decision –

making. (N 00, M 03, M 05)

2) Absorbed Fixed Cost: Fixed Costs do not change due to increase or decrease in activity.

Although such Fixed Costs are absorbed in cost of production at a normal rate, they are

irrelevant for managerial decision – making. However, if Fixed Costs are specific, they

become relevant.

3) Committed Cost: It is a cost in respect of which decision has already been taken, and such

decision cannot be altered, e.g. entering into irrevocable agreements for Rent, Technical

Collaboration, etc. Committed Costs are not relevant for decision – making. This should be

contrasted with Discretionary Costs, which are avoidable costs.

13. Write short notes on explicit and Implicit Costs.

Define Explicit Costs. How is it different from Implicit Costs?

Particulars Explicit Costs Implicit Costs

1. Meaning Costs which involve some cash

payment or outflow of resources.

Cost which do not involve any

cash payment at all.

2. Also known as Out – of – Pocket Costs. Economic / Notional / Imputed

Costs.

3. Measurement These are actually incurred,

and hence can be easily and

objectively measured.

They are not actually incurred.

They cannot be easily measured

and involve subjective

estimation.

4. Recording in books Recorded in books of account. Not recorded in books of

account.

5. Purposes Accounting, Reporting, Cost

Control & Decision Making.

Decision – Making like asset

replacement, make or buy, etc.

6. Examples Salaries, Wages, Advertisement,

etc.

Interest on own Capital, Rent of

own premises, Salary of


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Proprietor, etc. which are not

actually paid.

Note: Depreciation is considered as “Deemed Explicit Cost”, since the cost of Assets purchased (by

making a cash outlay in the past) is written off / apportioned during the life – time of those assets.

14. Enumerate the types of costs on the basis of Functions.

On the basis of Functions to which they relate, Costs are classified as under –

1) Production Cost: The cost of the set of operations commencing with supply of materials,

labour and services and ending with the primary packing of product. Thus it is equal to the

total of Direct Materials, Direct Labour, Direct Expenses and Production Overheads. In a

wider sense, it includes all Direct Costs and all Indirect Costs related to the production

(including Research and Development Cost apportioned, if any)

2) Administration Cost: The cost of formulating the policy, directing the organization and

controlling the operations of the undertaking, which is not directly related to Production,

Selling, Distribution, Research or Development activity or function. Examples: Office Rent,

Accounts and Secretarial Department Expenses, Audit and Legal Expenses, Directors

Remuneration, etc. (N 96)

3) Selling Cost: The cost of seeking to create and stimulate demand and of securing orders.

These are also called Marketing Costs. Examples: Market Research, Advertisement, Salaries,

Commission and Travel Expenses of Salesmen, Show – room Expenses, Cost of Samples, etc.

(N 99)

4) Distribution Cost: The cost of the sequence of operations which begins with making the

packed product available for dispatch and ends with making the reconditioned returned empty

package, if any, available for re – use. Examples: Distribution Packing (secondary packing),

Carriage Outwards, Maintenance of Delivery Vans, cost of transporting articles to central or

local storage, cost of moving articles to and from prospective customers (as in Sale or

Return), cost of warehousing saleable products, etc. (N 99)

5) Research Cost: Cost of development of new product and manufacturing process,

improvement of existing products, process and equipment, finding new uses for known

products, solving technical problems arising in manufacture and application of products, etc.

(N 92, M 96, N 98, N 00) 6) Development Cost: The cost of the process which begins with the implementation of the

decision to produce a new improved product, or to employ a new or improved method and

ends with commencement of formal production of that product or by that method, i.e. cost

incurred for commercialization / implementation of research findings. (N 92, M 96, N 98,

N 00) 7) Pre – Production Cost: The part of Development Cost incurred in making a trial production

run prior to formal production. (N 00)

8) Conversion Cost: The total of Direct Wages, Direct Expenses and Production Overhead,

Cost of converting Raw Materials to the finished stage or converting a material from one

stage of production to the other. (M 03)

Special Note as regards Distribution Costs:

Primary Packaging Cost is included in Production Cost. Secondary Packaging Cost is

Distribution Cost.

In exceptional cases, e.g. in case of Heavy Industries Equipment supply, installation cost at

delivery site for Heavy Equipments which involves assembling of parts, testing, etc is

included in Production Cost but not Distribution Cost. For example, Installation Cost of a

Gas Turbine at Plant Site is included in the Cost of Production of Gas Turbine.

15. What is a Cost Centre? Discuss the various types of Cost Centres.

1) Cost Centre: It is defined as –


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(a) A location – e.g. Chennai Factory, Kolkata Factory, etc.

(b) A person – e.g. Sales Manager L, M, etc.

(c) An item of equipment – e.g. Machinery P, Q or Process I, II, etc.

Or a group these, for which cost may be ascertained and used for the purpose of Cost

Control.

2) Classification : cost Centres can be classified as under –

(a) Based on Type:

Personal Cost Centre Impersonal Cost Centre

It consists of a person or group of persons. It consists of a location or an item

equipment (or group of these).

(b) Based on Role:

Production Cost Centre Service Cost Centre

It is a Cost Centre where Raw Material is

processed and converted into Finished

Product.

It is a Cost Centre which serves as an

ancillary unit and renders services to a

Production Cost Centre.

Here, both Direct and Indirect Costs are

incurred.

Here, only Indirect Costs are incurred.

There are no Direct Costs, as there is no

measurable and saleable output.

Examples: Machine Shops, Welding

Shops and Assembly Shops, etc.

Examples: Power – House, Gas Production

Plant, Material Service Centres, Plant

Maintenance Centres, etc.

(c) Based on Activity:

Operation Cost Centre Process Cost Centre

It consists of machines and / or persons,

carrying out similar operations.

It consists of machines and / or persons,

engaged on a specific process or a

continuous sequence of operations.

All machines / operators performing the

same operation are brought together under

a Cost Centre, the purpose being

ascertainment of cost of each operation

irrespective of its location inside the

factory.

Cost is analysed and related to a series of

operations in sequence. Generally, these

constitute a single location, as in Oil

Refineries and other process industries.

16. Define a Cost Unit. Give suitable illustrations.

1) Cost Unit is a unit of production, service or time or combination of these, in relation to which

costs may be ascertained or expressed. It should be one with which expenditure can be most

readily associated.

2) Cost Unit is a form of measurement of volume of production or service. This unit is generally

adopted on the basis of convenience and practice in the Industry concerned.

3) Cost Units differ from one business to the other. They are usually units of physical

measurement, e.g. number, weight, area, volume, time, length and value.

17. Define a Cost object. Give suitable illustrations.

1. Cost object is anything for which a separate measurement of cost is desired.

2. Cost object is defined as any unit of Cost Accounting selected with a view to accumulating all

cost under that unit.

3. Cost objects may be a product, a service, a project, a customer, a brand category, an activity, a

programmed, a division or department, a group of Plant and Machinery, a group of employees

or a combination of several units.


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18. Write short notes on the various methods of costing.

Businesses vary in their nature and in the type of products or services they produce. Hence,

different methods of cost ascertainment are used in different businesses. Costing methods to

be employed are determined based on – (a) the method of production and (b) the unit of cost

used. The various methods of costing are –

METHODS OF COSTING

For Goods For Services- Operating Costing

Specialized Production Standardised Production

Job Batch Contract Single / Unit Process / Joint

Costing Costing Costing /Output Operation and By-

Costing Costing Product

Costing

Work is

undertaken

on receiving

a customer’s

order /

assignment.

Output under a

Job consists of

similar units, it

is not feasible

to ascertain

cost per unit.

Execution of

work is

distributed

over two or

more

financial

years.

Product(s) is

produced

from single

process.

One product is

produced from

a series of

sequential

processes.

Many

products are

produced

from many

sequential &

parallel

processes.

Multiple Costing: It represents a combination of two or more methods of costing given above. For

example, if a Company manufactures Cars including its components, the component parts will be

costed by Batch Costing System, but the cost of assembling the Car will be computed by the Single or

Output Costing method. The whole system of costing is known as Multiple Costing.

The following table summarizes the various methods of costing applied in different industries-

Nature of Output Method Cost Ascertainment Examples of Industries

A. Based on

customer

specifications:

- Single Unit Job Costing For each order / job /

assignment.

Automobile Workshops,

Interior Decoration, etc.

- No. of similar

units

Batch costing For each batch / lot of

units produced.

Pharmaceuticals, Printing

Press i.e. visiting cards,

invitations, etc.

- Execution of

works

Contract Costing For each contract. Roads, Brickworks,

Colliery, Paint

Manufacturing, etc.

B. Similar units of

single product,

from:

- Single Process

(N 95)

Unit or Output

or Single Costing

For the entire activity,

but averaged for the

output.

Quarries, Brickworks,

Colliery, Paint

Manufacturing, etc.

- Series of

Processes

Process or

Operation

For each process or

operation.

Oil Refining, Breweries,

etc.


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Costing

C. Multiple

varieties of

activities and

processes

Multiple Costing Combination of any of

the methods listed

above.

Production of TVs,

Computers etc, Automobile

Assembly.

D. Rendering

Services

Operating

Costing

For every type of

service (no identifiable

tangible cost unit).

Transport, Hotels, Cinema,

Banks, Hospitals,

Professional Institutions,

etc.

19. List the Method of Costing and Cost Unit applicable for the following industries.

Industry Method of Costing Unit of Cost

1. Interior Decoration Job Per Job

2. Advertising Job Per Job

3. Toy Making Batch Per Batch

4. Pharmaceuticals Batch / Unit Per Unit / Box

5. Ship Building Contract Per Ship

6. Bridge Construction Contract Per Contract

7. Cement Unit Per Tonne or Per Bag

8. Coal Single / Unit Per Tonne

9. Brick Works Single / Unit Per 1,000 Bricks

10. Steel Process Per Tonne

11. Oil Refining Process Per Tonne

12. Soap Process Per Unit

13. Sugar Company having own

sugarcane fields

Process Per Tonne or Per Quintal

14. Hospital / Nursing Home Operating Per Patient-Day or Room-Day

15. Road Transport Operating Per Tonne-Km / Passenger- Km

16. Radio Multiple Per Unit or Per-Batch

17. Bicycles Multiple Per Unit or Per Batch

18. Furniture Multiple Per Unit

20. Write short noted on Direct Expenses.

1. Direct Expenses or Chargeable Expenses: These are expenses other than materials and

labour which can be allocated directly to jobs, products, processes, cost centers’ or cost

units. Direct Expenses are “cost other than material and wages which are incurred for a

specific product or saleable services”.

2. Nature of Direct Expenses: (a) These are expenses other than Direct Materials and

Direct Labour, (b) These are either allocated or charged completely to Cost Centres or

Cost Units, (c) These are included in the Prime Cost of a product.

3. Examples:

(a) Hire Charges of special machinery

or plant for a particular production

order or job.

(b) Payment of Royaties.

(c) Cost of special moulds, designs &

patterns.

(d) Sub-Contracting Expenses or

outside work costs, where jobs are

sent out for special processing.

(e) Experimental cost before

undertaking the job.

(f) Travel & Conveyance Expenses for

a particular job.

4. Documentation: The basic document which is used for charging of Direct Expenses to

products or batches or work order, is the Invoice received from Suppliers of such service.

The payment to supplier of service is made on the basis of the Invoice, and the expenses

are booked in the accounts.


9874311319 Page 12

5. Identification of Direct Expenses: For the identification of Direct Expenses with the

main product or service, the code number of that product or service should be inscribed

on invoice received from supplier of services. For example, if a machine is hired to

complete a particular product, then the Hire Charges paid for that machine is a Direct

Expenses of that particular product. For charging these Hire Charges to that particular

product, the invoice / bill received towards Hire Charges should be coded / inscribed with

the Product Code, to ensure that this expense is charged to that particular product.

Alternatively, if cash is paid, then the Cash Book Analysis will show the Product Code

which is to be charged with the cost of hiring machinery.

CHAPTER 2

MATERIALS

1. What is Just in Time (JIT) Purchases? What are its advantages?

Just in Time (JIT) Purchases means organizing the purchase of goods or materials such that

their receipt in Stores Department immediately precedes their use. The advantages of JIT

purchases are-

1. Cost Savings: JIT purchases results in cost savings. The costs of stock-out, inventory

carrying, materials handling and breakage are reduced.

2. Cost of consumption: due to frequent purchases of Raw Materials, its issue price will be

equal to the replacement price. The method of pricing for valuing materials issues will be

realistic to reflect current costs.

3. Supplier Co-ordination: Suppliers of Raw Materials co-operate with the Company and

supply requisite quantity of goods or materials for which order is placed just before the

start of production.

4. Materials Management: Goods spend less time in warehouses or on store shelves before

they are exhausted. Risk of obsolescence is thereby reduced.

2. What is ABC Analysis?

1. Meaning: ABC Analysis is a form of inventory control wherein different degrees of

control are exercised over different items of materials, on the basis of the investment

(value) involved. For example, in the making of aircraft, cryogenic engines involving

high costs will be monitored closely, while cost of tyres, nuts and bolts, etc. will be given

comparatively lesser attention.

2. Categorization: Under this system, Raw Materials Items are divided into three categories

according to their importance in terms of value and frequency of replenishment during a

period. These categories are –

(a) A Category –Highly Important.

(b) B Category - Moderately important.

(c) C Category – Least Important.

3. Analysis & Control: The three categories are classified and differential control is

established as under-

Category % in Total

Value

% in Total

Quantity

Extent of Control

A 70% 10% Constant and Strict Control through

Budgets, Ratios, Stock Levels, EOQ,

Procedural checks, etc.

B 20% 20% Need based selective control – periodic

review – not strict or excessive.

C 10% 70% Little control – focus on saving associated


9874311319 Page 13

costs.

Note: ABC Analysis is also called by other names such as HML (High Moderate Low)

Analysis, (or) 70-20-10 Analysis, (or) Pareto Analysis, (or) Selective Stock Control.

3. What are the advantages of ABC analysis? The advantages of ABC analysis are –

1. Smooth Flow: ABC analysis ensures that minimum investment will be made in

inventories of stocks of materials or stocks to be carried, without affecting the production

schedule.

2. Cost Savings: The cost of placing orders, receiving goods and maintaining stocks is

minimized, specially if the system is coupled with the determination of proper economic

order quantities.

3. Control by exception: Management time is saved, since attention need be paid only to

some of the items rather than all the items.

4. Standardization of work: With the introduction of the ABC system, much of the work

connected with purchases can be systematized on a routine basis to be handled by sub-

ordinate staff.

4. What is meant by Bill of Materials (BOM)?

1. Meaning: (a) Bill of Materials (BOM) is a schedule of standard quantities of materials required for

any job or other unit of production. It is also known as “Materials Specification

List” or just “Material List”.

(b) It lays down the exact description and specifications of all materials and quantities

required for a job or product.

2. Prepared by: BOM is prepared by the Engineering or Planning Department, in a

standard form.

3. Copies: 5 copies to be used as given in the following table-

Department Purposes of BOM

Stores

Department

(a) To provide a basis for preparing material Purchase

Requisitions.

(b) To act as authorization for issuing total material

requirement.

(c) To reduce paperwork / clerical activity in verification of

every item of materials to be issued.

Purchase

Department

To compare with purchase requisition and place the purchase order.

Cost Accounting

Department

(a) To prepare budgets or estimates of material cost for jobs /

processes / products.

(b) To account for standard cost, compute material cost

variances, analyze reasons, and control excess cost of

material used.

Production

control Dept

(a) To control usage of materials.

(b) To save time otherwise spent in preparing separate

requisitions of materials.

Engineering or

Planning Dept

For record, reference and control purposes.

5. Write a brief note on Purchase Requisitions.

1. Meaning: Purchase Requisition is a form used for making a formal request to the

Purchasing Department, to procure the specified items of materials.

2. Prepared by: Purchase Requisition is usually prepared by – (a) Store-Keeper (for regular

materials), and (b) Head of production planning or Technical Department (for special


9874311319 Page 14

materials). It should be signed and approved by a responsible official, (e.g. Works

Manager), in addition to the one originating it.

3. Copies: 4 copies to be used by – (a) Purchase, (b) Planning, (c) Cost Accounting, and (d)

Stores Departments.

4. Pre-conditions: The following conditions should have been fulfilled in order to initiate

the purchase procedure-

(a) The item of material should be included in the Standard List (BOM) of the Purchase

Department as “Regular Item”. If a new item is required, suitable sanction and

approval shall be obtained.

(b) The stock of the item should have reached the Re-Order Level. This is the level at

which action can be taken to initiate the purchase procedure.

(c) There should be proper co-ordination between Purchase, Stores and Production

Departments.

6. What is Material Requisition Note (MRN)?

1. Meaning:

(a) Materials Requisition Note (MRN) is the document for issue of materials from Stores

to Production Department.

(b) MRN authorizes the Store-Keeper to issue the requisitioned materials and record the

same in Bin Card.

(c) The purpose of Material Requisition Note is to draw material from the Stores by the

concerned departments.

2. Origination:

(a) Where a “Materials List” (i.e. BOM) has been prepared: MRN can be prepared

by the production Department. Such requisition can be either for the whole of all

specified materials or in different lots, drawn upto the limit specified in the BOM

List.

(b) Where a “Materials List” (i.e. BOM) has been prepared: MRN should ideally be

prepared by the Planning Department. If there is no Planning Department, it may be

prepared by the concerned Production Department. In all cases, it should be duly

approved by a responsible official.

3. Copies: 3 Copies to be used by-

(a) Stores Department – for issuing materials

(b) Cost Accounting Department – to account for cost thereof.

(c) Receiving Department, i.e. department requiring the material – for control purposes.

7. Distinguish between Bin Card and Stores Ledger.

Particulars Bin Card Stores Ledger

1. Maintained by Store- Keeper. Cost Accounting Department.

2. Nature Stores Recording Document Accounting Record.

3. Contents Quantitative only. Quantitative cum Financial

Record.

4. Time of recording At the time of transaction. After the transaction takes place.

5. Source documents Recorded at source. No separate

source document required.

Posted from Material Requisition

Slips, Goods Received Notes, etc.

6. Manner of posting Each transaction is recorded

separately.

Transactions are posted on

summary basis.

8. What are the advantages of Perpetual Inventory Records?

Perpetual Inventory Records refer to the inventory records, i.e. Bin Card and Stores Ledger,

that are maintained on a upto date basis at all points of time. The following are its advantages-

1. Physical stocks can be counted and book balances adjusted as and when desired without

waiting for the entire stock- taking to be done.


9874311319 Page 15

2. Interim Financial Statements can be quickly prepared as stock figures are readily available.

3. Discrepancies are easily located and corrective action can be promptly taken to avoid their

recurrence.

4. A systematic review of the perpetual inventory reveals the existence of surplus, dormant,

obsolete and slow-moving materials, so that remedial measures are taken in time.

5. Fixing various stock levels and checking actual balances in hand with them, assist the Store

Keeper to maintain stock within limits and initiate purchase requisitions for correct quantity at

the proper time.

9. Distinguish between Periodic and Continuous Stock Verification.

Stock verification involves physical counting of actual stock available and comparing the same

with books and records to ascertain discrepancies if any. There are two methods of stock

verification- (1) Periodic, and (2) Continuous Stock Verification. The differences between these

two methods are –

Particulars Periodic Stock Taking Continuous Stock Taking

1. Timing Stock Verification takes place at

the end of a financial period, say

a year.

Stocks are verified at regular

intervals during the year. Since

stock-taking takes place regularly, it

is called continuous stock-taking.

2. Coverage All items of stocks are covered

in a single stretch of verification,

say over two or three days.

In each verification, two or three

items are covered on random basis.

In the entire period, all items are

covered on rotation basis.

3. Effect on work Regular stores procedures like

materials receipts, issues, etc.

may have to be stopped to

facilitate stock-taking.

There is no interference with regular

work flow.

4. Control Discrepancies can be known

only at the end of the period.

Responsibility cannot be easily

fixed.

Discrepancies are ascertained

immediately in order to take

corrective action and avoid

recurrence.

5. Records Inventory Records may also be

updated periodically, say weekly

or monthly, in fact, at any time

before physical verification.

Due to surprise element involved,

Inventory records must be

maintained up-to-date at all times.

Such records are called Perpetual

Inventory Records.

6. Interim results This does not facilitate or help

the quick compilation of interim

or final financial results.

It provides stock figures on real-

time basis. Hence final accounts can

be compiled quickly. Interim

Results can also be prepared easily.

10. Distinguish between ROL and ROQ.

Particulars ROL ROQ

1. Meaning It is the stock level at which next

purchase procedure should be initiated.

It is the quantity that should be

placed in the Purchase Order.

2. Question It answers the question when to

purchase

It answers the question what

quantity to purchase.

3. Formula ROL = Max. Usage x Maximum Lead

Time

ROQ = EOQ = 2AB

C

11. What is Economic Order Quantity? How is it computed?

“Optimum level of inventory is that which minimizes the total costs”. Discuss.


9874311319 Page 16

1. Meaning: Economic Order Quantity (EOQ) refers to the quantity to be purchased every time,

so as to minimize the total of all costs associated with purchase. The size of the order for

which the total purchase-related costs (i.e. Total of (a) Ordering Costs p.a. (b) Carrying Costs

p.a. and (c) Purchase Price p.a. are minimum, is known as the EOQ.

2. Computation: By applying Wilson’s formula-

EOQ = 2AB/C, where A = Annual Requirement of Raw Materials (in units)

B = Buying Cost per order

C = Carrying Cost per unit of Raw Materials per annum.

3. Note:

(a) Associated Costs of EOQ = (b) Associated Costs of EOQ may also be computed as = 2ABC

(c) At EOQ under Wilson’s Formula, Buying Costs p.a. = Carrying Costs p.a. = ½ of

Associated Costs p.a.

Quantity

12. Write short notes on the First – in – First – Out Method (FIFO).

1) Features:

(a) It is a method of pricing the issues of materials, in the order in which they are purchased.

(b) The prices at which earliest lots / consignments of materials were received are used firs,

before subsequent prices are used for pricing issues.

2) Advantages:

(a) Simple to understand and easy to operate.

(b) Gives better results in case of falling prices.

(c) Closing Stock of Material will reflect Current Market Prices.

(d) Cost of Consumption will be at actual cost, i.e. Opening Stock + Purchases (-) Closing Stock.

3) Disadvantage:

(a) Leads to complicated calculations and clerical errors, when the prices fluctuate frequently.

(b) Costs charged to the same job may show a variation from period to period, as each issue of

material to production is related to a specific purchase price.

(c) In case of rising prices and real profits of the Firm being low, this method will inflate profits,

since Cost of Raw Materials Consumed will be taken at old (lower) prices.

13. What do you understand by Last-In-First-Out (LIFO)? What are its advantages?

1. Features:

(a) It is a method of pricing the issues of materials, in the reverse order in which they are

purchased.

(b) The prices of the most recently received consignments, i.e. immediately last available

consignment, are exhausted first before previous consignment prices are taken up.

2. Advantages:

(a) Cost of Materials Consumed will reflect Current Market Prices approximately. This will

lead to better matching

(b) Does not inflate profits during periods of rising prices, unlike FIFO Method.

(c) In case of falling prices, profit tends to rise due to lower material cost, yet the finished

products appear to be more competitive and are at Market Price.

(d) In the long run, the use of LIFO helps to iron out the fluctuations in profits.

(e) During inflation, LIFO will tend to show the correct profit and thus there is some tax

saving.

3. Disadvantages:

(a) Leads to complicated calculations and clerical errors, when the prices fluctuate

frequently.

(b) Cost of different similar batches of production carried on at the same time may differ a

great deal.


9874311319 Page 17

(c) In time of falling prices, there will be need for writing off stock value considerably, to

stick to the principle of stock valuation, i.e. Cost or Market Price whichever is lower.

(d) This method is not acceptable under the Accounting Standards or to the Income Tax

Authorities.

14. Write short notes on Base Stock Method.

1. Under this method, a minimum quantity of stock is always valued at a fixed price, based upon

the earliest lot of materials. It is used as Base Stock or Reserve Stock to meet emergency

consumption requirements.

2. The quantity in excess of the Base Stock may be valued either on FIFO or LIFO basis.

3. This is more a method of valuing inventory than a method of valuing issues, since Base Stock

is valued at earliest price and balance stock is valued using FIFO or LIFO.

4. This method is not an independent method as it uses FIFO or LIFO. Its advantages and

disadvantages therefore will depend upon the use of the other method, viz. FIFO or LIFO.

15. Briefly describe the Simple Average Price Method.

1. Features: Materials issued are valued at Average Price, which is calculated by dividing the

total of all units rate by the number of unit rates.

Simple Average Price = Total of unit prices of each purchase

Total number of purchases

Example: If Materials issued are from 3 consignments with prices of Rs. 20, Rs. 27 and Rs.

22, the Simple Average Price would be (20+27+22) /3 = Rs. 23

2. Advantages:

(a) Useful when materials are received in uniform lots of similar quantity, else, it will give

wrong results.

(b) Useful when purchase prices do not fluctuate considerably.

(c) Simple to understand and easy to operate.

3. Disadvantages:

(a) Materials Issue Cost does not represent actual cost price. Since the materials are issued at

a price obtained by averaging cost prices, a profit or loss may arise from such type of

pricing.

(b) Gives incorrect results, if the prices of material fluctuate frequently.

(c) Price determination in unscientific, since there is averaging of prices without considering

quantity.

16. Write short notes on the Weighted Average Price Method.

1. Meaning: Weighted Average Price Method gives due weight age to quantities purchased and

the purchase price to determine the issue price.

Weighted Average Price = Total Cost of Materials received

Total Quantity Purchased

Note: Weighted Average Issue Price is calculated by dividing the Total Cost of Materials in

Stock, by the Total Quantity of Materials prior to each issue.

2. Advantages:

(a) It smoothens the price fluctuations, if any, due to material purchases.

(b) Issue prices need not be calculated for each issue unless new lot of materials is received.

3. Disadvantages:

(a) Materials Cost does not represent actual cost price, but only an approximate average.

(b) It may be difficult to operate, since every new lot received would require re-computation

of issue prices.

17. How is the Periodic Simple Average Price Method applied?

1. Features:

(a) At the end of each period, the price paid during that period for various consignments are

added up, and this total is divided by the number of purchases made during the period.


9874311319 Page 18

(b) The rate so computed is then used to price all materials issues made during the period,

and also for valuing the Closing Stock of Raw Materials.

Periodic Simple Average Price = Total of Prices paid in a period

No. of purchases in the period

Note: This method is similar to Simple Average Price Method. However, the Average is

calculated only at the end of the concerned period.

2. Advantages:

(a) It is simple to operate, as it avoids calculation of issue price after every receipt.

(b) This method can usefully be employed in costing continuous processes where each

individual order is absorbed into the general cost of producing large quantities of articles.

3. Disadvantages:

(a) This method cannot be applied in jobbing industry where each individual job order is to

be priced at each stage of its completion.

(b) It is unscientific, as it does not take into consideration the quantities purchased at

different prices.

(c) It also suffers from all disadvantages of Simple Average Price Method.

18. Explain the accounting treatment for Waste. RTP, M 86

1) Waste:

(a) It represents the portion of basic raw materials lost in processing, having no recoverable

value.

(b) Waste may be – (i) visible – remnants of basic raw materials, or (ii) invisible – disappearance

of basic raw materials through evaporation, smoke, etc.

(c) Shrinkage of material due to natural causes may also be a form of a material wastage.

2) Accounting Treatment:

(a) Waste may be classified into Normal and Abnormal Waste.

(b) Cost of Normal Waste is absorbed in the cost of net output, whereas Abnormal Waste is

transferred to the Costing Profit and Loss Account, as a Loss.

19. Explain the accounting treatment for Scrap. RTP, M 86, N 08

1) Meaning: Scrap is the incidental residue from certain types of manufacture, usually of small

amount and low value, recoverable without further processing.

2) Control Measures: Measures to control Scrap Losses and obtain maximum gainful utilization of

raw material are –

(a) Proper product designing by the Production Planning Department.

(b) Use of standardized materials, equipment, personnel and efficiency by the Production

Department.

(c) Preparation of periodical scrap reports, comparison of actual with standards and identifying

deviations and corrective action taken by the Cost Control Department.

3) Accounting Treatment: Scrap may be treated in cost accounts in the following ways –

(a) Other Income: Where the value of scrap is negligible, such value may be excluded from

costs. Hence, the cost of scrap is borne by good units. Income / Receipt from Scrap

Realisation is treated as Other Income.

(b) NRV of Scrap: The Net Realisable Value (NRV) of Scrap, i.e. Sales Value less Selling and

Distribution Cost, is deducted from Overheads. Alternatively, the NRV can be reduced from

Materials Cost. This method is followed when scrap cannot be aggregated job or process –

wise.

(c) Specific Identification: When scrap is identifiable with a particular job or process and its

value is significant, the Scrap Account is charged with full cost. The credit is given to the job

or process concerned. The profit or loss in the Scrap Account, on realization, will be

transferred to the Costing Profit and Loss Account.


9874311319 Page 19

20. Write short notes on accounting treatment for material spoilage. RTP, M 86, M 03, M 05,

M 07, N 07, M 09

1) Meaning: Spoilage refers to materials which are badly damaged in manufacturing operations, and

they cannot be rectified economically, and hence taken out of process to be disposed of in some

manner without further processing.

2) Classification: For accounting purposes, Spoilage is classified into Normal and Abnormal, and

dealt as under –

(a) Normal Spoilage Costs (i.e. which is inherent in the operation and hence unavoidable) are

included in costs either charging spoilage loss to the job / Process or by charging it to

Production OH so that it is spread over all products. Any value realized from spoilage is

credited to Job / Process a/c or OH a/c, as the case may be.

(b) Costs of Abnormal Spoilage (i.e. arising out of causes not inherent in manufacturing

process) are charged to the Costing P & L Account. When spoiled work is the result of rigid

specification, the cost of spoiled work is absorbed by good production while the cost of

disposal is charged to Production OH.

21. What is meant by “Defective Work”? Explain the accounting treatment for Defective Work.

RTP, M 86, M 00, M 03, N 03, M 05, M 07, N 07, N 08, M 09

1) Meaning: Defective Work signifies those units of production which can be rectified and turned

out as good units by the application of additional material, labour or other service, e.g. duplication

of pages or omission of some pages in a book.

2) Reasons: Defective arise due to sub – standard materials, bad supervision, improper planning,

poor workmanship, inadequate equipment and careless inspection. To some extent, defectives

may be unavoidable, but with proper care it is possible to avoid defect in the goods produced.

3) Reclamation of loss from defective units: In the case of articles that have been spoiled, it is

necessary to take steps to reclaim as much of the loss as possible. For this purpose –

(a) All defective units should be sent to a place fixed for the purpose,

(b) These should be dismantled,

(c) Goods and serviceable parts should be separated and taken into stock,

(d) Parts which can be made serviceable by further work should be separated and sent to the

workshop and taken into stock after the defects have been removed, and

(e) Parts which cannot be made serviceable should be collected in one place for being melted or

sold.

4) Treatment of Defectives: Defectives are generally treated in two ways –

(a) They can be brought upto the standard by incurring further costs – additional material and

labour,

(b) They can be sold as inferior products (seconds) at lower prices, where possible.

5) Control over Defectives: Control of defectives may cover the following two areas –

(a) Control over defectives produced.

(b) Control over re – working costs.

For exercising effective control over defectives produced and the cost of re – working, standards

for normal percentage of defectives and reworking costs should be established.

6) Spoilage vs Defectives: Spoilage cannot be repaired or re – conditioned. However, Defectives

can be either rectified and transferred into standard production or sold as seconds.

CHAPTER 3

LABOUR COST

1. How is Idle Time Cost treated in Cost Accounts? RTP, N 85, M 93, M 94, M 00,

M 03, M 06, N 08

Classification and Analysis: For Cost Accounting and analysis purposes, Idle Time is classified into

–


9874311319 Page 20

Particulars Normal Idle Time Abnormal Idle Time

1. Meaning It refers to the idle time inherent in every

work situation. It is estimated in advance.

It refers to the idle time over and

above normal idle time. Abnormal

= Actual Less Normal.

2. Nature It is unavoidable and cannot be eliminated

totally.

It is avoidable. It is further sub –

classified into – (i) Controllable,

and (ii) Non – Controllable.

3. Treatment Cost of Normal Idle Time is treated as a

regular part of cost of production. It is treated

–

(a) Either as Direct Wages by inflating the

Wage Rate (for Direct Workers) or

(b) As Production OH (for Indirect Workers).

Cost of Abnormal Idle Time

constitutes a Loss, which should

be debited to Costing Profit and

Loss A/c. If it is controllable, the

responsibility should be fixed on

the person in default.

4. Focus In the long run, normal idle time may be

reduced through improved technologies,

methods & procedures.

Controllable Idle time should be

eliminated through proper

managerial action.

2. How is Overtime Premium treated in Cost Accounting? RTP, M 85, N 95, M 02, M 03, N

04, M 06, M 08

Overtime Premium is generally treated on the basis of the situation demanding Overtime Work –

Situation Accounting Treatment of Overtime Premium

1. Due to genuine labour shortage. Treated as Regular Cost of Production, as Direct

Labour, by inflating normal wage rate.

2. At Customer’s desire, e.g. immediate

delivery, etc.

Charged to the Job directly. Such amount will be

suitably recovered from the customer by charging at a

higher rate.

3. Irregular overtime to meet production

requirements due to unexpected

developments.

Charged to Job – treated as Factory Overheads.

4. Due to fault of a particular department,

e.g. non – availability of materials

during normal time.

Charged to the department in default, in order to fix

responsibility and prevent recurrence.

5. Due to abnormal conditions, e.g. strike,

etc.

Charged to Costing Profit and Loss Account as Loss.

3. What is Labour Turnover? What are the terms associated with Labour Turnover? RTP, N

85, N 94, M 96, M 03, N 04

1) Meaning: Labour Turnover is the rate of change in the composition of labour force during a

particulars period, measured against a suitable index. It arises because every Firm is a dynamic

entity and not a static one.

2) Terms: The terms associated with computation of Labour Turnover are – (a) Separation, (b)

Replacement, (c) New Recruitment, (d) Accession, and (e) Average Labour Force. These

concepts are as under –

Term (a) Separation (b) Replacement (c) New Recruitment

Explanation Left and discharged Substitutions New additions due to

expansion, etc.

Old Worker Goes Out Goes Out -

New Worker - Comes In Comes In


9874311319 Page 21

(d) Accessions represent the total number of

new workers joining the Firm, whether

by way of replacement or otherwise.

So, Accessions = Replacements + New Recruitments.

(e) Average Labour Force=[Number of workers at the beginning + Number of workers at the end]

2

4. What are the causes of Labour Turnover? N 85, M 11

The major causes of labour turnover are – (1) Unavoidable Causes, and (2) Avoidable Causes.

1. Unavoidable Causes 2. Avoidable Causes

These are causes under which it becomes

obligatory on the part of management to ask one

or more of their employees to leave the Firm, e.g.

–

(a) Seasonal nature of the business,

(b) Shortage of Materials, Power, low product

demand, etc.

(c) Change in the Plant location,

(d) Disability, making a worker unfit for work,

(e) Disciplinary measures,

(f) Personal reasons, e.g. ill health, premature

retirement, family responsibilities, etc.

These are causes that require the attention of

management on a continuous basis so as to keep

the labour turnover ratio as low as possible, e.g.

–

(a) Dissatisfaction with job, remuneration, hours

of work, working conditions, etc.

(b) Strained relationship with management,

supervisors or fellow workers,

(c) Lack of training facilities and promotional

avenues,

(d) Lack of recreational and medical facilities,

(e) Low wages and allowances.

CHAPTER 4

OVERHEADS

1. What is Overhead Cost?

1) Meaning: Overheads comprise of Indirect Materials, Indirect Employee Costs and Indirect

Expenses, which are not directly identifiable or allocable to a cost object in an economically

feasible way. So, the total of all Indirect Costs, viz. Indirect Materials, Indirect Labour and

Indirect Expenses, is collectively called as “Overheads” (or on cost).

2) Exclusions: (a) expenditure arising out of abnormal situation in business activity, (b) Items not

related to business activities, e.g. Donation, Loss / Profit on Sale of assets, etc. and (c) Borrowing

Cost and other financial charges including foreign exchange fluctuations, will not form part of

OH.

3) Nature of OH: Indirect Costs are called Overheads, since they are incurred generally (and not

specifically) –

(a) Over various products,

(b) Over various Departments or Cost Centres, and

(c) Over various heads of account.

2. How are Overheads classified on the basis of functions?

Based on functions, Overheads are classified into four types, viz. –

Classification Sub – Classification

1. Factory or

Manufacturin

(a) Stores Overheads (expenses connected with purchasing & handling of

materials)

Alternatively, Accessions =

Number of Workers at the end

of the period

Add: Number of Separations during

that period

Less: Number of Workers at the

beginning of the period.


9874311319 Page 22

g or

Production

OH

(b) Labour Overheads (expenses connected with labour and amenities), and

(c) Factory Administration Overheads (expenses connected with

administration of Factory).

2. Office and

Administrativ

e OH

(a) Office Expenses (incurred on routine office work – Telephone, Stationery,

etc. ), and

(b) Administrative Expenses (incurred on Office Personnel, i.e. their Salaries,

Facilities, etc.)

3. Selling and

Distribution

OH

(a) Selling Expenses (incurred to persuade customers to purchase the Firm’s

products and / or engage its services, that is to maintain & expand the

market), and

(b) Distribution Expenses (incurred to execute orders).

4. R&D OH (a) Research Expenses and (b) Development Expenses.

3. List the methods of segregating Semi – Variable Costs into Fixed & Variable Costs.

Semi – Variable Expenses usually have two parts – a fixed part and a variable part. By a systematic

analysis, all Semi–Variable expenses can be segregated into variable and fixed portions. The

following methods can be applied for segregation of Semi-Variable Costs into Fixed and Variable

portions.

1) Graphical Method (or) “Line of Best Fit” Method.

2) Analytical Method (or) Best Judgement Method.

3) High and Low Points Method.

4) Comparison by Period or Level of Activity Method.

5) Least Squares Method.

4. Distinguish between Allocation and Apportionment.

The differences between Allocation and Apportionment are –

Particulars Allocation Apportionment

1. Meaning Assigning a whole item of cost

directly to a Cost Centre.

Distribution of OH to more than

one Cost Centre, on some equitable

basis.

2. Nature of Expenses Specific, Identifiable and Direct. Unallocable, General and Common

3. Number of

Departments

One Many

4. Amount of OH Charged of Full Charged in Parts or Proportions

5. How can Pre – Determined Overhead Absorption Rates be determined?

Pre – determined Overhead Absorption or Recovery Rates may be determined in any of the following

methods.

Data used for rate determination Formula for OH Recovery Rate

1. Last Year Actuals Overhead Recovery Rate = Last Year Actual Overhead

Last Year Actual Output

2. Current Year Estimates Overhead Recovery Rate = Current Year Budgeted Overhead

Current Year Budgeted Output

3. Normal Activity Levels Overhead Recovery Rate = Normal Overhead Costs

Normal Volume of Output (or Hours)


9874311319 Page 23

6. Describe the accounting treatment of Under–absorption of Production Overheads.

Describe the accounting treatment for Over–absorption of Production Overheads.

DIFFERENCE IN ABSORPTION = OH Variance = Absorbed OH Less Actual OH

Absorbed OH is greater than Actual OH

(Credit Balance in OH Control A/c )

OVERABSORPTION

(represents Savings in OH Expenditure)

Absorbed OH is less than Actual OH

(Debit Balance in OH Control A/c)

UNDERABSORPTION

(represents Increase in OH Expenditure)

Accounting Treatment (any one of the following) Analysed as due to –

1. Write Off: Small

amounts may be credited

to Costing P & L A/c.

2. Deferral: May be carried

over to next year, by

transfer to OH Reserve

A/c or Suspense A/c.

3. Cost Reversal: In case of

large amounts, cost of

jobs may be reduced /

adjusted by passing

reversal journal entries.

Normal Reasons

e.g. genuine planning errors,

changes in assumptions, etc.

Treated as increase COSTS

(using Supplementary OH

Recovery Rate), and

apportioned to production, i.e.

–

Abnormal Reasons

e.g. Strike Period Wages,

Labour Court Award,

Obsolete Stores, Penalties

paid etc.

Treated as LOSS and debited

to Costing P & L Account.

(Also see Note below)

Units Sold Closing Stock of

Finished Goods

Closing Stock of WIP

Debited to Cost of Sales A/c FG Control A/c WIP Control A/c

Note: When underabsorption is small and immaterial, it is fully debited / transferred to Costing P & L

A/c, irrespective of whether it is due to normal or abnormal reasons.

Reasons for Absorption Differences: OH Absorption Rates for any period are pre – determined

based on the normal activity data. However, there may be differences between Absorbed OH and

Actual OH due to the following reasons –

1) Difference between Budgeted and Actual Expenditure. (This is called as Expenditure Variance.)

2) Difference between Budgeted and Actual Output (Volume Variance), which may arise due to –

(a) Difference between planned and actual hours. (This is called as Capacity Variance),

(b) Difference between planned and actual quantity of output per hour. (This is called as

Efficiency Variance), or

(c) Difference between planned and actual days worked (This is called as Calendar Variance.)

CHAPTER 5

COST ACCOUNTING SYSTEMS

1. Briefly describe about the Non-Integrated Accounting System.

1) Meaning: The Non – Integrated or Cost Control System seeks to recognize the movements and

flows of Cost within the Firm. For example, materials issued to production, Production OH

absorbed, abnormal costs etc. are not recognized and recorded specifically in the financial

accounting system. These cost transactions within the Firm are recorded under the cost

accounting system.

2) Ledgers: The following Ledgers are maintained under the Non – Integrated Accounting System –

(a) Stores Ledger or Raw Material Ledger – for every item of Raw Materials and Stores items.


9874311319 Page 24

(b) Job Ledger or Work in Progress Ledger – for showing item of Raw Materials and Stores

items.

(c) Stock Ledger or Finished Goods Ledger – for every item of Finished Product manufactured.

(d) Cost Ledger – for preparing Control Accounts in respect of the above Subsidiary Ledgers,

and also for impersonal accounts.

2. What are the features of the Non – Integrated Accounting System?

Write short notes on General Ledger Adjustment A/c Cost Ledger Control A/c.

1) Entity Aspect: Cost Flows / movements within the Firm as well as transactions with outsiders

(Suppliers, Customers) are captured by the system, e.g. issue of materials from Stores to

Production Department is recognized as a transaction, even if no outsider is involved.

2) No Personal Accounts: The Non – Integrated System involves the use of Nominal Accounts and

three Real Accounts (Stores Ledger Control A/c, WIP Control A/c, and Finished Goods Control

A/c). Personal and other Real Accounts are not used in this system.

3) General Ledger Adjustment Account: For completing contra – posting involving Personal

Accounts and other Real Accounts (Cash, Bank, Assets, etc.), the General Ledger Adjustment

Account is used. This account is also called as Cost Ledger Adjustment, or Cost Ledger Control,

or General Ledger Control A/c.

4) Costing P&L A/c: A Trial Balance is drawn under this System. The Costing P&L Account is

prepared, to ascertain the Profits as per Cost Records. Balance Sheet is not prepared under this

System.

5) Reconciliation: Non – cost transactions are not fully recorded by this System. Hence, whenever

Non – Integrated System is in use, regular Financial Accounting should also be done in parallel.

This creates the need for reconciling between Profits as per Cost Records and Profits as per

Finished Records.

CHAPTER 6

CONTRACT COSTING

1. What do you mean by Contract Costing?

1) Contract: Contract refers to a large job / assignment / work order, where the execution of work is

spread over two or more financial years. Generally, a Contract commences in one financial year,

but ends in a different year.

2) Contract Costing: Contract or Terminal Costing involves ascertainment of costs of contract. It is

an extension of principles of job costing for long – term projects like Civil Construction, Ship

Building, Interior Decoration, etc.

2. Distinguish between Job Costing and Contract Costing.

Job Costing Contract Costing

i. Job refers to any specific assignment, contract or

work order wherein work is executed as per

customer’s requirements.

Contract refers to a large job / assignment /

work order. The execution of work is

spread over two or more financial years.

ii. Job Costing is applied in Printing Press, Furniture

works, Interior Decoration and other similar work.

Contract Costing is applied in activities like

Civil Construction, Ship Building, etc.

3. What do you mean by Cost plus Contract? List its merits and demerits.

1) Meaning: A Cost plus Contract is one where the Contract Price is ascertained by adding a

percentage of profit to the total cost of the work. Such type of contracts is entered into when

contract costs cannot be estimated with reasonable accuracy due to unstable conditions e.g.

material prices, labour, etc.


9874311319 Page 25

2) Advantages and Disadvantages:

Advantages Disadvantages

(a) The Contractor is assured of a fixed

percentage of profit. There is no risk of

incurring any loss on the contract.

(b) It is useful particularly when the work to be

done is not definitely fixed at the time of

making the estimate.

(c) Contractee can ensure himself about the

cost of the contract, as he is empowered to

examine the books and documents of the

Contractor, to ascertain the accuracy of the

costs.

(a) There is no incentive to the Contractor to

avoid wastages and achieve economy in

production.

(b) The Contractee may not know the actual

cost of contract till its completion, unlike a

Fixed Price Contract, where his outflow /

cost is pre – determined.

4. What do you mean by Fixed Price Contract? What are its advantages and disadvantages?

1) Meaning: A Fixed Price Contract is one where the Contract Price is fixed and determined in

advance at the time of entering into the agreement. Such type of contracts is entered into when

contract costs can be reasonably estimated with a degree of certainty.

2) Advantages and Disadvantages:

Advantages Disadvantages

(a) The Contractee’s outflow on the contract is

known and determined in advance.

(b) It is useful specially when the costs of

work to be done can be determined with

certainty.

(a) Contractor may resort to the use of

materials of lesser quality / price to increase

his profit margin.

(b) Contractor may incur losses if he had not

estimated the contract costs properly or if

price levels increase due to abnormal

reasons, after entering into the agreement.

(c) Contractee cannot have any idea about the

real costs since he cannot examine the

books of the Contractor.

5. What do you mean by Escalation Clause?

1) In Fixed Price Contracts, the Contract Price is fixed and pre – determined. If there is an increase

in prices of materials, rates of labour, etc. during the period of execution of a contract, the Total

Contract Costs may rise and the Contractor’s profit may be reduced.

2) This increase in prices may induce the Contractor to use materials of lower quality and price in

order to maintain his profit margin on the contract.

3) To overcome such a situation, the agreement generally contains a stipulation that the Contract

Price will be increased by an agreed amount or percentage, if the prices of materials, wages etc.

rise beyond a particular limit. Such a stipulation / condition is called Escalation Clause.

4) Accounting Treatment: The amount of reimbursement due should be determined by reference to

the Escalation Clause. The amount due from the Contractee should be recorded by the following

Journal Entry in the Contractor’s Book, at the end of every each year –

Contractee’s Account Dr.

To Contract Account

6. List the rules / principles for recognition of profit on incomplete contracts.

Profit on Incomplete Contracts is recognized based on the Notional Profit and Percentage of

Completion. The rules of recognition are –

Note: Alternatively, the amount due under Escalation Clause can

be added to the value of Work – in – Progress at the end of every

year.


9874311319 Page 26

Description Percentage of Completion Profit to be transferred to P & L A/c

1. Initial Stages ≤ 25% NIL

2. Work Performed

but not substantial

26% to 50% 1 x Notional Profit x Cash Received

3 Work Certified

3. Substantially

completed

51% to 90%

(See Note c)

2 x Notional Profit x Cash Received

3 Work Certified

4. Almost complete 91% to 99%

(See Note c)

Profit is recognized on the basis of

Estimated Total Profit (See Question 16)

5. Fully complete 100% Notional Profit x Cash Received

Work Certified (See Note d)

Notes:

(a) Percentage of Completion = Work Certified

Contract Price

(b) If there is a loss at any stage, i.e. irrespective of percentage of completion, such loss should be

fully transferred to the Profit and Loss Account.

(c) Substantially completed can also be considered as 51% to 95% completed. In such case, the

next slab of Almost Complete contracts will be taken as 95% to 99% completed.

(d) For fully complete contracts, the balance portion of profit is recognized only upon receipt of

Retention Money. If entire amount is fully received, the whole of profit can be recognized.

(e) The principle of prudence / conservatism is generally followed for recognizing profit. Hence,

for exact 50% completion, 1/3rd

of Notional Profit will be recognized (and not 2/3rd

).

CHAPTER 7

JOINT PRODUCTS AND BY PRODUCTS

1. What do you mean by Joint Products?

Meaning: Joint Products are - Example

1. Two or more products,

2. Produced from the same process or operation,

3. Considered to be of relatively equal

importance.

In refining Crude Petroleum, gasoline, fuel oil,

lubricants, paraffin, coal tar, asphalt and

kerosene are all produced. These are known as

Joint Products.

2. What are Co–Products?

Meaning: Co-Products are - Example

1. Two or more products,

2. Belonging to the same line of activity, but

arising from different processes or

operations,

3. Considered to be of relatively equal

importance.

Rice and Wheat are agricultural produce, but

they arise from different cultivation processes.

So, they are Co-Products. Similarly Timber

Boards made from different trees are Co-

Products.

3. What are By-Products?

1) Definition: By-Products are “products recovered from material discarded in a main process, or

from the production of some major products, where the material value is to be considered at the

time of severance from the main product.”

2) Meaning: By-Product refers to incidental waste, arising during the course of manufacture, which

has a commercial name and value. It refers to secondary or subsidiary product incidentally arising

during the manufacturing process.

3) Examples: (a) Molasses arising in the manufacture of sugar, (b) Tar, Ammonia and Benzole

obtained on carbonization of coal, and (c) Glycerine obtained in the manufacture of soap.


9874311319 Page 27

CHAPTER 8

PROCESS COSTING

1. What is a Process? What is Process Costing?

1) Process: Process is a district stage in manufacturing or production, wherein Raw Material is

converted from one identifiable form into another, before it is finally converted into the saleable

final product.

2) Process Costing:

(a) It is a method of costing, whereby costs are charged to processes or operations, and averaged

over units produced.

(b) This method is useful in the manufacturing of products like steel, soap, chemicals, rubber,

vegetable oil, paints, varnish, etc. For these products, the production process is continuous

and the output of one process becomes the input of the following process till completion.

2. Compare Process Costing and Job Costing.

Particulars Job Costing Process Costing

1. Meaning Job refers to specific contract work order

or arrangement, where work is executed

as per customers’ requirements.

Process refers to a stage in

manufacture where raw materials are

converted from on form to another.

2. Nature of

work

Specialized production based on

customers’ specifications.

Standardized mass production.

3. Quantity of

Output

Each job is distinct from the other.

Output consists of one or a few items

only.

Output of each process consists of

similar (homogeneous) units, in

large quantities.

4. Cost Centre Job itself. Process itself.

5. Cost Unit Job itself. Output of the process

6. Cost

Compilation

Costs are compiled by reference to job,

irrespective of its time of completion.

Costs are compiled by reference to

processes, for a specific time period.

7. Cost

Assignment

Cost is computed for each job or unit of

work. It is not averaged.

Cost is first ascertained for the

process, and then averaged over the

number of units produced.

8. Cost

Transfers

There is no transfer of costs from one job

to another.

Cost of one process is transferred to

next process, by reference to Process

Flow.

9. WIP

valuation

Different jobs might be complete at

different degrees. Hence, WIP consists of

job-wise cost incurred till date.

The concept of equivalent

production is applied. It is presumed

that all units of closing WIP are

uniformly semi-complete on an

average.

10. Supervision

& Control

Close supervision is necessary, since

each job is distinct from the other.

Comparatively easier, since

processes are standardized.

11. Cost

reduction

Comparatively less scope for Cost

Reduction, and required active

management decisions.

Cost Reduction scope is high, due to

mass production and economic of

scale.

CHAPTER 9

OPERATING COSTING

1. What is Operating Costing?

1) Meaning: Operating Costing is the method of asetaining the costs of providing / operating /

rendering a service.


9874311319 Page 28

2) Applicability: It is applicable to undertakings that provide services rather than produce

commodities. This method is usually adopted in the case of – (a) Transport Companies, (b)

Gas and Water Works Departments, (c) Electricity Supply Companies, (d) Canteens, (e)

Hospitals, (f) Theatres, (g) Schools etc. that are engaged in the provision of services.

2. How are cost units determined in the rendering of services?

The principle of Operating Costing is to accumulate costs under suitable headings and to express

them in terms of number of units of service rendered. Unlike production activities where cost unit is

readily ascertainable, operating costing requires the determination of cost units / denominator factors

for expression of costs.

The factors that have a bearing on cost are identified based on study of technical and operating data.

Thereafter, the cost units that are unique to a specific service are identified as the denominator factors.

Some illustrations of cost units usually used in various service undertakings are as below –

1. Hospitals - Patient –Days, Room – Days, Operations. (M 02)

2. Hotels - guest Days, Room Days. (M 02)

3. Passenger Transport - Kilometres, or Passsenger – Kilometres. (M 02)

4. Cargo Transport - Quintal – Kilometres or Tonne – Kilometres.

5. Canteens - Number of meals served, Number of tea cups sold etc.

6. Electricity Supply – Kilowatt Hours.

7. Boiler Houses - Quantity of Steam raised.

8. Cinema House - Number of Tickets, Number of Shows.

3. Write short notes on Absolute and Commercial Tonne – Kilometres.

Composite units like Tonne – Kilometres, Quintal – Kilometres etc. may be computed in two ways –

1. Absolute (Weighted Average) Tonne – Kilometres: This is the sum total of Tonne –

Kilometres, arrived at by multiplying various distances by respective load quantities carried.

2. Commercial (Simple Average) Tonnes – Kilometres: It is derived by multiplying total

distance (i.e. Kilometres), by average load quantity (Tonnes).

CHAPTER 10

STANDARD COSTING

1. Define the term Standard Cost. Is it the same as Estimated Cost?

1) Standard Cost is the pre – determined operating cost calculated from Management’s standards

of efficient operation and the relevant necessary expenditure.

2) It is used as a basis for – (a) Price Fixing, and (b) Cost Control through variance analysis.

3) It reflects – (a) quantities of material and labour expected to be used, (b) prices expected to be

paid for materials and labour during the coming year, and (c) Factory Expenses applicable to

production based on good performance and practical capacity operation of the factory.

4. Distinguish between Standard Costing and Budgetary Control

Describe and contrast the scope and techniques of Standard Costing and Budgetary

Control.

Particulars Standard Costing Budgetary Control

1. Meaning Standards Costs are pre-determined

costs representing what the costs

should be, at the level of efficient

conditions of production and

operation.

Budgets are financial and / or

quantitative statements, prepared

and approved prior to a defined

period of time, of the policy to be

pursued during that period for

achieving that objective.


9874311319 Page 29

2. Coverage They are generally restricted to

Costs.

They include estimates of Income,

Costs and employment of Capital.

3. Scope The scope of Standard Costing is

comparatively narrow, since it

covers mainly Production Costs.

Budgeting is more wide-ranging as

it relates to the operations of the

business as a whole. It covers

capital, sales and financial

expenses in addition to production.

4. Basis These are determined by the

collection of technical data related to

production and applying costs to

each element of production.

These are determined based on

Management’s plans of what

should b e done to achieve a certain

objective and how to actually

achieve it.

5. Cost Objective Standard Costing is concerned with

the ascertainment and control of each

element of cost for each unit.

Budgetary Control is concerned

with the origin of expenditure at

functional levels.

6. Control Focus Control is exercised by comparing

sales and production units values at

standard cost with actual costs, i.e.

actual costs are compared with

standard cost of actual output.

Control over budgetary figures is

exercised by comparing actual

figures with those budgeted.

Particulars Standard Costing Budgetary Control

7. Finance vs

Cost

Standard Cost is a projection of Cost

Accounts.

Budget is a projection of Financial

Accounts.

8. Variance

Reporting

Under the Standard Costing system,

variances are usually revealed

through different accounts.

Control is exercised by statistically

putting budgets and actual side by

side. Variances are normally not

revealed in the accounts in case of

Budgetary Control.

9. Scope of

Variance

Analysis

Standard Costing System is a more

technically improved system by

which various causes of variances for

each cost element can be analyzed in

minute detail and corrective action

taken accordingly.

Under Budgetary Control System,

Co9ntrol over expenses is general

and broad in nature, and not in as

detailed manner as in Standard

Costing.

10. Effect of

temporary

conditions

Standard Costs are usually semi-

permanent in nature and may not be

changed unless and until there are

changes in the basic price structure or

in the methods of operations.

Budgeted Costs are estimated

considering actual conditions and

attainable targets of a period, in

view of the conditions that are likely

to be prevalent in that year. The

effect of short-term changes in cost

structure, etc. will be fully reflected

in Budgeted Costs.

11. Permanence Standard Costs are usually semi-

permanent in nature and may not be

changed unless and until there are

changes in the basic price structure or

in the methods of operations.

They are estimated usually for one

year and take into account the

practical problems of operations and

are kept at a level, which the Firm

hopes to achieve in the year for

which the budget is being prepared.

12. Parts vs

Whole

A Standard Costing System cannot be

operated in parts. All items of

expenditure included in cost units are

to be considered.

Budgetary control is possible even

in parts or for particular type of

expense according to the attitude of

management, e.g. Advertising or

R&D Expenses Budget.


9874311319 Page 30

5. Outline the relationship between Standard Costing and Budgetary Control.

1. Budgeted and Standard Costs are intended to exercise cost control and judge performance by

setting up targets.

2. Both systems provide benchmarks against which the actual performance and costs are

compared, variances are calculated and the reasons for the variances ascertained.

3. A Budgetary Control System can operate without Standard Costs. The two systems are not

inter-dependent, i.e. they can exist independently.

4. However, when Budgets are being developed, Standard Costs are of immense help since they

are long-term estimates of the same activity and represent Management’s view of the level of

efficiency that should prevail. Similarly, for determination of standards, information on past

budgeted and actual costs is useful.

Though the two are not independent, they are inter-related & function well as complementary to one

another.

Chapter 11

MARGINAL COSTING

1. What is Marginal Costing?

1. Marginal Costing is a technique of decision-making, which involves-

(a) Ascertainment of Total Costs,

(b) Classification of Costs into – (i) Fixed and (ii) Variable, and,

(c) Use of such information for analysis and decision-making.

2. Marginal Costing is the ascertainment of Marginal Cost, and of the effect on Profit of changes

in volume or type of output, by differentiating between Fixed Costs and Variable Costs.

2. Explain the concepts of Variable Cost and Fixed Cost, in the context of Marginal Costing.

Particulars Variable Cost Fixed Cost

1. Meaning Variable Cost is that portion of cost,

which changes or varies

proportionately based on output /

volume/ quantity.

Fixed Costs are costs which are assumed to

remain constant, for a given period of

time, irrespective of level of output during

that period.

2. Items Variable Cost = Direct Materials +

Direct Labour + Direct Expenses +

Variable Production OH + Variable

S&D OH.

Fixed Cost = Fixed Production OH +

Administrative OH + Fixed S&D OH.

3. Examples Raw Materials, Labour (based on

number of units produced), Power,

Royalty (based on production), etc.

Rent, Salary, Insurance, etc.

4. Cost per

unit

Variable Cost per unit is assumed to

remain constant at all levels of

output.

Fixed Cost per unit of output will vary

inversely with changes in the level of

output. As output increases, Fixed Cost per

unit decreases, and vice-versa.

5. Point of

incurrence

Variable Costs are incurred only

when production takes place.

Hence, no production means any

Variable Costs.

Fixed Costs are incurred even at zero level

of output. Hence, even at Nil Activity

Level, Fixed Costs will be incurred.

6. Cost

Behaviour

Once incurred, variable Costs will

increase proportionately based on

the level of output / quantity.

Fixed Costs, once incurred, will be

constant at all output levels.

7. Nature Variable Costs are considered as Fixed Costs are treated as period-related


9874311319 Page 31

product-related costs. costs.

8. Inclusion

in

Inventory

Variable Costs are Product Costs,

and hence included in inventory

valuation. So, Inventory Value

comprises Direct Materials + Direct

Labour + Direct Expenses +

Variable Production OH.

Fixed Costs are not included in Inventory

Valuation. They are charged off fully to the

Profit and Loss Account in the period in

which it is incurred.

3. Distinguish between Marginal Costing and Absorption Costing.

Particulars Marginal Costing Absorption Costing

1. Cost

Recognition

Only Variable Costs are included

for product costing & inventory

valuation.

All product-related costs, whether Fixed or

Variable, are considered for product costing

& inventory valuation.

2. Classification Classification of expenses is

based on nature, i.e. Fixed and

Variable.

Classification of expenses is based on

functions, i.e. Production, Administration,

Selling and Distribution.

3. Treatment of

Fixed Costs

Fixed Costs are regarded as a

Period Cost. Profitability of

different products is analyzed by

their PV Ratio (and not Net Profit

Ratio).

Fixed Costs are charged to cost of

production. Each product bears a reasonable

share of Fixed Cost and thus the profitability

of a product is influence by the

apportionment of Fixed Costs.

4. Presentation Cost data presented highlight the

Total Contribution and

contribution of each product.

Cost data are presented on conventional

pattern. Net Profit of each product is

determined after subtracting Fixed Cost

along with their variable costs.

5. Effect of

Stockholding

on Cost pu

Difference in the quantity of

Opening Stock and Closing Stock

does not affect the unit cost of

production.

Difference in the quantity of Opening and

Closing Stock affects the unit cost of

production due to the impact of related

Fixed Cost.

6. Variance

Reporting

Only Fixed OH Expenditure

Variance can be computed.

There is no Volume Variance

since Fixed Overheads are not

“absorbed”.

All Fixed OH Variances (Expenditure,

Volume, etc.) can be computed and reported.

6. Write a brief note on Profit Volume Ratio (PV Ratio).

1. Meaning: Profit Volume Ratio (PV Ratio) is the relationship between contribution and Sales

Value. It is also termed as Contribution to Sales Ratio.

2. Formula: PV Ratio = Total Contribution x 100 (or) Contribution per unit x 100 (or)

Total Sales Value Sales Price per unit

= Change in Contribution x 100 (or) Change in Profit x 100 (or)

Change in Sales Change in Sales

3. Significance of PV Ratio:

(a) PV Ratio is considered to be the basic indicator of the profitability of the business.

(b) The higher the PV Ratio, the better it is for a business. In the case of a Firm enjoying

steady business conditions over a period of years, the PV Ratio will also remain stable

and steady.

(c) If PV Ratio is improved, it will result in higher profits.

4. Improvement of PV Ratio:

(a) By reducing the Variable Cost,

(b) By increasing the Selling Price, or


9874311319 Page 32

(c) By increasing the share of products with higher PV Ratio in the overall sales mix. (where

a Firm produces a number of products)

5. Uses of PV Ratio:

(a) To compute the Variable Costs for any volume of Sales.

(b) To measure the efficiency or to choose a most profitable line. The Overall Profitability

line. The Overall Profitability of the Firm can be improved by increasing the sales /

output of a product giving a higher PV Ratio.

(c) To determine Break-Even Point and the level of output required to earn a desired profit.

(d) To decide the most profitable sales-mix.

7. Write short notes on the Break Even Point (BEP).

1. Meaning: Break-Even Point (BEP) is the level of Sales at which Total Contribution equals

Fixed Costs. Hence, at that level, there is neither a Profit nor a Loss to the Firm (Total

Revenue = Total Costs, and Profit / (Loss) = Zero).

2. Formula:

(a) Break Even Point (in Rs.) = Fixed Costs

PV Ratio

This is denoted as BES. (Break Even Sales Value)

(b) Break Even Point (Qtty) = Fixed Costs

Contribution per unit

This is denoted as BEQ. (Break Even Quantity)

Total Revenue

Actual Sale Value

Total Costs

MOS Value

Costs and Profit

Revenues BES BEP 0

in Rs.

Loss Fixed Costs

BEQ MOS Qtty Actual Sale Qtty

Quantity

3. Assumptions underlying Break Even Analysis: (a) Total Costs can be easily classified into Fixed and Variable categories.

(b) Selling Price per unit remains constant, irrespective of quantity sold.

(c) Variable Costs per unit remain constant. However Total Variable Costs increases with

increase in output levels.

(d) Fixed Costs remain the same for a period, irrespective of output.

(e) Productivity or Efficiency of the factors of production will remain the same.

(f) The state of technology, process of production and quality of output will remain

unchanged.

(g) There will be no significant change in the level of Opening and Closing Inventory.

(h) The Company manufactures and sells a single product. In the case of a multi-product

Company, the sales-mix remains unchanged.

(i) Both Revenue and Cost functions are linear over the range of activity under

consideration.

(j) All resources required for production are abundantly available.

4. Significance of BEP: BEP represents the Cut-Off Point for Profit or Loss of the business. At

the BEP, the Profit or Loss equals zero. The significance of BEP may be summarized as-

Level of Sales Impact on Profits

Less than BEP Firm incurs Losses. [Contribution < Fixed Cost]


9874311319 Page 33

Equal to BEP No Profit & No Loss. [Contribution = Fixed Cost]

Greater than BEP Firm earns Profits. [Contribution > Fixed Cost]

Note: A Firm should operate above the Break-Even Point in order to earn Profits.

8. What are the limitations of Break-Even Chart?

1. The Variable Cost line need not necessarily be a straight line because of the possibility of

operation of law of increasing returns or law of decreasing returns.

2. The Selling Price may not be a constant factor. Any increase or decrease in output is likely to

have an influence on the Selling Price per unit.

3. When a number of products are produced, separate Break-Even Charts will have to be

prepared. This poses a problem of apportionment of Fixed Expenses to each product.

4. Break-Even Charts ignore the Capital Employed in business, which is one of the important

guiding factors in the determination of profitability and returns.

5. The Break Even Chart assumes that business conditions will not change. This assumption is

not realistic.

9. What are the different types of Break-Even Charts?

1. Contribution Break-Even Chart: This chart shows Contribution earned by the Firm at

different levels of activity.

2. Cash Break-Even Chart: In this chart, Variable Costs are assumed to be payable in cash.

Besides this, the Fixed Expenses are divided into two groups, viz. (a) those expenses which

involve cash

3. Control Break-Even Chart: Both budgeted and actual cost data are depicted in this chart.

This chart is useful in comparing the actual performance of the Firm with the budgeted

performance, for exercising control.

4. Analytical Break-Even Chart: This chart shows the break-up of Variable Expenses into

important elements of cost, viz., Direct Materials, Direct Labour, Variable Overheads, etc.

Also the appropriations of Profit such as Equity Dividends, Preference Dividends, Reserves,

etc are depicted in this chart.

5. Product wise Break-Even Chart: Separate Break-Even Charts for different products can

also be prepared to compare the profitability of the products or their contribution.

6. Profit Graph: Profit Graph is a special type of Break-Even Chart, with shows the Profit or

Loss at different levels of output.

Contribution Break Even Chart

BEP

Total Sales

Total Costs

Total Contribution

Fixed Costs

Output

Cash Break Even Chart (M 01)

Total Sales

Total Costs

Total Cash

Cost

Total Fixed Costs

Cash Fixed Costs

Total BEP

Cash BEP


9874311319 Page 34

10. What do you understand by Margin of Safety?

1. Meaning: Margin of Safety (MOS) represents the difference between the Actual Sales and

Break-Even Point Sales. It can be expressed as a percentage of Total Sales, or in Value, or in

terms of quantity.

2. Formula:

(a) Margin of Safety (in Rs.) = Total Sales Less BEP Sales

(or)

= Profit

PV Ratio

(b) Margin of Safety (Qtty) = Total Sales Qtty Less BEQ

(or)

= Profit

Contribution per unit

Total Revenue

Actual Sale Value

Total Costs

MOS Value

Costs and Profit

Revenues BES BEP 0

in Rs.

Loss Fixed Costs

BEQ MOS Qtty Actual Sale Qtty

Quantity

Actual BEP

Control Break Even Chart

Total Sales

Actual Total Costs

Budgeted Total Cost

Output

Output

Budgeted BEP

Analytical Break Even Chart

Total Sales

Total Costs

Reserves

Equity & Pref

Dividends

Variable OH Direct Labour

Direct Matls

Fixed Costs

Output Product Wise Break Even Chart

BEP

Product A

BEP

Product B

Loss

Area

Profit

Area

Profit Graph

BEP


9874311319 Page 35

3. Significance:

(a) Upto BEP, the Contribution earned by the Firm is sufficient only to recover Fixed Costs.

However, beyond the BEP, the Contribution is called Profit (since Fixed Costs are fully

recovered by then).

(b) Profit is the Contribution earned out of Margin of Safety Sales.

(c) The size of the Margin of Safety shows the strength of the business.

(d) A low MOS indicates that the Firm has large Fixed Expenses and is more vulnerable to

changes in Sales.

4. Improvement in Margin of Safety:

(a) Increase in Selling Price, provided the demand is inelastic so as to absorb the increased

prices.

(b) Reduction in Fixed Expenses.

(c) Reduction in Variable Expenses.

(d) Increasing the Sales Volume provided capacity is available.

(e) Substitution or introduction of a product mix such that more profitable lines are

introduced.

11. Discuss the relationship between Angle of Incidence, BEP and MOS.

ϴ ϴ ϴ

ϴ

Condition 1: Low BEP & Large AOI: Fixed Costs are low and the rate of profit earning is high.

Large MOS shows that the Firm enjoys financial stability. Low BEP indicates that the business could

be run profitably even if there is a fall in Sales, unless the Sales are very low.

Condition 2: Low BEP & Small AOI: In this case, the conclusions are same as in Condition 1,

except that the rate of profit earning is not so high as in Condition 1. The Firm breaks – even quickly

and its Fixed Costs are low but it does not have a high rate of profit earning.

Condition 3: High BEP & Small AOI: This shows that the Fixed Costs are high and MOS is low.

The business is very vulnerable, even a small drop in activity may result in a loss.

Condition 4: High BEP & Large AOI: This shows that Fixed Costs are high and MOS is low. The

business is likely to incur losses through a small reduction in activity. However, after the BEP, the

business makes the profits at a high rate.

12. Write a brief note on Indifference Point.

1. Meaning: Indifference Point is the level of Sales at which Total Costs (and hence Total Profits)

of two options are equal. The decision-maker is indifferent as to option chosen, since both

options will result in the same amount of profit.

2. Formula:

BEP

Total Sales

Total Cost

Fixed Cost

Total Sales Total Sales

Total Sales

BEP BEP BEP

Fixed Cost

Total Cost

Fixed Cost Fixed Cost

Total Cost Total Cost


9874311319 Page 36

(a) Indifference Point (in Rs.)

= Difference in Fixed Costs

Difference in PV Ratio

(or)


Difference in Variable Cost Ratio

(b) Indifference Point (in units) = Difference in Fixed Costs

Difference in Contribution per unit

(or)


Difference in Variable Cost per unit

Note: Indifference Point may also be

called the Cost Break Even Point.

Profit of Option Y

Indifference Point

Profit of

Option X

Amount

In Rs.

Quantity

3. Significance: Indifference Point represents a cut-off indicator for deciding on the most

profitable option. At that level of Sales (i.e. Indifference Point), Costs and Profits of two options

are equal. The profitability of different options are –

Level of Sales Most Profitable Option to be chosen Reason

Below

Indifference Point

Option with Lower Fixed Cost Lower the Fixed Costs, lower will

be the BEP. Hence, more profits

beyond BEP.

At Indifference

Point

Both options are equally profitable. Indifference Point

Above

Indifference Point

Option with Higher PV Ratio (lower

Variable Cost)

The higher the PV Ratio, the

better it is.

Note: Indifference Point is calculated only in respect of two options. Where more than two

options are considered, Indifference Point can be calculated on a comparative basis for two

combinations.

13. Distinguish between Indifference Point and Break-Even Point.

Particulars Indifference Point Break-Even Point

1. Definition Indifference Point is the level of Sales

at which Total Costs and Profits of

two options are equal.

BEP is the level of Sales at which

the Total Contribution equals Fixed

Costs. Hence, there is neither a

Profit nor a Loss to the Firm.

2. Formula Indifference Point (in Rs.)


Difference in PV Ratio see Qn 14

Break Even Point (in Rs.) =

Fixed Costs

PV Ratio

3. Significance It is the activity level at which Total

Cost under two alternatives are equal.

It is activity level at which the

Total Revenue from a product or

product mix is equal to its Total

Cost.

4. Purpose Used to choose between two

alternative options for achieving the

same objective.

Used for profit planning.

14. What do you understand by Key Factor or Limiting Factor?

1. Key Factor represents a resource whose availability is less than its requirement. It denotes

the Resource Constraint situation. It is a factor, which at a particular time or over a period

limits the activities of a Firm.


9874311319 Page 37

2. It is also called Critical Factor (since it is vital or critical to the Firm’s success) and Budget

Factor (since budgets are formulated by reference to such limitations or restraints).

3. Some examples of Key Factors are – (a) Shortage of Raw Materials, (b) Labour Shortage, (c)

Restrictions in Plant Capacity, (d) Demand or Sales Expectancy, (e) Cash availability, etc.

4. In case of Key Factor situation, the procedure for decision-making is as under-

Step Description

1 Identify the Key Factor

2 Compute Total Contribution or Contribution per unit of the product.

3 Compute Contribution Per Unit of the Key Factor, i.e. Contribution per Direct Labour

Hour, Contribution per kg of Raw Material, etc.

4 Rank the products based on Contribution per unit of the Key Factor.

5 Allocate the key resources based on Ranks given above, and other conditions specified in

the question.

15. What is Cost-Volume-Profit Analysis? What are its objectives?

1. Cost-Volume-Profit Analysis (CVP Analysis) is the analysis of three variables, viz. Cost,

Volume and Profit, which explores the relationship existing amongst Costs, Revenue,

Activity Levels and the resulting profit.

2. CVP Analysis aims at measuring variations of Profits and Costs with Volume, which is

significant to business profit planning.

3. CVP Analysis makes use of the Marginal Costing principles for planning and for making

short-run decisions.

16. What are the limitations of Marginal Costing?

1. Difficult to classify: It is difficult to classify exactly the expenses into Fixed and Variable

category. Most of the expenses are neither totally variable nor wholly fixed.

2. Contribution is not final: Contribution of a product itself is not a guide for optimum

profitability unless it is linked with the Key Factor.

3. Wrong pricing decisions: Sales Staff may mistake Marginal Cost for Total Cost and sell at a

price, which will result in loss or low profits. Hence, Sales Staff should be cautioned against

incorrect pricing decisions, while giving them information on Marginal Cost.

4. Stock Valuation: Overheads of fixed nature cannot altogether be excluded particularly in

large contracts, while valuing the WIP. This aspect is not considered in Marginal Costing.

5. Naïve assumptions: Some assumptions regarding the behaviour of Revenues and Costs are

not necessarily true in a realistic situation. For example, additional output can be sold only by

reducing sale prices.

6. Ignores time value: Marginal Costing ignores time factor and investment. For example, 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. The effect of time value of money is not analyzed by

Marginal Costing.

Chapter 12

BUDGETARY CONTROL

1. Define the term Budget.

1. Definition: Budget is a financial and / or quantitative statement, prepared and approved prior

to a defined period of time of the policy to be pursued during that period for the purpose of

attaining a given objective. It may include income, expenditure and employment of capital.

2. Features:

(a) Financial and / or Quantitative Statement.


9874311319 Page 38

(b) Futuristic – prepared and approved prior to a defined period of time.

(c) Goal Oriented – for the purpose of attaining a given objective.

(d) Components – Income, Expenditure and Employment of Capital.

2. Define the term Budgetary Control. What are its salient features?

1. Definition: Budgetary Control is defined 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 base for its revision.”

2. Salient features:

(a) Objectives: Determining the objectives to be achieved, over the budget period, and the

policy(ies) that might be adopted for the achievement of these ends.

(b) Activities: Determining the variety of activities that should be undertaken for

achievement of the objectives.

(c) Plans: drawing up a plan or a scheme of operation in respect of each class of activity, in

physical as well as monetary terms for the full budget period and its parts.

(d) Performance Evaluation: Laying out a system of comparison of actual performance by

each person, section or department with the relevant budget and determination of causes

for the discrepancies, if any.

(e) Control Action: Ensuring that when the plans are not achieved, corrective action are

taken, and when corrective actions are not possible, ensuring that the plans are revised

and objective achieved.

1. What are the different types of Budgets?

Distinguish between Fixed and Flexible Budgets.

Budgets may be classified on the following bases –

1. Time – Period 2. Conditions 3. Capacity 4. Coverage

(a) Long – term Budget & (a) Basic Budget and (a) Fixed Budget and (a) Functional Budget and

(b) Short – term Budget (b) Current Budget. (b) Flexible Budget. (b) Master Budget.

1. BASED ON TIME PERIOD:

Long Term Budget Short Term Budget

(a) Budgets which are prepared for periods

longer than a year are called Long – Term

Budgets.

(b) Such Budgets are helpful in business

forecasting and forward planning.

(c) Examples: Capital Expenditure, R&D

Budget.

(a) Budgets which are prepared for periods less

than a year are known as Short – Term

Budgets.

(b) Such Budgets are prepared in cases where a

specific action has to be immediately taken

to bring any variation under control.

(c) Example: Cash Budget.

2. BASED ON CONDITIONS:

Basic Budget Current Budget

A Budget, which remains unaltered over a long

period of time, is called Basic Budget.

A Budget, which is established for use over a

short period of time and is related to the current

conditions, is called Current Budget.

3. BASED ON CAPACITY:

Particulars Fixed Budget Flexible Budget

a) Definition It is a Budget designed to remain unchanged It is a Budget, which by


9874311319 Page 39

irrespective of the level of activity actually

attained.

recognizing the difference

between fixed, semi –

variable and variable costs is

designed to change in

relation to level of activity

attained.

b) Rigidity It does not change with actual volume of

activity achieved. Thus it is known as a Rigid

or Inflexible budget.

It can be re – casted on the

basis of activity level to be

achieved. Thus it is not rigid.

c) Level of

Activity

It operates on one level of activity and under

one set of conditions. It assumes that there

will be change in the prevailing conditions,

which is unrealistic.

It consists of various budgets

for different levels of

activity.

d) Effective of

variance

analysis

Variance Analysis does not give useful

information as all Costs (fixed, variable and

semi – variable) are related to only one level

of activity.

Variance Analysis provides

useful information as each

cost is analysed according to

its behaviour.

e) Performance

Evaluation

Comparison of actual performance with

budgeted targets will be meaningless,

especially when there is a difference between

two activity levels.

It provides a meaningful

basis of comparison of the

actual performance with the

targets.

4. BASED ON COVERAGE:

Functional Budget Master Budget (M 97)

Budgets, which relate to the individual

functions in an organization, are known as

Functional Budgets, e.g. Purchase Budget,

Sales Budget, Production Budget, Plant

Utilisation Budget and Cash Budget.

It is a consolidated summary of the various

functional budgets. It serves as the basis upon

which budgeted Profit & Loss Account and

forecasted Balance Sheet are built up.

2. Write short notes on Flexible Budgets.

1. Meaning: It is a Budget, which by recognizing the difference between fixed, semi – variable

and variable costs, is designed to change in relation to level of activity.

2. Need: The need for the preparation of Flexible Budgets arises in the following circumstances

–

(a) Seasonal fluctuations in sales and / or production.

(b) Introduction of new products, product designs and versions on a frequent basis,

(c) Industries engaged in make – to – order business like shipbuilding,

(d) An industry which is influenced by changes in fashion, and

(e) General changes in sales.

3. Situations: Flexible Budgeting may be resorted to in the following situations –

(a) New Business: In case of new business venture, due to its typical nature, it may be

difficult to forecast the demand of a product accurately.

(b) Uncertain Environment: Where the business is dependent upon the mercy of nature.

(c) Factor market conditions: In the case of labour intensive industry where the production

of the concern is dependent upon the availability of labour.

3. What are the types of Functional Budgets?

Functional Budgets are broadly grouped under the following heads –

1. Physical Budgets: Budgets that contain information in terms of physical units about sales,

production, etc. For example, Quantity of Sales, Quantity of Production, Inventories,

Manpower Budgets.


9874311319 Page 40

2. Cost Budgets: Budgets which provide Cost Information in respect of manufacturing, Selling,

Administration, etc. for example, Manufacturing Costs, Selling Costs, Administration Cost, R

& D Cost Budgets.

3. Profit Budgets: Budgets that enable the ascertainment of Profit, for example, Sales Budget,

Profit & Loss Budget, etc.

4. Financial Budgets: A Budget, which facilitates to ascertain the Financial Position of a

concern, for example, Cash Budgets, Capital Expenditure Budget, Budgeted Balance Sheet,

etc.

4. List the commonly used Functional Budgets.

1. Sales Budget.

2. Production Budget.

3. Plant Capacity Utilisation Budget.

4. Direct Materials – Usage & Purchase Budgets.

5. Direct Labour – Requirement & Recruitment Budgets.

6. Overhead Cost Budgets – Factory OH, Administration OH, and S&D OH Budgets.

7. Cost Summary Budgets – Primary Cost Budget, Cost of Production Budget, Ending –

inventory Budget, Cost – of – Goods – Sold Budget.

8. Specific Budgets – R&D Cost Budget, Capital Expenditure Budget, Cash Budget.

9. Budget Summaries / Master Budget – Budgeted Income Statement and Budgeted Balance

Sheet.

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